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An ounce of good sense now could save the U.S. economy a pound of unnecessary pain downstream
December 23, 2010 — 2:53 PM UTC by Ron Rhoades, Guest Columnist
Imagine that it is now 2025, and over two decades have passed since the U.S. Securities and Exchange Commission (SEC) adopted a “new federal fiduciary standard” for the delivery of investment advice to retail consumers. Today hundreds of millions of individual Americans, and America itself, suffer from the consequences of the Commission’s action.
Over the decades a string of failures by Congress, the SEC, and the NASD/FINRA failed to raise the provision of investment advice to the level of a true profession, bound together by the requirement of an appropriate strong fiduciary standard of conduct. Instead, investors remained in largely arms-length relationships with their “financial advisors.”
All the while massive marketing campaigns by Wall Street firms touted “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach. All this occurred as the Commission, FINRA and other securities regulators ignored the fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.”
Inadequate capital formation
Following is an abbreviated history of the endeavors to apply fiduciary principle to the provision of investment advice, illustrating the many actions taken by the Commission and FINRA (formerly NASD). Before addressing such history, however, I visit the “present circumstances” (imagining that it is now 2025), in which I explore how these actions resulted in the current lack of trust in the securities markets, leading to inadequate capital formation, stagnant U.S. economic growth, and the resulting increased hardships suffered by all Americans.
The Consequences of the SEC’s Actions: 2012-2025 and Great Depression II
The Commission should have known that, rather than fulfilling its mission to “protect investors” and to “facilitate capital formation,” the results of its rule-making efforts in 2011-2012 (in which the fiduciary standard was re-defined as a much lower standard of conduct) would bring about the exact opposite result. Rather than enhancing the regulation of the market participants – who had largely effected the stock market crash of 2008-9 through the formulation and sale of “sh**ty” products to individual and institutional investors – the SEC instead chose to de-regulate, by lowering the standards of conduct expected of those who provide investment advice to dual registrants.
The SEC continued to permit dual registrants to “switch hats” back and forth, preparing financial plans and investment portfolio strategies for retail investors, and thereafter switching back to a product sales role in which only casual disclosure was required of the existence of a conflict of interest. The SEC failed to require that the many hidden fees and costs of pooled investment vehicles were at least estimated and affirmatively disclosed to the client. Industry compensation practices between financial intermediaries, adverse to the interests of individual investors, such as 12b-1 fees, payment for shelf space, and payment for order flow continued. While rules existed to prohibit directed brokerage, any reasonable statistical analysis would have concluded that this conflicted practice persisted between mutual fund complexes and the brokerage firms which promoted the funds of those complexes.
Customers of both broker-dealer and investment adviser firms, believing they were receiving objective advice, instead received advice which was in the best interests of the brokerage or investment advisory firm. The term “best interest” came to be utilized far too loosely. In essence, clients of “fiduciaries” who said they “operated in the best interests of our customers” were sold “sh***y products” – often products with large fees, costs and tax inefficiencies – creating a huge drag on the returns of individual investors.
A small number of fee-only investment advisers remained out there, committed to avoiding – not just disclosing – conflicts of interest. But, by eschewing the multiple revenue sources enjoyed by those adhering to the lower “new federal fiduciary standard,” these fee-only advisers remained a substantial minority. It was just too lucrative, and too attractive to new entrants into the securities industry, to become an advisor subject only to the much lower casual disclosure-based “harmonized” standard of conduct.
Broker-dealer and investment adviser firms operating under the new “federal fiduciary standard” often consumed 30% or more of the gross returns investors could expect from the capital markets. The financial services industry, as a proportion of the overall U.S. economy, grew to unforeseen levels.
Time passed, and slowly clients realized the harm to which they were subjected. Media articles continued to appear noting the many conflicts of interests which were not avoided, and which infected the supposed “fiduciary relationship” between adviser and client.
Clients, already confused as to what obligations were owed to them by their “financial consultants,” slowly began to realize that they could not trust any financial advisor. Yes, there were fee-only advisers out there, but the reasonable compensation these fee-only advisers received was insufficient to counter the large marketing budgets of the broker-dealer firms; hence, while fee-only advisers somewhat thrived within their small population, the movement never grew large enough, in the face of the economic incentives offered by regulators to those able to enjoy a lower standard of conduct, and to counter the large advertising budgets of the majority of the firms working in the conflict-ridden brokerage and advisory world.
The use of common titles, and the high fees received by those operating under a conflict-ridden standard of conduct, resulted in the inability by higher-quality advisors receiving lower, level compensation arrangements to distinguish themselves.
As a result, clients’ trust was betrayed. The life savings they entrusted to their “fiduciary” adviser failed to earn returns even close to the market indices. Even worse, as the SEC de-emphasized the requirement of due diligence under the duty of care of a fiduciary, many new “sh**ty” investment products were developed and subsequently “blew up” – destroying the life savings of many individuals. Clients rightfully regarded the actions of their “advisers” as fraudulent. Clients of the new type of “fiduciary” advisor had their trust betrayed.
As the media continued to report on these travesties, investors largely abandoned the use of financial advisors altogether. Yet, lacking the skills to navigate the intricacies of the capital markets themselves, and subject to behavioral biases which were not countered with the aid of a knowledgeable and trusted adviser, investors fled the capital markets following the inevitable price declines in the equities markets, returning only well after prices had recovered nearly fully – thereby losing out on much of the long-term returns of the capital markets. And, unable to discern all of the fees and costs of the investment products existing, or the risks to which they were exposed, many investors paid dearly.
As scandal upon new scandal was exposed by the media, many individual investors fled the capital markets altogether, for all time. Not knowing who to trust, they chose to not participate at all in capital formation at all, instead choosing to place their savings in depository accounts.
The result should have not been unexpected. The cost of capital dramatically increased for U.S. corporations, and less capital formation resulted. Economic growth stagnated, and at times the U.S. economy even contracted. Foreign investors, sensing the problems with the U.S. system of securities regulation and the resulting economic difficulties, pulled back on their foreign equity and debt investments in U.S. companies, further exacerbating the U.S. economic decline. From 2020 to the present day, and continuing, another Great Depression is underway.
Downgraded from AAA
Unlike 2008 to 2011, when large fiscal and monetary stimuli (by government spending, tax cuts, and direct loans to and capital investments in businesses) helped the economy recovery, this time the Federal Government – already burdened with trillions upon trillions of both federal public debt – possessed insufficient resources to stimulate the economy. U.S. government debt was downgraded from its previous “AAA” rating, and other currencies in the world were now seen as safe havens. The costs of government borrowing escalated as interest rates rose, thereby further putting pressure on the Federal Government’s depleted coffers.
Declining state revenues also led several states and many municipalities, saddled with their own large debt obligations, to default on municipal bond interest and principal payments. Individual investors suffered huge losses as the pace of public and private bankruptcy filings increased.
All the while, the Baby Boomers had now largely retired, and many turned to the U.S. and state governments for assistance. Individuals had poor returns derived from holdings in depository (rather than the greater returns offered over the long term in the capital markets). Those individual investors that participated in the capital markets, largely through intermediaries, suffered as well, due to the high fees and costs which deflected so great a portion of the gross returns of the capital markets into the hands of financial intermediaries.
Retirees were increasingly forced to turn to federal and state governments for assistance. But promised public benefits were not available, as social security and Medicare trust funds had been depleted. And continued economic decline led to even lower federal and state revenue
collections, resulting in the inability of governments to provide essential services to their citizens.
Now, it is 2025. Unemployment remains well above 20% in the United States. America’s economy continues to contract, and deflation has set in. There is no end in sight to the current economic crisis, nor any available intercession by government to “turn the tide.” America can no longer afford the social safety net promised to its citizens. As unemployment benefits prove inadequate or lapse, and requirements for food stamps become more strict, many more Americans have turned to food banks. But, in a much worse situation than 2009-2010, the cupboard was largely bare. Many of those who charitably contributed to food banks now were their customers. And many Americans, including children, go hungry each day as a result.
A Special Joint Commission has just reported back on the causes of the ongoing present economic crisis. Their conclusion? It all flowed back to the SEC’s flawed rule-making in 2011 and 2012.
The SEC largely ignored the importance of trust in establishing the regulatory structures for broker-dealers and investment advisers (and their representatives), and the SEC refused to adhere to the established true nature of the fiduciary-client relationship. Following the enactment of the Dodd-Frank Act, the SEC instead enacted rules which resulted in “ethical pollution” of the investment adviser-client relationship. By permitting two hats to be worn, effectively, at the same time (and by enabling the switching of hats back and forth, at will), the SEC, in essence, enabled consumers’ trust to be betrayed.
The SEC’s adoption of a “new federal fiduciary standard” was not, in reality, anything like the fiduciary standard applied to other fiduciary professional advisors, such as attorneys and physicians. The SEC thereby eroded the entire concept of “fiduciary” within U.S. culture. As a result, consumers’ trust in other professions also declined.
Looking back on the SEC rule-making efforts of 2011-2012, one can only wonder, “What were they thinking?”
• Why didn’t the SEC foresee the dramatic adverse consequences, upon capital formation and economic growth, resulting from the erosion of trust?
• Why didn’t the SEC see that Americans needed trusted advisors governed by a true, bona fide fiduciary standard – not “pretenders” capable of betraying trust at every opportunity?
• Why didn’t the SEC realize that the “new federal fiduciary standard” the SEC adopted (which was not really a fiduciary standard at all, but rather only slightly enhanced the protections afforded to those in arms-length relationships) was doomed to utter failure, and with far-ranging negative consequences to individual Americans, and to America itself.
Now, in 2025, at last the Federal Government is poised to act. Congress, unwilling again to delegate to the SEC the formulation of standards of conduct, and reacting finally to an economic crisis of record proportions, has now enacted new legislation requiring that all those providing financial and investment advice to individual Americans – and to business entities, pension plans, and institutions – be governed by the bona fide fiduciary standard of conduct.
Disbanding the SEC
But, as a means of restoring trust in our system of regulating financial intermediaries, the U.S. Securities and Exchange Commission is to be disbanded. The U.S. Congress recognized that the SEC’s “regulatory capture” by the securities industry was too prevalent, and that the American public would not have their confidence restored in the SEC. Instead, the SEC’s functions are to be transferred to other agencies – the Federal Reserve, the Consumer Financial Protection Agency, and others.
At long last the “back-door” and often hidden compensation streams flowing to financial intermediaries from financial product manufacturers are to be shut down. No more 12b-1 fees. No soft dollar compensation. A requirement to ensure true best execution. Statistical tests to determine if the financial intermediaries engaged in selling a particular financial product are in any way favored over other brokers or dealers by the investment manager. And – no payment for shelf space.
And FINRA? 86 years was long enough to realize that FINRA was a failed experiment, in which standards of conduct were never (as long ago contemplated by Senator Maloney) raised to the highest levels, but instead migrated ever lower. FIRNA was disbanded as well, to be replaced with a true professional regulatory organization, with individuals as members, substantial representation by consumer advocates on its governing body. All securities professionals will be required to join this professional regulatory organization and be governed by its strict, bona fide, fiduciary standard of conduct.
What about the financial institutions themselves? They are shrinking, and consolidating. This too has caused disruption, as many highly intelligent individuals previously educated for and working in the capital markets were forced to go back to school to learn how to engage in professions and pursuits more valuable to the U.S. economy. Eventually they will emerge as engineers, physicians, innovators, and entrepreneurs.
At long last, truly effective reform of financial intermediation has taken place. Too bad it took so long. And it is so sad that America, suffering today, will take decades to recover (if it ever will) from the ill-advised rule-making efforts of the SEC in 2011 and 2012.
The SEC’s 2011-2012 adopted rules – which lowered the standards of conduct for those providing investment advice – ended up destroying trust in financial intermediaries. This in turn resulted in less capital formation, which then led to the present economic crisis.
Too bad hundreds of millions of Americans had to suffer (and continue to suffer) from the ill-advised decisions made in 2011 and 2012 by a handful of SEC commissioners.
Ron A. Rhoades, JD, CFP® serves as Chief Compliance Officer and Director of Research for Joseph Capital Management, LLC, a registered investment adviser with offices in New York, North Carolina, Georgia and Florida. This article represents his views only, and not necessarily the views of any organization to which he may be affiliated.
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