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What the 8 pillars of a FINRA-replacing entity for RIA oversight look like and how personal accountability is key

First and foremost, the PRO would have as it members individuals (not firms) who are qualified to become members of the profession

Author Guest Columnist Ron Rhoades July 28, 2013 at 4:11 PM
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Ron Rhoades: Only we, as professionals, if armed with a history of its practical application, will be able to call upon Congress to implement a true fiduciary standard and the formation of a professional regulatory organization.

Fiduciary Advisor Advocate

Fiduciary Advisor Advocate

July 29, 2013 — 7:21 PM

This is very good…very ambitious but very good. Here’s where I get confused- it seems to me that a lot of brokers like to call themselves advisors when in fact they are brokers. If I am not mistaken a broker is compensated via the placement of product- they receive some form of compensation…commission, trailer or whatever. An advisor, on the other hand, in my experience is compensated for their advice and not via a commission from resulting product placement. In the case of the real advisor- I can understand how a fiduciary standard can work…develop a definable, repeatable process, disclosure all levels of compensation etc. I don’t understand how a fiduciary standard can work however for the broker whose compensation is tied to the placement of products. There is a complete misalignment of interests and motivation isn’t there?

So, one idea would be complete disclosure regarding how and how much everyone in the food chain is paid. If I were building a house and hired a contractor (let’s call that contractor the advisor) I would want to know how that contractor is paid. Am I paying him for his advice or is he being paid a spread between building costs and what he charges me? I would want the former because that contractor is working for me and I have a better chance of getting the best plumbers or electricians. The worst would be if they got paid both ways-

Stephen Winks

Stephen Winks

July 29, 2013 — 9:56 PM

Ron,

Brilliant as usual !

The only thing we can cotrol in this discussion is ourselves. Thus, it is the broker and advisor who shape the industry not the broker/dealer or custodian must be the change agents. If a group of top brokers were to state, it is unacceptable to give up 60% of their gross revenues for inferior competitive market position in advisory services—the major brokerage firms (where brokers average $1 mikllion in gross revenue a year) would immeduiately respond. The same for independent broker dealers that only retain 20% of less of gross revenues. This is called leadership.

Brokers and advisors have the power to foster highly constructive innovation required for professional standing in advisory services in the consumer’s best interest.

Because expert professional standing in support of the consumer’s best interest is important to the consumer, can the broker and advisor remain in a tenable position of working at cross purposes with the best interests of the investing public? If our leading institutions and regulators are failing to enstill the trust and confidence of the investing public,—then it is up to brokers and advisors to be more demanding. This is how a free market works. Brokerage firms and their regulators run the risk of becoming irrelevent, terribly expensive and demonstrably at cross purposes with the investing public.

SCW

Fiduciary Advisor Advocate,

Your point that there is a complete misalignment of interests and motivations is absolutely correct but it is not resolved by compensation disclosure. The solution is recognizing that financial services are not homogenius. Leave it to the consumer and enterprising advisors to sort this out. There are actually four levels of counsel that commonly exist today:

1. Transactions: There is commission sales where access is provided to a wide variety of products (which can be obtained for free) where the broker is not accountable for and has no ongoing responsibility for recommendations. This space is dominated by discount brokerage firms in the consumer direct space. Full service brokers which are not accountable or responsible for recommendations charge a premium for product access but by definition can neither add value nor offer overarching counsel as it triggers fiduciary responsibility and liability not supported by their broker/dealer. The notion of professional standing and skill is beyond the internal compliance protocol of broker/dealers under the regulatory auspices of FINRA and the SIFMA as in accord with compliance protocol, brokers literally do not render advice.

2. Financial Planning: Financial Planning is needs based selling establishing a rationale for investing such as educating children or retirement as opposed to consumption. There are no statutes pertaining to educating children or saving for retirement or buying a vacation home or boat. Though there is noble aspiration to act in the consumer’s best interest, because planners are supported in large part by broker/dealers which do not acknowledge or support fiduciary standing, the expertise and individual intiative required by under resourced independent brokers is daunting to act in a fiduciary capacity based on objective non-negotiable fiduciary criteria of statute, case law and regulatior opinion letters. In tha absence of large scale institutionalized support for fiduciary standing afforded by custodians or iB/Ds, the planner is on their own, alone, as a practitioner where no operating scale is not possible and technical resources are limited.

3. Investment Management Consulting:.Large brokerage firms treat advice as a product brokers sell where there is little or no control over the broker’s value proposition, cost structure, margins or professional standing as required for individualized advice (beyond persobnalized) necessary for fiduciary duty and professional standing.

4. Fiduciary Counsel: Fiduciary counsel treats advice as an expert authenticated prudent investment process managed by advisors based on expert non-negotiable fiduciary criteria of statute, case law, regulatory opinion letters. Skill is determined by best practices in executing (i) an asset/liability study, (ii) investment policy statement, (iii) portfolio construction, monitoring and management. This entails: (i) advanced technology which supports continuous comprehensive counsel, transparency and modern approaches to portfolio construction required for fiduciary standing, (ii) expert authenticated prudent investment process as cited above which makes advice safe to acknowledge and to confirm professional standing, (iii) work flow management tied to a functional division of labor (advisor, CAO, CIO) so advice is scalable, easy to execute and manage as a high margin business at the advisor level at a lower cost than a packaged product.(where by definition individualized advice is not possible), (iii) conflict of interest management, not presently possible in a brokerage format.

Of these four levels of counsel, the entire industry will gravitate toward fiduciary counsel in the consumer’s best interest. Given the development of large scale institutionalized support for fiduciary standing the aspirational goal of planner could actually be fulfilled, but such a support mechanism does not presently exist today—unless denmanded by brokers and advisors alike in a scalable, easy to use and manage, authenyicated expert format..

FINRA and the SIFMA have little to do with the development of these enabling resources as they continue to lobby for a lesser consumer protection for retail investors than that afforded to all other investors. Yet if advisors and brokers who wish to align with the best interests of the investing public were to demand world class advisory services support in the consumer’s best interest, it would be created in six months and demonstrably proven so at a lower cost than a packaged product. Brokers and advisors just haven’t asked, perhaps because they do not know what is possible.

There is a choice of loyalty to the consumer or loyalty to the broker/dealer. If given that choice, the consumer will choose fiduciary standing in their besty interest every time. Anyone that does not think so is deceiving themselves. Thus the opportunity is to protect the trust and confidence of the investing public and aligning with the best interests of the consumer. The best interest of the brtoker/dealer is irrelevent. The extraordinary regulatory powers granted by Congress to former brokerage industry industry trade associations (National Association of Securities Dealers) FINRA and (the Securities Industry Association) SIFMA became immediately subordinated to the best interest of the investing public when those powers were granted.. The problem is these regulatory biodies are still acting as brokerage industry trade associations rather than being principally focused on thest interst of the investing public. How can “retail investors” be accorded lesser consumer protections than all other investors? Pretty obvious.

SCW

Fiduciary Advisor Advocate

Fiduciary Advisor Advocate

July 30, 2013 — 12:33 PM

I would not disagree with pretty much everything you mentioned. A couple of thoughts- I did not mean to suggest that disclosure of compensation is, by itself, sufficient to alleviate the inherent misalignment. Of course a demonstrated process which is clear, documented, based on fundamentally sound investment practice/ theory and repeatable is a necessary requirement. During my tenure in this industry (which is long) that has been the mantra in the institutional 'sponsor’ community, asset management business and increasingly in the alternative space. There really is no reason why many, if not all, of these 'fiduciary standards’ cannot be applied to smaller asset pools except…they would require disclosure and ultimately bump up against the revenue model for BDs.

One man’s opinion is that the reason the BD community hasn’t asked for a means of aligning interests isn’t because they don’t know it is available- I think it is because it would kill the golden goose and be such a shocking culture change. Unfortunately, many brokers who consider leaving the wire house world for independence under the auspicious of client realignment (Fiduciary Advisors) and have institutional/ demonstrated capabilities at their disposal- don’t use them…the predominant question is how do they get paid and they are much more comfortable being compensated via transactions or spread than via an advice fee.

I agree with you- let the consumer decide. But that decision should be based on disclosure and adequate information. I also agree with you that given clarity regarding process, investor will take the fiduciary route. If folks decide to go in a different direction so be it- but let’s not hide the ball on them. Let’s work to help clarify for the investor what they should expect from their 'advisor’ and one way to understand the incentives and motivation of the 'advisor’ is to follow the money trail.

Stephen Winks

Stephen Winks

July 30, 2013 — 1:34 PM

Fiduciary Advisor Advocate,

The wonderful thing about innovation and modernity is that it makes many seemingly complex problems so easy to resolve.

If the broker could provide an unprecedented level of counsel at less cost to the consumer and increase compensation 50%—all of which is readily achievable—suddenly the brokerage industry’s inability to adapt is no big deal, its their market share to loose.

History tells us there has never been an instant in a free market where the consumer’s best interest did not prevail.The goose that laid the golden egg is the goose that is aligned with the best interest of the investing public. The old goose is ready for retirement.

As the average age of the broker approaches 55, the next generatron of brokers will be advisors. 70% of industry revenues are expected to be fees by 2015. How long will the next generation of advisors put up with any excuse for an inferior approach to advisory services that is terribly expensive and precludes professional standing? Why are brokers paying 60% plus of their revenues for an inferior competitive market position? How long will the FINRA and the SIFMA as regulators continue act as trade associations protecting the industry’s best interests rather protecting public trust, the consumer’s best interest, fiduciary duty and the professional standing of the broker? The obvious conflicts are trying the patients of professional advisors, consumers and even Congress despite 2000 industry lobbiest and a former highly regarded Senator Judd Gregg trying to influence Congress. Fiduciary duty is literally the right thing to do and the industry has a loosing hand if not by political influence, then by the workings of the free market that outdates the brokerage model of 70 years ago.

The invisible hand of the free market as envisioned by by Adam Smith (coincidently in 1776) in the age of enlightenment is remarkably elegant. It has never failed. Todays modernity mantra of faster, better, cheaper is alive and well. The brokerage industry and its regulators haven’t figured it out yet and are literally stuck in another time. The only complexity is trying to hang onto an expensive outdated business model inconsistent with professional standing and the consumer’s best interest.

SCW

Andrew May

Andrew May

July 30, 2013 — 10:55 PM

This idea is also espoused by people in the futures industry to get rid of the National Futures Association (NFA). The joke told about FINRA is that it is a “member organization” in name only. Broker-dealers (BDs) and registered representatives feel that it does not do much for its members. Like all organizations, after a while, it becomes more concerned with defending its turf. FINRA is making it cost prohibitive to operate a broker-dealer and thus the number of B-Ds is declining and the number of registered investment advisers (RIAs) is soaring. FINRA’s attempt to become the self-regulatory organization for investment advisers scarred a number of people who fled FINRA to death!

PPott

PPott

July 31, 2013 — 6:51 PM

A very interesting series of articles from someone who seems at odds with brevity. The idea of a PPO has been floated often but the industry is too fragmented and lacks regulatory oversight.

The author loves to say that the fiduciary standard will rescue consumer confidence and yet there is little concrete proof to back that claim up. In fact, ERISA plans, which by definition entail fiduciary oversight are coming under attack for being to expensive to the detriment of the participants. The fiduciary standard doesn’t provide protection.

The public also deserves rules – concrete rules under which they can invest, and not a mumbo jumbo which requires a panel of experts to discern the violation.

Stephen Winks

Stephen Winks

July 31, 2013 — 7:10 PM

PPott,

There is an overwhelming case for simplicuity and modernity, in everyone’s best interest.

The solution may indeed be free enterprise innovation which renders brokerage and regulatory self interest irrelevent, if the best interest of the consumer continue to be dismissed.

Professional standing, serving the client’s best interest, the streamlining of cost and better advisor compensation will win the day.

SCW

Ron Rhoades

Ron Rhoades

July 31, 2013 — 8:10 PM

Thank you for the discussion and comments.

In reply to PPott, let me state:

(1) I have met with hundreds of individual investors over the years. When I explain to them what their non-fiduciary “financial advisor” is really getting paid (which is nearly always unknown to the consumer), and all of the fees and costs being paid, and the tax inefficiency of their portfolio design (or select products used therein), they are always quite angry at their (now former) advisor. An upcoming article, to be published at RIABiz shortly, will provide a recent, concrete example. Moreover, there is substantial academic evidence which ties consumer trust to capital markets participation, and fiduciary standards to consumer trust. The series of articles did not include the numerous citations contained in the white paper upon which the articles were based; I will post the white paper, in full, to my blog, within the next few weeks. Follow me on Twitter (@140ltd) or connect with me on LinkedIn to be notified of such posting. (2) Although the ERISA statute posits a fiduciary standard, under a rule adopted in 1976 by the DOL most “advisors” to defined contribution plans are NOT operating as fiduciaries. Of course, this may change soon – with the re-proposal and adoption of the DOL’s “Definition of Fiduciary” rule (if and when finalized). (3) It is possible to provide more specific principles under the fiduciary standard. This will be the subject of a future article. With such guidance, both consumers as well as advisors will know what is expected of one practicing under the fiduciary standard of conduct. Also, the fiduciary standard is no more vague than the inherently low standard of “suitability.”

The public expects, and deserves, advisors they can TRUST to act in their best interests, and as expert advisors. It’s that simple.

There will be those who don’t understand the fiduciary standard (and its many benefits to both consumers and to professional advisors), who resist change, and whose personal economic interests are adversely impacted by the application of the fiduciary standard. There will be firms whose entire business models will not fit the fiduciary standard of conduct. But these are not valid reasons to not embrace a fiduciary standard for all providers of personalized investment advice.

Do you desire to be a product seller? Fine. Quit calling yourself an “advisor” or using any other title or designation which leads the consumer to believe you are acting in a relationship of trust and confidence. Put the consumer on notice of the merchandizing status. Stop providing personalized investment advice, and confine yourself to describing the product you are selling. These are the requirements expressed early on by the SEC, and which are reflected in judicial decisions applying the state common law fiduciary standard to brokers found to be in relationships of trust and confidence with their clients. Moreover, as some fellow academics opined recently in a law review article, and I paraphrase – to engage as a product seller, while creating an aura that you are a trusted advisor – is fraud, plain and simple.

But – if you desire to provide personalized investment advice, then embrace the fiduciary standard of conduct. Realize that consumers possess a reasonable expectation that you will act in their best interests. Seek to minimize conflicts of interest which may arise between you and the client. Understand that being a fiduciary does not involve selling a particular product; rather, it is seeking out the very best strategies and products to fit the needs of your client. Understand that, unlike a rules-based system (with a plethora of rules to navigate), the fiduciary principle is easy to follow – you simply have to do the right thing by the client each day. In this situation, going to work each day is something you look forward to. Being a fiduciary – and living it each and every day – is very low-stress. And it leads to much closer relationships with clients – another added bonus.

Moreover, if you embrace fiduciary status, don’t seek to wear “two hats” at once (as many jurist has opined – an impossible situation). Never seek to remove the fiduciary hat (because once a relationship of trust is formed, the client’s trust will continue on and on, regardless of any disclaimer or waiver). And, instead of learning how to “sell,” concentrate your education on becoming the expert advisor. Become a “financial educator” to your client. Be their trusted advisor in all things financial. Enable your clients to achieve their goals. Do all of these things, and it is a great life to lead. It is one of the most rewarding careers anyone can have. And, I would be honored to call you a “professional colleague.”

Lastly, I am not known to be brief in my writings. And presenting history often involves conveying excerpts from many past events. But I hope readers regard what I have to say as substantive and helpful as we seek to move toward a true profession.

Thank you.
Ron

Stephen Winks

Stephen Winks

July 31, 2013 — 10:51 PM

Ron,

Amen.

SCW


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