Originally published on InvestmentNews.com, June 11, 2013
By Knut Rostad
Last October, Carlo V. di Florio, then director of the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations, said in a speech that conflicts of interest are “viruses that threaten an organization’s well-being … [and] if not eliminated or neutralized, even the simplest virus is a mortal threat to the body.”
Just a few months later, the March 1 SEC release regarding a potential uniform fiduciary standard, among other matters, set out specific potential parameters, including conflicts of interest and duty of loyalty, that the SEC would consider when coming up with a fiduciary standard. These parameters offer a starkly different view of conflicts of interest and the duty of loyalty.
That duty is the very heart of the fiduciary standard. The Dodd-Frank law requires that a uniform fiduciary standard be in the “best interests” of the client “without regard” to the financial interests of the broker or the firm.
Thus if a material conflict isn’t avoided, the burden to overcome the conflict is high. Casual disclosure and client consent alone don’t suffice.
Informed consent is required. The conflict also must be managed such that the recommendation remains in the client’s best interests.
This point underscores that “disclosure” isn’t a duty but is a “relief from a duty of avoiding a conflict,” according to Boston University School of Law professor Tamar Frankel.
In this context, the discussion on the “duty of loyalty” parameters and possible prescriptions that the SEC may consider is of particular importance.
As the term is used in the SEC release, “loyalty” takes on a new meaning. It means “disclosure.”
The act of disclosure is deemed to fulfill the duty of “loyalty.”
Examples of language excerpted from the SEC release:
- “We should facilitate disclosures to retail customers about the terms of their relationship.”
- The rule “would ex-pressly impose certain disclosure requirements.”
- “Disclosure of all material conflicts of interest”
- “An overarching general obligation to disclose all such conflicts.”
Avoidance Vs. Disclosure
The focus in the SEC release on disclosure of conflicts, as opposed to avoiding conflicts, could be interpreted to mean that conflict disclosure is superior to conflict avoidance. This interpretation would be wrong, as it would turn well-established legal precedent on its head.
The implications of mistakenly equating loyalty and disclosure are better appreciated in the broader historical context, in which the SEC largely is silent. The SEC release is silent on why conflicts historically have been considered major impediments to unbiased advice.
It is silent on how and why conflicts of interest can cause great harm to investors, much less that the Investment Advisers Act of 1940 itself was, in large part, a response to widespread concerns about conflicts of interest and the need to protect investors from “misrepresentations of unscrupulous tipsters and touts.” (See Arthur V. Laby’s discussion in “Selling Advice and Creating Expectations: Why Brokers Should be Fiduciaries” (Washington Law Review, 2012).)
It is not surprising, then, that Mr. Di Florio notes: “Conflicts of interest can do great harm,” and, “A failure to manage conflicts of interest has been a continuing theme of financial crises and scandals since before the inception of the federal securities laws.”
Moreover, the SEC release is silent on the long-standing practice of the commission urging advisors to avoid conflicts of interest, and the independent research that underscores the dangers that conflicts pose to investors, the general ineffectiveness of disclosure or the relevance of the knowledge gap between investors and brokers, which was clearly noted in the 1995 Tully Report, named for Merrill Lynch & Co. Inc. chairman Daniel P. Tully.
The report noted, in unambiguous terms, how it is a “rare client who truly understands the risks and market behaviors of his or her investments.” In sum, the fiduciary duty of loyalty is instrumental to inspiring investor trust in the capital markets.
Long-standing legal, academic and industry views — those articulated by Supreme Court justices and SEC chairmen alike — of the dangers of conflicts and the vital role of the duty of loyalty are omitted in this release. Instead, there is, essentially, a discussion of disclosure.
The SEC release provides a picture of the duty of loyalty that is very different from the duty of loyalty required by the Advisers Act.
“No Less Stringent’?
In summary, it:
- Makes disclosure the optimum response to conflicts. So much so that it allows more casual disclosure and oral disclosure (disclosure that is more “efficient” for the firm to deliver), while requiring neither “client consent” nor “informed client consent” of material conflicts of interest (disclosures that are more effective for the client).
- Re-brands conflicts. By omitting discussion of dangers associated with conflicts, conflicts are effectively re-branded to be like or similar to other general information required to be disclosed in the ADV.
- Redefines loyalty. As conflicts are re-branded, loyalty is redefined. The “duty of loyalty” has meant, in essence, “to do the right thing.” In this discussion, it essentially means “to disclose doing the wrong thing.”
Dodd-Frank requires that a uniform fiduciary standard be “in the best interests” of a client “without regard to the financial or other interest of the broker, dealer or investment adviser providing advice.” Dodd-Frank also requires that the standard “shall be no less stringent than the standard applicable to investment advisers under sections 206(1) and 206(2) of the Advisers Act.”
The assumptions of the duty of loyalty and conflicts embodied in the SEC release represent a profound departure from the Advisers Act. If these assumptions were to be adopted in rule making, the duty of loyalty essentially would be removed, and caveat emptor would reign.
Is such a uniform standard “no less stringent” than the Advisers Act? It isn’t.