Mourning the Passing of the 40 Act

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Click here to listen to a podcast commemorating the 80th anniversary of the 40 Act and the future of the fiduciary standard, featuring Knut Rostad, Ron Rhoades and Jim Allen.

This year is already in the history books: the worst pandemic in a century; the largest protests and riots for racial justice since 1968; the most divisive presidential election since … who knows; and the passing of the civil rights fighter, Congressman John Lewis, which stirred the nation.

Little wonder, then, that 2020 has been a well-kept secret as the most significant year since 1940 for investor protection and federal regulation of securities. In 1940 the Investment Advisers Act (40 Act) was enacted. This year it’s been effectively repealed.

But its passing has gone unnoticed.

In the long shadow of the market crash and severe depression, the 40 Act was the equivalent of investors’ civil rights legislation.

It articulated an unambiguous clarity, vision and national purpose around what investors should expect from investment advice. It reflected FDR’s moral vision that the securities industry needed a “simple code of ethics.”

The 40 Act separated sales from advice. Its legislative background demonstrates what advising a client as fiduciary entails, how it differs from pushing a product and why it matters. The 40 Act ploughed new ground. It planted its flag squarely on the urgency to eliminate conflicts of interest.

In the 1963 Capital Gains Research case, the Supreme Court agreed. The Court spoke of the need for advisers to be impartial and, “as free as humanly possible from the subtle influence of prejudice.”

Citing an SEC report, the Court noted compensation, “should consist exclusively of direct charges to clients for services rendered,” and advisers should not engage in, “any activity which may jeopardize his ability to render” unbiased advice. Also, “The highest ethical standards” must prevail.

The Supreme Court set out in just four pages how the SEC and industry leaders envisioned fiduciary advice in 1940. The vision was forward thinking and by any definition progressive. Drawn from history and common sense, it set out the basis for a new professional standard.

It’s 2020. The SEC deeply diminished the meaning of the 40 Act. At the same time, ideas from the SEC and the leaders of the brokerage industry’ on regulating “advice” were enshrined in Reg BI and Form CRS. Such ideas will directly affect retail investors. The higher 40 Act standard is important. Yet the experience of most retail investors is with a broker – not an independent adviser.

The impact of Reg BI for retail investors is larger. In it, eliminating conflicts is roundly rejected. The big idea is selective disclosure, i.e., the disclosure of some information, and nondisclosure (read: concealment) of other information.

The SEC chairman set the tone in July 2017: “A priority for me is getting the wealth of information that the SEC has into the hands of investors (because) the best way to protect yourself is to check out who you are dealing with and the SEC wants to make that easier”.

Those words resound loudly. The message: Investors are investigators and the SEC should be their investing Google app.

The word disclosure permeates Reg BI. In the 770-page Reg BI release, it occurs more than 1,000 times. Yet, there are just 88 citations for eliminating or disclosing conflicts.

With “disclosure” so dominant, it’s no surprise that avoiding conflicts is discouraged.

But there is more. Even mitigating conflicts at the firm level is rejected by Reg BI because it would be unfair to broker-dealers when it is not also required of investment advisers. It would, says the SEC, burden broker-dealers with additional compliance costs.

This could further encourage migration from brokers to advisors, which could negate the SEC’s stated goal of, “preserving retail access (in terms of choice and cost) to brokerage products and services.” The SEC’s concern with the BD’s financial well-being outweighs concern for that of investors.

Form CRS, the new disclosure required of brokers and adviser, illustrates the principle of selected disclosure. Form CRS makes brokers and advisers (and their respective conflicts) appear indistinguishable. Here is some of the required language for a dual registrant:

When we provide you with a recommendation as your broker-dealer, or act as your investment adviser, we have to act in your best interest and not put our interest ahead of yours. At the same time, the way we make money creates some conflicts with your interests ….

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Form CRS also omits disclosing how brokers and advisers differ based on their roles and purposes, how broker customers are in relationships of three with their sales broker and manufacturers, or how clients of advisers are in relationships of two with only a fiduciary adviser.

The distance separating the thinking behind the 40 Act and Reg BI and Form CRS is vast. In 1940, the urgency to eliminate conflicts reflected a generation scarred by the market crash and ensuing depression. By 2020, the urgency to eliminate conflicts has been transposed to the benefit of having conflicts. As such, diminishing advisers’ fiduciary standard and letting “brokers be brokers” stand out. This thinking ignores prior jurisprudence and common sense, and is devoid of the experience of the past 90 years.

The 40 Act’s public good over decades is incalculable. As civil rights legislation, its importance must be noted and its passing mourned. Then new thinking should be applied and new plans laid. Throughout the words of Vanguard founder Jack Bogle should be recalled, “Press on, regardless”

Knut A. Rostad, MBA, is the co-founder and president of the Institute for the Fiduciary Standard, a nonprofit formed in 2011 to advance the fiduciary standard through research, education and advocacy.