fi360 Blog

Coming Soon To a Theatre near You: The Latest Adventures in Fiduciary Advice

Warning: This movie is rated ‘FG’ – Fiduciary Guidance. For Mature Advisers Only.

Plot: The Starship Pension Prize has discovered a strange new plan-et inhabited by the Klingons, a crafty race known for hawking lightly regulated insurance products.  The Starship’s chief officer, Captain James T. Kirk, plans to explore compliance with the Federation’s fiduciary adviser rule.

Voice over by Kirk, with a scene of deep space and scary music in the background:  Fiduciary advice: the final frontier.  These are the voyages of the Starship Pension Prize.  Its mission: to explore strange new eligible investment advice arrangements, to seek out generally accepted investment theories, and to boldly go where no regulator has gone before.

Opening Scene: 2^nd Voice over by Kirk as he writes inside his cabin: Captain’s Star Log: 2275. The Fiduciary Adviser Rule has been in effect for 263 years.  We have received disturbing reports that in far flung galaxies of the Universe, a number of Klingon advisers are blatantly ignoring it.  I am planning to personally investigate a strange new phenomenon picked up by the Starship Pension Prize from the plan-et we now orbit.  The sounds, when amplified, seem to be saying ‘risk-free investment; can’t go wrong.’ 

(Script: Kirk walks to the transporter chamber and motions to Chief Medical Officer Dr. Leonard “Bones” McCoy and First Officer Spock to join him.)  He turns to Chief Engineer “Scotty” Scott: Beam us down, Scotty.  I need to check out the eligible investment advice arrangement on the plan-et.  My sensors indicate it is a computer model advice program.

Scott:  Aye-aye, Cap’tun. 

Spock: Captain, I recommend we set the phasers to stun.  The Klingons are known for their self-dealing.

(Script: The Starship team is seen materializing on the planet below.  They are greeted by a Klingon advisor who is smiling and jabbering as he shoves a thick document at Kirk.)

Kirk:  Crap.  The Klingon is trying to sell me an annuity in my 401(k) even before I can audit his computer program!  My sensors aren’t detecting an annuity anywhere in the computer advice program.  Bones! What do I do?  Doesn’t this Klingon even have a heart beat?  As a fiduciary, shouldn’t he know that I’m in the accumulation phase and that inflation outweighs longevity risk at this point?

McCoy:  Jim, unfortunately, the Klingon can survive quite nicely without a heart and be richly rewarded at the same time.  He can recommend the annuity option within the plan and then shed his fiduciary duty when  cross-selling high-load products to the plan-et’s participants and beneficiaries outside of the eligible investment advice arrangement.

Kirk: Spock, can you detect any signs of intelligent life?

Spock: Unfortunately, no, Captain. I must agree with Bones.  Not only is there no heart, but I can find no conscience – fiduciary or otherwise – in this Klingon.  More importantly, he has apparently researched the rule carefully and complied with the letter of the law.  I’m looking at an obscure section of the Fiduciary Adviser rule, (b)(4)(i)(G)(2)(i), which was written in the year 2011 by an extinct federal agency on Earth known as the Department of Labor.  Incredibly, DoL allowed earthlings in the retirement plant to invest in an annuity option, notwithstanding the fact that the annuity could not be properly analyzed by the computer program.

(Spock pauses, then displays a quizzical look.)  Captain, you would think that our advanced civilization would have computers capable of comparing accumulation rates of annuities versus equities, and other critical factors such as the equity premium and inflation risk.  But apparently our scientists have not been able to succeed yet in mastering this process.  All this Klingon adviser needs to do is furnish the plan-et participant with a general description of the annuity and how it operates.  He then satisfies his disclosure requirements under the rule.  Hence the Klingon’s irritating grin.   

Kirk:  Dammit, Spock, that loophole is big enough to drive a photon torpedo through.  Beam us up, Scotty!  I’m going to see if there are any DB plans left in the Universe to audit.

Recent cases place emphasis on diversity of investment options for retirement plans

A body of law appears to be forming across federal Circuit courts giving employers greater guidance on how to build the range of investment options available in employee retirement plans in a way that fulfills the employers' fiduciary duty under ERISA.  The most recent case, Renfro v. Unisys Corp., comes from the Court of Appeals for the Third Circuit.  

In Renfro, plan participants claimed the employer breached its fiduciary duty by choosing investments for its 401(k) plan that had excessive fees.  The trial court and Third Circuit disagreed, however, finding that the employer offered a broad enough range of investment options with different fees. 

In reaching its decision, the Third Circuit looked to the Hecker v. Deere case from the Seventh Circuit and the Braden v. Wal-Mart Stores, Inc. case from the Eighth Circuit.  As the Third Circuit noted, Hecker and Braden “share a similar analytical framework for evaluating an ERISA breach of fiduciary duty claim targeting the selection and maintenance of a mix and range of investment options in a 401(k) defined contribution plan.”  Both cases examined the characteristics of the mix and range of investment options and then evaluated the validity of claims challenging fund selection against the backdrop of the reasonableness of the mix and range of investment options.

Draft SRO Bill not in best interests of investors or advisers

Yesterday, the House Finacial Services Committee released a discussion draft SRO bill for investment adviser oversight. The bill would authorize the creation of one or more self-regulatory organizations. This was one of three options presented by the SEC staff in January, the others being SEC self-funding and the authorization of a single regulator for dual registrants.

Fi360 opposes the bill and still believes that a fully funded SEC is the most cost effective and least conflicted option. If there is a silver lining, it is that the bill calls for one or more SROs, opening the door for an alternative regulator to FINRA that gives investors the choice of advisors who are being held accountable to a true fiduciary standard.  

For more information, consult the following resources:

• Text of the draft bill
• The House Financial Services Committee's page for Tuesday's hearing on the bill. Expect testimony to be linked to this page in the coming days.
• fi360's official statement on the bill
• fi360's executive summary of the bill
• The Advocacy page of fi360.com.  The most recent section is related to the release of the draft bill. We will be posting more information there soon, including an executive summary of the bill. You can also view materials related to the SEC's study on investment adviser examinations in the fifth section from the top.
• While the bill opens the possibility for multiple SROs, bill sponsor Representative Bachus said in a press conference yesterday that he endorses FINRA as regulator.
• fi360's Blaine Aikin gives his first reaction to the bill in an AdvisorOne article, Draft Bill Calling for SRO for Advisors Introduced in House
• Duane Thompson discusses the House proposed bill that would give SROs oversight of investment advisers with Registered Rep
• The website of SROIIA, the startup self-regulator for advisers that hopes to gain authorization as the higher standard alternative to FINRA
• Financial Planning Coalition press release and statement
• Duane Thompson speaks out about his reaction to the House hearing on SRO, fiduciary standard

The Battle over Principle

"War is the continuation of policy (politics) by other means."
- Karl von Clausewitz, Prussian military strategist

Von Clausewitz, a witness to the titanic struggle between nations in the Napoleonic era, once wrote of war being merely an extension of foreign policy.  So, too, in perhaps less dramatic fashion, should the struggle over investment advice be viewed as shifting over the years from the marketplace to Washington politics. 

Today, the most important distinguishing feature between Wall Street and independent financial advisors is the common law fiduciary standard.  Wall Street, while eagerly adopting the lucrative business model of advisors, over the last decade has pressed Washington to keep the FINRA sales model for regulation in play for its advisory services.

When reviewing the uneven battle between the two, given Wall Street’s deep pockets, the latest salvo from the wirehouses is likely to be fired on Sept. 13, when its supporters in Congress convene a House subcommittee to hear testimony on ways to strengthen the Commission’s investment adviser examination as well as on a uniform fiduciary standard for brokers and advisors. 

While the question of a self-regulatory organization for investment advisers can be expected to dominate the discussion, the subtext that will be hard to ignore is how an SRO will ultimately shape the pending uniform fiduciary standard for brokers and advisers.  Will it be an overlay of advisor conduct largely based on principles that follow the common law standard under the Advisers Act, or a rules-dominated standard administered by FINRA, or a mix of the two?

Lack of Dodd-Frank progress reflects politics being put ahead of duty

Recently during a business meeting I referred to myself as the “doomsday girl” of the office.  As in-house counsel, it’s my job to expect the worst out of any situation, even the most amicable of business relationships.  And so I go down the path of imagining the worst case scenario and put into place any measures that I believe will prevent the worst or at least assist with cleaning up a messy situation as quickly as possible.  In other words, I do what I can to fulfill my fiduciary responsibilities as an attorney and act in the best interests of my client.  It’s something investment advisers who serve as fiduciaries can certainly relate to.  But as I was driving to work today reflecting on where we were a year ago when the Dodd-Frank Act was signed into law and where we are now, I came to the scary realization that although a lot of very smart people work in Washington, there appears to be a fundamental lack of fiduciary conduct and understanding in the lawmaking and regulatory world.  

During my time at the SEC, I can vividly remember senior staff asking “how is this good for investors” anytime we discussed a potential solution to a policy issue or a new rule proposed by an SRO.  We were keenly aware that our work was for a greater good and that we had a duty to fulfill the mission of the agency to protect investors.  Of course, our attempts to do so weren’t always successful once special interests and politics inserted their noses, but at the core, we still tried our best to focus on investor interests.  These days, as I watch Washington from the outside, it’s astounding just how political things have gotten.  Party lines are drawn, lobbyists’ arguments win the day over the opinions of industry experts, and the American people are left without the protections needed to prevent future abuses of their trust.

DOL extension of 408(b)(2) and participant-level disclosures

Today, the  DOL issued the final rule on the extension of the 408(b)(2) and participant-level disclosures applicability dates. The effective date of 408(b)(2) has been extended to April 1, 2012, with the final regulation due by the end of the year. Participant-level disclosures would be due 60 days after the effective date of 408(b)(2), at the latest, in order to give adequate transition time between the disclosures to the plans and subsequent disclosures to the participants.

To learn more about 408(b)(2) disclosure requirements, visit the following resources:

• Our March 3rd webinar with ERISA attorney Fred Reish-The Fiduciary Trend: The Combined Effects of the Proposed Advice Regulation and 408(b)(2)
• The DOL website for final 408(b)(2) rule requirements and fact sheet
• Commentary from the law firm of DrinkerBiddle

Fiduciary Debate Evades, and is Finally Caught, in Partisan Crossfire

The old adage, ‘History Repeats Itself,’ threatens to prove its validity once again at the SEC. For those of us who remember the halcyon days of the longest-serving SEC chairman, Arthur Levitt, one of his biggest headaches was finding a quorum for an SEC meeting. Forget for a moment that he oversaw the agency during one of the longest running bull markets in U.S. history. That undoubtedly made his job a lot easier. Levitt liked to joke about needing to avoid running into another commissioner in the halls of the SEC and inadvertently violating the public meeting notice requirement. At the time, it seemed more attention was paid to keeping the five seats on the Commission filled than what the independent agency was actually doing.

Less noticed were Levitt’s diligent efforts to achieve consensus before a public vote by the commissioners. Levitt was carrying on an unstated tradition at the agency that a unified front was vital, and that it was far better to delay a vote and resolve differences behind closed doors than air them in a public forum.

Efforts at civility collapsed after hard-charging New York Attorney General Elliott Spitzer upstaged the SEC in 2003 by filing complaints against several SEC-regulated mutual fund groups for late trading. The SEC, suddenly awake and irritated by Spitzer’s grandstanding, uncovered front-running practices as well and, as is typical after a scandal, turned to the policy front to prevent any future embarrassments.

It was here that fissures in the bipartisan wall at the Commission started to appear when Donaldson, a Wall Street executive and Bush family friend appointed to calm the agency, sided consistently on major rules with the two appointed Democrats in 3-2 votes.

Bipartisanship hit a low point with the SEC’s independent fund director’s rule in 2005, which would have required an independent chairman for each mutual fund. The U.S. Chamber of Commerce immediately challenged the SEC in federal court. It was at this juncture that some observers first noticed subtle overtones of a fiduciary dispute in the background of the commission spats. If you were for the independent director’s rule, you were pro-fiduciary and pro-shareholder; if you were against, you were pro-management and anti-fiduciary. Donaldson was called to testify by the Senate Banking Committee, where Republican senators found the new divisions “troubling” and “disturbing.” The Republican commissioners who opposed the director’s rule called for more economic study and claimed the SEC ignored a Fidelity study favoring management directors.

The political rift was further exacerbated by the SEC’s subsequent rule to register hedge fund advisors. Again, a partisan 3-2 vote resulted, with the debate playing out in a lawsuit by hedge fund manager Phillip Goldstein, including a related argument over whether the fiduciary duty of the advisor was to the fund or the fund’s investors. The U.S. Court of Appeals for the D.C. Circuit flatly stated advisors were fiduciaries to the fund, not its investors, although its primary basis for vacating the rule was something else.

Following this split-vote trend, after the Financial Planning Association sued the SEC over the so-called “Merrill Lynch rule” permitting brokers to offer fee-based advisory programs without being subject to the fiduciary requirements of the Advisers Act, one would have thought the same voting pattern would have been repeated. For once, however, this same Commission pulled together in the midst of their public feuding and voted unanimously for the final rule. Here again, though, new fissures opened, this time on the staff level. After the FPA filed suit, shortly thereafter the SEC re-opened the proposed rule for additional comment. When the final rule was adopted, several commissioners publicly scolded SEC staff involved in the re-drafting for undisclosed turf disagreements between the division overseeing brokers and the division overseeing advisors. This rule, like the fund governance and hedge fund rules, was thrown out by the D.C. Circuit court.

Fast forward to 2009. Enter the Obama Administration and financial services reform in the midst of a financial crisis. All new faces on the Commission since the Donaldson regime, and presumably a clean slate to work from, except for a surprising emphasis by the Administration on a fiduciary requirement for brokers. Almost as if a magic wand had been waved and memories vanquished, two earlier critics of a fiduciary duty, incoming chairman Mary Schapiro and her FINRA colleague Elisse Walter, were now strong supporters on the Commission, with no apparent explanation for their sudden conversion. Along with Commissioner Luis Aguilar, who was the first commissioner ever to unequivocally support a fiduciary mandate for brokers providing retail advice, the political dynamics had suddenly changed. But similar to the earlier partisan disputes in 2004-2006, the new Republican commissioners, Kathleen Casey and Troy Paredes, called for delays and more study on a fiduciary standard’s economic impact.

This brings us to the present. The good news, as we all know, is the fiduciary issue is no longer in the policy closet gathering dust. The bad news is that it has become a partisan football where reasoned discussion over its merits is an unwanted stranger. Certainly studies filling an information void should be welcomed by policymakers, and a cost-benefits analysis is certainly lacking in the fiduciary debate. But prematurely assuming the worst --that a fiduciary standard will displace clients, reduce the number of advisors, and increase cost of services, as the Republican commissioners and Members of Congress have implied -- is wildly speculative. Forestalling a fiduciary standard without any grounds for doing so is a weak excuse when it would be far easier to closely examinine the existing fiduciary advisory practices that have flourished over the years.

Yet today the SEC and Congress find themselves in redux on this and many other issues, with frequent public dissents by commissioners, an activity once called a “rare display of conflict” by the trade press. Conversations with insiders at the agency indicate significant policy differences remain between the two SEC division staffs in addition to the more public ones among the commissioners.

It is still very likely that the Commission will proceed and adopt a fiduciary standard for brokers’ retail advice, if not by the end of this year, then definitely by the end of 2012 if a Republican Administration is elected. Witness the quick 3-4 day turnaround by the SEC under Donaldson in adopting a revised fund director’s rule only a few days after an adverse ruling in U.S. Chamber v. SEC, and on the day of his resignation.

Or, what is also possible – although it is too early to detect rumblings about a lawsuit – would be if the Chamber, SIFMA, or a large broker-dealer challenged the SEC fiduciary rule for brokers in court, alleging ‘arbitrary and capricious’ conduct by the SEC in ignoring the lack of economic data. Presumably this would buy time until a new Administration repeals the rule. Something of the reverse has happened before, but under ERISA and without the pressure of a lawsuit. A controversial fiduciary adviser rule was adopted by the Bush administration within days of President Obama’s inauguration but strongly opposed by consumer and labor groups. Shortly after the administration change, the newly appointed leadership at the Department of Labor suspended it and re-proposed a modified rule one year later.

Shakespeare’s famous quote, “What’s past is prologue,” was never more true in the rough and tumble politics that are becoming all too common at the SEC. 'Fiduciary' is just the latest political football to be caught in the vortex.

CFP Board Case Histories: Analysis of a Planner’s Fiduciary Duty can be Unnerving at Times

For the brokerage industry, still bracing for the impact of a sweeping fiduciary standard by the SEC, there is a new canary in the coal mine.  It’s called Anonymous Case Histories, or ACH, courtesy of the CFP Board of Standards.  As a compilation of various disciplinary events covering the waterfront of advisory issues, a search of the ACH site is a must for financial advisors and their compliance officers.

Granted, to-date only a small number of the CFP case histories posted are related to fiduciary issues, but that is bound to change over time.  A recent search using the term ‘fiduciary duty’ turned up eight fiduciary cases, and of these, only six had practical application to client situations.  These were informative, nonetheless, even though all  of them preceded the Jan. 1, 2009, effective date of a broad fiduciary duty for CFP certificants and, as summaries, were lacking at times in the kind of useful detail to be found in court cases. 

One case in particular highlights the travails that can face a well-meaning fiduciary advisor, depending on your interpretation of due diligence.  The case in question was a litigation matter self-reported by a certificant.  The CFP designee – let’s call him Smith - and his partner were sued by the wife of the deceased client, the wife alleging negligence and misrepresentation on the part of Smith, resulting in a consequential error on the husband’s life insurance application.  The case began with Smith recommending the couple increase their life insurance coverage by purchasing new term policies.  Smith completed the husband’s $1 million policy application by phone, and a $250,000 policy for his wife, mailing both to the couple for their signatures.  In the initial client interview, the husband had indicated he did not have any DUI convictions in the past five years and confirmed this in the telephone call with Smith.  The old $300,000 policy was allowed to lapse, and sometime later the husband died in a single-car accident.

SEC Backlog Leaves Self-Dealing Loophole Intact

Last December, the SEC approved the second extension of a ‘temporary rule’ making it easier for brokerage firms to self-deal under the Investment Advisers Act of 1940.  The latest extension of the rule, first adopted in 2007, carries on through the end of 2012.

The rule in question, 206(3)-3T, significantly loosened the original principal transaction restrictions for investment advisors.  That provision of the law requires an advisor selling stocks or bonds out of its own inventory to inform the client in writing and receive consent prior to executing each principal transaction.  Of course, few investment advisors engage in principal transactions, so this provision of the law gathered dust for nearly 70 years until the wirehouses lobbied the SEC for relief after an increasing number of their registered reps began to register as investment adviser reps in the early 2000s.  Under ERISA, such activities would be strictly prohibited, offering additional support to the Department of Labor’s claims that its own fiduciary protections provide the highest standard under federal law.

In what is a familiar line up of public commenters, advisor and consumer groups generally opposed the original temporary rule, and the brokerage industry supported it.  The temporary rule essentially streamlines compliance by allowing broker-advisors to secure a blanket, revocable consent in advance from the client for principle trades, along with a boilerplate disclosure of the conflicts and how these would be managed while acting in a fiduciary capacity.  It also includes several other restrictions by prohibiting self-dealing in discretionary accounts and banning trading in stock or bond issues where the broker-dealer serves as an underwriter, except for investment grade bonds.  Many proponents of a strong fiduciary standard argue that it is impossible to manage such conflicts where loyalty to the firm and client is so clearly at odds.

So far the SEC claims the temporary rule is working, stating there is no evidence of dumping of devalued stocks or bonds into client accounts, although it has admitted to finding numerous technical problems with compliance.  In addition, former SEC Investment Management Division Director Buddy Donohue last summer notified SIFMA, Wall Street’s lobbying organization, that it did not plan to renew the temporary rule, saying that only a ‘few’ firms used the exemption.  The SEC then contradicted itself several months later by saying ‘some’ firms were relying on the rule, and therefore needed to extend it yet again.  However, the Commission didn’t offer the number of firms relying on the rule or an explanation for the discrepancy with the Donohue missive.

The latest wrinkle is twofold.  First, in extending the temporary rule another two years, the SEC’s proposing release stated that it intends to address principal trading issues in a final rule imposing a fiduciary standard on brokers, therefore allowing 3T to lapse in 2012.   Thus there is an assumption that a fiduciary rule will be in effect no later than Dec. 31, 2012.  Although many observers remain confident that the SEC will muster enough political courage to adopt a fiduciary standard for brokers in the face of strident House opposition, the clock is ticking down.  Secondly, the Dodd-Frank Act also required the SEC and other federal agencies to purge from their regulations any reference to credit agency ratings, and to report back to Congress on actions taken.  Since 3T is a temporary rule, it appears likely that the SEC will use this as a basis for ignoring the temporary rule’s current reliance on bond ratings, even as it has begun removing references to the ratings agencies under other securities rules.

Given these mixed signals coming from the SEC, and in particular by not offering any details on how brokerage firms are managing their fiduciary duty of loyalty in the presence of sloppy compliance, the possibility that credit ratings for principal transactions will likely be left in place is not reassuring news that the SEC is serious about a strong fiduciary duty.

"The price of reform is a small one compared to the cost of crisis"

Throughout the comment periods for the SEC staff's fiduciary study and the DOL's recent proposal to update the definition of fiduciary, it has been perplexing to hear the increasing rhetoric claiming that expanding fiduciary protections will kill business. Over and over again, we have heard the request for a thorough cost-benefit analysis followed by a summary conclusion that such analysis likely will show that costs outweigh the benefit of fiduciary reform. 

This leaves us asking what exactly is the cost of principles?  Should we only adhere to fiduciary principles and putting the client’s interest first when it is good for business?  Congress certainly didn’t think so when it passed the Investment Advisers Act in 1940 and ERISA in 1974, and it's hard to imagine why Congress or anyone else would take a different view now at a time when our economy is still recovering from severe market failures and investors are sitting on the sidelines holding their money outside of the market.