The Conundrum of Mary Jo White

Last week, I set out from California on a journey to the center of the (political) earth in Washington, D.C., to join up with a small band--we happy few--of colleagues to meet with Mary Jo White, chair of the SEC. The purpose of our expedition was to look her in the eye, so to speak, and set forth our views on the critical need for the SEC to issue rules requiring stockbrokers (that is, registered representatives of broker/dealer firms, or B/Ds) to adhere to the fiduciary standard of conduct set forth in the Investment Advisers Act of 1940, commonly known as the "40 Act." 

Some Background
To bring all up to date: the SEC and the U.S. Department of Labor since 2010 have been seeking to issue new rules that will redefine what it means to be a "fiduciary" under, respectively, the Employee Retirement Income Security Act of 1974, or ERISA, which oversees retirement plan accounts of plan participants, and the 40 Act (as amended by the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010, or Dodd-Frank bill), which oversees retail accounts of individual investors.

The Department of Labor issued its rule-making fiduciary redefinition in 2010 but was forced to withdraw it in the face of hostile fire from special interest groups representing big stockbrokerage firms, big insurance companies, big consulting firms, big mutual fund companies, and so on that do business in the retirement plan marketplace. Acceptance of such rules would upset the apple cart of their business models which are often rife with impenetrable conflicts of interest designed to maintain a structure of hidden (and therefore high) costs. (The Department of Labor has postponed issuance of its "Conflict of Interest Rule-Investment Advice" until at least January 2015 and perhaps even later.)

On the individual retail investor side, the SEC has stood by over the years and watched while these business models have grown Frankenstein-like features. Stockbrokers have morphed from order-takers (governed by the suitability standard of conduct under the Securities Exchange Act of 1934) into full-blown investment advisors that the SEC has allowed to avoid adhering to the fiduciary standard of conduct that registered investment advisory firms, or RIAs, must follow pursuant to the 40 Act. 

Chair White now has the ability to reverse a good deal of the harm that these B/Ds can do to individual retail investors. On one hand, that would be nothing short of revolutionary in the Washington political landscape: bucking the political pressure generated by the millions and millions of dollars that have been (and are currently being) thrown at House and Senate members by the aforementioned moneyed and well-organized crowd of special interest groups representing those who just don't want to be fiduciaries. 

On the other hand, perhaps not so revolutionary but merely a rather simple implementation of what is authorized (but not mandated) by Dodd-Frank: adoption of rules requiring stockbrokers, when providing "personalized investment advice" to individual retail investors, to adhere to a fiduciary standard of conduct "no less stringent" than the standard that must be followed by RIAs registered pursuant to the 40 Act. 

Fitting a Square Peg Into a Round Hole
The fundamental, underlying problem faced by chair White, of course, is reconciling the fiduciary standard of conduct that requires RIAs to put the "best interests" of their investor clients first with the fiduciary duty owed by stockbrokers as agents to the interests of their B/D principals. 

I've written about this conundrum before, but it wouldn't hurt to review the issues at hand here once again. In a nutshell, stockbrokers have a fiduciary duty to do what's in the best interests of their employer, but they don't have a fiduciary duty to do what's in the best interests of their investor clients. That's an inherent conflict of interest that no serious-minded person well-versed in these issues can "harmonize" in any way.  

It's impossible to serve two masters at the same time, which is why it's impossible for a stockbroker to give investor clients objective advice based on a fiduciary standard. Because stockbrokers don't have to follow a fiduciary duty, the only way they can provide investment advice is if it's mere happenstance and not to be relied on in making serious decisions. 

The problem begins when a B/D entity advising its investor clients from a strategic perspective is also the manufacturer of the products being offered as the solution. In order to be a good employee of the B/D, a stockbroker must do the best job that it can to sell products manufactured by the B/D. When a stockbroker sells a product, the advice that it provides to an investor client must be incidental in nature as a matter of law. This, in effect, means that the investor cannot depend on the stockbroker's advice when it tells the investor that the product is suitable for it.  

Legally, then, a client making investment decisions is to ignore the stockbroker's advice and not rely on it because often it's inherently biased against the best interests of the client. That's because the B/D is the manufacturer of the products. If a stockbroker seeking to sell a product isn't able to do so, it might miss out on its quarterly bonus check or a trip to Hawaii with the spouse and kids, or even lose his job. 

The regulations are straightforward. A B/D is in the business of manufacturing products and selling them to anyone who wants to buy them. There's nothing wrong with that. In fact, it's the same as if a B/D were a car dealer employing salespeople attempting to sell, say, a Ford to anyone who steps on the lot. But there's a big difference: the car buyer already knows what the dealer wants to do--sell him a Ford--even before setting foot on the lot. 

But few investors have any awareness of the motivations of Wall Street. Indeed, Wall Street has done an excellent job blurring the distinction between what stockbrokers really are--Ford salespersons with a single-minded motivation to sell the products manufactured by their Ford-dealer employer--and the fairy tale of what's portrayed: a friendly client-centric experience with the best interests of their clients at heart. The investing public simply doesn't understand the difference between the advertising they see and the contracts they sign. Reading the provisions found in some of these contracts is akin to a seminar on how to pluck a goose without the goose knowing that it's been plucked.  

Although Wall Street's business model, as noted, is the same as that of the Ford dealer--to sell products to anyone who comes along--there is one difference: Wall Street won't even match the transparent but honest motivations of a Ford dealer. Truth in advertising and Wall Street just don't seem to go well together in the same sentence. 

If Wall Street were really interested in having a total commitment to the long-term interests of its clients, it would embrace a fiduciary standard. But it does just the opposite: It lobbies in Washington, spends big bucks on politicians, and does everything it can as an industry to avoid what a fiduciary standard requires. In 2007, former SEC chair Christopher Cox described the Wall Street business model as a "witch's brew of hidden fees, conflicts of interest" which is "at odds with investors' best interests." (Note in this regard that the Department of Labor's proposed rule is titled, "Conflict of Interest Rule-Investment Advice.") As I've said before, it's just as easy--actually, easier--to follow a fiduciary standard, to do what's in the best interests of investors within a truly client-centric business model. 

To be sure, RIAs and their investment advisor representatives seem to be in the news for their transgressions as much as B/Ds and their stockbrokers. The "dually registered" (that is, as both a B/D and an RIA) Bernie Madoff notwithstanding, the scale of wrong-doings and the amounts of fines appear to be so much higher with B/Ds. That, in part, appears to be due to the vast size of B/Ds and the legions of stockbrokers they employ pushing products that are later judged to be "unsuitable" for investors. 

Certainly, there are bad apples in the RIA community, but those relatively few are the exception in an otherwise largely transparent system. To reduce that number even further, in 2012 I proposed in this column that both B/Ds and RIAs should follow the higher "sole interest" fiduciary standard of conduct found in ERISA. [http://www.morningstar.com/advisor/t/54224665/the-great-compromise-to-the-fiduciary-debate.htm? &single=true] Dodd-Frank called for a fiduciary standard of conduct to apply to stockbrokers "no less stringent" than that required under the 40 Act. This doesn't mean, however, that the more stringent fiduciary standard found in ERISA could not be applied to B/Ds and RIAs alike. At least one prominent commentator found merit in that admittedly politically far-fetched idea. [http://www.thinkadvisor.com/2012/05/16/consider-scott- simons-modest-proposal-to-solve-the?page_all=1] 

Chair White faces a conundrum, no doubt. It's clear that she has a very sophisticated understanding of all the issues involved. She is fully aware of what the right thing to do is in this situation. But actually doing it will require an immense amount of political will that would be truly rare in this day and age.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.