Mon, November 23, 2009
Securities Industry: Seeking Dilution of the Fiduciary Standard?
The big guns in the securities industry have expressed a desire for a “harmonized fiduciary standard” for broker-dealers and investment advisers. That sounds good, but as the details emerge, it looks more and more as though this "harmonized" standard is actually a "gutted" standard, tailored for the benefit of large financial companies.
Back in June I noted that the Treasury department’s white paper on financial regulatory reform recommends that the fiduciary standard of care be applied to broker-dealers.
The report advised that
The SEC should be permitted to align duties for intermediaries across financial products. Standards of care for all broker-dealers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers. In addition, the SEC should be empowered to examine and ban forms of compensation that encourage intermediaries to put investors into products that are profitable to the intermediary, but are not in the investors’ best interest.
In reflecting on this recommendation, I kept coming up with the same concern. Broker-dealers work for their employers, not for their clients. Usually they’re functioning as salespeople for their employers’ products. How can they act as fiduciaries in such a situation? A fiduciary, after all, is obliged to act in the best interest of his or her client, even if that means doing something that isn’t the most profitable thing for the fiduciary. Imagine your broker at (insert name of your favorite big brokerage company here) calling you up and saying, “Hey, would you like to buy some exchange-traded notes? They’re actually for a company that we think might go bankrupt. We’re trying to unload them from our inventory so we don’t get stuck with them.” That’s what a real fiduciary would have to do.
I’ve expressed some reservations about how applying a fiduciary standard to brokers could possibly work. I even went out on a limb a bit and wrote an article for FiLife.com in which I argued that brokers should be treated as salespeople and not as fiduciaries. After all, if you go to a Honda dealership, you know they’re not going to advise you to buy a Lexus. Why not give consumers a clear statement that brokers are in the business of selling products? That should be acknowledged up-front, and a broker should have to disclose what everything costs the client and how much their commission is for each product. If you want to take the broker’s advice, then it’s caveat emptor, and there would be no fiduciary relationship.
The financial industry has a different take on the Treasury dept. proposal. Now that the Securities Industry And Financial Markets Association (SIFMA) has testified before the House Committee On Financial Services its views on how a fiduciary standard should work, the industry’s views on “fiduciary” are clear: they want to re-define the word. What’s left out of their proposed definition is as important as what is included.
For starters, SIFMA is urging that its “harmonized” fiduciary standard be allowed to supersede all existing state common-law definitions of fiduciary care when it comes to investment advice. That’s a head-turner: if the new standard is going to overrule all the historical standards of fiduciary responsibility, it needs to be at least as high as the standard it replaces.
Alas, a look at the fine print indicates otherwise. For example, a footnote to SIFMA’s congressional testimony states:
We note that broker-dealers are already subject to and operate under many core fiduciary principles, including the following…: just and equitable principles of trade; suitability of recommendations; best execution of transactions; fair and balanced disclosure to investors; supervision; and training.
Much could be said about how misleading this statement is, but I’ll just make one point: “suitability” of recommendations is not a core fiduciary principle. Under a “suitability” standard, a broker can recommend the purchase of a mutual fund that pays a healthy commission for several years and doesn’t have to disclose that there are a couple of comparable funds that would cost the investor a lot less money in fees. Such an action wouldn’t meet true fiduciary standards. The fact that SIMFA presents suitability as if it’s a core fiduciary principle is not encouraging.
Knut Rostad, one of the founders of The Committee for the Fiduciary Standard, wrote recently about a webinar in which he and Kevin Carroll, SIFMA’s Associate General Counsel, discussed SIFMA’s views on the standard of care that should be applied to broker-dealers.
When questioned directly, Carroll was unwilling to confirm that SIFMA’s harmonized fiduciary standard would include a duty for a broker to keep investment expenses under control. This is one of the things that a prudent fiduciary must do. Carroll also suggested that some brokerage business models would “permit brokers to NOT disclose compensation, fees and expenses, while, at the same time still fulfilling fiduciary disclosure obligations” under SIFMA’s vision of a fiduciary standard. It really looks as though SIFMA wants to take the word “fiduciary” and bend it to its own purposes. This would clearly be a step backwards for consumers if it were adopted.
What’s more disturbing about all this is that SIFMA’s representative testified that its “vision of a harmonized fiduciary standard is even stronger and more pro-investor than any other alternative.” Really? More pro-investor than a standard that requires disclosure of what an investor is being charged in fees and commissions? More pro-investor than a standard that requires an adviser to keep costs down, even if it means not boosting the bottom line by pushing products with bigger profit margins?
Treasury’s aforementioned white paper recommending the widening of the fiduciary standard noted that
In general, a broker-dealer’s relationship with a customer is not legally a fiduciary relationship, while an investment adviser is legally its customer’s fiduciary.
What SIFMA proposes is a standard that would designate broker-dealers as “fiduciaries” without subjecting them to the obligations that have historically been associated with that term. Not only would this “harmonized” standard create an illusion that investors are receiving a high level of protection when working with brokers, the standard would be applied to non-broker advisers as well. It would actually reduce the protections presently given to investors who deal with registered investment advisers. That would be a windfall for big brokerage firms and financial companies and a disaster for consumers.