Insights from the experts in investment fiduciary responsibility.

Is the Fiduciary Standard at a Crossroads?

Posted by Duane Thompson on February 12, 2014

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>>>Financial advisors, typically those who are fiduciaries, counsel their clients to ignore the cacophony of market noise surrounding them on a daily basis.  Better to concentrate on the importance of staying the course for the long-term.  These same advisors would be well-advised to take the same sort of medicine with regard to the long-term outlook for the much-maligned but enduring fiduciary standard.

At a recent TD Ameritrade Conference, as well as in other commentary in the trade press, some in the ‘purist’ camp of the fiduciary movement now argue that the SEC’s plans for regulatory harmonization, including a diluted fiduciary standard, will forever change the fiduciary standard as we know it today.  It is far better, they say, to oppose any changes to the ’40 Act standard under which investment advisers currently operate than risk a regression to something more akin to the brokerage industry’s transaction-oriented fair dealing standard. 

Some of the purists, as well-intentioned as they may be, are forgetting that the fiduciary standard is not a Johnny-come-lately to the investment scene.  It has endured numerous trials throughout history.  Just as water finds its own level, it is far more likely that the powerful Wall Street lobby will find that any success  they may have in their effort to dilute the present standard will be limited and transitory.

The most recent fiduciary debate can probably be dated to 1999, when the SEC first proposed an exemption from the Investment Advisers Act of 1940 for brokers using advisor-like titles and charging fees for advice instead of commissions.  However, when we turn back the pages of time even further, we can see recurrences of the same battle in the 1920s and ‘30s when brokers expropriated the popular title of investment counselor until Congress restricted use of the term in the ’40 Act.  Originally envisioned as a purely census registration of investment counselors, the ’40 Act soon was fleshed out by the Commission in an enforcement action over principal trading by a broker-advisor, compelling the agency to articulate a fiduciary duty of loyalty for investment advisers In the Matter of Arlene Hughes. While the Supreme Court decision in Capital Gains  is often cited as a basis for an adviser’s fiduciary duty, the 1963 decision only affirmed that longstanding obligation.

And if we care to look at the fiduciary duty of care, we find that in 1830 a long-running debate began over a prudent investment standard first established under Harvard College v. Amory, 9 Pick. (26 Mass.) 446, 461 (Mass. 1830).  The Court rejected Harvard’s argument that the trustees should have invested in an annuity instead of common stocks on behalf of a widow’s estate.  It took another 150 years of trustee litigation and state laws specifying which investment products were prudent before diversification of common stocks was embraced as an appropriate means of reducing risk in trust portfolios.  The debate over Modern Portfolio Theory continues today, suggesting the periodic revisions to the so-called Prudent Man Rule, and the duty of care, are not over.

Turning to the present-day, we can see signs that the secular trend towards a more fiduciary future remains intact.   Brokers today are more likely to come under some form of fiduciary duty than ever before, and it is not just a common law standard in which particular facts and circumstances for each case must be examined.   For example, in reviewing  the number of dual registrants in the Investment Adviser Registration Depository, the ranks of brokers transitioning into investment adviser representatives continue to swell the ranks so that today some 262,000 of the nearly 305,000 individuals serving as fiduciaries under federal and state securities laws are brokers, many of whom undoubtedly would have remained brokers had Congress not eliminated fixed commissions in 1975, allowing market forces to intervene.

Moreover, there is an ever-expanding number of broker-dealer firms where key personnel (top-producing brokers and home office senior managers) recognize that advice-giving brokers are, in fact, functional fiduciaries. These leaders often advocate behind the scenes to change the culture of their firms by demanding products, policies, and procedures that avoid conflicts of interest and stand-up to the scrutiny of proper due diligence. Due to the nature of our work at fi360, we see this growing trend first hand whereas it is likely to go unrecognized by other fiduciary advocates.

It is true that the current standard is under assault by others in the brokerage and insurance industry, who would like to eliminate common-law precedent under the ’40 Act to the new fiduciary standard for brokers.  But there are larger forces at work expanding the fiduciary duty in other areas of the industry.  As part of Dodd-Frank, municipal bond advisors will soon be subject to a new fiduciary duty.  The Municipal Securities Rulemaking Board only last week also proposed a complementary best execution standard.

Joining traditional retail advisors under the ’40 Act as well are private fund advisors.  It hardly needs to be added that, separate from Dodd-Frank, the Department of Labor is also expected to include many securities brokers under ERISA’s fiduciary definition, thereby adding even more fiduciary advisors to the ranks of investment professionals than ever before.

In the worst-case scenario  that the purists suggest may happen, the SEC will abdicate its role of protecting investors by establishing a benign regulatory regime that would allow brokers to give lip service to a new standard that would be fiduciary in name only.  As a uniform standard it would  also apply to investment advisers, thereby reducing fiduciary accountability and investor protections that now exist under the ’40 Act  – precisely the opposite outcome from the intended purpose of pending regulatory reform initiatives.

Such a dire prognostication is inconsistent with the big picture context of historical and recent events.  The fiduciary standard has made incredible progress over the last 10 to 15 years, first in undergoing a robust industry debate, and in which the 2008 economic crisis put pressure on policymakers to move beyond the theoretical to the point where standards are likely within a few years.  Not only that, but purists must keep in mind that the fiduciary standard is not just a single standard limited to the securities industry, but a series of standards that continue to evolve under other laws, whether it is under the Uniform Prudent Investor Act, ERISA, bank trust laws, or in arbitration forums.

Even under securities laws, if the worst-case scenario comes to pass, it may not last long before a court of law intervenes.  It is important to keep in mind that the courts will look to legislative intent and perhaps common law precedent, such as the overriding fiduciary duty for brokers holding discretionary trading authority over client assets.  And with respect to a fiduciary standard for brokers, Congress stated in Dodd-Frank that it must be no less stringent than the ’40 Act standard. 

There are other backstops that might help with the right leadership at the Commission.  Under Dodd-Frank, the SEC was also granted additional powers to restrict the use or marketing of specific products, which could be employed if the new fiduciary standard fails to live up to its promise.  Separately, the SEC also has authority under Dodd-Frank to make binding arbitration optional.  While controversial  on its own, case law would serve to counterbalance any ill-conceived rules when the courts look to legislative intent and common law precedent, not just agency interpretation.

It is always good to be vigilant, and the fiduciary movement is doing its job in closely monitoring developments and challenging erroneous assumptions at a time when, over the next few years, the SEC and DoL are likely to adopt new standards of conduct.   The standards will constantly be tested by the courts in enforcement actions, and possibly in administrative challenges by fiduciary advocates if the rules are too weak.

In the meantime, lest we forget, there will always be the need for society to have safeguards in place for the institutions entrusted with managing the assets of others.  Over time the legal concept of a fiduciary duty to act in the best interest of the client, plan participant, trust – or whatever form it takes -- has prevailed over countless obstacles.  It will continue to do so in the future.

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