Uniform Fiduciary Standard – A Regulatory Trojan Horse

The SEC appears to be on the verge of adopting a universal fiduciary standard for all financial professionals.  On the surface, this appears to be a big leap forward for investor protection and it’s being hailed by many as a foolproof way to align the interests of investors with those of the industry.  But don’t be fooled by this regulatory Trojan horse – like most major regulatory initiatives, this will benefit the investment industry at the expense of investors.

At issue is the blurring of the different standards of investor protection that distinguish traditional stockbrokers form registered investment advisers (RIAs).  Brokers are held to a rules-based suitability standard whereas RIAs have been deemed by the courts to have a fiduciary duty to their clients.  In recent years, a hybrid model has emerged whereby financial professionals are registered as both brokers and investment advisers, a practice known as dual registration.

We’re the first to acknowledge that, in its purest sense, the fiduciary standard is the holy grail of investor protection.  However, that’s not what investors currently get and as we see it, things are going to get worse.  Fiduciary protection today is predicated on a game of disclosing, not eliminating, the inherent conflicts of interest between investors and the investment industry, so the very essence of the fiduciary protection gets disclosed away.  Creating a universal fiduciary standard that extends to all financial professionals dispensing investment advice entails defining the concept of fiduciary duty, and that’s where the real trouble starts.

Rules vs. concepts

Fiduciary duty, as applied to the investment industry, is not uniformly defined by regulators.  In fact it wasn’t until a 1963 United States Supreme Court decision that investment advisers were deemed to be fiduciaries.  The Court held that investment advisers were required to “…eliminate, or at least [to] expose, all conflicts of interest…”

Fiduciary duty as we know it today is a legal concept rooted in common law (unlike the suitability standard which is based on regulatory rules) and that is the magic of it.  The courts, where judges have the ability to hold the investment professionals’ feet to the fiduciary fire, generally resolve disputes between RIAs and investors.  RIAs understand this and tend to play it safe; they don’t want their fate to rest in the hands of a judge who actually understands the concept of fiduciary duty.

The new universal fiduciary standard is going to be defined by regulators, and therefore it will be rules-based.  Once you lay out a new set of rules, participants immediately find loopholes, and Wall Street loves loopholes.  It’s our view that once all the loopholes are factored in to the new universal fiduciary standard, investors will receive even less protection than they currently do under the already watered down existing standard.

The Securities Industry and Financial Markets Association (SIFMA) has called for a “universal standard of care.”  We agree with them that the term fiduciary should be dropped, as the end product of this process will not come close to resembling a genuine fiduciary obligation.

Rule making and enforcement

Who is going to write and enforce these new rules?  We’d put our money on the Financial Industry Regulatory Authority (FINRA) popping out of this Trojan horse.  FINRA, the private corporation that currently acts as the brokerage industry’s self-regulatory organisation (SRO), has been lobbying the halls of Congress very aggressively to land the job of running a proposed SRO for RIAs (see our commentary FINRA – An Ineffective Regulator).

Among many things that FINRA does is operate a mandatory binding arbitration system for disputes that may arise between brokers and investors.  It’s widely acknowledged that FINRA’s arbitration system is rigged in favour of the industry.  It’s foreseeable that FINRA will insist that disputes under this new universal fiduciary standard be resolved via their arbitration system.  Arbitration panels that are hand picked by the industry and have little understanding of fiduciary obligations will decide investors’ disputes.

It’s our view that SEC Chairwoman, Mary Shapiro (who formerly ran FINRA) is holding off on moving forward with a uniform fiduciary standard until this new SRO is up and running, with her old cronies at FINRA calling the shots.

Be careful what you wish for

It’s ironic that some of the most vocal supporters of a uniform fiduciary standard are also the most vocal opponents of FINRA getting their hands on this proposed new SRO.  These supporters should be careful what they wish for – we suspect there’s an unpleasant surprise in that Trojan horse.

A uniform fiduciary standard may sound like a great idea, but when we factor in reduced investor protection and the likely FINRA involvement, we see a scenario where these newly minted fiduciaries, not the investors, will be the real winners.

We continue to believe that the SEC can end this debate once and for all by banning dual registration.  Investment professionals need to decide if they want to be an investment adviser or a broker, they can’t be both.  Regulators should resist the temptation of reinventing the fiduciary wheel to accommodate this new hybrid business model.

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