Obama administration, SEC, FINRA, FPA, fi360, U.S. Supreme Court and SIFMA raise fiduciary bar to different heights

January 21, 2011 — 4:24 AM UTC by Elizabeth MacBride

8 Comments

Brooke’s Note: The SEC finally issued its report late last night (Jan. 21) about whether a true fiduciary standard should apply to stock brokers. The answer: yes. Elizabeth will publish her analysis soon.

Editor’s note: RIABiz is republishing this story, written last spring, which includes many groups’ definitions of the fiduciary standard. The SEC is expected, on Friday, Jan. 21, to release a study on how it will apply the fiduciary standard to broker-dealers.

Added note: This story now has a worthy sequel based on the wave of expert comments appended to it.

The dictionary on my Mac says fiduciary means “involving trust.” From the Latin fidere, “to trust.”

If only the definitions in Washington, D.C., were so clear.

One of the questions facing the Congress and the Obama administration as they struggle to craft new regulations for the financial system is how to harmonize regulation of broker-dealers and investment advisors.

Broker-dealers currently operate under a lower no-penny-stocks-to-widows suitability standard – a difference that has driven some advisers crazy, because it means that broker-dealers have been able to advise their clients to buy investment vehicles that weren’t necessarily in their best interests. Advisers, on the other hand, have been held to a higher, though admittedly vague, fiduciary standard developed over the years through case law, which requires that investors’ interests be put first.

The Administration has proposed that the “standards of conduct for all brokers, dealers, and investment advisers, in providing investment advice about securities to retail customers or clients … shall be to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.”

But what might that be interpreted to mean, either on Capitol Hill as part of a larger package of legislation, or if left vague in the ultimate regulation, by companies and courts across the country?

The question now at hand is how detailed the description of the fiduciary standard ought to be, and what exactly, it ought to say.

During a summer of speeches, hearings and interviews, key players in the debate have given – either broadly or specifically – their ideas of what the fiduciary standard should look like.

U.S. Securities and Exchange Commission is most likely to end up with the responsibility of regulating financial advice, though through what mechanisms and subsidiary regulatory bodies is still an open question. On June 18, SEC Chairman Mary Schapiro gave a speech at the New York Financial Writers’ Association Annual Awards Dinner in which she laid out her view of a fiduciary standard:

“I believe that, when investors receive similar services from similar financial service providers, they should be subject to the same standard of conduct — regardless of the label applied to that financial service provider. I therefore believe that all financial service providers that provide personalized investment advice about securities should owe a fiduciary duty to their customers or clients.

The fiduciary duty means that the financial service provider must at all times act in the best interest of customers or clients. In addition, a fiduciary must avoid conflicts of interest that impair its capacity to act for the benefit of its customers or clients. And if such conflicts cannot be avoided, a fiduciary must provide full and fair disclosure of the conflicts and obtain informed consent to the conflict.

A fiduciary owes its customers and clients more than mere honesty and good faith alone. A fiduciary must put its clients’ and customers’ interests before its own, absent disclosure of, and consent to, conflicts of interest.

While I believe that a consistent fiduciary standard of conduct should be applied to all financial professionals providing personalized investment advice, I also understand that the fiduciary standard is not a panacea to deter all fraud against individual investors.”

FINRA

FINRA, which currently regulates the practices of brokerage firms, works under the oversight of the SEC. It may end up with the job of regulator, still functioning under the SEC or conceivably under another agency. To give you a sense of the scope: it regulates 4,900 brokerage firms and 650,000 registered securities representatives. It doesn’t currently regulate the nation’s 11,300 investment advisors.

In a speech June 17 at the Exchequer Club in Washington, Chairman Rick Ketchum suggested that a standard should include the following principles:

• Every person who provides financial advice and sells a financial product is tested, qualified and licensed;
• Advertising for financial products and services is not misleading;
• Every product marketed to them is appropriate for recommendation to that investor;
• A full and comprehensive disclosure for the services and products being marketed that address, in plain English, the risks, including the worst-case risks, of the product; and
• Every person who is in the business of regularly providing financial advice is subject to a federally crafted fiduciary standard.”

Consumer Protection and Investment Advisor Groups

Seven groups – the Certified Financial Planner Board of Standards (CFP Board); the Consumer Federation of America (CFA); the Financial Planning Association (FPA); Fund Democracy, the Investment Adviser Association (IAA); the National Association of Personal Financial Advisors (NAPFA), and the North American Securities Administrators Association (NASAA) – banded together to back extending the current fiduciary standard to broker-dealers.

The current fiduciary standard stems from the Investment Advisors Act of 1940, which lays out in excruciating detail what an investment advisor is and does and how he or she is subject to regulation. It doesn’t outright include a definition of the fiduciary standard, but its provisions leave room for interpretation. And in the nearly 70 years since it was written, the Supreme Court and various state courts have interpreted the act, creating a body of case law that defines the current fiduciary standard.
Just try explaining that to a bevy of young staffers on Capitol Hill.

In 1963, the Supreme Court offered an interpretation in SEC v. Capital Gains Research Bureau Inc. I’ve taken this quote from the web site of fi360, a company that offers education and certification for advisers on fiduciary issues.

Here’s what the Supreme Court said:

“A fundamental purpose common to these statutes securities legislation enacted in the 1930sand1940] was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry…(as)investment advisers could not completely perform their basic function–furnishing to clients on a personal basis competent, unbiased and continuous advice regarding the sound management of their investments—unless all conflicts of interest between the investment counsel and the client were removed.”

Committee for the Fiduciary Standard

Speaking of fi360, its chief executive, Blaine Aikin, is a founding member of the Committee for the Fiduciary Standard. The Committee is promoting codifying the existing fiduciary standard. Anyone can join the committee through its linkedin site. The group’s steering committee has put forward five principles to be included in the fiduciary standard:

1. Put the client’s best interest first.
2. Act with prudence; that is, with the skill, care, diligence and good judgment of a professional.
3. Do not mislead clients; provide conspicuous, full and fair disclosure of all-important facts.
4. Avoid conflicts of interest.
5. Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

SIFMA

The Securities Industry and Financial Markets Association has embraced the idea of a fiduciary standard, but is laying low – at least in public – on the specifics of what it should be. No doubt this lobbying powerhouse is crafting a careful position behind the scenes.

Its language so far does put it in opposition to the investment advisor groups advocating to extend the existing standard to broker-dealers, with one of the key differences being that SIFMA wants a federal standard rather than one that is applied differently in different states. SIFMA wants a new, “single maximum strength” standard, says spokesman Travis Larson.

If you know of other organizations that have taken a stand on the fiduciary standard, please let me know. I suspect there are many.

Editor’s note: Here’s a quick Wall Street Journal review of Elizabeth’s article.


Mentioned in this article:

Financial Planning Association
Association
Top Executive: Lauren S. Schadle, CAE, Executive Director and CEO

National Association of Personal Finance Advisors
Association
Top Executive: Ellen Turf



Share your thoughts and opinions with the author or other readers.

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Bob Ellis said:

September 18, 2009 — 8:03 PM UTC

Elizabeth:

I believe the whole debate of fiduciary vs. suitability is a red herring to disguise a marketing and perceptions battle. I have met many, many honest reps who do the right thing for their clients every day, and a whole raft of incompetent RIAs who put their same clients into a limited menu of money managers or mutual funds based on the comp they receive back to net against the client fees. Many clients pay less fees through BDs than through RIAs for what is often a very shallow level of advice.

The right answer is harmonization as both sides continue to throw dust in the public’s eyes. I have attached a recent brief on the topic. I believe the right answer is a quality process that puts the client’s interests first. The only real difference should be that a RIA selects specific asset managers and the rep selects products. Often they are even the same asset management firm!

Unless both sides come together and acknowledge their strengths and problems, as well as those of the other side, I think this dispute will wind up as a “pox on both their houses” and speed the movement to self-service for the mass affluent.

Bob

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Knut Rostad said:

September 18, 2009 — 10:02 PM UTC

Bob,

I fear you miss the point. No responsible adviser claims, as you suggest, that brokers are all bad and advisers are all good. That really is a red herring.

The point is very different — it is what is required in law of advisers and brokers.

The different requirements are material. The meaning of loyalty for the client in fiduciary law and the meaning of caveat emptor and 'fair dealing’ for the customer in commercial contract law are clear. In the commercial contractual relationship, the broker may generally put his own best interest first; in a fiduciary relationship, the adviser must put the client’s best interest first. From the investor’s perspective, they put the broker and adviser in opposing roles. Think about it. If an investor is wronged by a broker, the investor’s burden is to prove the broker is wrong; if the investor is wronged by a fiduciary adviser, the adviser’s burden is to prove he is right.

These opposing roles have practical consequences for investors. The RIA is required to put investors’ best interests first, act in a prudent manner; disclose in writing conflicts and all important facts; avoid or manage in the investor’s interest all material conflicts; disclose fees and control expenses; follow and document a due diligence process in making decisions; and diversify investments. A broker, just meeting the minimum legal requirements, has no such requirements.

The stark different legal requirements represent clear choices for Congress and regulators. Lets all hope they choose well.

Knut A. Rostad
Chairman
The Committee for the Fiduciary Standard

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Jan Sackley said:

September 22, 2009 — 9:39 PM UTC

Elizabeth, Thank you for your effort to articulate the opinions of various groups about the nature of a fiduciary standard.

I think one of your first lines points to the true meaning and the appropriate source of reliance to guide a fiduciary. That is, “involving trust.” Fiduciary law has evolved over hundreds of years under common law and was not created by the 40 Act, as some would have us think. I do not think that the concept is vague to the courts as they have been applying it to trust, Erisa and estate accounts for years.

I do want to point out that the proposed Investor Protection Act of 2009, as you have accurately quoted, uses the terminology “SOLELY in the interest of the customer or client” (emphasis added). I believe there is a small but distinctive difference between “sole interest” and “best interest.” I discuss this further in my op-ed in InvestmentNews: http://bit.ly/12Clrd

Thanks for keeping on top of the developments on this topic.

Jan Sackley, Principal
Fiduciary Foresight
269-323-8119
jansackley@gmail.com
www.fiduciaryforesight.com

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Brooke Southall said:

September 22, 2009 — 10:12 PM UTC

I just received an e-mail from William Roberts of the American Institute of Certified Public Accountants who read Elizabeth’s article and has contributed his group’s view of how 'fiduciary’ is best defined:

The AICPA supports requiring professionals who are providing investment advice to adhere to a fiduciary standard of care, the same standard of care to which investment advisers are currently required to adhere by operation of law under the Advisers Act of 1940. Thus, we support requiring that broker-dealers, when providing investment advice, be required to adhere to a fiduciary standard of care.

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Stephen Winks said:

September 23, 2009 — 1:57 PM UTC

If we base fiduciary standing just on the Investment Advisors Act of 1940, which is mostly an anti fraud statute for money managers with little practical instruction of what is entailed for advisors to establish fiduciary standing, then it does little to advance fiduciary standing as descriped in more depth in ERISA and UPIA.

Don’t take the bait that the 40 Act is the point of reference—the fact that ERISA and UPIA even exist would suggest otherwise.

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Ron A. Rhoades said:

September 23, 2009 — 3:10 PM UTC

James Madison once wrote, “If men were angels, government would not be necessary.”

There exist many sound reasons for the imposition of broad fiduciary standards of due care, loyalty, and utmost good faith upon all financial planners and all those providing investment advice to individual consumers. (1) The financial world has become increasingly complex for consumers; specialization of function has resulted. Fiduciary status is often imposed upon specialists as a means of protecting the entrustor (client) from abuse by the person who possesses the expert knowledge, given the high costs required for a client to higher another expert to monitor the advisors’ conduct. (2) There exist high costs attendant to gaining the requisite financial literacy necessary for a consumer to protect his or her own interests; financial literacy efforts, while important, will not turn the average American into a knowledgeable consumer of investment products and financial services – anymore than I can be expected to become a surgeon to operate upon myself. (3) Disclosures are insufficient protection; many academics have pointed out that, due to behavioral biases, disclosures are largely ineffective as a consumer protection mechanism. In essence, fiduciary status is imposed because other means of consumer protection have proven themselves inadequate.

From the standpoint of public policy, fiduciary status is imposed upon providers of investment and financial advice as a means of maintaining trust in our capital markets system (so fundamental to encouraging capital formation, which in turn promotes economic expansion). Additionally, if Americans do not make sound choices (with the assistance of trusted advisors) on matters affecting their own personal future financial security, then governments will bear increased burdens in future years as they are called upon to provide for the basic needs of their citizens.

The imposition of fiduciary status results in both affirmative obligations (such as extensive due diligence) imposed by the duty of due care, along with prohibitions on forms of conduct (such as full disclosure of all material facts) imposed by the duty of loyalty. These fiduciary obligations are distinct from the more limited duties (some of which might be characterized as “quasi-fiduciary) on broker-dealers and their registered representatives. The Securities and Exchange Act of 1934, and regulations promulgated thereunder by FINRA, have been interpreted to apply a “suitability standard” to the activities of broker-dealers (BDs) and their registered representatives (RRs). The application of the suitability standard, along with rules mandating certain forms of disclosures, reflects a modest modification of the purely commercial, arms-length nature of the relationship between a product salesperson and the customer. Even in arms-length relationships, the Restatement (Second) of Contracts provides that “[e]very contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” More particularly as to BDs, the U.S. Securities and Exchange Commission has applied the “shingle theory” in holding that every BD and RR owes to its customers a duty to deal fairly with customers. See LOUIS LOSS & JOEL SELIGMAN, SECURITIES REGULATION 3814 (3d ed. rev. 2004), which states that under the “shingle theory … even a dealer at arm’s length implicitly represents when he or she hangs out a shingle that he or she will deal fairly with the public.” The shingle theory is a contractual theory, not a fiduciary theory. See id.

Except for the protections of suitability and other highly specific rules, for the customers of BDs as a general rule “caveat emptor” still applies; in other words, customers are not entitled to “trust” their BD and RR. Instead, customers must take action to protect their own interests. Yet, through their advertising and marketing efforts, this is precisely what BD firms desire their customers to do. And, BDs in recent decades have entered into the practice of providing financial advice (as a means of selling products), yet don’t want their activities restricted by the affimative and proscriptive rules imposed upon fiduciaries.

In contrast, the Investment Advisers Act of 1940 (IAA) has been construed (based on the 1963 U.S. Supreme Court decision of SEC vs. Capital Gains Research Bureau) to apply broad fiduciary duties to registered investment advisers (RIAs) and their investment adviser representatives (IARs). (In fact, from the inception of the IAA, the SEC understood that it imposed fiduciary duties; in that respect, 1963 was only an affirmation of that fact.)

The fiduciary standard of conduct has been called “the highest standard of conduct under the law.” In American law, it has generally been held to give rise to two major duties – the duty of due care and the duty of loyalty. A third duty – that of utmost good faith – is sometimes held to exist, mostly as a “gap-filler” by courts in fashioning relief in which a breach of the other two duties does not clearly exist.

The fiduciary duty of due care in turn gives rise to several specific obligations. Among them is the investment adviser’s fiduciary duty to the client to exercise – with good judgment, knowledge, and due diligence – that degree of care ordinarily possessed and exercised in similar situations by a competent professional properly practicing in his or her field. Additionally, under the duty of due care (as well as other specific federal laws) an investment adviser shall maintain the confidentiality of client information.

One key aspect of the fiduciary duty of due care involves due diligence involves three key components: (A) Is the overall investment strategy proposed by the adviser sound? (B) Are the investment products chosen to implement that strategy the best for the client? (C) Are the investment strategy and products appropriate to meet a particular client’s needs? I would further submit that whether due diligence has been appropriately undertaken (as to “A” and “B” above) is tested through an application of the Frye and Daubert standards used by state and federal courts, as to the admissibility of certain expert testimony (i.e., is the investment strategy supported by generally accepted academic research, or through statistical back-testing using appropriate data sets; if not, has the client been made aware of the speculative nature of the investment strategy, or an investment strategy’s reliance on qualitative judgment of economic or market events, and the unique risks relating to same and their potential impact on the client).

While much has been promoted of following a correct process in adhering to the duty of due care, just as important is substantive due care. In other words, through the correct application of the requisite knowledge and experience, has good judgment been exercised at each and every stage of the process undertaken, in order to accomplish the requisite due care. Stated differently, following procedural steps is important, but if you don’t exercise good judgment at each step, you don’t effectively observe the duty of due care.

I turn now to the other “major” fiduciary duty – which sets fiduciary relationships so far apart and distinct from arms-length relationships. The fiduciary duty of loyalty is often characterized as the necessity to act in the client’s best interests. Yet, embedded within the duty of loyalty are three specific rules: (1) the “no conflict” rule (“a fiduciary must not place itself in a position where its own interests conflict with those of its client”); (2) the “no profit” rule (“a fiduciary must not profit from its position at the expense of the client”); and (3) the “undivided loyalty” rule (“a fiduciary owes undivided loyalty to its client and therefore must not place itself in a position where his or her duty toward one client conflicts with a duty that it owes to another client.”) Various procedures exist to deal with the apparent hardship resulting from the seemingly strict application of these specific rules. Accordingly, and since these specific duties are still an elaboration of general principles, the fiduciary duty of loyalty is perhaps better understood by a description of the investment adviser’s specific duties as derived from various judicial and administrative decisions, which I suggest include the following:

(A) The investment adviser shall at all times place and maintain its client’s best interests first and paramount to those of the investment adviser; (B) The investment adviser shall not, through either false statement nor through omission, mislead its clients; (C) The investment adviser shall affirmatively provide full and fair disclosure of all material facts to its client prior to a client’s decision on a recommended course of action, including but not limited to: (1) all material fees and costs associated with any investment, securities and insurance products recommended to a client, expressed with specificity for the particular transaction contemplated; and (2) all of the material benefits, fees and any other material compensation paid to the investment adviser (and additionally those benefits, fees and other material compensation paid to the investment advisor representative ) or to any firm or person with whom he or she or it may be affiliated, expressed with specificity for the particular transaction which is contemplated. (D) The investment adviser is under an affirmative obligation to reasonably avoid those conflicts of interest which would impair the independent and objective advice rendered to the client. As to any remaining conflicts of interest which are not reasonably avoided, the investment adviser shall ensure the intelligent, independent and informed consent of its client is obtained with regard thereto. In any event, any proposed arrangement in which a conflict of interest remains should be prudently managed in order that the client’s best interests are preserved and that the proposed arrangement is substantively fair to the client.

The last sentence in this elaboration of the fiduciary duty of loyalty has sometimes been met with “denial” within the securities law legal community. Some securities law attorneys, in an apparent misconstruction of the SEC vs. Capital Gains Research Bureau decision, believe that all an investment adviser must do, when a conflict of interest exists, is to undertake full disclosure of that conflict. If the client proceeds, that is all that is required. This is an incorrect understanding of the fiduciary duty of loyalty. To avoid a conflict of interest, disclosure must occur of all material facts and affirmatively made in order that the client achieves an understanding of both the material fact (which includes any conflicts of interest) and the impact of such conflict of interest upon the client. The INFORMED CONSENT of the client is required. In other words, the investment adviser must ensure such informed consent, which can only be obtained if the client truly understands both the existence of the conflict of interest and its material ramifications. And, if an investment adviser proposes a course of action to the client which would harm the client (i.e., not be the best course of action, but something less), no client who truly understands the conflict of interest and its ramifications would consent to such harm.

In summary, a BD and its RRs are representatives of the product manufacturer (or product distributor). In contrast, a registered investment adviser and its investment adviser representatives are representatives of the client (i.e., purchaser of the product). These are two distinct and wholly different hats. It would be rare indeed that these two hats can be worn at the same time, and even rarer if hats can be “switched” at will and the client understand the switch.

In conclusion, I would submit that the “new federal fiduciary standard” proposed by FINRA is not a fiduciary standard at all. It focuses only on disclosures of conflicts of interest and other material facts. While federal securities law ('33 Act, ’34 Act) are fundamentally disclosure-based regimes, the imposition of fiduciary status results in something much more than mere disclosure of material facts and conflicts of interests. It requires an understanding that serving the “best interests of the client” is not just about providing a “good” investment product. The true, bona fide fiduciary duties of due care, loyalty, and utmost good faith require much more, as alluded to above.

Each of us serves as guardian of fiduciary duties. Let us not, to paraphrase the late Justice Benjamin Cardoza, permit fiduciary duties to be redefined to become far lesser standard, nor eroded by “particular exceptions.” Let us preserve these high standards. Let us focus our efforts on fostering a greater understanding of fiduciary standards, deriving best practices to promote better adherence to same, and steadfastly preserving fiduciary standards. In so doing, we will serve not only the best interests of our clients, but also of our emerging profession. In so doing, we will promote a better economic future for all Americans, as well as America itself.

I applaud the work of the Committee for the Fiduciary Standard in espousing true fiduciary standards and principles. Keep up the great work. – Ron

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Clark M. Blackman II said:

September 23, 2009 — 7:06 PM UTC

As one of the 12 founding members of The Committee for the Fiduciary Standard and the incoming Chair of the AICPA’s Personal Financial Planning Executive Committee, I believe we are at a critical cross-roads. As Chair of the PFP’s Fiduciary and Competency Task Force for the AICPA since 1999 I have been very directly involved with this question of who is a fiduciary, and what does it mean to be one, for many years. I am finally getting excited about the opportunity that lies ahead for the investment industry, the individual advisor who wants to be considered a professional, and the investing public, who desperately need to be able to count on their advisor to ALWAYS do what is right by them. As the true and authentic fiduciary standard becomes a reality, and I believe it will (the cross-roads we are at today is this…it will either be now, or forever become yesterday’s old news that died under the weight of politics and unenlightened self interest). There will surely be some upheaval, but it will result in real change we can believe in. And when we have finished “breaking some eggs,” we will have an omelet that is worthy of the time, energy, and treasure of all those that are committed to keeping the public’s interest in the forefront, and it will be very, very difficult to argue that the world is not a better place because of it. Thank you, Ms. McBride, for being involved in getting the word out regarding this critically important issue. Keep up the good work.

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Clark M. Blackman II said:

December 6, 2016 — 3:57 PM UTC

Until brokers are willing to put their responsibility as a fiduciary in writing, and subject themselves to the onerous legal penalties for breach of fiduciary duty, then any claim to serving the client's best interest and not one's own (or the firm's) best interest is simply lip service. It is meaningless until the investor has the legal right to enforce a standard that, as Jan made clear, has been around for centuries. Many if not all states ( I'm most familiar with Texas), have well defined, specific legal rules and penalties relating to breach of a fiduciary standard of behavior; e.g., the statute of limitations is six years instead of three, the statute runs from discovery of breach - not the date of breach, the fiduciary is deemed guilty until they prove themselves innocent (another way of saying what Knut said about obligation of burden of proof), fees for the duration of the relationship are subject to refund, and penalty is three times damages (if damages exist - existence of damages is not a requisite condition to proving breach of duty). Being a true professional has a cost. It means subjecting yourself to one very real economic downside; a professional is subject to a standard that impairs their ability to make money from exploiting their relationship with their client, and to maintain of level of competence that truly qualifies them as an expert in their field. A professional has "clients," not customers. When the brokerage industry is willing to accept that the most important thing in their business is their clients, and not a "book of business" from which generating maximum revenue is job one, and they accept the enormous legal consequences of not meeting a true professional standard of behavior, then one can reasonably talk about "a red herring to disguise a marketing and perception battle."

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