Advisor Perspectives

By Knut A. Rostad

Originally posted on Advisor Perspectives, July 23, 2018

Gary Cohn, former economic advisor to President Trump, told The Wall Street Journal in February 2017 that the DOL Rule was “a bad rule.” His point on fiduciary duties then is as incisive as ever today. Translated to language of our time, with respect to the SEC’s proposed regulation best interest (RBI), ”It’s okay to pig out on junk-food investments.”

The heart of RBI is its compliance and ethics program as required in written policies and procedures. Federal securities regulations were conceived as a code of ethics in 1933 by President Roosevelt to be, ”simple enough for the public to understand.” The Advisers Act of 1940 reflects this vision; the Supreme Court affirmed it in 1963 as a federal fiduciary duty for advisers.

RBI should have required robust due care and loyalty duties. It doesn’t. The Institute does not support RBI as is. Its major shortcomings require reengineering to get to a real best interest fiduciary standard.

First, rigorous language must reflect retail investors’ recognized shortcomings and the debilitating impacts of conflicts. The DOL Rule description of best interest is an excellent model:

Investment advice is in the ‘‘Best Interest’’ of the investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity….without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

Second, policies and procedures must apply the principles and deal with conflicts. Since 1933 we have learned again and again that casual disclosure alone doesn’t cut it. It fails to mitigate the debilitating harms of material conflicts. The Advisers Act of 1940, informed by common law, requires far more. This includes:

  1. Disclosures must be affirmative and must include “specific facts.” The SEC emphasizes that conflicts must be disclosed “with sufficiently specific facts so that the client is able to understand (them) … and can give informed consent to such conflicts or practices or reject them.”
  2. Disclosures must be understood. How the disclosure is written and delivered matters. The broker or adviser is responsible for it to be understood by the client. Disclosure must “Lay bare the truth … in all its stark significance,” Justice Cardoza wrote. The SEC noted, “In the Matter of: Arlene W. Hughes,” there is no one appropriate disclosure method, no “one size fits all” because “The method and extent of disclosure depends on the particular client involved.”
  3. Informed consent must be attained. Written client consent must be “clear and specific to the transaction” and “intelligent, independent and informed.”
  4. The transaction must be fair and reasonable. Even with client consent, “the recommendation must be fair and reasonable,” as Professor Tamar Frankel writes. “Courts will generally not enforce an unfair and unreasonable bargain.”

RBI fails investors. It’s not based on fiduciary principles. For example:

  • RBI ignores core differences between advisers and brokers – basic legal, contractual and business differences. Most fundamentally, brokers give incidental advice in sales relationships of three (the broker, the client and the asset manufacturer) while advisers give fiduciary advice in intimate relationships of two (the advisor and the client).
  • RBI policies and procedures provide no requirements or uniform guidance, and do not define “mitigation” or “best interest.” They don’t require specific mitigation measures.
  • RBI embraces conflicted advice. It disagrees conflicts should always be avoided if possible. It agrees, however, that conflicted advice and un-conflicted advice are equal before the law.
  • RBI frets that if brokers eliminate conflicted recommendations they will lose revenue and their customers will be harmed by not buying these products (RBI, 274).
  • RBI removes “ethics” from its language. In 125,993 words, ethics are mentioned three times, and not regarding the RBI proposal.

There is clarity. Some commenters worry that RBI fails to say what ”best interest” means. Actually RBI offers a lot of clarity on what RBI best interest means – clarity from what RBI ignores. It ignores research and experience that reveals retail investors’ shortcomings, and that puts the trustworthiness of financial professionals alongside Congress members and car salesmen. It ignores research that shouts out the remedy for investor distrust and confusion: real transparency and clarity around conflicts and fees. Together, RBI rejects the rationale for the Advisers Act of 1940 and fiduciary principles dating from Hammurabi.

Together, RBI’s conflicts obligations require about what FINRA requires today. SEC Commissioner Stein suggests RBI is better called, “Regulation Status Quo.”

Despite this clarity, the RBI paints a mythical picture that strains basic sensibilities. Take the claims that brokers will be obliged to do more than just disclose conflicts. That brokers will be obliged to disclose and mitigate certain conflicts. This assurance, however, is not borne out by what RBI says “mitigation” means and requires. Once the legalese is swept away, “mitigation” is found to only require “disclosure.”

Ditto for the discussion of fee disclosure. RBI speaks of disclosing “certain categories of fees they should expect to pay” to mean the methods and sources of compensation. The “how” of compensation. RBI explicitly rejects requiring that a broker be required to disclose the fees a retail customer pays,

“We are not proposing a requirement that firms personalize the fee disclosure for their retail customers.” Investors know the difference between how a vendor is compensated and paid by a customer and what they pay a professional. Still confusion persists. RBI has been discussed by SEC staff to seem to mean brokers are required to disclose all actual fees.

RBI shouts, ”best interest” – but speaks a language of, as Commissioner Peirce offers, “suitability-plus.” RBI language prioritizes flexibility and choice. It reads more like a pitch for a Sunday buffet than it does requirements of a high standard of conduct.

Putting choice ahead of professional conduct, the RBI buffet embraces the junk food Mr. Cohn champions.

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