W. Scott Simon
What I’ve described in this column over the years as the “Fiduciary Wars” continues unabated, with the latest battle being waged by the U.S. Securities and Exchange Commission when it issued Regulation Best Interest on June 5.
I’ve also pointed out more than once when discussing these wars that it is impossible to fit a square peg into a round hole. This irreconcilability refers to the nature of the two diametrically opposed business models–suitability-based and fiduciary-based–which prevail in the investment world of nonfiduciaries and fiduciaries, respectively.
The fiduciary duty of loyalty–the fundamental, underlying fiduciary duty that undergirds all others–is absent from Reg BI. That isn’t surprising because, despite the misleading term “best interest,” Reg BI does not, because it cannot, magically transform nonfiduciaries such as registered representatives (that is, stockbrokers) into fiduciaries, legally.
Try as it might, the SEC couldn’t–in 1,363 pages of regulations, just as the U.S. Department of Labor couldn’t in nearly 2,000 pages of its own Conflict of Interest Rule regulations–make the square peg of the business model followed by nonfiduciaries fit into the round hole of the business model followed by fiduciaries.
The net result of the SEC’s Rube Goldberg-like exertions is nothing more than a cacophony of words that muddies the waters even further, making it even more difficult for investors to know and understand the crucial differences that characterize how an investment fiduciary and a nonfiduciary each engage in business.
Some commentators–even in the fiduciary camp–admit grudgingly that Reg BI is good because nonfiduciaries are now forced to make additional, needed disclosures. And that’s supposed to be a good thing … how? It is not, but instead it is a terrible thing because it provides the marketing departments at wire houses an open field to run wild in portraying the advantages of Reg BI to investors. This includes messaging how nonfiduciaries must now place the best interests of their customers ahead of their own, making them sound like fiduciaries. But they aren’t, any more than they were in the caveat emptor world in which they operated prior to issuance of Reg BI–and the world in which they continue to operate.
The fact is, nothing has changed for the better with issuance of Reg BI, in my view. Its sum and substance are simply the suitability rule all over again, plus added disclosures. Those disclosures can now be explained to investors with more “flexibility.” Usually it’s a good thing when the government allows the private sector to have some flexibility when dealing with the government and/or the public. But to the ears of this fiduciary, that word is a dog whistle for giving the wordsmiths in marketing departments at wire houses the green light to write disclosures that confuse investors with even more double-talk and blanket the media with new and more creative ways to spread gibberish.
Everyone knows, especially lobbyists for nonfiduciaries, that no one (including investors) reads disclosures in any sphere of daily life. That’s one reason, of course, why these lobbyists pushed so hard to get more “flexible” disclosures of conflicts added to Reg BI. That way, they could rope-a-dope the SEC into believing that adding such disclosures would be a good thing because it would enhance investors’ understanding. (I was once involved in trying to understand the labyrinth of fees charged by a wire house when attempting to offer fiduciary services to an $80 million nonprofit. In the disclosures, the wire house provided the customary “your fees might be higher if other [unnamed, of course] parties are involved, blah, blah, blah.” When I asked how much those fees were and who they want to, I was met with dead silence, of course. When I prompted the nonprofit, the existing client of the wire house, to also ask– same result. In such cases, it seems that a nonfiduciary would rather lose the business than provide accurate information even to its existing clients. Of course, many such clients never read the small print and have no idea that they’re being had.)
Even when investors do read disclosures, they don’t do so with knowing understanding. But not to worry. Your friendly nonfiduciary will help you understand those confusing disclosures with the aid of a series of “conversation starters” that Reg BI obligingly inserts here and there. Kind of makes you think of FDR’s fireside chats on the radio. Those nonfiduciaries are just plain old helpful folks sitting down with investors and having earnest conversations.
And it may very well be that a poll would show that 90% (or even 99%) of nonfiduciaries are earnest folks, just wanting to do good for their customers. The problem is that, whether or not they know it, the legal standard, the business model, under which nonfiduciaries operate is inherently conflicted. It’s not by chance that the DOL rule was titled, in part, the Conflict of Interest Rule.
The business model followed by a nonfiduciary registered representative such as a stockbroker necessarily creates conflicts of interest with a customer because the interests of the two parties must clash. That’s because a representative is under a legal requirement–the suitability standard of conduct under the Securities Exchange Act of 1934 (’34 Act)–to maximize revenue (within the bounds of suitability) for its broker/dealer employer. So even though nonfiduciaries cannot be fiduciaries to their customers by law, they must be fiduciaries to their broker/dealer masters–their employers–by the same law. In short, a registered representative represents its employer, not its customer.
There will be a tidal wave of marketing sweeping across the land courtesy of the nonfiduciary industry with a subliminal message: “Folks, we’re just like fiduciaries–heck, we might as well be fiduciaries.” Because of the much smaller amounts of money available to the fiduciary industry, its response will be relatively feeble in comparison. Perhaps it could include something like: “Brokers are Fiduciaries to Their Employers, Not Their Customers.” Or even paraphrase Chevy Chase from his old Saturday Night Live sketches: “I’m a Fiduciary and You’re Not.”
A nonfiduciary such as a broker is driven (consciously or not) by its business model to increase revenues for its broker/dealer employer because it is legally required to do so given the fiduciary duty it owes to the broker/dealer. This often results in voracious, revenue-maximizing conduct on the part of the nonfiduciary that’s wholly acceptable legally as long as the financial products the nonfiduciary recommends meet the suitability requirements of the ‘34 Act (and now the added disclosure requirements of Reg BI). Of course, the nonfiduciary’s clients are on the other end of that greedy conduct and, as a result, must bear (often unknowingly) its detrimental consequences.
It’s now apparent why a square peg cannot fit into a round hole: the continuous presence of an 800- pound gorilla that sits between nonfiduciaries and their customers and legally demands fealty from those nonfiduciaries at (oftentimes great) financial expense to their customers. This is the Mother of All Conflicts of Interest in the investment world and, from it, many other conflicts inherent in the non- fiduciary business model flow. Regulation BI does nothing to change that central reality–even if the SEC had issued 10,000 or 100,000 pages of regulations.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.