W. Scott Simon
Retirement plans qualified under the Employee Retirement Income Security Act of 1974, as amended (ERISA), are governed by a dizzying array of regulations and laws that require great expertise and knowledge to master.
This complexity includes the framework of securities law that applies to those providing “advice” to sponsors of retirement plans. The term advice is placed in quotes here because pretty much everyone who has something to say about the goings-on in the retirement plan industry fails to mention that the U.S. Securities and Exchange Commission (SEC) has affirmatively chosen not to enforce certain laws already on the books. The repeated failures to exert leadership–nay, even more basically, to enforce the law–has largely contributed to the current fiduciary wars.
The Investment Advisers Act of 1940 (’40 Act) defines an investment advisor as any person or firm that, for compensation, is engaged in the business of providing advice to others or issuing reports or analyses regarding securities. A broker, in contrast, is defined by the SEC as “any person engaged in the business of effecting transactions in securities for the account of others.”
There’s a broker-dealer exemption in the ’40 Act, and it’s quite specific: “In general, a broker-dealer whose performance of advisory services is ‘solely incidental’ to the conduct of its business as a broker-dealer [i.e., effecting securities transactions] and that receives no ‘special compensation’ is exempted from the definition of investment adviser.”
As a result, the ’40 Act clearly delineated the roles of those who give ongoing advice (fiduciaries) from those who sell products on a transaction-by-transaction basis (non- fiduciaries). For many years, this arrangement required fiduciaries to meet the best interest fiduciary standard of the ’40 Act while protecting non-fiduciaries that were not in the business of providing ongoing advice from having to comply with that standard.
Over time, however, brokers could see that there was a lot more money to be had on the fiduciary side of the ledger than on the non-fiduciary side that they were stuck on. They began to encroach more and more on the turf of fiduciary advisors by providing advice to investors that decidedly was not solely incidental in nature to the business of being a broker-dealer. This would have been fine and dandy had non-fiduciary brokers had the good grace to register as investment advisors and subject themselves to the best interest fiduciary standard required by the ’40 Act.
Eventually the SEC responded, not by scolding non-fiduciary brokers to get back on their side of the line or, if they insisted on crossing the line, to register as a fiduciary advisor. Rather, the response in 1999 was what came to be known (infamously in some circles) as the “Merrill Lynch Rule.”
That rule–far from pushing brokers back on their side of the line–sought instead to accommodate them with additional broker-dealer exemptions that the SEC would allow under the solely incidental clause of the ’40 Act. For example, the Merrill Lynch Rule allowed brokers to offer wrap accounts and charge fees based on assets under management–without having to be subjected to the best interest fiduciary standard of the ’40 Act. They accomplished that in short order by reportedly accruing $300 billion in fee-based accounts that didn’t require oversight by a fiduciary.
Brokers were given the green light to invade the other guy’s territory without penalty and, to boot, didn’t have to live by the other guy’s rules. The Merrill Lynch Rule was a pretty neat set-up, but only if you were a broker giving solely incidental advice and didn’t want to be a fiduciary. By allowing brokers to charge fees without requiring them to subject themselves to the best interest fiduciary standard of the ’40 Act, the SEC was, in effect, subordinating the interests of investors to those of non-fiduciary service providers.
Of course, that begs the question of who, in their right mind, would welcome and have greater comfort receiving advice solely incidental in nature–that is, advice that’s minor/secondary/supplemental–rather than advice subject to the best interest fiduciary standard? Did investors really want more advice with less accountability?
Eventually, in 2007, the U.S. Court of Appeals for the District of Columbia Circuit put the kibosh on the Merrill Lynch Rule by holding that the SEC couldn’t negate the ’40 Act through rule-making. Instead of vigorously keeping fee-receiving fiduciary investment advisors on one side of the line and commission-receiving non-fiduciary brokers on their side of the line, the SEC chose to not enforce that clear divide.
It’s thought the reason why the SEC made that choice was that the red line between ongoing fiduciary advice and non-fiduciary advice provided solely incidental to a securities transaction was no longer clear, given the practices that the SEC itself had allowed brokers to undertake while invading the other guy’s territory and not adhering to the existing rules in place. So it looks like we have the SEC to thank for investors not being able to tell a non-fiduciary broker from a fiduciary advisor.
In any event, brokers cannot, as a matter of law (which has not been enforced by the SEC), provide substantive investment advice. Nonetheless, many people–including commentators who should know better–continue to chant the mantra that brokers provide “investment advice.” For example, they cite the annual cost of a broker’s advice as being, say, 0.25%. That’s a reference to a typical annual 12b-1 fee, but this fee has absolutely nothing to do with delivering investment advice.
According to the SEC, 12b-1 fees are paid by a mutual fund out of fund assets to cover distribution expenses and sometimes shareholder servicing expenses. Distribution expenses include payments for marketing and selling fund shares such as compensating brokers and others who sell fund shares, as well as paying for advertising, printing, and mailing of prospectuses to new investors, and printing and mailing sales literature.
It’s important to understand that brokers will continue to receive 12b-1 commissions in such scenarios even if they never again say another peep to their clients after the initial sale of a mutual fund. The only way that an investor can stop 12b-1 income flowing to a non-fiduciary broker is to sell the mutual fund.
In sharp contrast, those on the other side of the line–fiduciary advisors–can see their advisory fees stop abruptly when an investor decides that their advice is no longer valuable and decides to fire them. In that scenario, the investor also has the option of retaining or selling the mutual fund.
One of the participants in the recent presidential debates said something to the effect that all too often when government gets involved in something, it screws up things. Then it tries to “fix” the ensuing problems that it has caused by providing a “solution” that makes things even worse. The SEC’s record in this area demonstrates the truth of that assertion.
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.