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The Morals of the Marketplace

It appears that the DOL is on a mission to accommodate the business models of interest groups that just don't want to be fiduciaries, writes Scott Simon of Prudent Investor Advisors.

W. Scott Simon, 11/07/2013

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.


Many of the business entities for which investment advisors labor in the retirement plan marketplace affirmatively choose to refuse to assume fiduciary responsibility and liability under the Employee Retirement Income Security Act of 1974 (ERISA). In effect, then, they are governed, among other things, by the "the morals of the marketplace," the phrase immortalized by Benjamin N. Cardozo, Chief Judge of the New York Court of Appeals, in the case of Meinhard v. Salmon (249 N.Y. 458, 464, 164 N.E. 545, 547 (1928)). (Cardozo later became a Justice of the United States Supreme Court in 1932.) This phrase, as rendered in that legal opinion, is simply code for an ancient Roman phrase of commerce: caveat emptor (or "buyer beware").

But should caveat emptor (the buyers, of course, being plan sponsors and, indirectly, plan participants and their beneficiaries) really be the guiding light for certain advisors when dealing with ERISA plans? It sure seems so, at least from the perspective of the U.S. Department of Labor (DOL). Phyllis C. Borzi, assistant secretary of labor for the employee benefits security administration, is in charge of the thankless job of reworking the DOL's definition of a "fiduciary." Should caveat emptor really be the lodestar for the relationship between plan participants and some advisors whose status may be redefined under the fiduciary standard planning to be proposed by the DOL?

Borzi has been quoted as saying that it's possible the new fiduciary rule will allow "potentially problematic, conflicted" transactions but that any such transactions will be accompanied by appropriate disclosures that might produce a potentially positive benefit. Problematic (meaning, according to my Microsoft Word thesaurus, "difficult," "tricky," "challenging," "sticky," "awkward," "knotty") transactions, conflicted transactions (only "potentially," of course) being allowed in ERISA plans? Really? And what are "appropriate" disclosures, or "inappropriate" ones for that matter? If the disclosures are appropriate, how might they produce "a potentially positive benefit"?

Disclosures as Pure Pabulum
Disclosures are usually of little help to, for example, plan sponsors because any information that may be divulged in a disclosure is simply that: information. But information about ABC is not the same as knowledge about, or understanding of, ABC. For example, one large, well-known investment consulting firm (XX)--a federally regulated registered investment advisory firm--states in its Form ADV brochure: "Conflicts of interest--real or apparent--are inherent in many of XX's businesses. Some of those conflicts are inherent in any large, diversified financial services firm, while others stem from the nature of the services we offer to clients."

While the foregoing disclosure contains information, the typical plan sponsor (or any sentient being) would not be able to glean any knowledge or understanding from it other than its service provider is engaged in conflicts of interest. The disclosure doesn't even convey to a sponsor that the consultant is probably engaged in any conflicts with the sponsor itself, much less that such conflicts could be harmful to the sponsor and the participants (and their beneficiaries) in the sponsor's plan.

The information in a disclosure is rarely (never, more like) adequate in providing a plan sponsor with knowing understanding of a situation and the sometimes-myriad implications that can arise from that situation. A plan sponsor, as the recipient of information contained in a disclosure, often has no independent context, no requisite body of knowledge upon which to draw that would allow it to understand the disclosed information in order to be in a position to make an informed decision. That's why such disclosures are, by and large, pure pabulum.

Borzi's regulatory worldview appears to be the following: In situations where the DOL cannot resolve the inherently unbridgeable contradictions between the fiduciary standard and the suitability standard, it will allow disclosures to be made. The DOL seems to favor attempting to disclose its way out of such contradictions--thereby moving toward the suitability camp and away from the fiduciary camp--and allowing "potentially problematic, conflicted" transactions to flourish. Disclosures that accompany such transactions will somehow result in the Cleansing of the Temple.

Regulation of Business Models or Accommodation of Them?
Borzi has also been quoted as saying that "ERISA doesn't regulate business models." Indeed, it doesn't, and that's in keeping with Dodd-Frank's call to keep business model neutrality in mind when crafting a new fiduciary standard. But isn't it also true that the DOL shouldn't be accommodating business models that simply do not--because they cannot--work in the ERISA environment? That is, should the DOL be attempting to jam business model square pegs into the round hole of ERISA fiduciary law?

Well of course it shouldn't. But that's exactly what the DOL is attempting to do. In fact, the square pegs of non-fiduciary business models can work in the ERISA fiduciary environment only if the fundamental, underlying duty of all fiduciary law is perverted--the duty of loyalty that's been in existence in the Western world for nearly 1,000 years.

In the ERISA setting under section 404(a), this duty requires an advisor to place a plan participant's interests--"exclusively" AND "solely"--ahead of its own. As Judge Cardozo also noted in Meinhard over 80 years ago, "A trustee [i.e., a fiduciary] is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio [i.e., strict adherence to even the finest points of etiquette] of an honor the most sensitive, is then the standard of behavior."

Instead of perverting ancient fiduciary legal precepts by adding more and more information-only disclosures, shouldn't the DOL be taking the opposite tack? Shouldn't it, in effect, be saying: "We don't need no (more) stinkin' disclosures. We don't need no (more) stinkin' exemptions to prohibited transactions." Come hell or high water, though, it appears that the DOL is on a mission to accommodate the business models of interest groups that just don't want to be fiduciaries and will spend untold amounts of money to ensure that such remains the case.

Taking Borzi at Her Word
Appearing before the annual conference of the American Society of Pension Professionals & Actuaries last week, Borzi noted that the DOL's fiduciary re-proposal--she called it the "conflicts of interest rule"--is the "highest priority" of the DOL's employee benefits security administration. Elsewhere, she has stated: "In the [fiduciary] re-proposal, there is only one rule: that you have to put the best interest of your client first and, as part of that process, refrain from conflicts of interest." Further, Borzi succinctly states the critical issues at hand: "The human costs of conflicts of interest and the insufficient protection that disclosure affords are two themes we return to frequently." These are all noble words, and those with an interest in seeing that their meaning is actually implemented as a rule in accordance with all the precepts of fiduciary law should be heartened by them.

And yet, Borzi has also stated: "[F]iduciaries will be in a better position to make informed decisions [as a result of providing disclosures]. It's about making sure they have access to all the information they need [from disclosures] to assess the quality of their investment."

But disclosures--which the DOL seems to believe can be tidied up and somehow used to erase unbridgeable conflicts of interest--are wholly inadequate, no matter how detailed. These conflicts are inherent in a fundamentally rotted-out business model that profits immensely from 12b-1 fees, revenue-sharing, commissions, proprietary investment products, principal trading et al., at the expense of participants (and their beneficiaries) in retirement plans. This model is not being regulated by the DOL but is being actively accommodated by it and in that process is perverting the fiduciary law that pervades ERISA.

The answer, of course, is to have a participant-centric retirement plan system in which fiduciaries with real skin in the game are utilized by plan sponsors. These fiduciaries are required by law to step in and protect (solely and exclusively) the interests of plan participants from those--subject, in part, only to the morals of the marketplace--that would prey on them.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understandingis the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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