News, Vision & Voice for the Advisory Community
The stakes are high and the outcome is still uncertain; here's what we know
September 30, 2011 — 3:07 PM UTC by Alex Potts Guest Columnist
Brooke’s Note: The back-and-forth of events relating to what standards we set for financial advice in this country and who polices them have gone on long enough to lull all but the most steadfast political junkie to sleep. Alex Potts reminds us in this recap that the stakes are as high as ever for RIAs and tells us that it’s not too late to make a difference in the outcome of the legislative process.
For the past few years, financial advisors have been anticipating — or in some cases, dreading — sweeping regulatory change from Congress and the Securities and Exchange Commission. And change is coming — it’s the one point upon which conservatives and liberals, regulators and legislators all agree.
From last year’s Dodd-Frank legislation to proposed SEC rule making to the new bill from House Financial Services Committee Chairman Spencer Bachus, R-Ala., which is being debated now, RIAs and brokers are bracing for the new regulations sure to come.
Areas of agreement
There is also agreement on what is driving this change.
If investors’ anger and voters’ rage at their losses from the Great Recession were not enough, Bernie Madoff’s $50 billion Ponzi scheme managed to shake investors’ confidence in financial advisors. The Barron’s cover story on Sept. 28, 2009 documented this atmosphere of distrust, which drove record numbers of investors to fire their financial advisors and try someone new — or go it alone.
That’s where the agreement ends and the division begins. Since the call for change began, the debate has fundamentally been between the following two perspectives:
- Applying the principles-based fiduciary standard governing registered investment advisors to anyone providing investment advice, which would be enforced by the SEC and state regulatory agencies.
- Creating a universal standard that “harmonizes” the differences between the fiduciary standard and the rules-based suitability standard that would be enforced by a self-regulatory organization such as the Financial Industry Regulatory Authority Inc., which currently regulates broker conduct.
While the debate has progressed over the past two years, the opposing approaches, and the organizations backing them, are still at loggerheads.
Those in favor of applying the principles-based fiduciary standard to anyone offering investment advice include the Financial Planning Association, The Committee for the Fiduciary Standard, the Investment Adviser Association and other organizations that represent RIAs.
They argue for applying the principles-based fiduciary standard embedded in the Investment Advisers Act of 1940, which provides a high degree of protection for investors without burdening individual RIAs with complex regulations and paperwork. Fiduciary-standard advocates also continue to support maintaining SEC oversight of RIAs managing assets above $110 million.
The groups in favor of “harmonizing” the fiduciary standard with the suitability standard include the Securities Industry and Financial Markets Association, the National Association of Insurance and Financial Advisors and the Insured Retirement Institute, among others.
They claim that applying the fiduciary standard to commission-based brokers will eliminate investment options for all but affluent individual investors, arguing that fee-only RIAs tend to serve only the affluent. This group also argued that the SEC lacks the resources to police financial advisors, and proposed shifting that responsibility to a self-regulatory organization, such as FINRA. See: Debate continues: Fiduciary standard no panacea.
To understand these opposing perspectives, we need to take a step back to view the differences between how brokers have been regulated versus registered investment advisors.
For more than 70 years, RIAs have been held to a principles-based fiduciary standard defined by the Investment Advisers Act and later upheld in a 1963 Supreme Court decision, SEC v. Capital Gains Research Bureau. See: How 10 top groups define 'fiduciary’.
There are five core principles associated with the fiduciary standard as outlined by the Committee for the Fiduciary Standard:
- Put the client’s best interests first
- Act with prudence; that is, with the skill, care, diligence and good judgment of a professional
- Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts
- Avoid conflicts of interest
- Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts
Is 'suitable’ suitable?
Brokers, on the other hand, are currently held to a “suitability” standard defined in the Securities Exchange Act of 1934. Instead of following the principle of putting clients’ interests first, the suitability standard is less strict. As long as a product is regulated and trades on an appropriate market, brokers can recommend investments that may pay higher broker commissions, have higher management fees or introduce higher investment risk, without disclosing any conflicts of interest. See: The suitability standard, defined.
For decades, these dueling regulatory standards coexisted, until the “Great Recession” rattled investors’ confidence and Bernie Madoff eroded their trust.
Therefore it’s no surprise that the push for new regulation places advocates for the fiduciary standard in opposition to those who would press for more relaxed guidelines — with both sides claiming to have investors’ best interests at heart.
The Dodd-Frank legislation passed last year did nothing to end this debate or clarify how financial advisors will be regulated. Instead, it mandated studies by the SEC on the fiduciary standard and whether or not an SRO should oversee financial advisors.
While the SEC issued a report in January that advocated applying the fiduciary standard to anyone providing investment advice, the rulemaking process has been delayed. See: One-man think tank: Four red flags in the SEC’s fiduciary report.
Some of the delay can be attributed to SEC members Kathleen Casey and Troy Paredes, who issued a dissenting opinion, questioning the recommendation to fundamentally change the rules.
In addition, Richard Ketchum, FINRA’s chief executive, testified in favor of the bill, and has already proclaimed that his organization is the ideal body to regulate RIAs and brokers.
While the Bachus bill does not explicitly mention the fiduciary standard, its intention to shift regulatory responsibility to an SRO does not bode well for fiduciary advocates.
One thing is certain. This battle will continue at least through the end of this year. Considering the stakes involved, particularly for RIAs and investors, it makes sense to urge our politicians to protect the principles-based fiduciary standard, and apply the Hippocratic oath to proposed legislation that would govern how we regulate the financial services industry to protect investors … First, do no harm.
Alex Potts is president and chief executive of Loring Ward, a San Jose, Calif.-based firm that provides investment strategies and business development support for independent financial advisors.
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