Debate continues: Fiduciary standard no panacea

Elizabeth’s note: After Ron Rhoades’ column on the ficuciary standard was posted yesterday, David Bellaire, the general counsel and director of government affairs for the Financial Services Institute, which represents independent broker-dealers and financial advisors, sent us this response. We’re glad to be the conduit for more viewpoints.

In a recent column entitled One-Man Think Tank: Inside the legal issues of the Goldman Sachs hearings columnist Ron Rhoades greatly oversimplifies the issues that are relevant to enhancing investor protection. Mr. Rhoades’ column suggests that the solution is simple – just eliminate the grossly unfair suitability standard and replace it with the clearly superior fiduciary duty. If only it were that easy. However, the question of how to improve investor protection is far more complicated than the simple formulation suitability = bad and fiduciary = good. For proof of that fact, one only has to remember that Bernard Madoff perpetrated his fraud through an investment adviser subject to the fiduciary duty. Clearly something more than the fiduciary standard is necessary if we truly want to protect investors.

The Financial Services Institute is committed to enhancing investor protection. We believe that a successful effort to achieve this goal must focus on each of the following issues:

Standard of care

Investors’ understanding of the standard of care owed to them by their chosen financial advisor must be improved. An appropriate standard of care will ensure transparency in these business relationships, effective disclosures to clients, and efficient low-cost investment solutions and operations while promoting and enhancing investor protection. Each of the existing standards has their shortcomings. Mr. Rhoades’ article points out the conflicts of interest that exist under the suitability standard, but he fails to point out the inherent conflict of interest that exists for each retail investment adviser — namely, “How can I recommend that investors select me to advise them when I know there are many of my competitors with a stronger track record who can advise them more cheaply?” (to use Mr. Rhoades’ words, if I am a “just OK” choice) The standard of care issue must be addressed carefully and thoughtfully to ensure investors are protected.

Other regulatory requirements

Currently, financial advisors affiliated with broker-dealers are required to pass qualifying examinations to demonstrate their competence, participate in continuing education programs and submit advertising materials for review and approval by their firm. The broker-dealer is subject to minimum net capital requirements, must participate in SIPC, and carry a fidelity bond. Unfortunately, SEC investment advisers and their affiliates are subject to none of these requirements under the Investment Advisers Act and the fiduciary duty standard. This imbalance must be corrected to improve investor protection for all.

Examination and enforcement

A significant regulatory gap exists between the resources dedicated to the examination of broker-dealers and those committed to the examination of registered investment advisers. The SEC and industry regulatory organizations examine more than half of the approximately 4,900 registered broker-dealer firms each year Every broker-dealer is examined at least once every three years.

By contrast, the SEC projected that fewer than 10% of the more than 11,000 registered investment adviser firms would be examined during fiscal years 2009 and 2010. These statistics come from a speech given by Richard G. Ketchum, FINRA chairman, before the NAVA Government & Regulatory Affairs Conference on June 8, 2009.

Legislation pending before Congress seeks to address these concerns by adjusting jurisdictional boundaries and increasing SEC funding. However, improving regulatory examination and enforcement for investment advisers and broker-dealers is more complicated than changing the responsible regulator or throwing money at the problem. Improvement here requires careful consideration if we intend to improve investor protection.

Different investors require different levels of service and advice

Further complicating the effort to enhance investor protection is the great diversity of business models utilized by financial firms to deliver products and services to investors. Insurance companies, wirehouses, discount firms, clearing firms, independent broker-dealers, and others make up the marketplace. Some investors make their own investment decisions and want to place orders in the cheapest fashion possible. Other investors want to put their faith and trust in an investment adviser they pay to make these decisions for them. The existing financial service business models were developed to address the various needs of members of the investing public. Quite simply, different investors require different levels of advice and service, and the market has responded to address these needs. These different business models and investor needs are relevant considerations in this important regulatory reform effort.

Clearly, many moving parts must be considered if we are to improve investor protection. The current language in Section 913 of Restoring American Financial Stability Act (RAFSA) was offered by Sens. Tim Johnson (D-SD) and Mike Crapo (R-ID) and calls for the SEC to study all the issues surrounding broker-dealer and investment adviser oversight and harmonization. This study will provide the SEC, the financial services industry, consumer groups, and others with great familiarity of the retail market the opportunity to shape these important regulatory reforms.

Expertise in these areas is essential to ensure that the final regulatory reforms address the standard of care, regulatory requirements, and examination issues effectively and without unintended consequences that may harm investors. Therefore, we urge support of Section 913 of RAFSA as the most effective means of insuring effective enhancements to investor protection.

So let’s stop tinkering around the edges by engaging in the suitability/fiduciary debate and instead address these issues holistically through the Johnson-Crapo Study.