fi360 Blog

The SRO Debate: Alive and Well?

During our most recent webinar exploring regulatory reform, we received a question regarding whether investment advisors will still be supervised by the SEC or their respective state.  In recent months, the Administration, Congress and regulators have been much more focused on other capital market issues as they consider financial regulatory reform, and the issue of oversight of investment advisors has gone largely unrecognized in Congressional hearings and proposed legislation. 

However, recent media reports make it appear as though regulation and oversight of advisors is still a burning topic.  Earlier this month, Texas securities regulator and NASAA President Denise Voigt Crawford stated she would like to see a greater role for the states in regulatory oversight of investment advisors and argued that the dividing line between SEC and state regulation should be raised from assets under management of $25 million (or less) to $100 million.  This week, however, the SEC's head of Investment Management, Andrew Donohue stated that the issue of whether advisors should be supervised by a SRO must be resolved before states are given more authority over advisors. 

But while oversight issues may be a hot topic among the industry and regulators, it is a lot less clear that it is an issue legislators are ready to address through legislation.  In fact, it was reported earlier this week that while the House Financial Services Committee plans to discuss investment advisor issues at a hearing on October 6, Congress may end up punting the fiduciary issue that has been a part of the public discussion to this point. 

While there continues to be much speculation about whether Congress will address fiduciary issues as well as oversight issues this fall through legislation, it is clear that the SEC is waiting for a signal from Congress on how to proceed.  Moreover, the SEC's ability to act is limited without legislation, particularly in the area of investment adviser oversight. 

It has been widely reported that the SEC lacks the resources to effectively oversee and examine the more than 11,000 investment advisors currently subject to its jurisdiction.  SEC Chairman Schapiro and Commissioner Aguilar have both publicly supported self funding for the agency as a means for increasing its budget, and Senator Charles Schumer has backed the idea with proposed legislation.  

Absent a legislative initiative to increase SEC resources, greater state involvement and/or SRO oversight of advisors could become the solution of choice to ensure more effective oversight of advisors.  But again, both solutions require legislation either to change the dividing line that separates state and federal regulation, or to set laws requiring any SRO responsible for supervising advisors to register with and be subject to the oversight of the SEC.  

Advisory trade groups and NASAA have argued against SRO oversight because they fear that FINRA will become the SRO of choice.  However, whether FINRA becomes the SRO responsible for advisors, it still stands to play a major role in regulating fiduciaries depending on how the fiduciary standard is extended to brokers that provide investment advice to investors.  All of these complicated issues likley will not be resolved anytime soon given the long list of issues Congress and the SEC are currently tackling.  Thus, the status quo of advisor oversight will stay in place for now.  However, given the growing list of frauds uncovered at the state and federal level this past year, advisors should not rule out a change in how they are regulated and the regulator to whom they answer, especially once Congress is finished tackling the larger reform issues early next year.  

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UPDATE 10/5/09:  On October 1, Congressman Paul Kanjorski released a discussion draft of the Investor Protection Act, which will be the subject of a House Financial Services Committee hearing on October 6.  Included among the various provisions of the legislative draft is a proposal for an independent study of the operations and structure of the SEC and SROs.  With regard to SROs, the draft bill specifically calls for the study of "the present self-regulatory organizational structure and a determination of whether the present reliance on self-regulatory organizations promotes efficient and effective governance for securities markets."  In addition, the draft legislation proposes to give the SEC the authority to collect fees from registered investment advisors to cover the cost of inspections and examinations of those advisors.  Given these proposals for a study and SEC funding, it is clear that Congress envisions the SEC and states maintaining their current roles overseeing advisors if this legislation is enacted and that an SRO for advisors would not become an option unless the independent study provided evidence that it could be an effective model.

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This question was asked during our most recent webinar exploring regulatory reform, "The converging worlds of brokers and advisors as fiduciaries under regulatory reform." To view a recording of this and previous webinars, as well as view the schedule of upcoming webinars, visit the webinars page of fi360.com.

 

 

Fiduciary Links: See you on the road

Two of the bigger industry conferenes take place the next two weeks.  First is the CFDD 2009 Advisor Conference, October 5-7 in Scottsdale, AZ followed by FPA 2009, October 10-13 in Anaheim. A look at the agendas for both of these conferences shows that fiduciary issues will be prominently featured at both events.  CFDD in particular features a number of fiduciary-focused sessions from designees and other friends of fi360.  With both of these conferences drawing such large attendance, we expect a number of our readers will be there.  Fi360 will be exhibiting at both events, so make sure you stop by and let us know that you are a regular reader of the fi360 Blog. Some of our best ideas come from the face-to-face interaction we have on the road.

Now on to the best links from the past week.

In the news/commentary:

• Geithner says "time is the enemy" of financial regulatory reform
• Advisors no longer thought to have the answers in the post-trust era
• Pittsburgh a model of economic diversity and symbol for the G-20 Summit
• DOL not waiting on Congress to address investment advice rules
• Contrary to what we thought, one report says Congress may forego the fiduciary issue and leave it in the SEC's hands.
• An InvestmentNews opinion column looks at Rakoff's decision in the Bank of America case.
• An Other Voice in InvestmentNews shoots holes in the idea that stocks vs. bonds is an either/or decision
• Another consumer-directed article explaining the fiduciary debate
• Roger Levy advocates participant-direction for 401(k) plans

From the organizations/associations/government/academia:

• The new Report to Plan Sponsors from Reish & Reicher covers "hard times" issues.
• A group of fi360 members is holding their second Fiduciary Forum in Western Michigan

From the blogs:

• The Broker's World blog sees fiduciary-processes becoming voluntarily adopted
• The WSJ Financial Adviser blog agrees and says becoming a fiduciary is inevitable just to stay competitive
• Is your firm capable of introducing venture finance into your clients' portfolios?
• The most common fiduciary shortfalls plan sponsors make and how to correct them
• Things are a little too quiet for Bob Clark in the regulatory reform debate

For more of the best links during the week, make sure you follow us on Twitter.

Silence on Fiduciary Legislation Could Be Golden

As I've discussed in recent weeks, Washington legislators and regulators are on a fast track to implement changes this year that will benefit investors.

After previously announcing last week that DOL rules on 401(k) investment advice are being pulled, Employee Benefits Security Administration (EBSA) head Phyllis Borzi stated this week that new rules will be ready for proposal by mid-November.  Although Robert Andrews and George Miller of the House Committee on Labor and Education have also been working on legislation that would address investment advice for defined contribution plans, DOL believes it needs to move quickly to implement effective regulation rather than wait for direction from Congress, which is already knee deep in health care and financial regulatory reform.  According to Borzi, EBSA is also eager to provide guidance on target date funds this year and to complete a review of plan and fee disclosure rules by early next year. 

On the financial reform front, House Financial Services Committee Chair Barney Frank reported he believes a financial regulatory reform bill will be complete before the end of the year.  Frank further outlined Congress' timeline on Wednesday during a hearing in which he explained the House Committee will begin to mark up financial reform legislation in pieces beginning in mid-October.  However, he is unsure whether the legislation will be considered as a whole package or in parts on the House floor. 

Frank intends for his committee to be done marking up proposed new laws by early November and also believes that legislation could pass through the Senate by Christmas.  In the meantime, there has been much speculation about whether the fiduciary legislation that appears in the proposed Investor Protection Act of 2009 will be a part of the overall reform package. Although the Act has not yet been listed on the legislative hearing schedule, in this case, no news could very likely be good news. 

Congress appears to be focused on addressing some of the more complicated issues first, and has taken steps along with the Administration to scale back legislation that has received the sharpest criticism in order to gain support necessary for passage.  The lack of discussion of the fiduciary standard is likely a result of the fact that the proposal to extend fiduciary obligations to all advice givers received widespread support from the SEC and various industry groups over the summer.  Indeed, there has since been much speculation that brokers may willingly change their business models to embrace the fiduciary standard.

Moreover, it is clear that the Administration and Congressional members are passionate about securing more consumer and investor protections.  While speaking about the proposed Consumer Financial Protection Agency (which would be focused on consumer products such as credit cards) at the House Financial Services Committee hearing on Wednesday, Geithner expressed the need for "strong minimum national standards for protection" and for consumers to understand the risks of products sold to them.  These are concepts that easily translate to protections for retail investors who are offered advice by investment professionals, a point likely not lost on policy and lawmakers in Washington.

Identifying the fiduciaries

Fiduciary duty is determined by facts and circumstances and it is not uncommon for fiduciaries to be unaware of their status. One of the first issues that will arise in breach of fiduciary duty litigation is determination of whether the defendent, in fact, owed a fiduciary duty. For the protection of the fiduciaries and investors alike, it is better to address this issue up front, by properly identifying the fiduciaries, documenting their status and role in the investment policy statement, and requiring the fiduciaries to acknowledge their status in writing. Not only will this help prevent misunderstandings, it ensures every step in the investment process is accounted for and that the fiduciaries are taking the proper steps to fulfill their role.

So what makes a person a fiduciary? There are four general categories of fiduciaries in regards to managing an investment process:

1. Those who are "named" in plan or trust documents
2. Those whose function equates to providing comprehensive and continuous investment advice
3. Those who have the discretion to buy and sell investable assets
4. Those who have the authority to appoint other fiduciaries

Where there can be some doubt as to fiduciary status is the case of hired investment advisors.  In the case of litigation or arbitration, a judge or panel would ask some form of the following three questions to determine status:

1. What were the scope of services being offered?
2. What was the client's level of sophistication in managing investments?
3. How many investment options were suggested to the client?

Again, it would be better for all parties if these questions were asked before any disputes arise that might lead to litigation or arbitration.  Better yet, the client and advisor should go over these questions and have a mutual understanding of fiduciary status before an engagement is solidified. If the advisor is brought on for a single, one-time purpose, such as a manager search, then the advisor is most likely not a fiduciary, whereas being hired on a retainer basis probably does arise fiduciary duty. The more sophisticated the client is, and therefore less dependent on the advisor, the less likely the advisor will be deemed a fiduciary. And, if an advisor only suggests a single investment option, that would probably indicate investment advice and the fiduciary status it carries.

Once the determination of fiduciaries is made, it is best to have the fiduciaries acknowledge their status in writing.  You can view a sample acknowledgement of fiduciary duty letter here. Not having a signed acknowledgement won't shield a fiduciary from their liability, but having one both prevents misunderstandings in the event of dispute and creates a greater awareness of the expectations of the fiduciary relationship.

Fiduciary Links: G-20 Week in Pittsburgh

As you may or may not know, fi360 is headquartered just outside of Pittsburgh, which this week is hosting the G-20 Summit. The G-20 is "the informal forums of 20 leading industrialized and emerging economies to discuss key issues in the global economy."  It's primary function is creating dialogue and understanding among those countries that make up 85 percent of the world's gross national product. One representative result of the last G-20 Summit in April of this year in London that would be of interest to our audience is the working group on enhancing sound regulation and strengthening transparency. Their report identified weaknesses brought to light by the world economic crisis and made recommendations for a system-wide approach to financial regulation, greater transparency in financial markets, promotion of capital and liquidity buffers, and more.  And, much as we've been focused on regulatory reform, financial regulatory reform is also apparently at the top of the agenda for this week's meetings.

We are proud of our city and like to think that Pittsburgh's role as host has symbolic value as how to prosper after economic collapse.  Still known more for our steel industry past, Pittsburgh is no longer a smoky industrial city, but one that is economically diversified with large manufacturing, health care, high tech, higher education, and banking industries that has been relatively unschathed during the current crisis.

Now on to the links:

In the news/commentary:

• A look at the passive vs. active management debate says that the three most important factors in choosing an active manager are the culture and structure of the firm and the quality of the decision-makers.
• A look at a court ruling that a retirement plan's investing in company stock did not constitute a fiduciary breach, along with a recommendation that due diligence and documentation on this type of investment is kept current and for the retaining of an independent fiduciary.
• Evaluating target date funds
• States are looking to take on more of the burden of regulating advisors
• First, the last-minute regulation from the Bush administration allowing conflicted advice was killed, then Congress confirmed advice will be addressed legislatively.
• How different groups are defining "fiduciary"

From the organizations/associations/government/academia:

• CFOs of DC plans say they intend to limit risk, increase auto-enrollment and contribution escalation, among other changes.
• Until it changes, selling insurance does not constitute fiduciary responsibility.

From the blogs:

• Michael Zhuang argues that diversification is still the most prudent course.
• For fiduciaries, prudence supercedes sales skills
• Judge Rakoff's decision re: Bank of America may be seminal moment in regulatory reform.
• How can trust be turned on and off?
• Blaine's recent appearance as guest webinar speaker is now available in archive

For more of the best links during the week, make sure you follow us on Twitter.

When Does Limiting Investment Choices Become a Problem?

It was no surprise to many that the Department of Labor just recently pulled the investment advice regulations that were issued under Section 408(g) of ERISA earlier this year.  The new administration was concerned that the regulation went beyond what the Pension Protection Act of 2006 envisioned with respect to advice provided to participants under the statutory exemption.  The DOL will probably wait for legislative action before revisiting the participant advice question next year.  Among the issues contested in this ongoing debate are whether conflicted participant advice of any variety should be allowed and is there a problem if the investment choices available to plan sponsors are limited.

I received a related question last week from an investment advisor who took issue with the wirehouse firms that only offer certain products to their clients.  He inferred that these were either proprietary products or products from firms having special arrangements with the broker dealer.  His argument was that when a limited menu is offered, you are not acting in the client's best interests.

A student in one of our classes a while back posed the question; "If you limit the universe of investment choices available to your clients, haven't you already committed a fiduciary breech?"

Ideally, the entire universe of investment products should be open to investors and one could argue that any fiduciary that limits or accepts a limited universe has committed a breech.  However, there are other fiduciary practices that argue for reducing the number of investment choices for various reasons such as; not overwhelming the unsophisticated participants (Practice 2.4), simplifying the investment process (Practice 2.5), and/or minimizing costs (Practices 4.4 & 4.5).  As long as there are sufficient choices that afford the participant, beneficiary, or client the ability to meet their investment objectives, then limiting the investment choices should not be a problem.  The tricky part is determining what is a sufficient number and that question is dependent on the specific facts and circumstances of each situation.  Of course, this assumes that limiting the number of choices is done through an objective due diligence process (Practice 3.1).  It is this due diligence process that should ferret out problematic conflicts, excessive fees, and other fiduciary issues and help to ensure that the participant, beneficiary, or client are best served.

Washington Abuzz with Reform Initiatives

While President Obama grabbed the headlines on the financial regulatory reform front with his address to Wall Street on Monday, legislators and regulators throughout Washington have been hard at work seeking to effect regulatory changes. 

The House Financial Services Committee announced its tentative hearing schedule for the next month and its plans to begin marking up financial reform legislation in October.  Missing from the hearing schedule is the issue of investor protection, and specifically proposals to extend the fiduciary standard to all advice givers and "harmonize" broker-dealer and investment adviser regulation.  However, consideration of the Consumer Financial Protection Agency signals Congress' continued eagerness to address key consumer and investor protection issues as a part of financial regulatory reform efforts.

Meanwhile, as questions continue to arise regarding the SEC's resources and capability to carry out its mission, especially in light of new reported failures by the SEC in the Madoff scandal, Senator Charles Schumer of the Senate Banking Committee announced he will propose legislation to allow the SEC to keep all fees and fines collected by the agency; a proposal that quickly drew criticism.  

Eager to restore accountability and public confidence (not to mention make the case to Congress for the agency's necessity), the SEC made several key announcements this week.  Of most interest on the fiduciary front is the announcement that the new Investor Advisory Committee has formed three sub-committees, one of which will consider the fiduciary duty owed to investors by those who provide investment advice.  In addition the Commission announced the creation of a new website with information about the Committee and that the Committee will next meet on October 5. 

The SEC also announced this week the formation of the new Division of Risk, Strategy, and Financial Innovation - a move that will help the agency more readily respond to risk in the market and new financial products and services - and its intention to explore global financial regulatory requirements with UK regulators.  

And on the 401(k) front, Phyllis Borzi, the Assistant Secretary of the Employee Benefits Security Administration, announced at the ASPPA conference this week that the Department of Labor is pulling investment advice regulations that were issued under 408(g) of ERISA earlier this year.  The Department of Labor is expected to propose new regulations, but no timeline for a proposal has been announced. 

Fiduciary Links

As Wall Street marks the one year anniversary of the market meltdown, let’s go back and revisit some of the stories from the past week.

Turmoil usually causes change, but DealBook argues that the changes are hard to find on Wall Street.

President Obama spoke with Wall Street yesterday about his financial reform plan; however some feel the window for change is closing.

In addition to the financial reform plan, the Obama administration also released an initiative to make retirement savings easier for individuals and small businesses.

The money market fund guarantee program will come to an end next week.  The program was initiated last year during the market meltdown. 

Obama’s financial reform plan calls for the “harmonization of regulation of investment advisers and broker-dealers.” Fi360’s Blaine Aikin examines the benefits of this process for broker-dealers in his Fiduciary Corner column.

You can also hear Blaine this week in the Financial Advisor Webinar Series.  He will cover the topic of “Regulatory Reform: Will you be a Fiduciary?” this Friday, September 18th at 4:00 pm EDT.

Why Brokerage-based Advisors (Should) Want The Fiduciary Standard

In my Fiduciary Corner column in Investment News this month, I make the case that advisors who work in wire-house firms should be, and often are, among the strongest proponents of the Obama Administration's proposal to extend fiduciary status to anyone who gives advice. If enacted, the proposal is likely to require brokerage firms to retool their management, sales and compliance structures for all but the purely transactional (generally online and/or discount) segment of their businesses.

There are many brokerage-based advisors who recognize that investment advice is a fiduciary function and are well prepared to embrace the change in regulatory approach and the resulting operational and cultural changes that are likely to occur. Here are five reasons why:

1. These advisors have already been operating under a fiduciary ethic (i.e., placing clients' best interests first and adhering to fiduciary duties) but have been constrained by suitability-oriented sales and compliance infrastructure and culture. They are often unable to use professional designations that may imply fiduciary status (e.g., AIF, AIFA, CFP, etc.) and to accept fiduciary status in writing.

2. As more clients and prospective clients become aware of the importance of working with a fiduciary when they seek investment advice, those who can and will acknowledge fiduciary status have a clear competitive advantage.

3. In a predominately suitability-oriented organization, training, resources and support for fiduciary activities are often inadequate. This will have to change if all forms of investment advice are subject to fiduciary laws and regulations. Already, a number of large wire-houses are beginning to plan or establish separate units within their organizations where the business model will be designed to foster a culture of fiduciary responsibility.

4. Products built for a suitability distribution network generally don't work well for distribution through fiduciaries. Sales incentives create conflicts and elevate internal expense levels. Imposition of the fiduciary standard should spark development of more products that are designed to compete on their investment merits alone. In a sales/suitability environment, YTB (yield to broker) is a necessary factor to consider because compensation is typically built into the product by the investment company rather than assessed at the overall account-level where compensation is set by the advisor.

5. Under the law, investment advice is recognized as a fiduciary service and advice givers may be held personally accountable for compliance with applicable fiduciary requirements. If a company-imposed suitability defense to a claim of fiduciary breach fails, the advisor's best defense is to be able to demonstrate that they adhered to fiduciary practices. It is much easier for an advisor to adhere to the fiduciary standard if the organization is geared to promote and sustain fiduciary conduct in all aspects of their business model.

I have received many calls and emails from brokerage-based advisors. Most have been supportive of the Administration's plan to extend fiduciary status to all advice givers, primarily for the reasons given above. I welcome you to post your thoughts about this aspect of the Administration's financial regulatory reform plan as well.

Fiduciary Links: The Converging Worlds of Brokers and Advisors

The quarterly webinar from fi360, The Converging Worlds of Brokers and Advisors as Fiduciaries under Regulatory Reform highlighted several action items for advisors as the “harmonization” process continues. Let’s take a look at the steps in our weekly links post. 

• Examine your service provider relationships. – Since the turmoil of last year’s downturn has abated, DC plan fiduciaries are turning back to their review process and examining their recordkeepers. The process includes the examination and disclosure of plan fees.

• Sharpen investment skills and fiduciary knowledge (meet the prudent expert standard). – Does the adherence to the prudent practices make a difference? The fi360 Blog examines the evidence.

• Tighten fiduciary aspects of your business. – Financial advisor Roger Wohlner describes his periodic monitoring process.

• Consider offering (more) consulting services. –The Fixing the 401(k) blog examines how advisors can help plan sponsors Keep the Fox out of the Hen House. 

• Join the Committee for the Fiduciary Standard and sign petition: www.fi360.com/advocacy

• If your calling is sales or trading, consider being a broker rather than an advisor; wearing two hats is a problem. – Don Trone highlights the fact that “comprehensive, continuous investment advice,” and not your title as a B/D or advisor, determines your fiduciary status as he covers a few Fiduciary Facts.