“The trouble is that brokers are screaming, ‘Trust me, trust me, you don’t have to bother your little head. I’ll take care of you, I’ll manage your securities and give you financial planning for you and your children and everybody else,’ Tamar Frankel, a law professor at Boston University told us. “‘Trust me, give me discretion to decide what to do with [your] money.’ If that’s not fiduciary, then what is?”
Ms. Frankel was on the phone to discuss the most important consumer issue you’ve probably never heard of. For more than half a century, the financial professionals who offer investing advice have fallen into two broad categories. Broker-dealers charge commissions on the securities they trade on behalf of clients. Investment advisers charge fees, typically as a percentage of assets under management. There’s another crucial difference. Investment advisers must register with the Securities and Exchange Commission and have a fiduciary duty to act in their clients’ best interests. Brokers, meanwhile, are self-regulated and operate by the standard of “suitability.”
“The brokers say they have a rule, and the rule is, they must give you suitable investment advice,” Ms. Frankel said. “I use my expertise to give you something that you can use, that’s suitable for you. But suitability doesn’t mean cheapest. It may be suitable, but you can go next door and get it at half price.”
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 called for the SEC to study the possibility of governing the two groups under one regulatory regime. But two years after Congress passed the law, the process has stalled. Worse, as far as Ms.Frankel is concerned, the Securities Industry and Financial Markets Association, or SIFMA, as the securities industry lobbying group is known, has put forward a vision of the rule that she said would turn the definition of the fiduciary standard on its head.
She isn’t alone. Wednesday, former chairman of the Federal Reserve Paul Volcker, Nobel-prize winning behavioral economist Daniel Kahneman and Vanguard Group founder John Bogle joined Ms. Frankel and eight other academics, investors and former regulators signed a declaration in support of a uniform standard that would require broker-dealers and investment advisers to act in their clients’ best interests. Their beef? “The fact is that brokers who are not registered with the Securities and Exchange Commission (SEC) are not required by law to put their clients first,” the statement read in part.
Or as co-signer Burton Malkiel, author of A Random Walk Down Wall Street, told The Observer: “If you’re a securities broker, you’re going to want to sell the things where you make the most money, where your commission is greatest. For me, that’s the opposite of how it should be. Investment advice should have the fiduciary duty that the customer comes first.”
The signatories to the declaration are joining the battle at a moment when the action has ground to a halt. An SEC study released in early 2011 recommended the creation of a uniform standard, and agency chairman Mary D. Schapiro has called the standard a priority. A late-2011 ETA for a proposed rule came and went, however, and in January, the SEC said it would be conducting a survey in support of a cost-benefit analysis for the rule. In support of the declaration, some of the signatories are visiting the SEC next month to argue for a fiduciary standard that would require investment advisers and broker-dealers to serve clients’ best interests and avoid conflicts.
Still, the SEC’s cost-benefit survey has yet to come out, and we couldn’t find anyone who would hazard a guess at when a rule will ultimately be proposed. “The longer it languishes, the more difficult it gets to move things along,” Dan Barry, head of government relations for the Financial Planning Association, told us, adding that he doesn’t expect to see a proposal this year.
Not only is the rule-making in a holding pattern, but there are some involved in the debate who think the sides aren’t so far apart. “SIFMA agrees something should be done, we think something should be done,” Mr. Barry told us. “There’s an unusual degree of support across a broad population of stakeholders,” agreed Barbara Roper, director of investor protection at the Consumer Federation of America.
Which isn’t to say that broker-dealers and investment advisers are joining hands and singing Kumbaya on the issue. “The investment adviser community, to my way of thinking, wants to take that statute that was designed to their business model and export it to the broker-dealer community,” Ira Hammerman, SIFMA’s general counsel, told us. “SIFMA is trying to take a more pro-investor, a more realistic approach,” he said, adding: “Customer choice is really at the center of what we’re saying.”
For their part, some investment advisers think SIFMA is trying to redefine the concept of the fiduciary standard to fit its current business model. “They say that all products now available through brokers should be available through the fiduciary standard,” said Knut Rostad, founder and president of the Institute for the Fiduciary Standard, which drafted the declaration signed by Ms. Frankel, Mr. Malkiel and others. “They are changing what the fiduciary standard means, and the additional point is that they’re changing the meaning to what the suitability standard currently is now.”
The parallel regulatory frameworks governing investment advisers and broker-dealers grew out of the stock-market crash of 1929. Broker-dealers were regulated under the Securities Exchange Act of 1934, while the Investment Advisers Act of 1940 and a series of court decisions set the standard of behavior of investment advisers registered with the SEC.
The dual structure was less of an issue in the early days, when the securities available to investors were fewer and far simpler. When a stockbroker called a customer to tout a company, the customer had a reasonable understanding of what the broker stood to gain—a commission on the securities bought and sold—and a sense that the broker would promote good investments—or risk losing future business.
As the financial products became more complex, incentives were harder to discern. Mutual funds, for instance, offered varying fee structures, allowing investors to decide how they wished to pay for the product: With an up-front sales charge that took an initial bite out of the principal, or with ongoing fees. An investment adviser registered with the SEC was required to recommend the product in a client’s best interest. A broker-dealer, on the other hand, could offer a client either one.
“If the branch manager tells you one product gets you 3 percent commission and that one gets you 7 percent, it’s the nature of human beings and capitalism and life that you’re going to sell that one,” Josh Brown, author of the blog The Reformed Broker and the book Backstage Wall Street, told The Observer. “There’s nothing illegal about it. As long as the product is suitable for the client, it can be done.”
Mutual funds, Mr. Brown said, are a tame example: “Principal protection funds, high-fee annuities. Private REITs, fucked IPOs, secondary offerings. There’s a litany of shit that you won’t find a fiduciary adviser selling.”
Which isn’t to say, supporters of the fiduciary standard would add, that brokers are bad actors by definition, but that the current regulatory regime creates situations in which the broker’s best interest may come in conflict with his client’s. SIFMA’s Mr. Hammerman didn’t dispute the point. “The broker-dealer model has many conflicts of interest,” he said. “If you’re a broker and you wanted a municipal bond portfolio, the best pricing might be trading with me because I have the best inventory for those bonds … And you say, ‘Fine, I’ll take it.’ I’m selling from my inventory a bond, and you’re buying it. We’re on different sides. There’s nothing wrong with that if you’re trading with me and I’ve given you disclosure. Or you might be more comfortable buying from a third party. The pricing might not be as favorable, but we can do that.”
That sounds a little like trusting Wall Street to deal fairly with less sophisticated investors—a notion with a history of, uh, mixed results—but Mr. Rostad said his group wasn’t trying to squelch all conflicts. “Commissions are a conflict, but they can be managed. In and of itself, proprietary products are not a conflict with the uniform standard.” The sticking point? “The issue with any conflict is, can you mitigate or manage the conflict so that you proceed in the client’s best interest?” he said.
Traditionally, broker-dealers have relied on written disclosures to mitigate potential pitfalls conflicts of interest. But disclosure is often insufficient protection: For one thing, how many investors read, let alone understand, the fine print at the back of a mutual fund prospectus? For another, academic research on the subject has shown that disclosure can create a false sense of safety with regard to conflict of interest.
Daniel Kahneman’s classic study on anchoring may indicate that once an investor has chosen to trust an adviser, a disclosure of conflict of interest is unlikely to shake the decision. The version of the uniform standard that Mr. Rostad is promoting calls for the disclosure of material facts. But a fiduciary rule that requires advisers to act in clients’ best interests would rely less on disclosure.“The bottom line of the research that we see is that even short, clear concise disclosure fails … in the sense that investors don’t believe it,” he said.
That’s one bottom line, anyway. Another is that a uniform standard is unlikely to be written anytime soon. Regardless of who wins the presidential election, meanwhile, it’s frequently speculated that Ms. Schapiro will leave the agency, making it anyone’s guess how rule-making will proceed under new leadership.
Perhaps because the battle is stalled, the crusaders for the fiduciary standard tend to take a philosophical tack. Mr. Malkiel told The Observer that he signed the declaration because he believes in the possibility of a “better world.” Andrew Golden, chief investment officer for Princeton University’s endowment, signed because the battle over the fiduciary standard is “about society, about protecting my mother and her personal account, about protecting my friends and my kids.”
“As the brokers themselves realize that they’ve signed onto something that calls for a standard of behavior, that they’re operating in companies that have signed on or been forced to sign on to that standard, it changes the appetite for the creation of certain securities and certain investments,” Mr. Golden said.
Mr. Rostad put it more grandly. “The capital markets depend upon trust, and the economy depends on the capital markets,” he explained. “We have a lot at stake in terms of making the free market economy work in a moment of historic, unprecedented levels of distrust and disgust.”