Is there a better example of “regulatory capture” at work than recent Securities and Exchange Commission (SEC) shenanigans over the fiduciary standard? Regulatory capture refers to the phenomenon that occurs when a governmental regulator becomes more concerned in protecting a regulated industry than the public the regulation was designed to protect.
The SEC’s mission statement begins: “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation….” If you think the SEC acts in accordance with the “protect investors” part of that statement, you’re living in a fantasy world.
In enacting financial reforms last year, Congress accepted the argument that imposing a fiduciary standard on all who render investment advice would provide important protection for investors. Rather than simply including such a requirement in the legislation, however, Congress handed the ball off to the SEC, requiring the agency study the fiduciary issue and report back to Congress on how to accomplish this goal. Bad idea.
In my May 2007 column (“SEC Smackdown”), I wrote about a decision by the U.S. Court of Appeals striking down what was known as the SEC’s “Merrill-Lynch Rule.” This rule allowed representatives of broker/dealers regulated by FINRA, their self-regulatory organization, to give investment advice without registering with the SEC under the 1940 Investment Advisers Act.
The 1940 Act, under which my investment management firm operates, explicitly requires advisers to act in a fiduciary capacity toward their clients. What does a fiduciary capacity mean? As a California court in the 2003 case of Wolf vs. Superior Court explains it: “A fiduciary relationship is any relation existing between parties to a transaction wherein one of the parties is duty bound to act with the utmost good faith for the benefit of the other party. Such a relation ordinarily arises where a confidence is reposed by one person in the integrity of another, and in such a relation the party in whom the confidence is reposed, . . . can take no advantage from his acts relating to the interest of the other party without the latter’s knowledge or consent.”
In short, fiduciaries must put their clients’ interests ahead of their own. They must not only disclose any conflicts with their clients’ interests, but must avoid them wherever possible. An investment adviser operating under a fiduciary standard must disclose any compensation or other benefit received as a result of recommending one investment over another. And the adviser cannot invest one client’s money in a way that’s detrimental to another client.
A fiduciary standard is incompatible with the standard broker/dealer business model, founded as it is on outright conflicts of interest with clients. As long as an investment is “suitable” for a client, a broker/dealer representative can recommend investments that provide him or his firm better compensation rather than alternatives that might be superior from the clients’ standpoint. For example, a broker/dealer representative under FINRA rules can safely recommend a poorly performing mutual fund operated by his firm that produces higher revenues for his firm over a superior fund that pays him or his firm nothing.
Broker/dealers can trade for their own accounts, or for those of favored clients, in ways that may be inimical to the interests of other clients. One of the more egregious recent examples of this practice is Goldman Sachs, which earned millions in fees from hedge fund manager John Paulson for packaging and selling—to other Goldman clients—subprime mortgage securities that Paulson believed would fail. Of course, Goldman received fees from the clients who purchased those troubled securities as well. Although the SEC did file civil fraud charges against Goldman in April 2010, which Goldman paid a fine of $550 million to settle, Goldman maintains emphatically that it did nothing wrong. And FINRA has taken no steps to require its broker/dealers not to engage in conduct similar to Goldman’s.
Given the SEC’s history of protecting the large broker/dealers at the expense of investors, I was concerned when the Dodd-Frank legislation sought input from the SEC on the fiduciary issue. The SEC has now issued the report as directed by Congress, and the result is worse than I’d feared.
First, in the report, the SEC reasserts its position that representatives of broker/dealers are exempt from registering under the 1940 Act, the very argument the Court struck down in 2007. This, of course, would exempt those firms from the explicit fiduciary requirement the 1940 Act imposes regardless how much trust and confidence the customer places in the representative.
Financial columnist Bob Veres calls this “Fiduciary Betrayal” in the March 2011 issue of his newsletter Inside Information. He also criticizes the SEC, in the section of the report labeled “Alternatives and Concerns,” for constructing a straw man—that applying a fiduciary standard to all activities of a broker/dealer would interfere with broker/dealers’ capital formation activities. No one in the Congressional debates leading up to passage of Dodd-Franks’ legislation suggested the law should do so. Veres finds it remarkable that the SEC spends considerable effort in the report defending the trading activities of the large broker/dealers for their own accounts, wondering “what public benefit it serves to have large institutional firms with billions of dollars in assets competing with their own customers for investment returns, recommending securities they want to unload, and offering to buy at a discount securities that they believe will appreciate in value.”
The issue is far simpler than the SEC lets on. If a person’s title suggests he or she is representing an investor, or has the investor’s interest at heart, using words like “adviser” or “consultant,” then that person should be held to a fiduciary standard. Ditto for firm advertising that suggests clients should place trust and confidence in the firm or its representatives for investment decisions or recommendations. Under state law, any such advertising would create a fiduciary duty. It’s time for the SEC to stop protecting broker/dealers from the responsibilities of a fiduciary when they hold themselves out as looking out for their customers.
David Raub has 20 years’ experience as a registered in-vestment adviser. He is co-owner of Raub Brock Capital Management in Larkspur. You can reach him at draub@northbaybiz.com
