How SIFMA, FSI , FINRA and the SEC Conspired to Doom the Advisory Profession
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Let us not claim we were “unaware.” Let us not claim “fiduciary fatigue.” Especially when the consequences are so grave.
Instead, let us recognize that – through “harmonization” – the broker-dealer community, aided and abetted by the SEC, is destroying the fiduciary standard, while imposing only new “casual disclosure” obligations upon broker-dealers. At its very core, this is an effort to make RIAs/IARs and BDs/RRs look identical.
And – once this is accomplished – FINRA will swoop in to seek oversight over the “harmonized” broker and investment adviser communities.
We must fight to ensure that our roles remain different. Fiduciaries represent the client, and act as the client’s representative, with a high degree of expertise. Brokers buy and sell products and securities, they represent issuers and product manufacturers, or act as agents to facilitate trades; they operate in arms-length relationships with their customers.
Let us not forget the principle, thousands of years old, that no man can serve two masters. You cannot be “partly loyal.” You are either loyal to the client’s interests, as a true fiduciary – or you are not.
Let us not merely surrender and then – a few years from now – lament that FINRA oversees us with a heavy burden of regulations. Let us not as some distant point in time just wistfully recall that once we had a vision of a profession where we could be treated respectfully and presumptively as professionals, and not as criminals.
If we ever desire to become true professionals – trustworthy in the eyes of our clients and the public-at-large, proud of our status as protector of the financial futures of our fellow Americans, and making a huge impact in the process of efficient capital formation and U.S. economic growth – then we must act. Now. Through our professional associations. And individually.
Here is a link to a sample letter you can send to your elected representatives to encourage them to stand up for the fiduciary standard. Better yet, visit your elected representatives at their home offices or in Washington, D.C.
The SEC’s proposed Regulation Best Interests, and its proposed interpretation of the fiduciary obligations arising under the Advisers Act, are deeply flawed. How did we get here? And why are the SEC’s actions so inherently wrong?
Act one: The conspiracy begins
It was early 2015. Two broker-dealer executives were talking over cocktails while attending a securities industry conference. [This is a fictional exchange, but likely close to the truth.]
“We’ve got to do something about this,” said one broker-dealer executive to another. “My reps keep telling me that customers keep asking if we act in their best interests. And we keep losing customers, and market share, to those pesky independent RIAs.”
“But what can we do?” replied the other BD executive. “We tried to reign in RIAs by getting FINRA to oversee them, but we couldn’t get that through Congress back in 2012. With FINRA’s help, we could have adopted rules to weaken the fiduciary standard.”
“Well, we will spend millions trying to defeat the U.S. Department of Labor’s ‘Conflict of Interest’ rule and that ‘Best Interest Contract Exemption.’ This is going to be close. Hopefully, we will find a friendly set of appellate judges in the very conservative 5th Circuit – that’s why we’ll file our litigation against the DOL Rule in Texas.” [Note: It was a close call. Brokers and insurance companies lost every battle in the courts, except one. They got a break with that 2-1 decision in the very conservative 5th Circuit Court of Appeals, which the DOL – following the change of Administrations - did not appeal.]
“And, auspiciously,” replied the other BD executive, “we managed to stop the SEC from advancing any fiduciary rules for BDs, as authorized under that darn Dodd Frank Act of 2010. Fortunately, every one of the recent SEC Chairs had close ties to Wall Street, or to the law firms that BDs and insurance companies hire.”
Stated the other BD executive: “But, even then, we are really taking it on the chin. Consumers are now aware of ‘fiduciary’ – even with our killing of the DOL Rule. And, if we don’t do something, chances are the next Administration – after this one – will try to put fiduciary back in place again. Both at the DOL and at the SEC.”
Each brokerage firm executive stared at his drink. They had each been in this business for decades, and they had successfully weakened a lot of market conduct regulation over the years. They had successfully maintained a “revolving door” at the SEC, including the domination of SEC senior staff by those with close ties to broker-dealer firms. And they had spent hundreds of millions of dollars spent lobbying both the U.S. Congress, agency officials, and even state legislators and regulators.
After a few minutes, one of the executives abruptly sat up, and excitedly said: “I know. Let’s make RIAs the same as brokers. Let’s lower the fiduciary standard, by SEC rules, to become far less restrictive. Our attorneys have been drawing up some legal arguments for years, in which they try to weaken the standard.”
“That’s a great first step,” replied the other executive, “but it does not solve the problem with consumers.”
“So, let’s take FINRA’s 2012 position[1] – that brokers operate in their customers’ ‘best interests’ already, even though we really don’t, and get it codified as an SEC rule, as well.”
The first executive thought for a minute, then, looking up from his scotch and soda, said: “That would mean brokers and investment advisers would be the same. All that would be required for conflicts of interest is disclosure. Of course, everyone knows that consumers don’t read disclosures. Even those few that read them rarely understand them.”[2]
The other replied, “So we have the SEC lower the fiduciary standard to just require casual disclosure of conflicts, and we have the SEC adopt a rule that gives consumers the illusion that broker-dealers and their reps act in the customer’s best interests. That’s brilliant! It means that consumers won’t be able to distinguish between brokers and advisers anymore!”
The first executive then chimed in: “But it’s even better than that. Once we get the SEC to adopt these rules, we can go to Congress again. We can show them there is no differences between brokers and investment advisers, and that they should all be regulated by FINRA!”
“But will the SEC do this for us?”
“If we are lucky with the 2016 Presidential election, the SEC will do what we ask. We will use our influence to have appointed as SEC Chair one of the many lawyers who have worked for years as a lawyer for Wall Street firms. And the Republicans in Congress will back him up, given our substantial contributions to their re-election campaigns.”
“Wow, this is brilliant. Let’s get to work!”
Act two. The broker-dealer firms and lobbyists combine with FINRA to imagine a weak “Best Interests” proposed rule
Of course, the foregoing is a fictional conversation. But it may not be far from the truth. For, after the enactment of The Dodd Frank Act of 2010, the large broker-dealer firms formed industry several task forces to seek either to roll back or limit Dodd Frank’s requirements and authorizations. One of such task forces was charged with defeating fiduciary standards for brokers.
FINRA, the “self-regulatory organization” whose members are broker-dealer firms, appeared to have led the way in the path toward a “best interest” standard for brokers. In his May 27, 2015 address to broker-dealer firm executives gathered at the 2015 FINRA Annual Conference, FINRA Chair and CEO Richard Ketchum inquired of brokers whether “the time has come to require broker-dealers, when recommending a security or strategy to retail investors, to ensure that the recommendation is in the ‘best interest’ of the investor.” Mr. Ketchum went on to equate FINRA’s “best interest” standard (effectively pronounced in 2012) with the “fiduciary standard.” Mr. Ketchum then outlined what a “best interest” standard for brokers would look like, and based it upon the provision of “consent” by the customer to conflicts of interest and “more effective disclosure” to customers by broker-dealer firms. At one time FINRA even touted its own standards as being higher than fiduciary standards of conduct.[3]
Shortly thereafter, in June 2015, a “best interests” proposed regulation was advanced by broker-dealer lobbyist organizations, SIFMA and FSI. Titled “Proposed Best Interest of the Customer Standard for Broker-Dealers,” this proposal formed part of the basis for the SEC’s proposed “Regulation Best Interests,” issued in April 2018.
Thereafter a new SEC Chair, who had long served Wall Street’s interests as an attorney, was indeed appointed. Despite strong concerns expressed by Democratic Commissioners, SEC Chair Jay Clayton promulgated a draft “Regulation Best Interest,” and then refused to extend the comment period on this (and two other major rules announced at the same time). The rush to enact this deeply flawed “Reg BI” is reflective of the perceived need to act quickly to effect these changes, as advanced by the broker-dealer community. As reported by Financial Planning magazine’s Tobias Salinger on Sept. 26, 2018, FSI – the other major lobbying firm for broker-dealers – had in the words of its leader, Dale Brown, “provided meaningful input” to the SEC. As reported, “The effort definitely carries time urgency, according to FSI board member and Securities America advisor Kim Kropp, who notes the midterm elections and the next presidential election could shift the balance of power at the federal level. FSI and its allies ‘have our chance to get something put in place,’ Kropp says. ‘The Department of Labor [rule] could be back, so let’s get this done, get this nailed down.’”
Act three: SEC Chair Jay Clayton acts to eviscerate the fiduciary standard
At the same time the SEC proposed Reg BI, it also proposed an interpretation of the Advisers Act’s fiduciary standard. And, as has become most clear to me from conversations in Washington, D.C., over the past few months with those in the know, the SEC’s is now advancing the view that all that is required of a fiduciary investment adviser, when a conflict of interest, is disclosure of the conflict of interest and mere consent by the client.
And an SEC senior staff member was recently said to have opined to policy makers that, with Reg BI, broker-dealers and investment advisers would have essentially the same rule – disclose conflicts, when they exist, and seek informed consent. There would be no major distinction between the two anymore.
In essence, the longstanding call by the broker-dealer community to “harmonize” broker-dealer and investment adviser regulation will have been accomplished. Yet those who support a true fiduciary standard have always known that “harmonize” meant “eviscerate” with respect to the fiduciary standard. And now, we are within several months, if not several weeks, of seeing this occur.
Current SEC Chair Jay Clayton chooses to ignore the law, and the SEC’s own precedents
The current SEC Chair seeks to water down the fiduciary standard to a meaningless disclosure standard, ignoring centuries of established law as well as its own precedent. Under the influence of broker-dealers, the SEC seeks to reverse course and lower the fiduciary standard to, in essence, require only disclosures of conflicts of interest, rather than their proper management.
In pursuing a rule that “interprets” the fiduciary standard as something far less than a true fiduciary standard, SEC Chair Clayton seeks to re-define, without the authority to do so, the English language. More importantly, he seeks to change the legal definition of “best interests” that has been written about by jurists for centuries.
The SEC ignores its own precedents: The obligation to keep the clients’ interests paramount is what “Best Interests” means
The SEC ignores its own precedents, by taking the view that, when a conflict of interest is present, all that is required is “disclosure” followed by the “consent” of the client.
For example, in “Amendments to Form ADV,” Investment Advisers Act Release No. 3060 (July 28, 2010), the SEC stated: “Under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients, which includes an obligation not to subrogate clients’ interests to its own ….” [citing Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003)]. [Emphasis added.]
The SEC has previously taken the position that disclosure is not enough when a conflict of interest is present - much more is required. The fiduciary standard acts as a restraint upon conduct. For example, in S.E.C. v. Moran, the court stated that “the SEC alleges that by allocating Liberty stock to his personal and family accounts and requiring his clients to pay a higher price for the stock the next day, Moran Sr. and Moran Asset placed their own interests ahead of their clients thereby violating the fiduciary duty owed to those clients … Section 206 of the Advisers Act establishes a statutory fiduciary duty for investment advisers to act for the benefit of their clients ….”[4] [Emphasis added.]
As stated in the Rocky Mountain Financial Planning SEC No-Action Letter: “We do not agree that ‘an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest.’ While section 206(3) of the Investment Advisers Act of 1940 (‘Act’) requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent. The adviser must have a reasonable belief that the entry of the client into the transaction is in the client's interest. The facts concerning the adviser's interest, including its level, may bear upon the reasonableness of any belief that he may have that a transaction is in a client's interest or his capacity to make such a judgment.”[5] [Emphasis added.]
It has long been the Commission’s position that the “an investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.”[6] SEC Staff has recently stated: “The duty of loyalty requires an adviser to serve the best interests of its clients, which includes an obligation not to subordinate the clients’ interests to its own.”[7]
In seeking to eviscerate the fiduciary duty of loyalty, the SEC ignores the federal courts’ interpretation of the “Best Interests” standard under the Advisers Act.
“An essential feature and consequence of a fiduciary relationship is that the fiduciary becomes bound to act in the interests of her beneficiary and not of herself.”[8]
It has long been the Commission’s position that the “an investment adviser must not effect transactions in which he has a personal interest in a manner that could result in preferring his own interest to that of his advisory clients.”[9]
The SEC ignores the U.S. Supreme Court’s interpretation of the fiduciary duty of loyalty
The U.S. Supreme Court has previously written about the fiduciary standard, generally, and in particular the fiduciary duty of loyalty.
In Justice Douglas’s majority opinion in Pepper v. Litton, it was stated:
He who is in such a fiduciary position cannot serve himself first and his cestuis second … He cannot use his power for his personal advantage and to the detriment of [the cestuis], no matter how absolute in terms that power may be and no matter how meticulous he is to satisfy technical requirements. For that power is at all times subject to the equitable limitation that it may not be exercised for the aggrandizement, preference, or advantage of the fiduciary to the exclusion or detriment of the cestuis. Where there is a violation of those principles, equity will undo the wrong or intervene to prevent its consummation … Otherwise, the fiduciary duties … would go for naught: exploitation would become a substitute for justice; and equity would be perverted as an instrument for approving what it was designed to thwart.[10]
The observation that a person cannot wear two hats and continue to adhere to his or her fiduciary duties was echoed early on by the U.S. Supreme Court, “The two characters of buyer and seller are inconsistent.”[11] The U.S. Supreme Court also observed: “If persons having a confidential character were permitted to avail themselves of any knowledge acquired in that capacity, they might be induced to conceal their information, and not to exercise it for the benefit of the persons relying upon their integrity. The characters are inconsistent.”[12]
The SEC misconstrues, at the urging of the broker-dealer community, SEC vs. Capital Gains
Commentators often opine that the U.S. Supreme Court approved, in its 1963 SEC vs. Capital Gains decision, of “disclosure” as the sole means of satisfying a fiduciary’s duty of loyalty, when a conflict of interest of present. But, such commentators choose to ignore these words in the decision – which cannot be ignored:
It is arguable -- indeed it was argued by ‘some investment counsel representatives’ who testified before the Commission -- that any ‘trading by investment counselors for their own account in securities in which their clients were interested . . .’ creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests ….”[13] [Emphasis added.]
These words, contained in the SEC vs. Capital Gains decision, are often ignored by commentators, most of whom are employed either directly or indirectly by broker-dealer firms[14] and hence, it may be assumed, are engaged in what can only be considered “wishful thinking.” Yet, their desired interpretation of the decision – that all that is required when a conflict of interest is present is disclosure of the conflict, followed by “mere” (not “informed”) consent – has no foundation in the law. The words of the U.S. Supreme Court – “in this case” and “we need not go that far … since here the Commission seeks only disclosure of a conflict of interests” – show the Court’s judicial restraint only. The U.S. Supreme Court’s holding was to apply a federal fiduciary standard to the conduct at issue; the Court was not called upon to delineate the many requirements imposed upon investment advisers as a result of such federal fiduciary standard.
It must be understood that in the SEC vs. Capital Gains enforcement action, where the Commission sought injunctive relief, the Commission only sought a breach of the fiduciary duty for the adviser’s failure to disclose. This limited nature of the enforcement action by the Commission is understandable. Failure to disclose a conflict of interest, when present, is clearly a violation of the fiduciary duty of loyalty. Proof of failure to disclose is easy to provide. In contrast, other requirements that exist (as are set forth in more detail in my edits to the proposed interpretation, set forth later herein, and specially as to the requirements of informed consent and continued substantive fairness), often require expert testimony, greatly complicating and making more expensive enforcement actions.
The 1933 Securities Act and the Securities and Exchange Act of 1934 both adopt a “full disclosure” regime as a protection for individual investors. But, as made clear by the U.S. Supreme Court, the Investment Advisers Act of 1940 goes further. It recognizes the long-standing understanding that the fiduciary standard exists because disclosure is inadequate as a means of consumer protection in situations in which there is a great disparity in power or knowledge.
The SEC ignores centuries of common law setting forth what “Best Interests” truly means
The SEC seeks to re-define “best interests” as something other than the fiduciary duty of loyalty. Yet, this is contrary to centuries of established legal precedent under state common law, which should be provided deferential treatment by the SEC.[15]
The use of the term “best interests” to describe the fiduciary duty of loyalty is found in numerous judicial decisions. This author’s recent search of a U.S. case law database revealed 963 judicial opinions in which the terms “fiduciary” and “best interests” appeared in the same decision. In addition, there are numerous decisions in other common-law countries, such as the United Kingdom and Australia, that also utilize the term “best interests” to describe the salient feature of the fiduciary obligation.
The duty of loyalty is the most distinctive of the duties imposed upon a fiduciary.[16] As stated by many jurists, the fiduciary duty of loyalty requires that the “best interest” that is made paramount is that of the entrustor, or client. This can be further understood by examining the triparte duties which flow from the fiduciary duty of loyalty: the duty to not possess a conflict of interest (the “no-conflict rule”); the duty to not profit off of the client (the “no-profit” rule); and the duty to avoid conflicts that might arise when serving multiple clients.[17]
The “No Conflict” Rule. Under the “no-conflict rule,” fiduciaries owe the obligation to their client to not be in a position where there is a substantial possibility of conflict between self-interest and duty.
Because an adviser must serve the best interests of its clients, it has an obligation not to subordinate its clients’ interests to its own. This was made clear by the SEC on January 22, 2011, when the SEC's Staff, fulfilling the mandate under §913 of the Dodd-Frank Act, released its Study on the regulation of broker-dealers and investment advisers. The overarching recommendation made in the Study is that the SEC should adopt a uniform fiduciary standard for investment advisers and broker-dealers that is no less stringent than the standard under the Advisers Act. Specifically, the Staff recommended the following:
[T]he standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.
[Emphasis added.][18]
The no-conflict rule is firmly embedded in the federal fiduciary standard arising under the Advisers Act. In SEC vs. Capital Gains, the U.S. Supreme Court explained the no conflict rule and provided the rationale behind the prohibition on serving two masters:
This Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of theauthoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them .... In Hazelton v. Sheckells, 202 U.S. 71, 79, we said: ‘The objection . . . rests in their tendency, not in what was done in the particular case … The court will not inquire what was done. If that should be improper it probably would be hidden and would not appear.’[19]
The “No Profit” Rule. Fiduciaries also possess the obligation not to derive unauthorized profits from the fiduciary position. This is called the “no profit” rule, also derived from English law.[20]
The SEC ignores the limited role waiver and estoppel possess when fiduciary duty of loyalty exists
It has long been observed that the fiduciary duty of loyalty, in situations where there exists vast asymmetry in power of information, is not subject to waiver by the client, nor will disclosures or disclaimers result in estoppel of the client’s later claim for breach:
[T]he law usually enshrines loyalty as a mandatory duty. This policy does not seek merely to protect the weaker party. A principal, however sophisticated and commercially alert, cannot waive her fiduciary’s duty of loyalty. As Tamar Frankel points out, this problem stems from common-law jurisdictions with the proprietary nature of the duty. At most, a principal may consent to a conflict of interest once she is aware of it, and can presumably measure the adverse consequences of the conflict.
Although this principle may appear far reaching, and might be expected to prove a considerable handicap to the financial industry, ways around the roadblock are built by the absolute nature of the duty of loyalty. First, the parties can narrow the scope of the service or the interests entrusted. Execution-only brokers, for instance, promise nothing more than a diligent, careful and loyal execution of exchange orders. These brokers do not provide any form of financial advice to their customers. They do not even promise to ensure that the trades match the risk profile of their clients. Perhaps the future lies with an explicit definition of the services an intermediary promises to provide: execution-only; trade-related advice; general assessment of the financial situation of the client; and investment management.
Nevertheless, views to the contrary notwithstanding, we do not believe that this evolution is redefining the duty of loyalty. It remains a discrete variable: a fiduciary is either loyal or she is not; she cannot be more or less loyal. She can only contract in the domain of her loyalty. Once she enters into this area, she is bound to an unlimited loyalty to her principal. The face of this duty may change, depending on the circumstances and the nature of the relationship. But the duty itself remains fundamentally the same: the agent must act in the interest of the principal.[21]
If a conflict of interest is not avoided and does exist in a fiduciary relationship,[22] mere disclosure to the client of the conflict, followed by mere (rather than informed) consent by a client to the breach of the fiduciary obligation, does not suffice; client understanding of the conflict of interest and its ramifications to the client followed by the client’s informed consent is required.
It should be noted that disclosure alone is not sufficient to create either a “waiver” of the client nor does it “estop” the client from pursuing a claim for breach of fiduciary duty under state securities statutes.[23]
Nor is disclosure sufficient to constitute waiver or estoppel under the Advisers Act.[24] If this were the case, fiduciary obligations – even core obligations of the fiduciary[25] – would be easily subject to waiver.[26]
Dissecting the “It’s only an implied fiduciary standard” argument
In support of the SEC’s evisceration of the fiduciary standard, broker-dealers (and the lawyers that they hire) take the position that, since the Investment Advisers Act of 1940 does not contain the word “fiduciary,” then it is only an implied standard, which is therefore weaker than an express standard. They point to the U.S. Supreme Court’s seminal decision in 1963, where – they state – the U.S. Supreme Court “found” a fiduciary standard in the Advisers Act.
Yet, the Investment Advisers Act of 1940 was always known to have applied the fiduciary standard. It was not created by the U.S. Supreme Court in 1963. The Court only confirmed the fiduciary standard that the SEC (and the securities industry itself) had always thought existed in the Advisers Act. As stated by the U.S. Supreme Court in Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979), “§206 establishes federal fiduciary standards to govern the conduct of investment advisers.” The U.S. Supreme Court stated: “[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”
Furthermore, I have found no legal support in federal court decisions for the proposition that the Advisers Act’s fiduciary standard is “implied,” nor for the proposition that – even it the fiduciary duty is “implied” – that it is a set of lesser fiduciary obligations. Loyalty to a client’s interests either exists, or it does not.
The SEC bows to pressure to conform the fiduciary standard to industry practices, rather than requiring the industry to conform to the fiduciary standard
The fact that the industry seeks to relax the core fiduciary duty of loyalty – to the point of rendering it meaningless as a protection for individual investors – should not be surprising. The commoditization of financial services (aided with the application of technology, and increased public awareness of the failures of most forms of active management), along with close ties between market participants (such as exist through revenue sharing, via 12b-1 fees, soft dollar payments, marketing support payments, payment for shelf space, payment for order flow, etc.), and the conflicts arising from combining in one firm brokerage (agency transactions) and dealer (principal, underwriting) functions, have all combined to place incentives on broker-dealer firms to relax regulatory oversight. Chief among their concerns is the application of the fiduciary standard, which would create greater fee transparency, greater competition in the marketplace among fee-based accounts, and great pressure upon the fees of pooled investment vehicles (some of which are sponsored by, or some of which sponsors possess close relationships with, broker-dealer firms).
Yet, pressures to conform the fiduciary standard of conduct – the highest standard under the law[27] – to the industry, should be resisted by the SEC. It is without question that one cannot be “halfway loyal.” The provider of investment advice to a client is either loyal, or is not. The fiduciary standard is a wholly different standard that the standards of conduct governing actors in arms-length relationships with their customers. Accordingly, application of a bona fide, true fiduciary standard of conduct requires conformance by the industry to the fiduciary standard, not the other way around.
The state securities administers also highlight the problems with the SEC’s “disclosure-only” approach
In their Feb. 19, 2019 supplemental comment letter to the SEC, the association for state securities administrators stated: “What is missing from the [Regulation Best Interest] proposal and statements by SEC officials is a recognition that disclosure cannot and should not be characterized as sufficient to satisfy an adviser’s fiduciary duty and more especially the adviser’s duty of loyalty. Disclosure of conflicts aside, an adviser’s duty is to act in the best interest of his or her client. The analysis does not and should not stop once the question of whether disclosure of the conflict has been made to the investor.”
It must be recognized that, even with enhanced safeguards afforded to consumers such as enhanced disclosure obligations, the arms-length relationship of the parties involved in the sale of an investment or insurance product can still be described as:
PRODUCT MANUFACTURER(S)
⇩
MANUFACTURERS’ (SALES) REPRESENTATIVES
⇩
CUSTOMER
The fiduciary relationship is altogether different. The fiduciary acts as a “purchaser’s representative” – i.e., on behalf of the client. The fiduciary “steps into the shoes of the client” and acts as if the client would act for himself/herself – but armed with the knowledge, skill, experience and hence expertise that the fiduciary possesses and is required to apply prior to making any recommendations to the client. The fiduciary relationship can be modeled as follows:
CLIENT
⇩
FIDUCIARY (PURCHASER’S OR CLIENT’S REPRESENTATIVE)
⇩
PRODUCT MANUFACTURERS
The roles of a fiduciary provider of investment advice, and the seller of investment products, are wholly distinct and should remain differentiated.[28] As stated by Professor Deborah DeMott: “The fiduciary’s duties go beyond mere fairness land honesty; they oblige him to act to further the beneficiary’s best interests.”[29] In other words, the SEC should not seek to “harmonize” what cannot be harmonized.
The SEC should be guided by state common law as to what fiduciary obligations require, when a conflict of interest is present
It is clear that under state common law the fiduciary standard of conduct requires much more than mere disclosure. And it has long been the SEC’s view that the fiduciary duty created by the Advisers Act encompasses state common law fiduciary obligations.[30] A "federal fiduciary standard" only exists to the extent necessary to resolve conflicts among the states or adhere to express legislative dictates.
Breach of fiduciary duty claims against investment advisers are typically based upon state common law, as the federal Advisers Act does not possess a private right of action (except in limited circumstances). Accordingly, maintaining consistency with state common law should be a major factor in how the federal fiduciary standard arising under the Advisers Act is applied. The interpretation of the fiduciary duties arising under the Advisers Act does not preempt, and should not seek to eclipse, state common law for breach of fiduciary duty by an investment adviser, given the limited remedies afforded to clients under the Advisers Act itself. Rather, the effect should be complementary.
Under the law, a multi-step process is required for the proper management of an unavoided conflict of interest:
Full, complete and affirmative disclosure of the conflict of interest (and its ramifications) must occur by the fiduciary to the client
The disclosure must not be combined with attempts to unduly influence or coerce the client. Informed consent cannot be obtained through coercion nor sales pressure.[31]
An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and business practices well enough to make an informed decision.46 The ramifications of the conflict of interest must be disclosed, so that the client understands the significance of the conflict of interest as it bears upon the client’s affairs.[32]
The disclosure must be frank. As stated by Justice Benjamin Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….”[33]
The disclosure must be full[34] and forthright. Even reasonably anticipated conflicts of interest must be disclosed.[35] However, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists; the SEC has brought enforcement actions in such cases.[36]
The fiduciary must ensure client understanding of the disclosures made
Following receipt of the disclosures provided, the client must achieve an understanding of the conflict of interest and its ramifications to the client, as well as an understanding of material facts disclosed.
As stated in an early decision by the U.S. Securities and Exchange Commission: “[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised and understands before the completion of each transaction that registrant proposes to sell her own securities.”[37] [Emphasis added.]
The client provides informed consent
The client must provide informed consent, not mere consent, in order for the consent to cure the conflict of interest and the potential for damage causes by such conflict.
Why is the tougher standard of informed consent, rather than mere consent, imposed? “By prohibiting all self-interested transactions and profit taking without a beneficiary’s informed consent – regardless of a fiduciary’s intent and irrespective of whether the beneficiary has suffered actual harm—fiduciary law eliminates a fiduciary’s incentives to abuse her position for her own gain.”[38]
To be informed consent, the consent of the client must be “intelligent, independent and informed.” Generally, “fiduciary law protects the [client] by obligating the fiduciary to disclose all material facts, requiring an intelligent, independent consent from the [client], a substantively fair arrangement, or both.”[39] [Emphasis added.].
Even then, the courts further test the transaction – is it substantively fair to the client?
Even if the procedural safeguards of full, complete and affirmative disclosure leading to client understanding and to the client’s grant of informed consent all occur, a remaining mandatory substantive requirement exists – that the fiduciary deal fairly with the client.[40] This is because no client would be presumed to authorize a fiduciary to act in bad faith.[41] As stated by one court:
One of the most stringent precepts in the law is that a fiduciary shall not engage in self-dealing and when he is so charged, his actions will be scrutinized most carefully. When a fiduciary engages in self-dealing, there is inevitably a conflict of interest: as fiduciary he is bound to secure the greatest advantage for the beneficiaries; yet to do so might work to his personal disadvantage. Because of the conflict inherent in such transaction, it is voidable by the beneficiaries unless they have consented. Even then, it is voidable if the fiduciary fails to disclose material facts which he knew or should have known, if he used the influence of his position to induce the consent or if the transaction was not in all respects fair and reasonable.[42] [Emphasis added.]
In other words, at all times, the transaction must be substantively fair to the client. This last requirement looks not at the procedures undertaken, but rather casts view upon the transaction itself. It requires that, even if the previous steps involving disclosure, client understanding, and informed consent are followed, at all times the proposed transaction must be and remain substantively fair to the client. If this is not so, the courts will set aside the transaction between the fiduciary and the client.[43]
For example, if an alternative exists which would result in a more favorable outcome to the client, this would be a material fact which would be required to be disclosed. A client who truly understands the situation would likely never gratuitously make a gift to the advisor where the client would be, in essence, harmed.
In the absence of integrity and fairness in a transaction between a fiduciary and the client or beneficiary, it will be set aside or held invalid.[44] As stated by Professor Tamar Frankel, for decades the leading scholar on the application of fiduciary law to investment advisers, “if the bargain is highly unfair and unreasonable, the consent of the disadvantaged party is highly suspect. Experience demonstrates that people rarely agree to terms that are unfair and unreasonable with respect to their interests.”[45]
The SEC seeks to aid and abet SIFMA, FSI and FINRA in obfuscating the merchandizing aspect of the broker-dealer business model
In its 1940 Annual Report, the U.S. Securities and Exchange Commission noted:
If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States. Court of Appeals for the District of Columbia in a recently decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest. He who would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not disguised as confidant and protector. He cannot commingle his trusteeship with merchandizing on his own account….[46]
Yet, the SEC’s proposed “Regulation Best Interest” provides to consumers the illusion that brokers act in the best interests of the client. The reality is that only enhanced disclosure obligations exist; there exists no actual constraints on brokers’ conduct. There is nothing in Regulation Best Interests that imposes new, substantive duties or restrictions upon brokers; they may continue to “merchandize” for their “own accounts.”
In the 1963 SEC Study of the Securities Industry, the SEC further cautioned broker-dealers against issuing statements that might create an appearance of trust, when no trust is deserved. In the Study, it was stated that:
[The Commission] has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [broker-dealer advertising] may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.”[47] [Emphasis added.]
While Regulation Best Interests encourages investors, by its very name, to fully trust their brokers, it does not impose any of the fiduciary duties upon brokers that would justify that trust.
In touting a new “best interests” standard that falls far short of a true fiduciary standard of conduct, SIFMA, FSI and FINRA perpetuate a 75-year history of opposing the substantial raising of standards of conduct for brokerage firms and their registered representatives. In so doing, FINRA continues its long-standing failure to live up to the hopes of Senator Maloney, who once stated that his Maloney Act of 1938 (which led to the establishment of NASD, now known as FINRA) had, as its purpose, “the promotion of truly professional standards of character and competence.”[48] One must wonder why, after so many failures to raise brokers’ standards of conduct beyond that of mere suitability obligations, FINRA has not yet been disbanded.
The use of the term “best interests” implies duties encompassing due care, loyalty, honesty and integrity, and should not be utilized lightly. Nor should the term “best interests” be utilized as puffery. As Judge Paul Crotty recently cautioned: “Goldman's arguments in this respect are Orwellian. Words such as ‘honesty,’ ‘integrity,’ and ‘fair dealing’ apparently [in Goldman’s eyes] do not mean what they say; [Goldman says] they do not set standards; they are mere shibboleths. If Goldman's claim of ‘honesty’ and ‘integrity’ are simply puffery, the world of finance may be in more trouble than we recognize.”[49]
Indeed, it could be argued that Proposed Regulation BI may well permit broker-dealers to engage in conduct that would otherwise, absent the federal regulation, violate state securities laws and/or other consumer protection laws which prohibit deceit and fraud. For example, Missouri securities legislation makes it unlawful for persons to engage in practices or a course of business that “operates or would operate as fraud or deceit.”[50] This language “quite plainly focuses upon the effect of particular conduct on members of the investing public, rather than upon the culpability of the person responsible.”[51]
The SEC should never assist the brokerage industry in committing fraud, by permitting a broker to state that he or she acts in the best interests of the customer – when in fact, by the express terms of the proposed Regulation Best Interests and its safe harbor (as then interpreted by the SEC in comments to policy makers, as imposing only an obligation of disclosure) – the broker is under no requirement to keep the best interests of the client paramount. These words of caution should guide the SEC:
The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.”[52] [Emphasis added.]
The SEC refuses to recognize the limits, and even perverse effects of, disclosure of conflicts as a remedy
Disclosure is a favored instrument of policy makers. During inspections and examinations by regulators,[53] violations for failures to disclose are easily discerned.
The purpose of disclosure, in the context of the financial intermediary – consumer relationship, is to seek to overcome the information asymmetry between the parties. It brings hidden profits and interests out into the light; some might say that “sunlight is the best disinfectant.” Through disclosure, the law seeks to empower the principal to decide whether or not to proceed with the recommended transaction. In essence, disclosure of a conflict of interest often puts the burden back upon the consumer to navigate the complex financial markets.
Under pressure from market participants, disclosures are often watered down. “Casual disclosures” are instituted, such as “our interests may differ from yours.” Rather than undertaking affirmative disclosures to customers, firms can direct customers to access the information on a web site. Less scrupulous actors will seek to hide the most embarrassing information in disclosure documents and customer services agreements consisting of dozens of pages, as often occurs now.
The SEC must recognize that disclosure is inadequate as a remedy, in the context of investment portfolio management and advice. Consumers don’t read disclosures. Nor do they understand them. More detailed or complex disclosures do not make them more effective. Nor are less detailed or “plain English” disclosures particularly effective. There is simply too much information asymmetry that cannot be overcome by financial literacy efforts. There are also simply too many behavioral bias that must be overcome.
The SEC’s emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities Acts on enhanced disclosures, results from the myth that investors carefully peruse[54] the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image of a vast majority of individual investors who are unable, due to behavioral biases[55] as well as a lack of knowledge of our complicated financial markets, to comprehend disclosures,[56] yet alone undertake sound investment decision-making.[57] As stated by former SEC Commissioner Troy A. Parades:
The federal securities laws generally assume that investors and other capital market participants are perfectly rational, from which it follows that more disclosure is always better than less. However, investors are not perfectly rational. Herbert Simon was among the first to point out that people are boundedly rational, and numerous studies have since supported Simon’s claim. Simon recognized that people have limited cognitive abilities to process information. As a result, people tend to economize on cognitive effort when making decisions by adopting heuristics that simplify complicated tasks. In Simon’s terms, when faced with complicated tasks, people tend to “satisfice” rather than “optimize,” and might fail to search and process certain information.[58]
Nor should clients possess the obligation to achieve a sufficient state of financial literacy in order to be able to undertake sufficient judgments about securities, themselves. Financial literacy efforts, except those directed at basic financial concepts such as budgeting, savings, and the proper use of credit, are insufficient to overcome the huge knowledge gap between financial and investment advisers and their clients. This knowledge gap occurs in other professions that are also bound by a fiduciary standard of conduct. As observed by the Financial Planning Association of Australia Limited, “The average person will no more become an instant financial planner simply because of direct access to products and information than they will a doctor, lawyer or accountant.”[59]
The inability of clients to understand disclosures should not be underestimated. In a 2005 study:
Madrian, Choi and Laibson recruited two groups of students – MBA students about to begin their first semester at Wharton, and undergraduates (freshmen through seniors) at Harvard. All participants were asked to make hypothetical investments of $10,000, choosing from among four S&P 500 index funds. They could put all their money into one fund or divide it among two or more. ‘We chose the index funds because they are all tracking the same index, and there is no variation in the objective of the funds,’ Madrian says … ‘Participants received the prospectuses that fund companies provide real investors … the students ‘overwhelmingly fail to minimize index fund fees,’ the researchers wrote. ‘When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80% still do not invest everything in the lowest-fee fund’ … [Said Professor Madrian,] ‘What our study suggests is that people do not know how to use information well.... My guess is it has to do with the general level of financial literacy, but also because the prospectus is so long.[60]
Other researchers have more recently explored these behavioral biases:
Nudging investors big and small toward better decisions. Decision, 2(4), 319-326 (“Investors significantly reduce their future returns by selecting mutual funds with higher fees, allured by higher past returns that do not predict future performance. This suboptimal behavior, which can roughly halve an investor’s retirement savings, is driven by 2 psychological factors. One factor is difficulty comprehending rate information, which is critical given that mutual fund fees and returns are typically communicated in percentages. A second factor is devaluing small differences in returns or fees (i.e., a peanuts effect).”[61]
Another similar study came to similar conclusions:
More problematic, naïve diversification may explain a number of investment decisions that otherwise appear irrational or uninformed. For example, our study contained two index funds that were described as identical except for fees—they tracked the same index, contained the same holdings, and reported the same past performance. Overall, 74.6% of WBL participants and 65.2% of MTurk participants who invested in the low-fee index fund also invested in the high-fee index fund. Similarly, 68% of MTurk investors allocated at least some money to a higher-fee actively managed fund that was really just a closet index fund, in that its holdings and performance were identical to those reported by the index funds. This was also true of 74.1% of WBL subjects. On a somewhat different point, 79.6% of WBL and 74.1% of MTurk investors allocated at least some money to a money market fund. They did so despite the instruction to invest for a thirty-year time frame for which liquidity concerns should be minimal. Notably, the reported returns of the money market funds were significantly lower than the other fixed income alternatives …
[W]e deliberately designed our study, in contrast to other experimental studies (and the real world of investing), to make fee information simple, accessible, and comparable. Our simplification was designed to enable us to differentiate between a cognitive failure—the inability to understand fee information—and a motivational failure—indifference to fees even when the fee information is clear and available. Our results suggest that subjects who are not motivated to seek and use fee information will fail to do so even when cognitive barriers are minimal …
Our results with respect to both fees and diversification raise broader questions about the extent to which retail investors understand the investment process. Efficient retirement investing demands that investors understand not only basic principles of costs and diversification, but also the effect of compounding, the value of asset allocation, and the consequences of these choices for investing over a thirty-year (or longer) time horizon … Given our subjects’ expressed levels of discomfort with the investment process, we predict that, rather than attempting to understand these concepts, investors search for short-cuts, heuristics, and opportunities to delegate … Delegating responsibility for investment decisions makes investors vulnerable to the choices of professionals—choices that may be opaque, shielded from market discipline, or tainted by conflicts of interest.[62]
Individual investors also possess substantial confusion about mutual fund fees and costs, such as loads and 12b-1 fees.[63] And many, many customers of brokers believe that the advice they receive from their broker is free.[64] Simpler disclosures do not appear to make mutual fund investors more sophisticated.[65]
Other investor biases overwhelm the effectiveness of disclosures. As stated by Professor Fisch:
The primary difficulty with disclosure as a regulatory response is that there is limited evidence that disclosure is effective in overcoming investor biases. … It is unclear … that intermediaries offer meaningful investor protection. Rather, there is continued evidence that broker-dealers, mutual fund operators, and the like are ineffective gatekeepers. Understanding the agency costs and other issues associated with investing through an intermediary may be more complex than investing directly in equities ….”[66]
Many other academic studies in recent years indicate the ineffectiveness of disclosures given the substantial behavioral biases individuals possess, as well as the perverse effects of disclosures upon providers of services.[67] For example:
Cain, Loewenstein, and Moore (2011) suggest that receiving unbiased advice in addition to (disclosed) biased advice can help ameliorate inadequate discounting of conflicted advice ... The empirical evidence on disclosure suggests that in isolation it may be ineffective and could actually exacerbate problems arising from conflicts of interest. Without other intervention, disclosure has been found to make advisors more comfortable in inflating their recommendations (Cain, Loewenstein, and Moore, 2005), increasing pressure on advisees to comply with advice (Loewenstein, Cain, Sah, 2011; Sah, Loewenstein and Cain, 2013), and confusing recipients when the information disclosed is not representative of objectivity (Dopuch, King, Schwartz, 2003). Additionally, people with low levels of financial literacy or who are anxious (Gino, Brooks, and Schweitzer, 2012) may not pay sufficient attention to the information that is disclosed.[68]
The inadequacy of disclosures was known even in 1930’s. Even back during the consideration of the initial federal securities laws, the perception existed that disclosures would prove to be inadequate as a means of investor protection. As stated by Professor Schwartz:
Analysis of the tension between investor understanding and complexity remains scant. During the debate over the original enactment of the federal securities laws, Congress did not focus on the ability of investors to understand disclosure of complex transactions. Although scholars assumed that ordinary investors would not have that ability, they anticipated that sophisticated market intermediaries – such as brokers, bankers, investment advisers, publishers of investment advisory literature, and even lawyers - would help filter the information down to investors.[69]
A growing body of academic research into the behavioral biases of investors reveals substantial obstacles individual investors must overcome in order to make informed decisions,[70] and reveal the inability of individual investors to contract for their own protections.[71]
The SEC must recognize that if a disclosure-based regime in the area of investment advice were effective, the law would have never evolved to possess a fiduciary standard of conduct. Congress would have never created the Investment Advisers Act of 1940. There would simply be no need.
But the law did so evolve – recognizing that sound public policy dictates (including the necessity to foster capital formation, capital markets efficiency, and economic growth) that when trust and confidence is placed in a financial adviser by her or his client, the conduct of the financial adviser must be constrained. Conflicts of interest, which can either consciously or unconsciously lead to poor advice, must be properly managed through the process of affirmative disclosure, ensured client understanding, informed consent, and testing for substantive fairness.
Recognizing that consumers lacked the information and expertise to even prove breaches of the obligation of the fiduciary duty of loyalty, consumers are aided when enforcing fiduciary duties in private court actions. Early on the law set out presumptions of breach of fiduciary obligation for unavoided conflicts of interest. Fiduciaries bear the burden of persuasion, for purposes of private law remedies, that they have complied with their fiduciary obligations. The fiduciary investment adviser must prove the instrinsic fairness of her or his actions so as to not be held in breach. Moreover, recognizing the severity of violations of the fiduciary duty of loyalty, not only may consumers sue for damages, but also for disgorgement of any undue profits from a violator. This also serves to counter the reality that the costs of litigation (or even arbitration) are too high for most individual investors. Even then, only a small percentage of individual investors that are harmed as a result of breaches of fiduciary obligations pursue private remedies.
At its very core, the fiduciary duty of loyalty restrains the conduct of one providing investment advice; the fiduciary duty of loyalty acts as a restraint upon greed. It restrains “choice” – but only in the sense that products and transactions that fail to meet higher standards of due diligence can no longer be permitted to be recommended to the consumer; comparative cost/benefit analyses are required of the fiduciary provider of investment advice (now held to the standard of an expert), and only the better investment strategies and investment products will survive such expert scrutiny.
Overwhelming and compelling academic research reveals that the greater the fees and costs associated with financial intermediation, the less the returns available in the capital markets are delivered to investors. As a result, as a practical matter most conflicts of interest involving the receipt of additional compensation to a provider of investment advice also result in greater fees and costs borne by the investors. Conflicts of interest under a “best interests” fiduciary standard are not prohibited altogether (in contrast to the “sole interest” fiduciary standard); nevertheless additional or incremental compensation to a provider of investment advice, resulting from a recommendation of an investment product or transaction, must be avoided when a true “best interests” fiduciary standard of conduct is applied. Clients of fiduciary advisers simply cannot provide informed consent to be harmed. Accordingly, a practical approach to managing conflicts of interest is for the provider of investment advice to agree with the client, in advance, on some amount of levelized compensation for the advice and services to be provided.
The SEC ignores the adverse impacts on capital formation and economic growth, when betrayals of trust will increasingly occur and consumers will more often lose confidence in their financial advisers
When investors are led, by a pronouncement that the broker (“financial advisor”) acts in the customer’s “best interests,” but then are betrayed when the broker acts from self-interest (non-adherence to the duty of no profit, and the duty of no conflict, which form core parts of the duty of loyalty), trust in our system of capital formation will fall. As trust falls, so will the SEC’s fail in its three-part mission – (1) to protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation.
There are numerous authorities which highlight the important role trust plays in facilitating capital formation and economic growth. As Rashid Bar and Luc Thevenoz wrote:
If [conflicts of interest] are widespread, the adverse effects of these conflicts can plague entire markets. If investors believe the agency costs of equity are too high, they will avoid buying shares in favour of bonds, thus limiting the access of business to capital. Similarly, lacking trust in asset managers or collective investment schemes, investors will forego the advantages of this form of investment: the expertise of the agent and the economies of scale offered by asset pooling. Instead, investors will make and implement their investment decisions alone and risk the potentially adverse consequences. From a macroeconomic viewpoint, those consequences can be dire in terms of misallocation of resources: capital markets may dry up and savings may vanish or be inefficiently invested. Conflicts of interest thus are a source of concern not only for individual principals, but also for society at large, and indeed the state. Public regulation is necessary insofar as individuals may not be able to fend for themselves and cannot enforce their rights alone.[72]
American business is the robust engine that drives the growth of our economy and delivers prosperity for all. An important component of the fuel for this engine is monetary capital. Yet, this monetary capital is not efficiently delivered to the engine of business today. It as if the engine is stuck using an outdated, clogged carburetor, in the form of substantial intermediation costs by current investment banking firm practices.
More importantly, the transmission system of our economic vehicle is failing, leading to far less progress in our path toward personal and U.S. economic growth. The transmission system is large, heavy and unwieldy; its sheer weight slows down our vehicle’s progress. Through costly investment products and hidden fees and costs, this transmission system unnecessarily diverts much of the power delivered by American business’ economic engine to Wall Street, rather than deliver it to the investors (our fellow Americans) who provide the monetary capital.
The ramifications of this inefficient vehicle, with its clogged carburetor and faulty transmission, are both numerous and severe. The cost of capital to business is much higher than it should be, due to the exorbitant intermediation costs Wall Street imposes during the raising of capital and its diversion of the returns of capital away from individual investors.
In fact, Wall Street currently diverts away from investors a third or more of the profits generated by American publicly traded companies. As Simon Johnson, former chief economist of the International Monetary Fund, observed in his seminal May 2009 article “The Quiet Coup” appearing in The Atlantic, wrote: "From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits … In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent."[73] More recently the financial services sector’s bite into corporate profits has been estimated at one-third or higher.[74]
The siphoning of profits by Wall Street, away from the hands of individual investors, has led to a high level of individual investor distrust in our system of financial services and in our capital markets. In fact, many individual investors, upset after finally discovering the high intermediation costs present, flee the capital markets altogether. (Many more would flee if they discovered all of the fees and costs they were paying, and realized the substantial effect such had on the growth or preservations of their nest eggs.)
The effects of greed in the financial services industry can be profound and extremely harmful to America and its citizens. Participation in the capital markets fails when consumers deal with financial intermediaries who cannot be trusted.
As a result of the growth of investor distrust in financial intermediaries, the capital markets are further deprived of the capital that fuels American business and economic expansion, and the cost of capital rises yet again. Indeed, as high levels of distrust of financial services continue,[75] the long-term viability of adequate capital formation within the United States is threatened, leading to greater reliance on infusions of capital from abroad. In essence, by not investing ourselves in our own economy, we are selling our bonds, corporate and other assets to investors abroad.[76]
It is well documented that public trust is positively correlated with economic growth.[77]
Moreover, public trust is also correlated with participation by individual investors in the stock market.[78] This is especially true for individual investors with low financial capabilities – those who in our society are in most need of financial advice; policies that affect trust in financial advice seem to be particularly effective for these investors.[79]
The lack of trust in our financial system has potential long-range and severe adverse consequences for our capital markets and our economy. As recently stated by Prof. Ronald J. Columbo:
Trust is a critical, if not the critical, ingredient to the success of the capital markets (and of the free market economy in general). As Alan Greenspan once remarked: ‘[O]ur market system depends critically on trust-trust in the word of our colleagues and trust in the word of those with whom we do business.’ From the inception of federal securities legislation in the 1930s, to the Sarbanes-Oxley Act of 2002, to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, it has long been understood that in the face of economic calamity, the restoration and/or preservation of trust – especially investor trust – is paramount in our financial institutions and markets.[80]
There is no doubt that “[t]rust is a critically important ingredient in the recipes for a successful economy and a well-functioning financial services industry. Due to scandals ranging in nature from massive incompetence to massive irresponsibility to massive fraud; investor trust is in shorter supply today than just a couple of years ago. This is troubling, and commentators, policymakers, and industry leaders have all recognized the need for trust's restoration ….”[81]
As the returns of the capital markets are diverted away from individual Americans - the owners of capital - to Wall Street,[82] the accumulation of capital falls. This results in less accumulated capital for investment purposes - an effect that compounds over time with severe negative consequences for the long-term health of the U.S. economy. The cost of capital to corporations increases. And innovation, without capital, equates to missed opportunities for U.S. economic growth.[83]
The fiduciary standard is the antidote for this problem of excessive rent-taking by non-fiduciary financial advisors. In Bayer v. Beran, Justice Shientag said: “The fiduciary has two paramount obligations: responsibility and loyalty … They lie at the very foundation of our whole system of free private enterprise and are as fresh and significant today as when they were formulated decades ago.”
Over the past century, our economy has transformed and become both more complex and more specialized. As Professor Tamar Frankel, long the leading scholar in the area of fiduciary law as applied to securities regulation, once noted: “[A] prosperous economy develops specialization. Specialization requires interdependence. And interdependence cannot exist without a measure of trusting. In an entirely non-trusting relationship interaction would be too expensive and too risky to maintain. Studies have shown a correlation between the level of trusting relationships on which members of a society operate and the level of that society’s trade and economic prosperity.”[84]
Fiduciary duties are imposed by law when public policy encourages specialization in particular services, such as investment management or law, in recognition of the value such services provide to our society. For example, the provision of investment consulting services under fiduciary duties of loyalty and due care encourages participation by investors in our capital markets system. Hence, in order to promote public policy goals, the law requires the imposition of fiduciary status upon the party in the dominant position. Through the imposition of such fiduciary status the client is thereby afforded various protections. These protections serve to reduce the risks to the client which relate to the service, and encourage the client to utilize the service. Fiduciary status thereby furthers the public interest.
Investment advisory services encourage participation by investors in our capital markets system, which in turn promotes economic growth. The first and overriding responsibility any financial professional has is to all of the participants of the market. This primary obligation is required in order to maintain the perception[85] and reality that the market is a fair game and thus encourage the widest possible participation in the capital allocation process. The premise of the U.S. capital market is that the widest possible participation in the market will result in the most efficient allocation of financial resources and, therefore, will lead to the best operation of the U.S. and world-wide economy. Indeed, academic research has revealed that individual investors who are unable to trust their financial advisors are less likely to participate in the capital markets.[86]
Furthermore, the application of a true fiduciary standard fosters the important public policy supporting individual savings and proper investing. As stated in a 2002 white paper authored by Professor Macy:
If people do not make careful, rational decisions about how to self-regulate the patterns of consumption and savings and investment over their life cycles, government will have to step in to save people from the consequences of their poor planning. Indeed, the entire concept of government-sponsored, forced withholding for retirement (Social Security) is based on the assumption that people lack the foresight or the discipline, or the expertise to plan for themselves. The weaknesses in government-sponsored social security and retirement systems places increased importance on the ability of people to secure for themselves adequate financial planning.[87]
Americans need expert, trusted financial and investment advice. But, without trust in financial advisers, due to the lack of a proper fiduciary standard applied to the delivery of financial advice, at all times, consumers are reluctant to seek out financial and investment advice. The issue of investor trust in financial intermediaries does not just concern asset managers and Wall Street’s broker-dealer firms; it affects all investment advisers and financial advisors to individual clients. As Tamar Frankel, a leading scholar on U.S. fiduciary law, once observed: “I doubt whether investors will commit their valuable attention and time to judge the difference between honest and dishonest … financial intermediaries. I doubt whether investors will rely on advisors to make the distinction, once investors lose their trust in the market intermediaries. From the investor’s point of view, it is more efficient to withdraw their savings from the market.”[88]
In conclusion
One can only guess at the motivations behind the SEC’s current Chair, Jay Clayton. Being a lawyer, he should be well-informed of the true nature of the fiduciary standard, as well as being fully aware of Justice Cardozo’s warning – promulgated over nine decades ago – that the fiduciary duty of loyalty should not be eroded by “particular exceptions.” Yet, Chair Clayton seeks not just to erode the fiduciary standard, but to wholly eviscerate it. One can only wonder if Chair Clayton is auditioning for the part of “worst SEC Chair in history,” as his actions undermine the SEC’s mission of capital formation, efficient markets, and investor protection.
Chair Clayton also proposes that the SEC, by endorsing the industry-planned “Regulation Best Interests” – which imposes no true “act in the best interests of the customer” obligation, but only an undefined duty to make more disclosures – engage in a rulemaking that might be construed by some as aiding and abetting broker-dealer fraud. Certainly the illusion of trust will be created among investment consumers, even though no true duty of loyalty exists under Regulation BI (nor any longer under the Advisers Act as interpreted by the SEC).
The challenge posed by the SEC Chair’s actions are immense. They threaten to take our emerging profession down the path toward oversight by FINRA, who will soon be able to argue that there is “no distinction” in the conduct standards of investment advisers and brokers. FINRA would then impose upon investment advisers burdensome rules, as principles-based regulation will have been abandoned. Regulation Best Interest, and the SEC’s proposed watering down of the fiduciary duties of investment advisers, combine to jeopardize the path toward a true profession for financial and investment advisers.
And these actions will discourage capital formation and deter U.S. economic growth. Trust is essential in this modern era of specialization, and more importantly in the area of financial services – given the complexity of the capital markets today and the vast information asymmetry that exists.
Together we must act, to deter the SEC from moving forward. The U.S. Congress can overturn this regulation. There exist many bipartisan reasons to do so – to protect American business owners, to foster capital formation and capital growth, and to prevent a government agency from destroying a legislative scheme for the regulation of broker-dealers and investment advisers that so long ago acknowledged their distinctively different roles in our system of financial services. The time for us to take action is now.
Ron A. Rhoades, JD, CFP® is director of the personal financial planning program and assistant professor – finance at the Gordon Ford College of Business at Western Kentucky University.
[1] FINRA’s position has been roundly criticized. For example, see Brian Rubin, Amanda Griffin, Melissa Fox and Yvonne Williams-Wass, “INSIGHT: When Precedent Doesn’t Really Stand for That Proposition: FINRA’s Suitability Rule and the Meaning of ‘Best Interest’” (Dec. 12, 2018), which can be found at https://news.bloomberglaw.com/securities-law/insight-when-precedent-doesnt-really-stand-for-that-proposition-finras-suitability-rule-and-the-meaning-of-best-interest [stating, in part: “Everyone knows that broker-dealers and investment advisers have different duties and obligations to their clients. Well, not quite everyone. In particular, not the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization (SRO) authorized by Congress as the primary regulator of broker-dealers … When it proposed the rule, the SEC observed that while broker-dealers currently operate under an “extensive” framework of rules and regulations, ‘there is no specific obligation . . . that broker-dealers make recommendations that are in their customers’ best interest’ … On November 7, 2018, the SEC’s Investor Advisory Committee (IAC) recommended that the Commission clarify the proposed regulation to more explicitly state that “a best interest standard is a fiduciary standard.” (Emphasis in original.) … Despite the apparent clear differences between the duties of broker-dealers and investment advisers, FINRA has a different view. On three occasions, FINRA has stated that broker-dealers must act consistently with their clients’ best interests.
· In an August 3, 2018, comment letter regarding Reg BI, FINRA stated, “FINRA’s suitability rule implicitly requires a broker-dealer’s recommendations to be consistent with customers’ best interest.”
· In a May 2012 Regulatory Notice regarding its then-new suitability rule, FINRA stated that, “[t]he suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.”
· Finally, in a January 2011 Regulatory Notice, FINRA stated that it is “well-settled that a broker’s recommendations must be consistent with his customer’s best interests.’”
In all three instances, FINRA cited SEC and FINRA case law for its position … Despite the language contained in these cases, most industry participants recognize that investment advisers must act in their client’s best interest due to the presence of a fiduciary relationship, but that broker-dealers are held to a less-stringent, reasonable basis suitability standard. FINRA, on the other hand, relying on misconstrued legal precedent, has asserted that acting in a client’s best interest is already implicitly required of broker-dealers … The lesson here appears to be that the next time that the SEC or FINRA relies on precedent that sounds too good to be true and appears to be contrary to accepted wisdom, the regulator should review the cases thoroughly before citing them ….”
[2] “It is indisputable that … asset managers owe a [duty of loyalty] to their clients …” Bahar, Rashid and Thévenoz, Luc, Conflicts of Interest: Disclosure, Incentives, and the Market. Luc Thévenoz and Rashid Bahar, eds., Kluwer Law International and Schulthess, 2007. Available at SSRN: https://ssrn.com/abstract=964778.
[3] In 2005, FINRA opposed the application of the Advisers Act’s fiduciary duties upon brokers who provided fee-based accounts, even though FINRA acknowledged that, “[f]rom a retail client’s perspective, the differences between investment advisory services and traditional brokerage services are almost imperceptible.” FINRA Comment Letter to U.S. Securities and Exchange Commission, July 11, 2005, re: “Certain Broker-Dealers Deemed Not to Be Investment Advisers,” Securities Exchange Act Release No. 40980; File No. S7-25-99, at p.2. Stating that “brokerage investors are fully protected,” FINRA even questioned the need for additional disclosures to investors. Also, in its widely criticized statement, FINRA expressed in 2005 that the SEC’s proposed disclosure for fee-based accounts “implies that customer’s rights, the firm’s duties and obligations, and the applicable fiduciary obligations are greater with respect to an investment adviser account than they are with respect to a brokerage account. As we have previously discussed, this is simply not the case.” FINRA’s statement was clearly erroneous, as everyone – and their mothers – agree that the fiduciary standard is a much higher standard than the suitability standard.
[4] SEC v. Moran, 922 F.Supp. 867, 895-6 (S.D.N.Y., 1996). See also In re Prudential Ins. Co. of America Sales Prac., 975 F.Supp. 584, 616 (D.N.J., 1996), stating: “An essential feature and consequence of a fiduciary relationship is that the fiduciary becomes bound to act in the interests of her beneficiary and not of herself.”
[5] Rocky Mountain Financial Planning, Inc. (pub. avail. Feb. 28, 1983). The need to avoid conflicts of interest was emphasized more recently by the D.C. Circuit Court of Appeals in examining the purpose of the Advisers Act, when it stated: “The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'” Financial Planning Association v. Securities and Exchange Commission, No. 04-1242 (D.C. Cir. 3/30/2007) (D.C. Cir., 2007) citing SEC vs. Capital Gains at 187.
[6] SEC Rel. No. IA-1092, October 8, 1987, 52 F.R. 38400, citing Kidder, Peabody & Co., Inc., 43 S.E.C. 911, 916 (1968).
[7] Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011) (hereafter “SEC Staff 2011 Study”), available at www.sec.gov/news/studies/2011/913studyfinal.pdf, at p. 22.
[8] In re Prudential Ins. Co. of America Sales Prac., 975 F.Supp. 584, 616 (D.N.J., 1996).
[9] SEC Rel. No. IA-1092, October 8, 1987, 52 F.R. 38400, citing Kidder, Peabody & Co., Inc., 43 S.E.C. 911, 916 (1968).
[10] Pepper v. Litton, 308 U.S. 295, 311 (1939).
[11] Wormley v. Wormley, 21 U.S. 421; 5 L. Ed. 651; 1823 U.S. LEXIS 290; 8 Wheat. 421 (1823).
[12] Michoud v. Girod, 45 U.S. 503; 11 L. Ed. 1076; 1846 U.S. LEXIS 412; 4 HOW 503 (1846).
[13] SEC vs. Capital Gains, at text accompanying note 48.
[14] Many broker-dealer firms (and dual registrant firms) seek to avoid restrictions upon their business practices, and the fiduciary standard of conduct – properly applied in accordance with common law principles - is perhaps the most significant restriction upon the conduct of the firm and its personnel. At is core, the fiduciary standard of conduct restrains conduct – and deters greed.
[15] The existence of “federal fiduciary standard” under the Investment Advisers Act of 1940, which serves to make uniform for any federal purposes the law should differences exist among state common law, does not mean that deference is not provided to the scope of fiduciary duties as they exist under state common law. See U.S. v. Brennan, 938 F.Supp. 1111 (E.D.N.Y., 1996) (“Other spheres in which the existence and scope of a fiduciary duty are matters of federal concern are ERISA and § 523(a)(4) of the Bankruptcy code. The analysis under each of these statutes continues to be informed by state and common law. See, e.g., Varity v. Howe, ___ U.S. ___, ___, 116 S.Ct. 1065, 1070, 134 L.Ed.2d 130 (1996); F.D.I.C. v. Wright, 87 B.R. 1011 (D.S.D. 1988) (bankruptcy).”) Id. at 1119.
[16] “What generally sets the fiduciary apart from other agents or service providers is a core duty, when acting on the principal’s behalf, to adopt the objectives or ends of the principal as the fiduciary’s own.” Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940, 91 Boston Univ. L.Rev. 1051, 1055 (2011).]
[17] Under English law, from which American law is derived, the broad fiduciary duty of loyalty includes these three separate rules: (1) The “No Conflict” Rule: A fiduciary must not place itself in a position where its own interests conflict with those of its client. (2) The “No Profit” Rule: A fiduciary must not profit from its position at the expense of the client. This aspect of the fiduciary duty of loyalty is often considered a prohibition against self-dealing. (3) The “Undivided Loyalty” Rule: A fiduciary owes undivided loyalty to its client and therefore must not place itself in a position where his or her duty toward one client conflicts with a duty that it owes to another client. These separate rules are alive and well in the United States.
[18] SEC Staff, Study on Investment Advisers and Broker-Dealers ii (2011) [hereinafter SEC Staff Study], available at http://www.sec.gov/news/studies/2011/913studyfinal.pdf.
[19] SEC v. Capital Gains Research Bureau (1963).
As the Virginia Supreme Court long ago stated: “It is well settled as a general principle, that trustees, agents, auctioneers, and all persons acting in a confidential character, are disqualified from purchasing. The characters of buyer and seller are incompatible, and cannot safely be exercised by the same person. Emptor emit quam minimo potest; venditor vendit quam maximo potest. The disqualification rests, as was strongly observed in the [English] case of the York Buildings Company v. M'Kenzie, 8 Bro. Parl. Cas. 63, on no other than that principle which dictates that a person cannot be both judge and party. No man can serve two masters. He that it interested with the interests of others, cannot be allowed to make the business an object of interest to himself; for, the frailty of our nature is such, that the power will too readily beget the inclination to serve our own interests at the expense of those who have trusted us.”
As was well-known in the early case law: "The principle is undeniable that an agent to sell cannot sell to himself, for the obvious reason that the relations of agent and purchaser are inconsistent, and such a transaction will be set aside without proof of fraud.” Porter v. Wormser , 94 N. Y. 431, 447 (1884). (Emphasis added.)
In an early speech by the Louis Loss, for long the leading scholar on the federal securities law, presented at a time when he served the Commission, Professor Loss stated: “[A]s an eloquent Tennessee jurist put it before the Civil War, the doctrine ‘has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, ‘Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that ‘a man cannot serve two masters.’ ” Address entitled “The SEC and the Broker-Dealer” by Louis Loss, Chief Counsel, Trading and Exchange Division, U.S. Securities and Exchange Commission on March 16, 1948, before the Stock Brokers’ Associates of Chicago.
[20] See Commission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, Release Nos. 34-58264; IC-28345 (July 30, 2008), at 23: “Second, investment advisers, as fiduciaries, generally are prohibited from receiving any benefit from the use of fund assets ….”
[21] Bahar, Rashid and Thévenoz, Luc, Conflicts of Interest: Disclosure, Incentives, and the Market. Luc Thévenoz and Rashid Bahar, eds., Kluwer Law International and Schulthess, 2007. Available at SSRN: https://ssrn.com/abstract=964778.
[22] In contrast, in arms-length relationships disclosure and consent creates estoppel, as customers generally possess responsibility for their own actions. This is fundamental to anti-fraud law, as applicable to arms-length relationships (“actual fraud”). Section 525 of the Restatement (Second) of Torts provides the general rule for fraudulent misrepresentation: “One who fraudulently makes a misrepresentation of fact, opinion, intention, or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.”
[23] In dealing with the state securities statutes, state courts often disallow the defense of estoppel in order to preserve the protections afforded to retail consumers. See, e.g., Go2net, Inc. v. Freeyellow.com, Inc., 109 P.3d 875 (Wash. App., 2005), stating in pertinent part: “We are persuaded that the better rule is to bar the defenses of estoppel and waiver in an action alleging violation of a securities regulation. The flexibility of such defenses is inconsistent with our Act's foremost objective of protecting investors. The statute provides the clean and surgical remedy of rescission as the sole recourse for an investor who proves a violation. It would upset the balance struck by the statute to allow factfinders to evaluate the investor's conduct on a case-by-case basis to determine whether it excuses the violation. We hold that equitable defenses are not available in an action under the Securities Act of Washington and conclude the trial court properly dismissed Molino’s defenses of estoppel and waiver.” Id. at ____.
See also, e.g., Covert v. Cross, 331 S.W.2d 576, 585 (Mo., 1960), stating: “The theory of estoppel the defendants sought to present 'would tend to nullify and defeat the very purpose of the statute, which is clearly penal in nature . . . The Act was passed to protect investors against their own weaknesses and to prevent the happening of such losses as are shown by this record.'” Covert, 331 S.W.2d at 585.
The concerns expressed in Covert were cited and echoed by the dissent in the Illinois appellate court Logan decision, which likewise expressed the view that the adoption of an equitable estoppel defense severely undermines the legislation regulating the sale of securities: “The very person sought to be protected, the investor, is denied recovery while the individual violating the law escapes liability. This result neither serves to compensate the innocent purchaser nor does it deter future violations of the Blue Sky Law. In fact, the majority decision could prompt clever promoters of questionable investments to ignore the Blue Sky regulations and, instead, encourage an investor to participate in the management of the company so that an estoppel defense could later be established. Clearly, use of estoppel as a defense in the instant actions is inconsistent with the express terms of the statute, as well as the policy underlying our Blue Sky Law. This law should be strictly enforced, and legal exceptions kept to a bare minimum.” Logan, dissenting opinion at 293 N.W.2d at 36A commentator further opines that the overall effect of allowing estoppel, even in limited circumstances, undermines the deterrent effect of the civil liability provisions: “Courts that allow the defense of estoppel lessen the blue sky laws' deterrent value and thus decrease compliance with the laws by hampering plaintiffs' chances of recovery. Repeated successful use of the defenses will result in decreased compliance with the laws. Courts that disallow estoppel, on the other hand, increase deterrence by allowing for more successful suits and creating a 'general climate of fear of the statutory civil actions.' To the extent that such courts increase deterrence, they further the primary goal of the laws.” Charles G. Stinner, Estoppel and In Pari Delicto Defenses to Civil Blue Sky Actions, 73 Cornell L. Rev. 448, 463 (1988)(footnotes omitted).
[24] Sections 206(1) and 206(2) of the Advisers Act make it unlawful for any investment adviser to employ any device, scheme, or artifice to defraud, or to engage in any transaction, practice, or course of business that operates as fraud or deceit on clients or prospective clients. Those antifraud provisions may be violated by the use of a hedge clause or other exculpatory provision in an investment advisory agreement which is likely to lead an investment advisory client to believe that he or she has waived non-waivable rights of action against the adviser that are provided by federal or state law. See, e.g., In the Matter of William Lee Parks, Investment Advisers Act Release No. 736 (Oct. 27, 1980) and In the Matter of Olympian Financial Services, Inc., Investment Advisers Act Release No. 659 (Jan. 16, 1979). See also Opinion of General Counsel Roger S. Forster Relating to the Use of Hedge Clauses by Brokers, Dealers, Investment Advisers and Others, Investment Advisers Act Release No. 58 (Apr. 10, 1951).
[25] An “irreducible core” of fiduciary duties exist, which are not subject to waiver by disclosure and consent under any circumstances. See A. Trukhtanov, The Irreducible Core of Fiduciary Duties (2007) 123 LQR 342.
[26] Note that the contractuarian view of fiduciary law has no place in fiduciary relationships in which there is a great superiority in knowledge held by the fiduciary. “[C]ontract law concerns itself with transactions while fiduciary law concerns itself with relationships.” Rafael Chodos, Fiduciary Law: Why Now! Amending the Law School Curriculum, 91 Boston U.L.R. 837, 845 (and further noting that “Betraying a relationship is more hurtful than merely abandoning a transaction.” Id. See also Laby, The Fiduciary Obligation as the Adoption of Ends, 56 Buff. L. Rev. 99, 104-29 (2008) (rejecting contractual approach as descriptive theory of fiduciary duties, and at 129-30 (arguing that signature obligation of fiduciary is to adopt ends of his or her principal).
Other scholars appear reject the contractualist theory of fiduciary duties more broadly. See, e.g., Tamar Frankel, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209 (1995) (“[C]ircumstances exist where fiduciary duties are not waivable for reasons such as doubts about the quality of the entrustors' consent (especially when given by public entrustors such as shareholders), and the need to preserve institutions in society that are based on trust. Further, non-waivable duties can be viewed as arising from the parties' agreement ex ante to limit their ability to contract around the fiduciaries' duties. Under these circumstances fiduciary rules should generally be mandatory and non-waivable … I conclude that private and public fiduciaries should be subject to a separate body of rules and reject the contractarian view..”) Id. See also Scott FitzGibbon, Fiduciary Relationships Are Not Contracts, 82 MARQ. L. REV. 303, 305 (1999) (“This Article explores the nature of fiduciary relationships, shows that they arise and function in ways alien to contractualist thought, and that they have value and serve purposes unknown to the contractualists.”) “Many courts deny the contractual approach.” Arthur Laby, Fiduciary Obligations of Broker-Dealers, 55 Villanova L.Rev. 701, 711 (2010).
[27] See, generally Black's Law Dictionary 523 (7th ed. 1999) ("A duty of utmost good faith, trust, confidence, and candor owed by a fiduciary (such as a lawyer or corporate officer) to the beneficiary (such as a lawyer's client or a shareholder); a duty to act with the highest degree of honesty and loyalty toward another person and in the best interests of the other person (such as the duty that one partner owes to another."); also see F.D.I.C. v. Stahl, 854 F.Supp. 1565, 1571 (S.D. Fla., 1994) (“Fiduciary duty, the highest standard of duty implied by law, is the duty to act for someone else's benefit, while subordinating one's personal interest to that of the other person); and see Perez v. Pappas, 98 Wash.2d 835, 659 P.2d 475, 479 (1983) (“Under Washington law, it is well established that ‘the attorney-client relationship is a fiduciary one as a matter of law and thus the attorney owes the highest duty to the client.’”), cited by Bertelsen v. Harris, 537 F.3d 1047 (9th Cir., 2008); also see Donovan v. Bierwirth, 680 F. 2d 262, 272, n.8 (2nd Cir., 1982) (fiduciary duties are the “highest known to law”).
[28] “The legal system provides for only two levels of trust and their differentiation is necessary for them to be useful tools for parties setting up relationships ... In essence, legal systems provide only two levels of loyalty between contracting parties, arm's-length and fiduciary relationships. The difference in the degree of trust that the two levels of loyalty entitle the parties is dramatic. Fiduciary relations impose a pure duty of loyalty, according to which the fiduciary must place the interests of his employer before his own. Arm's-length relations, by contrast, allow exploitation within the parameters of good faith.” Georgakopoulos, Nicholas L., “Meinhard v. Salmon and the Economics of Honor” (April 1998, revised Feb. 8, 1999). Available at SSRN: http://ssrn.com/abstract=81788.
[29] Deborah DeMott, “Beyond Metaphor: An Analysis of Fiduciary Obligation” (1988) Duke Law Journal 879 at 888.
[30] Brandt, Kelly & Simmons, LLC, Admin. Proc. File No. 3-11672, 2004 WL 2108661 (SEC Sept. 21, 2004).
[31] There must be no coercion for the informed consent to be effective. The “voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so.” Tamar Frankel, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.
[32] The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related professional advisory contexts, such as the duties imposed upon an attorney with respect to his or her client: “The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure.” In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007). "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) [emphasis added], quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); “[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients.” In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007) [emphasis added].
[33] Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926). See also “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, then-Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference, citing Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949). See also Bogert on Trusts, Paul D. Finn, Fiduciary Obligations (1977); J.C. Shepherd, The Law of Fiduciaries (1981). See also Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949).
[34] Even in arms-length relationships, a ratification or waiver defense may fail if the customer proves that he did not have all the material facts relating to the trade at issue. E.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1213 (8th Cir. 1990); Huppman v. Tighe, 100 Md. App. 655, 642 A.2d 309, 314-315 (1994). In contrast, in fiduciary relationships the failure to disclose material facts while seeking a release has been held to be actionable, as fraudulent concealment. See, e.g., Pacelli Bros. Transp. v. Pacelli, 456 A.2d 325, 328 (Conn. 1982) (‘the intentional withholding of information for the purpose of inducing action has been regarded ... as equivalent to a fraudulent misrepresentation.’); Rosebud Sioux Tribe v. Strain, 432 N.W. 2d 259, 263 (S.D. 1988) (‘The mere silence by one under such a [fiduciary] duty to disclose is fraudulent concealment.’)” (Id.)
[35] The Commission has stated that disclosure must occur not only of conflicts of interest, but also of potential conflicts of interest. See Release No. IA-1396, In the Matter of: Kingsley, Jennison, Mcnulty & Morse Inc. (Dec. 23, 1993).
[36] See, e.g., In the Matter of The Robare Group, Ltd., et al., Investment Advisers Act Release No. 4566 (Nov. 7, 2016) (Commission Opinion) (appeal docketed) (finding, among other things, that adviser’s disclosure was inadequate because it stated that the adviser may receive compensation from a broker as a result of the facilitation of transactions on client’s behalf through such broker-dealer and that these arrangements may create a conflict of interest when adviser was, in fact, receiving payments from the broker and had such a conflict of interest).
[37] In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).
[38] Evan J. Criddle, Liberty in Loyalty: A Republican Theory of Fiduciary Law, 95 Tex.L.R. 993, 1011 (2017), citing: See In re Primedia Inc. Derivative Litig., 910 A.2d 248, 262 (Del. Ch. 2006) (“[T]he duty of loyalty ‘does not rest upon the narrow ground of injury or damage to the corporation resulting from a betrayal of confidence, but upon a broader foundation of a wise public policy that, for purposes of removing all temptation, extinguishes all possibility of profit flowing from the breach of confidence imposed by the fiduciary relation.’” (quoting Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939))).
[39] Frankel, Tamar, Fiduciary Law, 71 Calif. L. Rev. 795 (1983).
[40] See Robert H. Sitkoff, The Fiduciary Obligations of Financial Advisors Under the Law of Agency (2013): (]T]here are mandatory rules within the fiduciary obligation that cannot be overridden by agreement. For example, the principal cannot authorize the fiduciary to act in bad faith. Even if the principal authorizes self-dealing, fiduciary law provides substantive safeguards, requiring the fiduciary to act in good faith and deal fairly with and for the principal …”
[41] See Robert H. Sitkoff, Economic Structure of Fiduciary Law, 91 Boston Univ.L.Rev. 1039, 1046 [“To be sure, there is a mandatory core to the fiduciary obligation that cannot be overridden by agreement. For example, the principal cannot authorize the fiduciary to act in bad faith.” and citing See, e.g., UNIFORM POWER OF ATTORNEY ACT § 114(a) (2006); UNIFORM TRUST CODE § 105(b)(2) (2000); RESTATEMENT (THIRD) OF TRUSTS § 78, cmt. c(2) (2007); RESTATEMENT (THIRD) OF AGENCY § 8.06(1)(a), (2)(a) (2006).j]
[42] Birnbaum v. Birnbaum, 117 A.D.2d 409, 503 N.Y.S.2d 451 (N.Y.A.D. 4 Dept., 1986).
[43] In the absence of integrity and fairness in a transaction between a fiduciary and the client or beneficiary, it will be set aside or held invalid. Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y. 2d 692, 698 (1978) (2006 WL 3016952 at *29).
[44] See Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y. 2d 692, 698 (1978) (2006 WL 3016952 at *29).
[45] Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209, further stating: “Where the beneficiaries are all sui juris and consent to the sale, it cannot be set aside if the trustee made a full disclosure and did not induce the sale by taking advantage of his relation to the beneficiaries or by other improper conduct, and if the transaction was in all respects fair and reasonable. On the other hand, the sale can be set aside if the trustee did not make a full disclosure, or if he improperly induced the sale, or if the transaction was not fair and reasonable ... In order to transform the fiduciary mode into a contract mode, four conditions must be met: (1) entrustors must receive notice of the proposed change in the mode of the relationship; (2) entrustors must receive full information about the proposed bargain; (3) the entrustors' consent should be clear and the bargain specific; (4) the proposed bargain must be fair and reasonable.” Id.
[46] Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.
[47] 1963 SEC Study of the Securities Industry, citing various SEC Releases.
[48] Senator Francis T. Maloney, Regulation of the Over-the-Counter Security Markets, Address at the California Security Dealers Association, Investment Bankers Association, National Association of Securities Dealers 2 (Aug. 22, 1939) (transcript available in the SEC Library at 11 SEC Speeches, 1934-61).
[49] Judge Paul Crotty in Richman v. Goldman Sachs Group, Inc., 868 F. Supp. 2d 261 (S.D.N.Y. 2012).
[50] §409.5-502(a) (emphasis added); cf. 17 C.F.R. § 240.10b-5©
[51] Aaron v. Sec. & Exch. Comm'n, 446 U.S. 680, 697, 100 S.Ct. 1945, 1955, 64 L.Ed.2d 611 (1980).
[52] James J. Angel, Ph.D., CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (Sept. 30, 2010).
[53] Given the substantial likelihood that many potential litigants will fail to pursue private remedies, a popular mechanism for enforcement of market conduct measures is regulation, including supervised self-regulation. There is an important role for government agencies to play in ensuring adherence to fiduciary standards of conduct, but micro-management by a regulator should be avoided. I submit that the limited enforcement resources of government should be devoted to: (1) asset verification – i.e., ensuring that investors’ assets are properly custodied; (2) compliance with broad policy purposes by tackling systemic dysfunctions; and (3) interceding in major violations – such as when a large number of clients is adversely affected by a firm’s course of conduct. While reported violations can and should be investigated and dealt with properly, frequent inspections of investment advisory firms – other than to verify custody of assets – should not occur absent cause. By raising the bar for providers of investment advice through the application of a bona fide fiduciary standard, a new era of integrity will be infused over time throughout the profession. As a consequence, providers of investment advice can then be treated as other professionals (such as attorneys, CPAs) – as professionals, and subject to examination only when good cause exist (and for verification of assets, as a means of deterring actual fraud, such as Ponzi schemes).
[54] For years it has been known that that investors do not read disclosure documents. See, generally, Homer Kripke, The SEC and Corporate Disclosure: Regulation In Search Of A Purpose (1979); Homer Kripke, The Myth of the Informed Layman, 28 Bus.Law. 631 (1973). See also Baruch Lev & Meiring de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7, 19 (1994) (“[M]ost investors do not read, let alone thoroughly analyze, financial statements, prospectuses, or other corporate disclosures ….”); Kenneth B. Firtel, Note, “Plain English: A Reappraisal of the Intended Audience of Disclosure Under the Securities Act of 1933, 72 S. Cal. L. Rev. 851, 870 (1999) (“[T]he average investor does not read the prospectus ….”).
[55] For an overview of various individual investor bias such as bounded irrationality, rational ignorance, overoptimism, overconfidence, the false consensus effect, insensitivity to the source of information, the fact that oral communications trump written communications, and other heuristics and bias, see Robert Prentice, “Whither Securities Regulation? Some Behavioral Observations Regarding Proposals for its Future,” 51 Duke L. J. 1397 (2002).
[56] Even a case note describing SEC vs. Capital Gains decision at the time of its issuance observed the inherent weakness of disclosures in dealing with the complex financial markets. The Supreme Court, 1963 Term—Dealing by Advisers in Recommended Securities, 78 Harv. L. Rev. 292, 294 (1964) (“If the investing public is truly naïve, disclosure does not provide a realistic method of protection.”)
[57] See, e.g., Lusardi A. Financial Literacy: An Essential Tool for Informed Consumer Choice?. Dartmouth College, Harvard Business School, and National Bureau of Economic Research; 2008. [“Most individuals cannot perform simple economic calculations and lack knowledge of basic financial concepts, such as the working of interest compounding, the difference between nominal and real values, and the basics of risk diversification. Knowledge of more complex concepts, such as the difference between bonds and stocks, the working of mutual funds, and basic asset pricing is even scarcer.”]
See also, e.g., FINRA and U.S. Department of the Treasury. Financial Capability in the United States National Survey—Executive Summary. Washington, DC: United States Department of the Treasury and the FINRA Investor Education Foundation; 2009. [“In today‘s complex financial marketplace, it can take a great deal of motivation, ability, and opportunity to sort through both relevant and irrelevant data necessary to make optimal decisions. This asks a great deal of consumers, many of whom face the pressures of time poverty as well as limited financial resources. Others simply cannot or do not want to perform all the tasks needed to optimize their financial situation (i.e., set decision criteria, diligently search for information, weigh attributes, and evaluate alternatives). Furthermore, these financial decisions are highly person or household specific: one family‘s decision may not work for another. And even if consumers go through a rigorous decision-making process, there can be problems with implementation.”]
[58] Troy A. Parades, Blinded by the Light: Information Overload and Its Consequences for Securities Regulation, 81 Wash. Univ. L. Rev. 417, 419-9 (2003).
[59] “Submission to the Financial System Inquiry by the Financial Planning Association of Australia Limited,” December 1996.
[60] Knowledge@Wharton, “Today's Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” citing Choi, James J., Laibson, David I. and Madrian, Brigitte C., “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds” (March 6, 2008). Yale ICF Working Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023.
The researchers updated their experiment in 2010. Choi, James, David Laibson, and Brigitte Madrian. Why does the law of one price fail? An experiment on index mutual funds. 23 Review of Financial Studies 1405 (2010) [“We asked 730 experimental subjects to each allocate a hypothetical $10,000 among four real S&P 500 index funds. All subjects received the funds’ prospectuses. To make choices incentive-compatible, subjects’ expected payments depended on the actual returns of their portfolios over a specified time period after the experimental session. We offered especially large incentives in one version of our experiment; for each of the 391 subjects in this implementation, choosing the most expensive portfolio instead of the least expensive portfolio reduced his or her wealth by $94 … no non-portfolio services were provided. Thus, the optimal portfolio allocates everything to the lowest-cost index fund … Our largest subject group (which received the largest incentives) consists of Harvard staff members—all white collar non-faculty employees – who on average have many years of experience managing their personal finances. Furthermore, 88% have a college degree, and 60% have graduate school education as well. Our next largest group of participants consists of MBA students from Wharton. The remaining subjects are college students recruited on the Harvard campus. Our MBA subjects report an average combined SAT score of 1453, which is at the 98th percentile nationally, and our college subjects report an average score of 1499, which is at the 99th percentile. When we measure financial literacy directly, we find that all three subject groups are more knowledgeable than the typical American investor … Despite eliminating non-portfolio services, we find that almost none of the subjects minimized fees. On average, staff, MBA students, and college students respectively paid 201, 112, and 122 basis points more in fees than they needed to when they received only the funds’ prospectuses to aid their decision … Even subjects who claimed to prioritize fees in their portfolio decision showed minimal sensitivity to the fee information in the prospectus. Subjects apparently do not understand that S&P 500 index funds are commodities. In our experiment, fees paid are increasing in financial illiteracy. In the real world, this problem is likely to be exacerbated by the financial advisors whose compensation is increasing in the fees of the mutual funds they sell to their clients. When consumers in a commodity market observe prices and quality with noise, a high degree of competition will not drive markups to zero (Gabaix, Laibson, and Li, 2005; Carlin, 2009). Our results suggest that such noise helps account for the large amount of price dispersion in the mutual fund market … In sum, although better disclosure and financial education may be helpful, the evidence in this paper and Beshears et al. (2008) indicate that their effect on portfolios is likely to be modest”] Id. (Emphasis added.)00
[61] Newall, P. W. S., & Love, B. C. Nudging investors big and small toward better decisions (2015), in abstract.
[62] Jill E. Fisch & Tess Wilkinson-Ryan, Why Do Retail Investors Make Costly Mistakes? An Experiment on Mutual Fund Choice, 162 U. PA. L. REV. 605, 636-37, 643, 645 (2014).
[63] See, e.g., Letter dated March 10, 2015 to Mary Jo White, Chair, SEC, from Consumer Federation of America, Americans for Financial Reform, Fund Democracy, Consumer Action, Public Citizen, and AFL-CIO (“One way that brokers obscure the costs that investors incur for their services is by charging for those services through 12b-1 fees rather than through up-front commissions. While there is nothing inherently wrong with charging for services in incremental payments, this practice suffers from several important short-comings. Because 12b-1 fees are not considered commissions, they are not subject to FINRA commission limits. Because the fees are buried within the administrative fee charged by mutual funds and annuities, investors often fail to understand how much they are paying or what they are paying for through these fees.”) Id. at p.4.
[64] The Rand Report (Jan. 2008 draft) reported that 75 out of 299 respondents to a survey (as to those who answered the question posed), or nearly 25%, reported that they paid “zero” fees to their broker or investment adviser. Interestingly enough, 70% of those investors surveyed indicated that they were very satisfied with their financial services advisor. This begs the question – if the 25% who thought they were paying nothing found out the truth, would they still be very satisfied? And if the other 75% who believed they were paying some fees (but who likely were unaware of the total actual fees and costs they paid) found out the true fees and costs paid, would they be satisfied with their financial advisor?
Likewise, while a 2011 Cerulli Associates survey of 7,800 households found that 47 percent would prefer to pay commissions rather than asset-based fees (preferred by 27 percent), lump-sum retainer fees (18 percent) or hourly fees (8 percent), a large percentage of those investors (33 percent) did not know how they currently pay for investment advice, with another 31 percent believing that the advice they currently receive is free (“Commissions Win The Day Over Fees,” 2011).
[65] John Beshears, James J. Choi, David Laibson, Brigitte C. Madrian, How Does Simplified Disclosure Affect Individuals’ Mutual Fund Choices? Explorations in the Economics of Aging, University of Chicago Press (2011). [“[T]he Summary Prospectus reduces the amount of time spent on the investment decision without adversely affecting portfolio quality. On the negative side, the Summary Prospectus does not change, let alone improve, portfolio choices. Hence, simpler disclosure does not appear to be a useful channel for making mutual fund investors more sophisticated and for creating competitive pricing pressure on mutual fund companies. Our experiments also shed light on the scope of investor confusion regarding loads. Even when our subjects have a one- month investment horizon— where minimizing loads is the only sensible strategy—they do not avoid loads. In our experiment, subjects chose funds with an average load of 3.00 percent in the conditions with an investment horizon of one month. This choice is like betting that the chosen portfolio has an (implausible) excess log return relative to the load- minimizing portfolio of 24 percentage points per year. We conclude that our subjects either do not understand how loads work or do not take them into account. We also conclude that the Summary Prospectus does nothing to alleviate these kinds of errors.”] Id.
[66] Jill E. Fisch, “Regulatory Responses To Investor Irrationality: The Case Of The Research Analyst,” 10 Lewis & Clark L. Rev. 57, 74-83 (2006).
[67] See, e.g., George Loewenstein, Cass R. Sunstein, and Russell Golman, Disclosure: Psychology Changes Everything, 6 Annu. Rev. Econ. 391 (2014) [“Psychological factors severely complicate the standard arguments for the efficacy of disclosure requirements. Because attention is both limited and motivated, disclosures may be ignored, especially if they are complex and provide unwelcome news, and new disclosures, even of valid information, may turn out to distract attention from older and possibly more important ones. As a result of limited attention and the other psychological factors discussed in Section 3, disclosure requirements appear to have been less effective in changing recipient behavior than their proponents seem to assume … Unfortunately, disclosure of misaligned incentives can have perverse effects on the producer side of the equation. Specifically, advisors who would have otherwise been intrinsically motivated to provide unbiased advice can feel morally licensed to provide biased advice once a conflict of interest has been disclosed. And because of insinuation anxiety, advice recipients may feel greater pressure, with this disclosure, to follow the now less trusted advice.” Id. at 413-4.
A study conducted by the Australian Securities & Investment Commission in 2006 found that advisors were six times more likely to offer “bad advice” (advice that was subjectively determined not to have considered key factual issues, did not fit the client’s needs, or was likely to leave the client worse off) when the advisor had a conflict of interest over compensation (e.g., commissions) and three times more likely when suggesting an associated product (e.g., an in-house fund). The study also found that consumers were rarely able to detect bad advice.
See also Carmel, Eyal and Carmel, Dana and Leiser, David and Spivak, Avia, Facing a Biased Adviser While Choosing a Retirement Plan: The Impact of Financial Literacy and Fair Disclosure. (July 9, 2015). [“The aim of the present study was to explore the effect of the advice given by the agent, along with that of two further factors: a fair disclosure statement regarding the agent’s conflict of interest, and the customer's degree of financial literacy. Two experiments conducted among undergraduate students in Israel showed that customers mostly follow the agent's recommendation, even against their best interest, and despite the presence of a fair disclosure statement.”]
[68] Jeremy Burke, Angela A. Hung, Jack Clift, Steven Garber, and Joanne K. Yoong, Impacts of Conflicts of Interest in the Financial Services Industry (RAND working paper, Feb. 2015), at pp. 39-40.
[69] Steven L. Schwarcz, Rethinking The Disclosure Paradigm In A World Of Complexity, Univ. Ill. L. Rev Vol. 2004, p.1, 7 (2004), citing “Disclosure To Investors: A Reappraisal Of Federal Administrative Policies Under The ‘33 and ‘34 Acts (The Wheat Report),“ 52 (1969); accord William O. Douglas, “Protecting the Investor,” 23 Yale Rev. 521, 524 (1934).
[70] As stated by Professor Ripken: “[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one’s own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is ‘doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases’ … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.” Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.
[71] See Robert Prentice, Whither Securities Regulation Some Behavioral Observations Regarding Proposals for its Future, 51 Duke Law J. 1397 (March 2002). Professor Prentices summarizes: “Respected commentators have floated several proposals for startling reforms of America’s seventy-year-old securities regulation scheme. Many involve substantial deregulation with a view toward allowing issuers and investors to contract privately for desired levels of disclosure and fraud protection. The behavioral literature explored in this Article cautions that in a deregulated securities world it is exceedingly optimistic to expect issuers voluntarily to disclose optimal levels of information, securities intermediaries such as stock exchanges and stockbrokers to appropriately consider the interests of investors, or investors to be able to bargain efficiently for fraud protection.” Available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397.
[72] Bahar, Rashid and Thévenoz, Luc, Conflicts of Interest: Disclosure, Incentives, and the Market. Luc Thévenoz and Rashid Bahar, eds., Kluwer Law International and Schulthess, 2007. Available at SSRN: https://ssrn.com/abstract=964778.
[73] Simon Johnson’s complete article is available at http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/?single_page=true. See also Simon Johnson, 2011, 3 Bankers: The Wall Street Takeover and the Next Financial Meltdown, Vintage Press.
[74] “Finance, which accounts for only about 8% of GDP, reaps about a third of all profits.” Noah Smith, http://noahpinionblog.blogspot.com/2013/02/finance-has-always-been-more-profitable.html.
See also James Kwak, Why Is Finance So Big? (Feb. 29, 2012): “Many people have noted that the financial sector has been getting bigger over the past thirty years, whether you look at its share of GDP or of profits. The common defense of the financial sector is that this is a good thing: if finance is becoming a larger part of the economy, that’s because the rest of the economy is demanding financial services, and hence growth in finance helps overall economic growth. But is that true? … the per-unit cost of financial intermediation has been going up for the past few decades: that is, the financial sector is becoming less efficient rather than more.” Available at http://baselinescenario.com/2012/02/29/why-is-finance-so-big/.
[75] The consulting firm Edelman Berland publishes a “Trust Barometer” each year that surveys various issues dealing with trust in both the U.S. and globally. One question posed is, “How much do you trust businesses in each of the following industries to do what is right?” Globally, the two industries listed at the bottom of the list are “Financial services” and “Banks” - both at 50% in the 2013 survey. 2013 Edelman Trust Barometer Executive Summary, available at http://trust.edelman.com/trust-download/executive-summary/.
[76] “Foreign investors now hold slightly less than 55% of the publicly held and publicly traded U.S. Treasury securities, 26% of corporate bonds, and about 12% of U.S. corporate stocks.1 The large foreign accumulation of U.S. securities has spurred some observers to argue that this foreign presence in U.S. financial markets increases the risk of a financial crisis, whether as a result of the uncoordinated actions of market participants or by a coordinated withdrawal from U.S. financial markets by foreign investors for economic or political reasons.” James K. Jackson, “Foreign Ownership of U.S. Financial Assets: Implications of a Withdrawal” (Congressional Research Service, April 8, 2013), p.1.
[77] Putnam, R., 1993, Making Democracy Work: Civic Traditions in Modern Italy, Princeton University Press, Princeton, NJ.; La Porta R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, 1997, “Trust in Large Organizations,” American Economic Review, 87, 333-338. In an influential paper, Knack and Keefer found that a country's level of trust is indeed correlated with its rate of growth. Knack, S. and Keefer, P. (1996). "Does social capital have an economic payoff?: A cross country investigation," The Quarterly Journal of Economics, vol 112, p.p 1251. See also Zak, P., and S. Knack, 2001, “Trust and Growth,” The Economic Journal, 111, 295-321.
Guiso, L., P. Sapienza, and L. Zingales, 2007, “Trusting the Stock Market,” Working Paper, University of Chicago.
[79] Georgarakos, Dimitris and Inderst, Roman, Financial Advice and Stock Market Participation (February 14, 2011). ECB Working Paper No. 1296. Available at SSRN: http://ssrn.com/abstract=1761486.
[80] Ronald J. Colombo, Trust and the Reform of Securities Regulation, 35 Del. J. Corp. L. 829 (2010).
[81] Id. at 875. Prof. Colombo further observed: “Increased regulation of broker-dealers is likely to do little harm, as it is unclear whether sufficient room for high-quality, affective/generalized trust exists here in the first place. And if, in the twenty- first century, the brokerage industry relies upon primarily cognitive and specific trust (due to increased movement toward the discount-broker business model), such increased regulation could be beneficial.” Id. at 876. Prof. Colombo explained the concept of cognitive trust: “Reliance and voluntary exposure to vulnerability stemming from cognitive trust is not based upon emotions or norms, but rather ‘upon a cost-benefit analysis of the act of trusting someone.’ For this reason, Williamson rejects even calling such reliance ‘trust.’ To him, such reliance is a form of calculativeness, which serves to economize on the scarcity of one's mental energies and time. The potential vulnerabilities accepted are not due to ‘trust,’ but to rational risk management-to the fact that ‘the expected gain from placing oneself at risk to another is positive.’ Id. at 836.
[82] The growth of the financial services industry has grown to an extraordinary proportion of the overall U.S. economy. As stated in a recent article by Gautam Mukunda appearing in the Harvard Business Review: "In 1970 the finance and insurance industries accounted for 4.2% of U.S. GDP, up from 2.8% in 1950. By 2012 they represented 6.6%. The story with profits is similar: In 1970 the profits of the finance and insurance industries were equal to 24% of the profits of all other sectors combined. In 2013 that number had grown to 37%, despite the after effects of the financial crisis. These figures actually understate finance’s true dominance, because many nonfinancial firms have important financial units. The assets of such units began to increase sharply in the early 1980s. By 2000 they were as large as or larger than nonfinancial corporations’ tangible assets …. " Gautam Mukunda, “The Price of Wall Street’s Power,” Harvard Business Review (June 2014).
[83] Indeed, many studies have demonstrated that Wall Street's excesses impair U.S. economic growth and the formation of new businesses and jobs. For example: “[F]inancialization depresses entrepreneurship. Paul Kedrosky and Dane Stangler of the Kauffman Foundation find that as financialization increases, startups per capita decrease, in part because the growth in the financial sector has distorted the allocation of talent. They estimate that if the sector were to shrink as a share of GDP back to the levels of the 1980s, new business formation would increase by two to three percentage points. We have substantial circumstantial evidence to show that these trends have had negative consequences at the macro level: 'the influence of finance sector size on economic growth turns negative when financial services become too large a share of an economy and that high levels of financial activity crowd out investment and R&D in the non-finance sector.'” (Emphasis added.) William A. Galston and Elaine C. Kamarck, The Brookings Institute.
The result of this excessive rent extraction by Wall Street is impairment of the growth of the U.S. economy. As Steve Denning recently noted in Forbes: “The excessive financialization of the U.S. economy reduces GDP growth by 2% every year, according to a 2015 study by International Monetary Fund. That’s amassive drag on the economy – some $320 billion per year. Wall Street has thus become, not just a moral problem with rampant illegality and outlandish compensation of executives and traders: Wall Street is a macro-economic problem of the first order … Throughout history, periods of excessive financialization have coincided with periods of national economic setbacks, such as Spain in the 14th century, The Netherlands in the late 18th century and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. ‘In a financialized economy, the financial tail is wagging the economic dog.’” Steve Denning, “Wall Street Costs The Economy 2% Of GDP Each Year,” Forbes (May 31, 2015).
[84] Tamar Frankel, Trusting And Non-Trusting: Comparing Benefits, Cost And Risk, Working Paper 99-12, Boston University School of Law.
[85] “Applying the Advisers Act and its fiduciary protections is essential to preserve the participation of individual investors in our capital markets. NAPFA members have personally observed individual investors who have withdrawn from investing in stocks and mutual funds due to bad experiences with registered representatives and insurance agents in which the customer inadvertently placed his or her trust into the arms-length relationship.” Letter of National Association of Investment advisers (NAPFA) dated March 12, 2008 to David Blass, Assistant Director, Division of Investment Management, SEC re: Rand Study.
[86] “We find that trusting individuals are significantly more likely to buy stocks and risky assets and, conditional on investing in stock, they invest a larger share of their wealth in it. This effect is economically very important: trusting others increases the probability of buying stock by 50% of the average sample probability and raises the share invested in stock by 3.4 percentage points … lack of trust can explain why individuals do not participate in the stock market even in the absence of any other friction … [W]e also show that, in practice, differences in trust across individuals and countries help explain why some invest in stocks, while others do not. Our simulations also suggest that this problem can be sufficiently severe to explain the percentage of wealthy people who do not invest in the stock market in the United States and the wide variation in this percentage across countries.” Guiso, Luigi, Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007); ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.
[87] Macy, Jonathan R., “Regulation of Financial Planners” (April 2002), a White Paper prepared for the Financial Planning Association; http://fpanet.org/docs/assets/ExecutiveSummaryregulationoffps.pdf provides an Executive Summary of the paper.
[88] Tamar Frankel, “Regulation and Investors’ Trust In The Securities Markets,” 68 Brook. L. Rev. 439, 448 (2002).
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