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Fiduciary Standard Quandary: First Avoid “Harm”onization

Fiduciary Standard Quandary: First Avoid “Harm”onization
November 14
00:46 2017

Perhaps fitting, given that he had taken time away from his day off at work, Rick Fleming, The Securities and Exchange Commission’s (SEC’s) Officer of Investor Advocate, warned the several dozen industry thought leaders assembled at last Friday’s TD Ameritrade Advocacy Leadership Summit the thoughts he was about to share were solely his own and did not represent those of the SEC, it’s staff, or anyone else. With that standard disclosure behind him, Fleming immediately launched into a blunt, but honest, assessment, of where things stand in the world of fiduciary. He began with this stark concern: He worried any cure might be worse than the disease.

With that in mind, Fleming felt it might be prudent to take a more defensive posture, one that focuses on preventing bad things from happening. Because, he says, “not everything is broke,” his goal is to make sure we don’t end up in a place that is worse than where we started.

Where, exactly, did this long-fought battle between the fiduciary standard and the suitability standard first start? “The Investment Advisers Act of 1940 (‘40 Act’) mandates that advice be provided in the client’s best interest,” says Skip Schweiss, managing director, Advisor Advocacy & Industry Affairs, TD Ameritrade Institutional and moderator of the Advocacy Leadership Summit. “The suitability standard, as originated under the Securities Exchange Act of 1934 and further evolved under the Financial Industry Regulatory Authority (FINRA), mandates that advice is suitable to the investor’s needs, taking into consideration things such as the investor’s income, net worth, risk tolerance, time horizon, liquidity needs, tax situation, etc. The ‘40 Act standard is considered by most to be more stringent than the ‘34 Act standard. Brokers operating under the ‘34 Act standard is a seller’s representative, and has a fiduciary duty to represent the interests of their employer. Brokers are paid by the product manufacturers and distributors to represent their interests. The investment adviser operating under the ‘40 Act is a buyer’s representative, paid by the investor to represent that buyer’s interests.”

When a rule cites “interests,” it most certainly entails there may be conflicts to those interest. Significantly, each standard addresses those conflicts in different manners. “The Advisers Act urges conflicts be avoided, but if they are not, then holds the adviser accountable for effectively disclosing and mitigating conflicts,” says Knut Rostad, President of the Institute for the Fiduciary Standard. “Mitigating material conflicts is, appropriately, a significant burden. The suitability standard does not urge conflicts be avoided and presumes conflicts are ubiquitous. It then holds customers accountable for identifying, reading, understanding and acting appropriately to protect themselves.”

Those intimately familiar with industry jargon would have no problem following this story was we been relaying it. For the lay public, however, it’s important to define the distinction being discussed in more approachable terms. Dan Moisand, Principal at Moisand Fitzgerald Tamayo, LLC in Melbourne Florida, does precisely that. He says, “From a practical standpoint, the fiduciary standard requires me to seek ‘best’ while suitability just requires ‘avoiding bad’.”

As with most competing products, it helps to provide a side-by-side comparison chart. “Early at The Committee for the Fiduciary Standard (this was from June 2010), we developed a chart (see below) explaining the differences between the Fiduciary Standard and Suitability,” says Kathleen McBride, founder of FiduciaryPath, Editor of the FP Fiduciary Survey and past chair of the Committee for the Fiduciary Standard. “It’s pretty much 180 degrees different in every comparison category. One thing that many investors, and even investment professionals don’t realize is: what happens when there’s a disagreement or problem? Under the ’40 Act Fiduciary Standard, investment advisers must prove they acted in the client’s best interest. (‘Solely’ in the client’s best interest, if ERISA.) Under Suitability, the customer must prove wrongdoing by the broker.”


                                                           Securities Broker Investment Adviser
Responsible to by law: The Firm The Client
Conflict of Interest:                  Allowed Avoided & any remaining managed in the client’s best interest
Conflict of Interest disclosure:             No Yes
Disclosure details of compensation:       No Yes
Variable compensation depending upon type and amount of product sold Yes No
Paid by Product manufacturer/distributor Investor
Titles used Financial Advisor Financial Advisor
Investment Counselor Registered Investment Adviser*
Investment Consultant
Wealth Manager
*The only title with legal meaning

Further complicating matters is yet a third standard, one promulgated under ERISA and regulated by the Department of Labor (DOL). “From my seat as a practitioner, 40 Act is all about the investment advice, DOL brings in other issues related to moving between account types,” says Moisand.

The DOL’s Conflict-of-Interest (a.k.a. “Fiduciary”) Rule adds an additional twist. “The DOL Fiduciary Rule’s ‘best interest’ fiduciary standard is the ERISA ‘Solely in the best interest of the client’ standard — as in trust law,” says McBride. “The Impartial Conduct Standard in the DOL Fiduciary Rule articulates ERISA, but eliminated the 5-Part test, which enabled some financial services companies and reps or agents to provide advice or recommendations in their own interest, not the investor’s. The ’40 Act does not say ‘solely,’ just in the client’s best interest.”

The DOL’s new Rule, still in various stages of implementation and without the teeth of (currently suspended) enforcement, diverges from the SEC definition of fiduciary in important ways. Schweiss says, “The DOL’s Conflict of Interest Rule builds upon the Employee Retirement Income Security Act (ERISA) of 1974. ERISA is a ‘sole interest’ standard, even higher than the ‘40 Act ‘best interest’ standard. ERISA mandates elimination of conflicts of interest, while the ‘40 Act, especially as enforced by the Securities & Exchange Commission, mandates managing and disclosing conflicts. The DOL rule does allow for conflicts under the Best Interest Contract Exemption, though its terms are quite stringent.”

Reliance on disclosure may be viewed as a loophole. “Some intermediaries or firms feel you can disclose conflicts away,” says McBride. “But disclosing conflicts is not sufficient to meet one’s fiduciary duty. I’d say, as a fiduciary process and practices expert, (please note, I am not a lawyer), one cannot ‘disclose’ one’s fiduciary duty away. In other words, under either the DOL Rule or the ’40 Act, fiduciaries must avoid conflicts of interest, clearly disclose unavoidable conflicts, and manage any unavoidable conflicts in the investor’s favor.”

It is at this point of convergence of disclosure where we see the “harm” emerging from harmonization. “Reliance on more disclosure as a remedy will water down the standard and provide weak consumer protection,” says Moisand.

The very term “harmonization” implies compromise. Because of this, Fleming feels taking this path might lead to a worse definition of “fiduciary.” He worries “harmonization may dilute the current high fiduciary standards of Registered Investment Advisers.”

“Instead of rising up to the higher ’40 Act or ERISA fiduciary standard,” says McBride, “some have tried already (2010, 2011; 2013) to ‘meet in the middle,’ which would mean lowering the standard of conduct, to somewhere between fiduciary or ‘investor’s best interest’ and the much less stringent suitability or ‘sales’ standard. They couldn’t be further apart. If there is any movement, it must be up to the fiduciary standard, not down to suitability-plus a bit more disclosure.”

Harmonization, then, produces some practical problems. “‘Harmonization’ is a wonderful word, though with real-world consequences for investors and financial service providers,” says Schweiss. “The ‘40 Act has worked quite well for 77 years now as a principle under which investment advisers are held. The other two standards are different, one higher and one lower. They each stem from different laws, regulations, case histories, and oversight and enforcement bodies. To ‘harmonize’ them, you’d have to either raise or lower one or more of the standards. I suspect that there would be strong industry opposition to ‘topping up’ to the ERISA standard. And there would likely be pushback from various constituents to reducing the higher standards to a lower level.”

But, is harmonization really needed? Rostad says, “All the voices for harmonizing are coming from the brokerage industry seeking to effectively eliminate the 40 Act and the Conflict-of-Interest Rule. Though rarely mentioned, the 40 Act and suitability standards have already been substantially harmonized, de facto, regarding conflicts in enforcement. Two former SEC regulators, Troy Paredes, former Commissioner, and Robert Plaze, former Deputy Director, Division of Investment Management, characterized their views of the small difference between suitability rules and potential uniform fiduciary standard rules under Dodd Frank, as ‘2-3%’ at the September 16, 2014 TD Ameritrade Summit.”

Fleming frames the problem in terms of the different (and competing) service models). “On one end,” he says, “there are the ‘do-it-yourselfers.’ For that segment, the broker [suitability] business model works really well for them. On the opposite end, there are the ‘do-it-for-me’ people. They want to fully delegate to a discretionary [fiduciary] adviser. Then there’s a middle ground of people who don’t trade a lot and still want their broker to call them with ideas, and there’s people in this group who also what full advice and need the advice.” The problem, according to Fleming, is “people don’t understand the distinction and there are different models.”

Where we go from here is anyone’s guess. “I don’t think anyone can accurately predict anything politically right now,” says McBride. But it’s important to remember that the SEC regulated securities, not insurance or other products used in retirement plans or accounts. This is not a job that SEC can do on its own. I know from years of discussions, including some very recent ones, that the DOL has, and wants to continue to, work with SEC and I have heard vice versa. Whether they will… is anyone’s guess.”

Rostad relies on official statements when he considers what directions things might go in. “The statements from Chairman Clayton are important,” he says. “Over the past four months, on a uniform fiduciary rule, the Chairman has been very clear that he believes that way forward is more and ‘better’ disclosure. In his inaugural speech on regulatory principles in July, he stated, speaking to investors, ‘The best way to protect yourself is to check out who you are dealing with, and the SEC wants to make that easier.’”

Likewise, Schweiss takes the same approach. “I take SEC Chairman Clayton at his word that he is interested in formulating some kind of fiduciary standard that might be somehow coordinated with the DOL rule. There are two basic paths he can choose: either ‘harmonize’ the BD and RIA standards; or leave the IA standard in place and somehow change the BD standard to better fit with the DOL rule. It will be fascinating to watch, and to engage in.”

McBride sees many potential solutions to the problem as articulated by Fleming. “The SEC could prohibit titles conveying advice and trust or confidence for anyone who is not at least a ’40 Act fiduciary,” she says. “In other words, no advisor-type titles, or else you’re a ’40 Act or ERISA fiduciary! They can regulate ads that claim “we put our clients first…always,” or “we’re their trusted advisor …see,  I’m at their daughter’s wedding!” They can regulate any broker who is providing advice under the current ’40 Act. They can become more aware of investor behavior vis a vis the often ‘perverse’ effects of disclosures (see “Exclusive Interview with Yale’s Daylian Cain: Just a Sugar Pill? Disclosure’s “Ah-Ha!” Moment,”, October 18, 2010). And they can raise the standard for dually registered BD-RIA Reps to always fiduciary. You can have both licenses, but the standard must always be the highest. They can refuse to harmonize down from ’40 Act. They have plenty of data and great staff studies to do all these things, that would enable Americans to end up with more in all their nest eggs.”

Moisand focuses squarely on the issue of titles. He says, “My hope is they at least view the word ‘Adviser(or)’ as an assumption that advice is not incidental and should therefore services should be rendered under 40 Act standards.”

It could be that Moisand is on to something. Towards the end of his talk, Fleming mused, “It would be easier if we shift from ‘suitability’ and ‘Fiduciary’ to ‘sales’ and ‘Advice.’ If you’re holding out as an adviser you ought to be held as an adviser”

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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