Ukraine! Biotech bubble! Crashing social media IPOs! China!
Have I got your attention? Yes? Phew. And sorry, because this article is about none of those—it’s about something critical for investors, but it’s a topic most find dry. What is it? The rules governing brokers and investment advisers. In recent weeks, SEC Chair Mary Jo White told her staff to fast-track their investigation into a potential uniform fiduciary standard for brokers and registered investment advisers, with an eye toward announcing a decision by yearend.
Her announcement accelerated a long-running debate in the financial press and industry blogosphere. One side says a uniform standard is necessary to ensure investors receive the best, most transparent advice. The other says it would hollow out the industry, leaving investors underserved and in the dark. In my view, though, both arguments—and the very idea of a uniform fiduciary standard—overlook the philosophical and historical reasons behind the current rules. A uniform fiduciary standard might create some winners and losers, but it won’t magically fix the financial services industry overnight.
For those not versed in industry rules and legalese, brokers and registered investment advisers currently adhere to two regulatory standards. Brokers are governed by the suitability standard, which requires them to sell investments that are, well, suitable for the client in question–something that’s a reasonable fit for their needs and financial situation. This standard doesn’t require them to put clients’ interests above their own or disclose conflicts of interest in compensation. If they get paid to sell one product or security over another, they don’t have to tell the client.
Registered investment advisers, by contrast, must uphold the fiduciary standard. This requires advisers to put investors’ interests before their own, disclose all potential known conflicts of interest and make recommendations they reasonably believe position the client to reach his or her investment goals.
At last count, there were over 10,500 SEC-registered investment advisers and 17,000 licensed at the state level. By contrast, there are over 630,000 licensed brokers—some are dual-registered as advisers, but many are held to the suitability standard only.
The change under SEC consideration—which first materialized in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010—would place the entire industry under the fiduciary standard. To many, it sounds good. The fiduciary standard mandates transparency and, on the surface, would seem to ensure all investors receive the best possible advice regardless of whether they work with a broker or adviser.
As with most things that sound too good to be true, however, there are some wrinkles.
While the rule change might sound wonderful, it actually goes against nearly 75 years of historical precedent. The law originally separating brokers from advisers—the Investment Advisers Act of 1940—was designed to separate investment sales from financial service. This concept has its roots in the days preceding the Crash of 1929, when countless shady brokers (then called Customers’ Men) masquerading as advisers pumped and dumped stocks their firms owned, ultimately destroying many folks’ livelihoods. Without clear standards or clear lines between sales and service, many investors didn’t realize the “advice” to buy certain stocks was better for the broker than for them.
So regulators drew a big line. On one side, salespeople who would take orders, pitch products and execute transactions. On the other, advisers who would do what their name implied. The rules governing each were designed according to that clear separation.
Over the past 30 years or so, the line has blurred. Brokers’ self-regulatory agency, once known as the National Association of Securities Dealers (NASD), morphed into the Financial Industry Regulatory Authority (FINRA). Brokers started racking up designations like “Certified Financial Planner.” Contrary to the law’s intent, they couched their sales pitches as product recommendations and hung themselves out as “advisors,” with an O (as opposed to the E used by actual investment advisers under the 1940 Act).
The uniform fiduciary standard is touted as a solution to this blurred line, but in my view, it’s no such thing. The blurring itself is the problem. Simply, sales and service should be separate. Period. When they aren’t, too many conflicts arise. Full disclosure doesn’t erase conflicts of interest. It brings them to light, but they still exist. They’re inherent in brokers’ pay model. Applying the fiduciary standard to salespeople would likely give investors a false sense of security about the advice they receive. They might not scrutinize the disclosed conflicts and instead simply accept the recommendation on faith and trust, regardless of whether reality warrants it.
The fiduciary standard doesn’t guarantee perfect advice or behavior. For one, advice is only as sound as the adviser giving it—an adviser might have a you-first mentality and compensation structure, but if they don’t have sufficient experience and expertise, their service might not be beneficial. The law, after all, doesn’t mandate market savvy. It just tries to encode and enforce certain principles.
Even then, rules don’t guarantee everyone under them upholds those standards. The fiduciary standard is a fine thing, but rules can be broken—and have been broken many times. As legendary investor Lucien Hooper wrote in a 1945 debate over establishing a professional standard for securities analysts, financial professions aren’t unlike “the professions of medicine, law, engineering or accounting. The fact that these other professions have ratings, it should be noted, has not enabled them to eradicate all the incompetents, crooks, and charlatans.” Ultimately, people are governed by their own values—their inner sense of right and wrong. If they lack conscience and an ethical compass, the rules might not matter to them. They might seek ways around them or break them and hope they don’t get caught.
If the fiduciary standard can’t guarantee perfect behavior in every corner of the investment adviser world, I fail to see how it can work some Mary Poppins magic on the brokerage world. I’m all in favor of anything bringing conflicts of interest to light—transparency is good. But I don’t think further blurring the line between sales and service is the answer. The more overlap there is, the more confusion potentially arises—the opposite of what those touting the uniform fiduciary standard want.
Whether or not the rule changes, this simple fact won’t: The only way to gauge whether a financial professional—regardless of designation—will give the best advice that puts you first is to research their values and principles. Find out everything you can about them—their philosophy, what motivates them, what they believe in, how they feel about the industry, what they as people value. Ask how their firm is structured to ensure their incentives are aligned with yours. Ask what systems and procedures they have in place to ensure you, the client, come first. What you find out will tell you far more than whatever rules they follow.
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