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This is part two of a three-part series of articles on disclosures and investor protection.
Last month I entered a minefield when I wrote that a main tenet of conventional wisdom of retail investor regulation and disclosure is all wet. This “wisdom?” “Investor confusion” is the problem that plagues regulators, and investors are at fault.
This wisdom is wrong.
Common sense and research prove this. However, unclear or misleading language and information confusion is the chief culprit that prevents form CRS disclosure from being effective. (Form CRS is the disclosure that SEC-registered investment advisors are required to provide to clients.)
As I and my co-authors argue here, the SEC has a unique opportunity to redo form CRS to help investors and investment professionals better understand how broker-dealers and investment advisers differ.
In 2018 the SEC crafted form CRS as a disclosure to explain differences between broker-dealers (BDs) and investment advisers (IAs). The disclosures were independently tested by the Kleimann Group, a company with expertise in authoring consumer disclosures. How did the disclosures do?
They failed miserably.
Kleimann revised the language and conducted in-depth interviews with investor participants in three cities. Suddenly, investor understanding shot up. The results were revealing.
The disclosures describe BDs and IAs regarding services and relationship, fees, obligations and conflicts. Here is what the tests showed:
Lack of clarity is the problem
The pillar of Reg BI, “best interest,” was (and remains) undefined. Investors and experts alike struggled to understand what “best interest” means. Investors also stumbled on the meaning and importance of “consent” and “mitigate.” Were investors at fault? Kleimann said “no:”
We, our subject matter experts, and our (investor) participants struggled with understanding and expressing these ideas cogently and explicitly.
Clear writing is rooted in clear thinking. Without such efforts at a policy level, our results will be modest.
The solution is plain language describing concrete ideas
In April 2018, the SEC issued guidance regarding form CRS. It said that broker-dealers’ “relationships and services” used “brokerage accounts” and customers will pay a “transaction-based fee.” Investment advisers were described as offering “advisory accounts,” with clients paying an ongoing asset-based fee.
It is hard to discern the difference between those two mechanisms.
In the revised disclosure, the SEC provided new language that described brokers as acting in “a sales relationship” and advisers in “an advisory relationship.” Kleimann noted many participants were “less comfortable” with the sales status: “Participants had positive attitudes towards the Investment Adviser accounts and somewhat negative attitudes towards the Broker-Dealer accounts.”
As for legal obligations, the revised language stated that advisers, by law, “must follow the highest legal standard of conduct, called a fiduciary standard.” And for brokers, by law, “must follow a best interest standard.”
The meaning of “best interest” in this context was not understood, even at the SEC itself. When the Reg BI was proposed in April 2018, Commissioner Kara Stein said it may better be called, “Regulation Status Quo.” Commission Hester Peirce called it “Suitability Plus.”
Subject matter experts, according to Kleimann, “struggled to develop a clear description of a standard that remains largely undefined in terms of its concrete obligations.” Yet, participants viewed “fiduciary” as having more requirements and accountability than “best interest.” The report noted:
Participants responded positively and strongly to the use of the phrases “highest legal standard” and “fiduciary standard.” …. Most understood that the standard would apply to all advice supplied about an Investment Adviser account...
… Participants had far more difficulty with the best interest standard. Few were able to offer a definition and nearly all perceived it as a lower standard than that of the Investment Adviser account. Most understood that the standard applied only when making sales recommendations.
The upshot: Language can clarify or confuse. Investors do not understand the terms best interest, conflicts of interest and mitigate, terms and words used by the SEC. Yet, apparently, investors do understand sales and advice, and the term, highest legal standard.
Kleimann’s revisions improved the SEC’s disclosure. Yet additional material information is required to help investors make informed decisions. That includes information to help investors compare and contrast the roles, purposes, services, compensation and obligations of IAs and BDs.
Bad disclosure that confuses or misleads is worse than no disclosure. Plain language describing concrete ideas is the basis of disclosure that works. This is language that tells investors the truth.
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.