It’s been two and a half years since President Obama signed the Dodd-Frank Act. Since then, the financial services industry has not moved closer to a uniform fiduciary standard, but seems to have moved further away. The issue is not whether broker-dealers are willing to adopt a standard, because, for the most past, they support the principles. The issue is that they are not willing to proceed until there is a better understanding of how a fiduciary standard may help or harm their complex business models. Their intransigence is not unreasonable. So what must we do to make them comfortable?
To begin, I would suggest fiduciary advocates put down their sharp pointy sticks. The argument that advisors working under a standard are good and thus brokers, who aren’t, are bad, is invalid. Not only invalid, it inflames the debate and delays any adoption. Neither side is in a position to win a character debate, so let’s focus our energy on a more productive dialogue.
Any discussion about moving a fiduciary standard forward will need to include three elements:
1. The principles associated with a fiduciary standard;
2. The practices associated with a fiduciary standard; and
3. Fiduciary safe-harbor procedures.
There appears to be industrywide consensus on the principles; some understanding and consensus on the practices; but virtually no dialogue, understanding or consensus about how to define the safe harbor.
Fiduciary Principles
This past year, Financial Advisor magazine, 3ethos and the Boston Research Group conducted the “Fiduciary Impact Survey,” which we plan to publish annually. The results of the first survey (published in the September issue) were a mix of surprises and disappointments.
The biggest surprise was the overwhelming support for the principles associated with a fiduciary standard.
We asked four questions (see Figure 1).
It should be noted that 20% of the 500 respondents who took the survey were registered reps, 20% were IARs and 60 % were RIAs. The takeaway from these four questions is that there appears to be consensus from brokers and advisors alike about the principles associated with a fiduciary standard.
Fiduciary Practices
The survey was disappointing, however, in that respondents scored lower than what we anticipated when it came to the adoption and understanding of fiduciary best practices. Though many wirehouse financial advisors are not permitted to acknowledge fiduciary status, leading advisors were adopting many of the fiduciary practices as industry best practices anyway—at least, that’s what we thought.
Unfortunately, the survey revealed that the median advisor/broker has only minimal knowledge of the practices associated with a fiduciary standard. More disturbing is the fact that one in three advisors holding themselves out as fiduciaries do not offer their clients the basket of services one would normally expect from someone making the claim.
Therefore, a critical next step is to build a consensus on the practices we should associate with a standard. As a starting point, I would suggest the following 17 practices, each of which is fully substantiated by existing fiduciary acts, legislation, regulations, regulatory opinion letters and case law.
A fiduciary should:
1. State the client’s goals and objectives;
2. Define the roles and responsibilities of decision-makers;
3. Brief decision-makers on objectives, standards, policies and regulations;
4. Identify sources and levels of client risk;
5. Identify client assets and asset class preferences;
6. Identify client time horizons;
7. Identify client expected outcomes (“performance”);
8. Define the strategy consistent with the client’s risk, assets, time horizon and expected outcomes;
9. Ensure that the client’s strategy is consistent with implementation and monitoring constraints;
10. Formalize the client’s strategy in detail and communicate it in writing (in other words, prepare an investment policy statement);
11. Define the process for selecting key personnel to implement the client’s strategy;
12. Define the process for selecting tools, methodologies and budgets to implement the client’s strategy;
13. Ensure that service agreements and contracts do not contain provisions that conflict with the client’s objectives;
14. Prepare periodic reports that compare performance with the client’s objectives;
15. Prepare periodic reports that analyze costs, or return on investment, with performance and objectives;
16. Conduct periodic examinations for conflicts of interest and self-dealing and breaches of a code of conduct; and
17. Prepare periodic qualitative reviews or performance reviews of decision-makers.
Fiduciary Safe-Harbor Procedures
Think of the typical broker-dealer as a complex factory. At one end of the factory floor, the broker-dealer offers fiduciary services, following all of these 17 practices. At the other end of the factory, the company offers brokerage services. To keep the services segregated, management builds a wall between the people engaging in the two different activities. But even after all the known safeguards are put in place, the fiduciary activities still somehow pop a circuit breaker on the broker-dealer side of the factory floor. Is there any way to insulate the broker-dealer from the unforeseen consequences of a fiduciary standard?
The answer is yes. Nearly every federal regulatory agency routinely defines procedures that can insulate impacted parties from the unintended consequences of new regulations, creating a safe harbor. Simply stated, if a firm can demonstrate that it has followed the safe-harbor procedures prescribed by regulators, then the firm can be sheltered from liability associated with new regulations.
Such procedures all share two characteristics: 1) They are voluntary. 2) The responsibility for demonstrating compliance with them rests with the party seeking relief. A classic example in the retirement industry is the Department of Labor’s 404(c) regulations, which describe procedures for pension plan sponsors who want to protect themselves from liability whenever they educate plan participants.
Using existing, comparable industry procedures as a model, we could define a fiduciary safe harbor this way:
1. The firm must define minimum qualifications (in terms of experience, licensing and training) for advisors who wish to serve in a fiduciary capacity;
2. The advisor must accept and acknowledge his or her fiduciary status in writing;
3. When serving in a fiduciary capacity, the advisor must agree to use only investment products, databases, software and technology approved by his or her firm;
4. Advisors must agree to maintain records demonstrating their procedural prudence (the details of their decision-making process); and
5. The activities of the advisor must be monitored by the firm.
Taking these actions will allow all firms, not just broker-dealers, to limit their liability to the conduct of the advisor and to the firm’s oversight, supervision and monitoring of the advisor. This way a wirehouse, with its complex infrastructure of capital markets products and services, can fence off its fiduciary advisory services and reduce the chance that it will make a transaction that’s prohibited.
There will be naysayers (the folks with the pointy sticks) who will pronounce that safe harbor procedures can be gamed—that sometimes client interests will not come first. This is true. But firms and advisors who do that would be easy to spot, and will be at risk of losing their safe harbor insulation.
The fiduciary safe harbor procedures I have suggested are similar to the supervisory procedures already being followed by FINRA member firms and to procedures SEC registered investment advisory firms should have in place. They are also business-neutral. No investment products or strategies will be deemed to be imprudent. The test of prudence will depend on the advisor’s decision-making process. Lastly, safe harbor procedures do not require Congress’s approval. They can easily be promulgated by regulators. Nor do they require additional funding. The cost of compliance is borne by the firms seeking the protection of the safe harbor.
If we want to see a meaningful fiduciary standard defined for the industry in the near future, we need to reach a consensus about the practices we associate with the fiduciary standard, and we need to define safe harbor procedures that insulate firms from the unintended consequences of adopting the fiduciary standard.
Donald B. Trone, GFS™ is the president of the newly constituted Leadership Center for Investment Stewards, and is the founder and CEO/Chief Ethos Officer of 3ethos. He is the former Director of the Institute for Leadership at the U.S. Coast Guard Academy; founder of the Foundation for Fiduciary Studies; and, principal founder of fi360.