Disclosures and Knowing Consent

If the SEC goes ahead and issues some sort of 'harmonized,' disclosure-heavy fiduciary status rule, it will perpetuate unnecessary costs for many individual retail investors, writes Scott Simon.

W. Scott Simon


Last week, the U.S. Department of Labor (DOL) announced that, yet again, it will postpone issuance of its redefinition (more formally, “Conflict of Interest Rule-Investment Advice”) of what it means to be a “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA) to January 2015. As a result, many of the Big Stockbrokerage Firms, Big Insurance Companies, Big Consulting Firms, Big Mutual Fund Companies, et al. that do business in the retirement plan marketplace remain content because their business models–which may be riddled with hidden (and therefore high) costs and impenetrable conflicts of interest–continue in existence, unmolested by any pesky regulators.

In addition to that marketplace, many such entities do business in the marketplace of individual retail investors. In one way or the other, these entities are regulated by the U.S. Securities and Exchange Commission (SEC) through securities laws. For example, stockbrokerage firms and their registered representatives (i.e., stockbrokers) are regulated by the 1934 Securities Exchange Act, which includes the suitability standard that governs the conduct of, well, stockbrokers.

The lobbyists for the trade associations which these entities belong to came out immediately after the DOL announcement to make it clear that the SEC should press ahead with its own fiduciary rule-making and not wait around for the DOL to get its act together. One such lobbyist representing large broker- dealers asserted that any DOL redefinition “should appropriately reflect the input of all market participants and continue to protect investor choice and access to investment guidance.”

Another lobbying group noted that a redefinition should “ensure small investors can continue to have access to affordable, objective financial advice.” Its website boasts that “over 5,000 personalized letters to the White House led to the DOL withdrawing their proposed redefinition of the term fiduciary, preventing millions of Americans to be priced out of financial advice on their IRAs.” Another lobbying organization representing the insured retirement income industry stated that no fiduciary redefinition should “deprive lower- and middle-income Americans from accessing affordable retirement planning services and advice…”

Any sentient human being with any knowledge of this long-running fiduciary wrestling match knows that this (relatively) newfound mantra of deep concern for the well-being of Main Street investors (whether at the individual retail level or the retirement plan level) has little to do with the well-being of Main Street investors. Rather, it has just about everything to do with the well-being of many Big Stockbrokerage Firms/Big Insurance Companies/Big Consulting Firms/Big Mutual Fund Companies, et al. that manufacture and distribute high-cost products and services to Main Street investors.

The president of a large “diversified financial services company” let the proverbial cat out of the bag when he said recently that he didn’t think that any DOL proposal to redefine the meaning of fiduciary was “healthy for the industry.” The “industry,” of course, is a reference to certain Big Stockbrokerage Firms/Big Insurance Companies/Big Consulting Firms/Big Mutual Fund Companies, et al. and their business models.

The lobbyists for the trade associations, as noted, quickly came out of the blocks after the DOL announcement to urge the SEC to issue its own fiduciary rule-making rather than wait for the DOL to promulgate its redefined fiduciary rule. These lobbyists want the SEC to write a rule that will be heavy on disclosures which, of course, must be limited in scope so that the various ways by which many financial intermediaries make money from individual retail investors and plan participants as well as the interlocking relationships that give rise to the material conflicts of interest by which this money can be made will continue to be largely concealed. And the big bow that ties up such a rule is that these intermediaries will get to be called a “fiduciary.” The worst of all possible worlds.

Disclosure Dilemma

The first problem with disclosures, of course, is that very few people (investor or otherwise) ever read them. The second problem is that disclosures rarely (or never, more likely) fully and completely lay out all the material facts in the relevant situation. So even in cases where investors do read disclosures, they are prevented from having a full account of all material facts–much less a complete understanding of all the costly and legal ramifications that can flow from those facts. It’s just not possible for an investor to legally “consent” to a conflict of interest without being presented with full and complete disclosure of all material facts and the oftentimes numerous consequences thereof. As a result, it’s almost never the case that an investor can give what I call “knowing consent” to a conflict of interest.

Here are a few examples of some truly opaque disclosure language that I’ve run across over the years:

From a Big Stockbrokerage Firm: “You are authorized to act on my behalf even though you or any [Big Stockbrokerage affiliate] may have a potential conflict of duty or interest in a transaction.”

Well, is there a conflict or not in a given investor’s situation? If there is, what are the actual costs to the investor of that conflict? No investor should be required to try and figure out any of these impenetrable disclosures.

From a Big Insurance Company: “Both [Big Insurance Company] sales reps and their managers, as well as the reps and managers of [Big Insurance Company affiliates] may be eligible for additional cash compensation such as bonuses, equity awards (such as stock options), training allowances, supplemental salary, financial arrangements, marketing support, medical and other insurance benefits, and retirement benefits as well as other benefits based primarily on the amount of proprietary products sold. Because this additional cash compensation is based primarily on the amount of proprietary products sold, [Big Insurance Company] sales reps and [Big Insurance Company affiliates] sales reps and their managers have an incentive to favor the sale of proprietary products. [Big Insurance Company affiliates] sales reps must meet a minimum level of sales production to maintain employment with [Big Insurance Company]. [Big Insurance Company] sales reps must meet a minimum level of sales of proprietary products to maintain employment with [Big Insurance Company].”

From a money manager: “While we have a fiduciary duty to be objective and recommend investments based exclusively upon your best interests, we receive payments from mutual fund companies that may undermine the objectivity of the advice we provide to you.” Actually, this one seems pretty cut-and- dried: The fiduciary duty to be objective is stated plainly but then that duty may be breached when some incentive payments enter the picture. In short, such advice isn’t worth squat. As the legendary Rex Sinquefield said: “Poor performance isn’t cheap; you have to pay dearly for it.”

From a Big Consulting Firm: “It is conceivable that [Big Consulting firm] may have an incentive to provide information regarding the investment strategies of other investment managers for use internally before providing such information to clients. It may also have an incentive to rate strategies selected for clients of [Big Consulting firm’s affiliated registered investment adviser offering a proprietary multi-manager platform] higher than those of other similar managers, or to rate higher the investment strategies of investment managers with whom it has negotiated a discounted fee.”

From a Big Insurance Company: “[Employer] acknowledges that [Big Insurance Company] has disclosed to [employer] through the Services Agreement and related documents that [employer] confirms it received and understands: (1) the nature of [Big Insurance Company’s] business relationships with each issuer of a funding vehicle that may be used in the plan; (2) a description of [Big Insurance Company’s] receipt of compensation payable by each funding vehicle; (3) a description of [Big Insurance Company’s] receipt of all other compensation payable in connection with the Services Agreement; and (4) a description of the charges, fees, penalties or other adjustments that may be imposed under the funding vehicles.”

If the SEC goes ahead and issues some sort of “harmonized” rule conferring fiduciary status on the kinds of entities that have fashioned opaque disclosure language like the preceding examples, we can be sure that we will see a continuation of same. Without a doubt, that will perpetuate unnecessary costs for many individual retail investors.

Anyone experienced in dealing with individual retail investors or plan participants knows the serious limitations of a disclosure-only system. Many investors simply cannot recognize–and knowingly consent to–conflicts of interest (and their ramifications) even when they are “disclosed.” Even fiduciaries at large sophisticated businesses charged with shepherding multi-billion dollar 401(k) plans cannot seem to fathom conflicts, whether disclosed or not. The last few years of litigation in the ERISA arena involving the retirement plans at Wal-Mart, ABB, Edison International, et al. prove that assertion beyond a shadow of doubt. So how are we to expect that mom-and-pop plan sponsors or individual retail investors will have a knowing understanding of conflicts of interest–assuming, of course, that they are even disclosed adequately in the first place?

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.

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