The FPA won its lawsuit against the SEC, but what did investors win?

Back in 2007, in what can best be described as a classic “David versus Goliath” victory, the Financial Planning Association won a lawsuit against the Securities and Exchange Commission preventing it from expanding the “broker exemption” to the Investment Adviser Act of 1940 to cover the management of client portfolios. As you hopefully know, the broker exemption exempts brokers from the fiduciary duty of investment advisors when their advice is “usual and incidental to the sale of securities.”

In 2005, the SEC tried to broaden the exemption to allow brokers to provide advice that isn’t necessarily in their clients’ best interest. Two years later, the U.S. Court of Appeals for the Washington district ruled in favor of the FPA’s challenge in what was widely hailed as a victory not only for the FPA, but for all retail investors, whose consumer protections have been consistently eroded by the SEC almost since the passage of the ’40 Act.

But was it really a victory? With the benefit of eight years of hindsight, it’s hard to believe that any of us can honestly answer “yes.” Consequently, our experience with the FPA lawsuit stands as both the rationale for the Institute for the Fiduciary Standard’s “Best Practices for Fiduciary Advisers,” which were released Sept. 30 — and a warning about the application of those standards.

Today, brokers who manage assets (who appear to be the vast majority) have a fiduciary duty to their clients when they offer advice about what changes to make in their clients’ investment portfolios. But, thanks to the brokerage exemption, they have no such requirement to advise in their clients’ best interests when selling them the assets to put into those portfolios.

Consequently, brokers truthfully can claim that yes, they do have a fiduciary duty to their clients, and then sell investment products that do not meet that standard of protection. (I have personally heard many brokers make just such a claim.) Yet as study after study has shown, not one client in a thousand understands the implications of the part-time fiduciary standard. But we understand it: The net result of the FPA’s “victory” was to strengthen brokers’ sales pitches, while enabling them to avoid acting in their clients’ best interests when creating their portfolios.

Ironically, had the SEC won the lawsuit, the fate of retail investors would be arguably better. It’s true that if they’d won, brokers wouldn’t have a fiduciary duty for either their investment advice or their portfolio recommendations. However, there wouldn’t be any ambiguity about brokers’ standard of care: They would never have to put their clients’ interests ahead of their own or their BDs’. While most investors would probably continue to believe their broker does have to put their interests first, independent RIAs would be able to tell prospective clients otherwise — and work to get that message out via the media.

Would investors really be better off under this hypothetical scenario? They’d at least have a chance of understanding the standard of care that their broker is legally obligated — and not obligated — to provide. To my mind, that chance is pretty slim in the current “sometimes I’m your fiduciary and sometimes I’m not” situation. To most folks, that’s just plain confusing. As Knut Rostad, president of the IFFS, put it, “Investors shouldn’t need a lawyer to understand what their broker is required to do for them.”

SEC ‘Eroding’ Client Protections

Of course, the FPA’s victory isn’t the only reason that investors are confused these days about brokers’ standards. As Rostad detailed last year in the Institute’s white paper, “Conflicts of Interest and the Duty of Loyalty at the SEC,” during the past 10 years or so, the SEC has been actively eroding the ’40 Act fiduciary standard that applies part-time to brokers. The commission has done this by morphing both a fiduciary’s duty to avoid conflicts and to act in the client’s best interest into simple disclosure (see “An SEC Broker Fiduciary Standard May Undermine the ’40 Act,”Investment Advisor, May 2015).

In that paper, Rostad concluded that at the SEC today, “conflicts are no longer viewed as inherently inconsistent with objective advice […]. The ‘new normal’ is that conflicts are OK.”

Investor confusion seems to be exacerbated by some of the advisory industry’s own accrediting organizations. For instance, the CFP Board appears to take it on faith that CFPs act as fiduciaries at all times for their clients, as its canons of ethics require. So does fi360, for advisors who have earned its Accredited Investment Fiduciary (AIF) designation. While both organizations may yank their accreditation from advisors who are sanctioned by the courts or regulators, by their own admissions, neither actively monitors their designees for compliance with a fiduciary standard, despite the fact that both organizations accredit brokers, who do not legally have an obligation to act as fiduciaries at all times. Consequently, brokers (and other advisors) can show clients their CFP or AIF standard to act as fiduciaries at all times, without any outside confirmation that they are actually doing so.

‘Concrete and Verifiable’

That brings us to IFFS’s “Fiduciary Best Practices.” In his Oct. 21 blog for ThinkAdvisor, Rostad wrote that the “Best Practices were developed because federal regulators and industry groups have fallen short in establishing, much less enforcing, a true ’40 Act fiduciary standard. […] Advisors must act to protect investors. They must raise the bar on standard practices, demonstrate they do so and speak out to investors of the great work of good advisors.”

Of the Institute’s best practices, five are fairly straightforward:

  • Communicate clearly and truthfully.

  • Ensure baseline knowledge, competence and ongoing education appropriate for the engagement.

  • Institute an investment policy statement or an investment policy process that is appropriate to the engagement and describes the investment strategy.

  • Abstain from principal trading unless a client initiates an order to purchase the security on an unsolicited basis.

  • The advisor affirms in writing adherence to Best Practices, and attains written affirmation from the firm that these practices may be met by the advisor.

The other practices warrant some discussion:

“Avoid conflicts and potential conflicts. Disclose all unavoidable potential and actual conflicts. Manage or mitigate material conflicts. Acknowledge that material conflicts of interest are incompatible with objective advice.” This last sentence is intended to undo the SEC’s erosion of the ’40 Act standard by acknowledging that major conflicts cannot be merely disclosed away. This practice also requires that after receiving a client’s acknowledgement of a conflict, advisors must “be able to demonstrate that the transaction remains reasonable and fair and consistent with the client’s best interest.”

“Provide, or instruct clients how to obtain, a written statement of total fees and underlying investment expenses paid by the client. Include any payments to the advisor or the firm or related parties from any third party resulting from the advisor’s recommendations.” Disclosing third-party payments to advisors’ firms is currently not required under any standard that I know of, yet is essential for clients to assess the magnitude of the financial incentives to make specific recommendations. I suspect that it is unlikely any BD will allow such a disclosure.

“Avoid compensation in association with client transactions. If such compensation is unavoidable, demonstrate how the conflict is managed and overcome, and [how] the product recommendation and compensation serves the client’s best interest.” This, of course, is about commissions, and seems to be a reasonable attempt by the Institute to enable brokers to comply with its Best Practices.

Avoid gifts or entertainment that are not minimal and not occasional. Avoid third-party payments, ‘benefits’ and indirect payments that do not generally benefit the firm’s clients and may reasonably be perceived to impair objectivity.” This is another attempt to reveal hidden conflicts.

“Consider peer group rankings in ensuring underlying investment expenses are reasonable.” Although this practice sounds as if it applies to advisory fees, the discussion suggests it addresses the relative costs of actively versus passively managed funds. It would seem that the usefulness of this practice would boil down to who decides which alternatives are included in a given “peer group.”

According to Rostad, “the Best Practices are crafted to be concrete and verifiable and understandable.” To my mind, “verifiable” is the operative consideration. While these standards represent a marked improvement over any existing fiduciary standard that I know of, without active verification by an independent body, they run the risk of becoming just a marketing tool.

— Read “Are Brokers Really as Anti-DOL Fiduciary as Their BDs?” on ThinkAdvisor.