Chairman George Miller’s latest bill to address issues in the retirement plan marketplace, H.R.2989, has two significant sections for the defined contribution marketplace. The first, “401k Fair Disclosure for Retirement” requires enhanced fee disclosures to plan sponsors and participants. The second, “Prohibition of Conflicted Investment Advice” seeks to reduce conflicts of interest by requiring that advice providers be registered under the Investment Advisers Act of 1940. These two pieces of the bill were previously separate bills, fee disclosure was introduced as H.R.1984 and investment advice was introduced as H.R.1988, but they were merged to create H.R.2989. Because we have already devoted substantial energy and effort to explain and support the fee transparency part of the bill, we believe it is important now to address the investment advice portion in greater detail.
Rand Report: Investor and Industry Perspectives on Investment Advisers and Broker-Dealers.
The investment advice portion of H.R.2989 is just one part of a larger debate related to competing regulatory structures and standards of care of broker-dealers and investment advisers. The Securities Exchange Act of 1934 (48 Stat. 881) regulates brokers and dealers, and the Investment Advisers Act of 1940 (54 Stat. 847) regulates investment advisers.Â Broker-dealers are subject to a standard of care that is built around “arms-length” relationships, “fair-dealing” and the concept of suitability. The primary requirement is that brokers must have an “adequate and reasonable basis” upon which to recommend a transaction to a retail client and this transaction must be suitable to a client’s financial situation, needs and risk tolerance. Broker-dealers also have other requirements, such as the best execution of securities transactions, reporting requirements and significant compliance and oversight rules; however, the fundamental fact is that nowhere in statute or regulation does it state that brokers owe a fiduciary duty to a client. Investment advisers, on the other hand, owe an affirmative fiduciary duty to their clients that requires them to act only in the best interest of the client and to avoid or disclose all direct and indirect conflicts of interest. Historically these different regulatory structures made sense because broker-dealers primarily executed investment transactions whereas investment advisers focused on supplying investment advice. However, over the past 10-15 years the lines of demarcation between broker-dealers and investment advisers have become increasingly murky. The advent of fee-based brokerage accounts that look and function very similarly to advisory accounts and the increasing use of titles such as “investment advisor” or “wealth manager” by brokers has made the distinction harder for consumers to understand (for background on fee-based brokerage accounts please read the Tully Report, the SEC rule, and the subsequent court case overturning the rule). In addition, many “independent” investment adviser representatives are registered representatives of broker-dealers and agents of insurance companies. To make matters worse, investors seem to be oblivious to the distinctions among the titles, regulatory structures and competing standards of care within the industry. For a more in-depth review of the regulatory history and current state of the industry we recommend a complete review of the RAND Report. Though it is long, the report should be required reading for all interested in this matter.
The description of the standard of care in Treasury’s proposal was deemed by many in the Investment Adviser world as a dilution of the fundamental fiduciary obligations. Critics were quick to point out that the use of the word “fiduciary” was notably absent. Critics were also upset that certain words and phrases in the description of the standard of care (“may”,”in substance” etc.) gave the SEC too much room to deviate from the Advisers Act.
* Any omissions to this list were purely unintentional. If you would like to add to this list please contact ryan@brightscope.com.
In order to understand what is happening in the world of investment advice, historical perspective is required. The growth in the investment advisory business has been the big trend for years in the investment world. Successful brokers are increasingly leaving their broker-dealers and setting up their own investment advisory businesses. The primary reason cited for this shift is the demands of clients who are fed up with Wall Street scandals and the conflicts of interest of their advisers. The broker-dealer industry is under attack from both sides of its retail business: discount brokers stealing its trading clients, and top brokers walking away with its high net worth clients. To stem their losses, broker-dealers have sought to position themselves as advice providers without having to don the cap of a fiduciary adviser. This shift has created great confusion for consumers and in our minds is the primary reason why a uniform standard of care for advice providers is required.
More than 60 percent of respondents believed that brokers have a fiduciary duty, and 90 percent of respondents believed that investment advisers have a fiduciary duty. The majority of respondents would not seek services from a broker if they knew that brokerage services provided fewer investor protections, that brokers did not have a fiduciary duty, or that brokers were not required to disclose all conflicts of interest. After being presented with the disclosure statement specified by the 2005 rule, 79 percent of respondents reported that they would be less likely to seek financial advice from a brokerage firm.
It appears that investors expect to receive advice from conflict-free advisers. Read in its entirety the Rand Report creates a compelling case for unifying regulation under the affirmative fiduciary obligations of investment advisers, not vice versa. The “confusion” arguments against the fiduciary standard of care fail this basic test of alignment with investor expectations.
There is a more fundamental flaw to Lemke and Stone’s argument. Their preferred approach, or rather the preferred approach of the broker-dealer industry, is to use “plain English.” Presumably, plain English means not using the term “fiduciary.” However, the term “fiduciary” is the term that is most beneficial to investors. There is a very clear legal standard and history dating back over a hundred years that accompanies the term “fiduciary” and that applies to a variety of relationships in a variety of industries; trustee/trustor,Â parent/child, lawyer/client etc.Â It is commonly accepted that the fiduciary standard is the highest standard of care known to the law and that no other standard can supersede or improve upon it. Because of the duty of prudence owed by fiduciaries, fiduciaries must adopt any practice, understanding or method deemed to be an improvement upon the existing standard. In such a way, the fiduciary duty requires fiduciaries to always elevate themselves to the highest standard of care then attainable. As such there is no need for an “improved” or “enhanced” standard of care.
While BrightScope supports a fiduciary standard of care for all investment advice providers, we recognize that the fiduciary standard of care is not a cure-all for financial regulation. There are certainly elements of investment adviser supervision that must be improved. In the short term, we believe the SEC is on the right track with two of its initiatives aimed at preventing fraud by investment advisers. The first initiative closed the loophole that allowed non-public broker-dealers to use accounting firms not registered with the PCOAB. This change is complete and is effective for audit periods ending after 12/31/2008. The second major initiative is a comprehensive review of Rule 206(4)-2 which regulates the custody practices of advisers and requires investment advisers with legal custody of client assets to maintain those assets with one or more qualified custodians. The SEC has already proposed a rule change: Release No. IA-2876. This is a critical rule change because as we have seen in practice advisory clients with assets not held with an independent custodian have a much higher risk of fraud. While we are still reviewing the comment letters on this proposed rule, at present we believe that investment advisers with “full custody” of advisory client assets should be subject to surprise examinations and required to conduct a SAS 70 Type II report. The SEC should look seriously at taking a bifurcated approach to custody with stricter rules in place for advisers with “full custody” and more lenient rules in cases in which advisers have limited custody solely for the purpose of withdrawing fees. While both cases are cause for concern, the former case is of significantly greater concern and affects a more limited set of advisers making regulation more effective. We also believe the SEC should adopt a non-rebuttable presumption that an investment adviser has custody if any related-person has custody of advisory client assets. In response to the current crisis, investor protections must be strengthened, not weakened. In some cases investment adviser regulation can learn from the regulatory standards used by FINRA to regulate the broker-dealer industry.
Given the multiplicity of parties involved in todayâ€™s 401(k) plan arena, many opportunities exist for business arrangements to go undisclosed. Problems may occur when pension consultants or other companies providing services to a plan also receive compensation from other service providers. Without disclosing these arrangements, service providers may be steering plan sponsors toward investment products or services that may not be in the best interest of participants.
While the real impact is unknown, the risks are great enough to retirement security that action is required.
It should be the intent of the legislation to align the standard of care of financial representatives with the expectations of investors and to strengthen investor protections. If “harmonization” is to occur it needs to be the harmonization of investor expectations with the standard of care of their advisers, regardless of whether that financial firm was heretofore regulated as a broker-dealer or an investment adviser. That means upgrading all providers of investment advice to the existing fiduciary standard for investment advisers, not lowering the fiduciary protection via a new “federal fiduciary” standard. Nowhere is this case more clearly evident than with retirement plans, where a higher percentage of investors are unsophisticated and lack the freedoms they have in non-retirement accounts. These investors deserve to have access to conflict-free advice from fiduciary advisers.
Plan participants and plan sponsors can benefit greatly from advice received from true fiduciaries who have only the client’s sole interest in mind. BrightScope stands in support of any piece of legislation that strengthens the standard of care owed to plan participants and plan sponsors.