The Securities and Exchange Commission released its final rule on broker and investment advisor standards of conduct in June. Now that observers have had time to digest the over 1,400 pages, several legal experts say it significantly weakens the fiduciary standard for registered investment advisors—so much so that some are now pushing for state regulators to take up the slack and heighten investor protections.
“[RIAs] are still fiduciaries, but the SEC redefined what an investment advisor fiduciary standard is,” said Brian Hamburger, president and CEO of MarketCounsel, a business and regulatory compliance consulting firm to investment advisors.
A group of 12 prominent law professors, including former Republican SEC Commissioner Roberta Karmel, wrote a letter expressing concern over the SEC’s reinterpretation of advisors’ fiduciary duty.
“The SEC came out of this process by lowering the standard for investment advisors much more than they raised the standard for brokers,” said John C. Coffee, Adolf A. Berle professor of law at Columbia University Law School, one of the authors of the letter. Coffee estimates that the standards for broker/dealers were raised by 10%, while the standards for RIAs were lowered 75%.
Critics point to three major changes to the common law interpretation of the fiduciary standard that weaken requirements for RIAs: In the original proposal, the rule said firms must put clients’ interests first; now, it simply says firms must not subordinate their clients’ interests to their own. Second, the original proposal said advisory firms needed to avoid any conflicts of interest, and then mitigate conflicts when they arise. Now, the ruling has changed that to avoid conflicts, “or” mitigate them. Third, the ruling removed language requiring advisors not to favor one client over another; that requirement has been demoted to a footnote.
Seemingly minor changes to language, yet the repercussions could be significant, these lawyers say.
“To not make the client worse is not the same thing as saying, ‘Put your client’s interest first,’” Coffee said. “There could be cases where you can make your client better off, and you aren’t doing it.”
For example, an advisor “might know that there is a much cheaper product out there offered by a competing firm, but they don’t tell you about it. They didn’t subordinate your interests, because they didn’t change anything, but they could’ve told you about a better opportunity, a better product offered by a competitor.”
The removal of the need for advisors to “seek to avoid” conflicts, and instead go straight to disclosure as a mitigation measure, has sparked most of the debate. The final proposal says, “an adviser must eliminate or at least expose through full and fair disclosure all conflicts of interest which might incline an investment adviser—consciously or unconsciously—to render advice which was not disinterested.”
“What that means is that if I just used to have to seek to avoid a conflict of interest first and then mitigate the impact, now they can just skip the avoidance altogether and simply mitigate the impact then and disclose what remains,” Hamburger said.
Barbara Roper, director of investor protection at the Consumer Federation of America, says the traditional advisory business was set up to avoid conflicts of interest; there weren’t revenue-sharing arrangements, proprietary products being pushed, or different share classes being sold in advisory accounts. “That’s not the case anymore at dual registrant firms,” she said.
“[The SEC says] you can’t place your interests ahead of the customer’s interests, but they make it pretty clear that as long as you disclose it, in an ADV Form that for some of these firms can be over 100 pages long, then that means you’ve got informed consent from the customer and you can go right ahead recommending the higher class option or the share class that pays you more.”
In a footnote on this change, the SEC cites SEC vs. Capital Gains Research Bureau, a 1963 Supreme Court case that many say imposed a fiduciary duty on investment advisors. The lawyers, in their letter, argue that the SEC misinterpreted that decision:
“It was a ‘scalping’ case in which the defendants repeatedly purchased a stock and then recommended it to their many clients, profiting when the stock went up. The lower courts had dismissed the Commission’s enforcement action against these defendants because no loss to investors was shown. An intent to injure investors was necessary, they said. But the Supreme Court disagreed, finding that the term ‘fiduciary’ had to be interpreted not under common law standards, but under broader equitable principles… In short, the investment adviser must seek to avoid conflicts of interest, not merely disclose them.”
Ronald Rhoades, director of Western Kentucky University’s Financial Planning Program, agrees, arguing that the Supreme Court actually said they could go further, but in that case, the SEC was only asking for a breach of fiduciary duty based on failure to disclose—something easy to prove—as opposed to properly managing the conflict.
“The SEC has interpreted SEC versus Capital Gains incorrectly,” Rhoades said. “It does not stand for the proposition that once you disclose a conflict of interest, you’re free to do what you want. When you disclose a conflict of interest under a bonafide fiduciary standard, you still have to properly manage the conflict, so that the client is not harmed.”
“The industry is quite happy because the industry says, ‘We had a conflict. And there was a disparity in the duties, and we’re now sort of all in the muddy middle,’” Coffee said.
The Investment Adviser Association, an advocacy organization for investment advisors, does not share the view of critics that the standard has been weakened. General Counsel Gail Bernstein says the SEC’s changes don’t materially impact her members. The removal of “client’s interests first,” for instance, was done because there are circumstances where that literally couldn’t be true.
“For example if you have more than one client and you allocate a limited investment opportunity, or you trade along your clients, which a lot of advisors do because they want to show their clients that they’re investing in the same things that their clients invest in,” she said.
The “client interests first” language is preserved in a footnote, she adds, and SEC Chairman Jay Clayton reaffirmed in a speech that this is still an obligation, “The Fiduciary Interpretation confirms the Commission’s longstanding view that an investment adviser must, at all times, serve the best interest of its client and not subordinate its client’s interest to its own.”
The IAA takes no issue with the “seek to avoid” change and believes that the final interpretation makes it clear in various places that you can’t just disclose conflicts; advisors still have to act in clients’ best interests.
“We think that when you read [the interpretation] as a whole, it really strongly reaffirms the fiduciary duty and to us, it makes pretty clear that you have to identify your conflict, you have to figure out how you’re going to manage them, and whatever happens you cannot let those conflicts taint your advice,” Bernstein said.
In a request for comment, an SEC spokeswoman pointed to Clayton’s speech, where he said much of the criticisms around the fiduciary standard interpretation were false and misleading and that the standard was as strong as ever.
Can It Be Challenged?
The concerns raise questions about whether any of this will be challenged in Congress or in the courts, but prospects look dim. When rules are challenged in courts, it’s typically based on a violation of the Administrative Procedure Act, but this is not a rule-making, Roper says; it’s an interpretation.
Further, litigation is costly, Rhoades said, and the push wouldn’t be coming from well-financed insurance companies or broker/dealers.
“The advisory community and the consumer groups here would be hard-pressed to come up with enough money to fund one lawsuit, and that lawsuit is going to take a year and a half, two years,” he said.
Many say it will take a Democratic administration in Washington—and a Democratic SEC—to see any movement on the issue. Coffee believes we’d need three Democratic commissioners in there, and that would take some time. That would also depend on who’s in control of the Senate review of nominees.
“If you amend this once, you can amend this back again,” Coffee said. “I don’t think this is going to change under an SEC that is dominated by Republicans. I’m not saying they’re corrupt or evil; I’m just saying they took the path of least resistance and greatest deference to the industry.”
Hamburger says he was originally reluctant to advocate for state legislative bodies to create their own fiduciary rules around financial advice in favor of a national standard. But now, given how the SEC has taken the teeth out of the fiduciary interpretation, he’s changed his mind.
“We support a true fiduciary standard for any investment professional who offers or appears to offer investment advice to retail investors,” Hamburger wrote in a recent comment letter to New Jersey’s Bureau of Securities in support of that state’s aggressive effort to mandate a fiduciary standard for advisors operating there. “Reg BI does not provide this protection and results in further confusion to consumers. That is why we support New Jersey’s fiduciary proposal.”
As investment advisors get larger, they’re finding themselves having to deal with more conflicts of interest, Hamburger says. And given the RIA channel was historically built on trust and a lack of conflicts, the industry should work to preserve that, he adds.
“I think that the trade groups are paying attention to the needs of their larger members who are saying that we need a little bit of relaxation when it comes to the legal standards of care or we need some relief when it comes to dealing with conflicts of interest,” he argues.
“What brought investment advisors to such great prominence over the last couple of decades has been that despite the volatility in the markets, they've been a trusted beacon that clients can turn to and develop a greater trust than clients typically have with brokerage firms. So I think that trust element is essential for investment advisors to continue to operate at a higher paradigm than broker/dealers.”
