Speech by SEC Commissioner:
Protecting Investors by Requiring that
Advice-Givers Stay True to the Fiduciary Framework
by
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
Investment Adviser Association Annual Conference
Chicago,
Illinois
April 29, 2010
Thank you for that kind introduction. It is my pleasure to be able to
join you today for the 2010 Investment Adviser Association Annual
Conference. At the outset, I want to make clear that the views I express
today are my own, and do not necessarily reflect the views of the
Commission, other Commissioners, or the staff.
Just last year, I stood before you and discussed the clear need for
regulatory reform. Today, it looks like legislation may literally be weeks
away. And while I have concerns about various provisions, overall it is a
positive development for the American public and all who invest in our
capital markets. The legislation is expected to bring greater transparency
to hedge funds and over-the-counter derivatives. Further, it creates both
a stronger framework to monitor potential systemic risk and a resolution
process if a "too big to fail" institution actually fails. Published
reports are carefully scrutinizing every detail of possible passage as we
wait to see what the ultimate legislation will look like. As the
legislation continues on its way and is amended before final passage, I
will continue to be a staunch advocate for regulatory reform that is
oriented towards investors.
By this I mean, that I am supportive of regulatory reform legislation
that would strengthen the investor protection regime that currently exists
and that results in enhanced protections and flexible authority to
regulate an unforeseeable future. This should not become an opportunity to
roll back long-held investor protections or create opportunities for
regulatory arbitrage.
Today, I am going to concentrate my remarks on the following:
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Congress should mandate that all providers of investment advice
should be fiduciaries;
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I am going to discuss a snapshot of certain of the current proposals
in Congress; and
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I will urge the SEC to move forward in rectifying previous regulatory
inaction.
All Investment Advice-Givers Should Be Fiduciaries
I would like to take you back in time to the passage of another piece
of historic legislation, the Investment Advisers Act of 1940. The Advisers
Act and its companion legislation, the Investment Company Act of 1940,
resulted from a comprehensive congressionally-mandated study conducted by
the SEC of investment companies, investment counsel, and investment
advisory services. Ultimately, the report concluded that the activities of
investment advisers and advisory services "patently present various
problems which usually accompany the handling of large liquid funds of the
public."1 The SEC's report stressed the need to improve
the professionalism of the industry, both by eliminating tipsters and
other scam artists and by emphasizing the importance of unbiased advice,
which spokespersons for investment counsel saw as distinguishing their
profession from investment bankers and brokers.2 The general objective "was to protect the public
and investors against malpractices by persons paid for advising others
about securities."3
The report stressed that a significant problem in the industry was the
existence, either consciously or, more likely, unconsciously, of a
prejudice by advisers in favor of their own financial interests. Reading
through the volumes of the SEC report, the evidence is clear that whenever
advice to a client resulted in a financial benefit to the advice-giver
over and above the fee it was feared that the resulting advice might be
tainted. Even more importantly, as cited by the Supreme Court, SEC staff
rejected an early market discipline argument by recognizing that "a
significant part of the problem was not the existence of a deliberate
intent to obtain a financial advantage, but rather the existence
subconsciously of a prejudice in favor of one's own financial
interests."4 Consequently, the Advisers Act required
advice-givers, as fiduciaries, to bear the burden of providing
disinterested advice and being able to prove it.
As stated by the Supreme Court, "[t]he Investment Advisers Act of 1940
thus reflects a congressional recognition of the delicate fiduciary nature
of an investment advisory relationship, as well as a congressional intent
to eliminate, or at least to expose, all conflicts of interest which might
incline an investment adviser consciously or unconsciously to render
advice which was not disinterested."5 Best of all, Congress and the Court placed the
burden for providing disinterested advice and eliminating or disclosing
conflicts squarely where it belonged, in the hands of the advice-giver.
This places the obligation in the hands of those responsible for upholding
their fiduciary duties rather than unfairly and unrealistically burdening
investors to discern conflicts and incentives an often impossible
task.
Flash forward from the 1930s to the events of the last two years, and
an array of examples will come to mind demonstrating the role that advice
tainted by conflicts of interest played in harming investors and harming
market integrity. Tainted advice led investors to invest billions of
dollars in auction rate securities because brokers told them they were
safe investments.6 Conflicts of interest at credit rating agencies
contributed to AAA ratings on products that turned out to be
worthless.7 Clearly, the concerns giving rise to the
Advisers Act are even more relevant today. We need to restore the clear
and strong rules that protect investors and, more than ever, we need to
ensure that investment advice is disinterested.
Recently, in the context of an enforcement case, our own Director of
the Division of Enforcement, Robert Khuzami, summed up the harm succinctly
when he stated, "The product was new and complex but the deception and
conflicts are old and simple."8 The events of the last two years have
underscored an age old truth that financial products and technologies will
continually change but the potential for deception and conflicts
endure.
Lack of a Fiduciary Duty Leads to Real Investor Harm
An issue that illustrates this is the discussion around extending the
fiduciary duty that underlies the investment adviser regulatory framework
to broker-dealers who provide investment advice. This is the ultimate
investor protection issue because the harm to investors is real if
broker-dealers giving advice are not held to the fiduciary standard and
fail to put their client's interests before their own.
The fiduciary standard has served advisory clients well for many years
and it should be the governing standard whenever investment advice is
provided. If you are giving investment advice to an investor, regardless
of the title on the business card, you should always be bound to do so in
the best interests of the client. While the scope of service may vary
between clients, the standards of loyalty and care in providing that
service should not.
Currently broker-dealers are providing investment advice without any
requirement that they serve as fiduciaries. In other words, broker-dealers
are being permitted to end-run the Advisers Act. While brokers are
required by current law to make certain disclosures about securities that
are offered to investors, they are not required to make disclosures about
certain of their own conflicts of interest. As a consequence, investors
are susceptible to receiving tainted advice from broker-dealers and they
will have no way of knowing that the advice was tainted by an undisclosed
conflict.
Because broker-dealers are not fiduciaries, investors are not required
to be informed of possible conflicts that may affect the advice they
receive. For example, investors may not be told that the representative
sitting across from them may receive undisclosed compensation from the
investment option he or she just recommended. Since many broker-dealers
aggressively market themselves as "financial advisers," investors have a
difficult time distinguishing them from investment advisers. As a result
of this confusion, they will fail to understand that the broker-dealer,
unlike an investment adviser, is not required to place their interests
first.
The danger is not simply that investors are unable to distinguish
between broker-dealers and investment advisers; it is that both entities
are providing investment advice to investors with dramatically different
consequences. Although often marketed in the same way, the investment
advice that investors receive from broker-dealers does not come with the
same protections as advice received from investment advisers.
The Advisers Act has been designed to empower investors and provide
them with the information that they need to evaluate conflicts and decide
whether to enter into or continue an advisory relationship. Broker-dealers
who are giving advice are not doing so within this investor-focused
fiduciary framework. As the noted expert, Tamar Frankel stated,
That is the difference between suitability standards and fiduciary
standards. The disclosure made under suitability standards is about what
is being sold and not who sells it. That is why the time has come to
change the law. The salesperson's temptation is too great when investors
trust them, and disaster is too painful if the investors cease to trust
all salespersons, and choose to avoid the financial markets
altogether.9
The fiduciary standard guards against the inherent bias that arises
when the broker-dealer is focusing on selling a product, rather than
focusing only on what is best for a client. Permitting broker-dealers to
provide investment advice without requiring them to act as fiduciaries is
to permit a practice that undercuts the core principles of the Advisers
Acts and leaves investors vulnerable to the same abuses described in the
1930s.
Landscape of Legislative Proposals
As we look at the landscape of legislative proposals, I have to first
reiterate what I said here last year. There is only one true fiduciary
standard, and it means an affirmative obligation to act in the best
interests of the client and to put the client's interests above one's
own.
Accordingly, it was heartening last year to see that the Obama
Administration in its White Paper on Financial Regulatory Reform
explicitly state that the standard of care for broker-dealers who provide
investment advice should be raised to the fiduciary standard applied to
investment advisers. This was followed by provisions in both the Wall
Street Reform and Consumer Protection Act (the "House Bill") 10 and the initial draft of the Restoring
American Financial Stability Act (the "Senate Bill")11 that would have extended to broker-dealers the
traditional fiduciary standard applicable to investment advisers.
Of the two legislative proposals, the initial draft of the Senate Bill
was significantly stronger. It would simply have eliminated the
distinction between broker-dealers and investment advisers when providing
investment advice. By comparison, the House Bill would instead require
that the Commission promulgate rules to subject broker-dealers providing
"personalized investment advice about securities to a retail customer" to
the standard of conduct in the Investment Advisers Act. In other words,
the House Bill would not apply the same standard to all brokers who
provide advice but rather only to those providing personalized services
to retail customers. This language limits the universal application of the
fiduciary standard and excludes many investors from its protection.
The Senate Bill, however, has abandoned its strong position in the face
of determined lobbying by the insurance and brokerage industries. The
revised version that was voted out of the Senate Banking Committee on
March 22nd has eliminated the provision applying the fiduciary standard to
brokers who provide investment advice. It would, instead, require a
one-year study by the SEC concerning the effectiveness of existing
standards for "providing personalized investment advice and
recommendations about securities to retail customers."
I continue to have concerns about this retreat from requiring a
fiduciary standard for all who provide investment advice. First, I see no
need to study the effectiveness of existing obligations for investment
advisers. We already have a strong, workable standard that has been in use
successfully for decades, and I would not support any attempt to weaken
it. Second, as with the House Bill, I question why the protection of the
fiduciary standard should be limited to "retail" customers. It is readily
apparent from recent Commission enforcement cases such as the cases
involving auction rate securities that all investors, including
institutional investors, need the protection of the fiduciary standard.
Third, I question why the study, as well as the reach of the House Bill,
should be limited to "personalized services." This qualification would
narrow the range of clients that would be protected by the fiduciary
standard, and I fear that it may become a loophole that would make it easy
to avoid putting clients first.
Finally, I don't believe that we need an additional study to conclude
that protection of investors requires that broker-dealers providing
investment advice be subject to fiduciary duties. I think that question
has long ago been asked and answered. We need to remain vigilant to make
sure that investors who receive advice do so from intermediaries held to
the high standards of care and loyalty embodied in the existing fiduciary
standard under the Investment Advisers Act.
SEC is the Regulator of the Investment Adviser Industry
As regulatory reform moves forward and the Commission evaluates its
priorities, we must recognize that strong laws and rules are only one
component of an effective regulatory framework. These laws and rules must
also be accompanied by robust examination and enforcement oversight. That
brings me to the SEC's Office of Compliance Inspections and Examinations
(OCIE).
I have previously spoken about the need to reinvigorate the SEC's
examination and inspections program by increasing our examination
resources, adding to the skills and experience of our staff, and removing
handcuffs imposed by ill-advised internal SEC policies. I've also
discussed the need for legislative action to clarify and expand the SEC's
examination authority to include, among other things, entities that should
be registered under the securities laws, entities that have recently
withdrawn from registration, and relevant records of certain associated
persons of registered entities.12
As I also mentioned last year,13 there is no doubt that OCIE's examination
resources need to be strengthened. For example, while the number of
registered investment advisers has increased over the past five years by
33%, from 8,623 to 11,500, the staff dedicated to examining advisers and
mutual funds has decreased over the same period by 13%, from 489 to 425.
As a result, we can examine only a fraction of the advisers and fund
complexes each year.
In order to address this problem, as well as others, the SEC must be
adequately resourced. As I have been consistently advocating, the single
most transformational act that Congress could undertake is to allow the
SEC to be self-funded. Unlike almost every other financial regulator, the
SEC remains without a consistent funding stream. Self-funding would enable
the SEC to set multi-year budgets and respond promptly to our dynamic
capital markets, while also maintaining appropriate staffing. Self-funding
would allow us to have the resources to keep up with the growth in the
industry.
Accordingly, I am pleased to report that the most recent version of the
Senate Bill would make self-funding a reality. Of course, the legislative
process is on-going and the results are far from predictable. I know that
the Investment Adviser Association has been a strong proponent of
self-funding for the SEC every time this issue has been seriously
considered. I thank you for being willing to speak frankly on the issue
and thank you in advance for the work to come.
Beyond the resource issue, there is another structural change that the
legislation would trigger. There is a provision in the Senate Bill that
would, in essence, disband OCIE as it currently exists. The Senate Bill
provides that the exam staff would be redeployed from the stand alone
Inspections and Examinations Unit to the Divisions of Trading and Markets
and Investment Management.
The proposed redeployment takes us back in time. In 1995, Chairman
Arthur Levitt created OCIE for the express purpose of consolidating
examination resources to better utilize them to protect investors.14 One of the criticisms of OCIE, as well as of
the entire SEC, is that it is too fragmented and does not utilize
expertise across the agency. I am concerned that creating specialized
groups of examiners at a time when the industry has numerous dual
registrants is to ignore the reality of those we regulate. Moreover, since
1995, the services provided by broker-dealers and by investment advisers
have increasingly come to resemble each other,15 undercutting the argument that separate
examination staff is appropriate.
While I am sympathetic to the need to integrate our examination
function more deeply into the workings of our rule-making and programmatic
divisions, I fear that this redeployment may have the opposite effect. The
resulting fragmented oversight could make it harder for the SEC staff to
detect and prevent wrongdoing.
Furthermore, and of the greatest concern to me, by legislatively
mandating separate and fragmented inspection and examination programs, the
SEC would lose the flexibility to make future determinations of how best
to oversee the industry. In a dynamic industry that is continually
evolving, and increasingly consolidating, it is necessary for the SEC to
be in a position to determine the most effective means to fulfill its
responsibilities. We should not have our hands tied as to what may be the
best way to provide effective oversight, either now or in the future. I
hope that the members of the Senate rethink this provision.
Rectifying Regulatory Inaction
Even as the legislative process winds its way forward, the Commission
continues to be active on a scale few can remember. Before I
discuss three initiatives that directly impact the investment advisers'
fiduciary framework, I would like to talk about the cost of regulatory
inaction. Much is written about the fear of too much regulation. However,
since I became a Commissioner, I have been struck by the opposite, the
cost of regulatory inaction. Thus, in the mix of priorities, I believe it
is important for the Commission to take on initiatives to rectify investor
harm resulting from regulatory inaction. The events of the last several
years have demonstrated the cost of regulatory inaction. I would like to
highlight two initiatives that would significantly improve the adviser
fiduciary framework and that have been languishing for decades.
For example, in 1999, the Commission proposed pay-to-play rules to
prevent the exact conduct that we have been confronting in states across
this country. These rules were not adopted and, in the decade since,
significant assets have been inappropriately allocated, and public
confidence in investment advisers and public pension funds across this
country has been shaken. If the rule had been adopted in 1999, would we be
facing pay-to-play scandals of this magnitude? It's doubtful.
Similarly, amendments to the core disclosure document of the adviser's
regulatory framework, the Form ADV Part II have languished. Initially
proposed in 2000 but not adopted, the Commission re-proposed these
amendments in 2008 but, again, failed to adopt them. This is a core
disclosure document that is antiquated and the Commission should
prioritize the adoption of these amendments.
Before I discuss these proposals in greater detail, I want to touch on
a custody initiative that is still to come.
The Need to Strengthen Custodial Practices to Protect Investors and
Their Assets
Last December, the Commission adopted amendments to various rules to
strengthen safeguards to protect clients' assets controlled by investment
advisers. This action was intended to protect against the misappropriation
of client funds by advisers who serve as custodians and hold on to, or
have control over, their client's assets. These advisers are now subject
to annual examinations by an independent auditor: a "surprise exam" to
verify client assets, and a review of internal custody controls. I know
there have been implementation issues with this rule and I know that the
industry has been working closely with our staff to insure compliance.
I would like to highlight one issue related to the recent revision to
the investment adviser custody rule. The Commission's adopting release
made it clear that this rule had the potential to disproportionately
impact small advisers who have the authority to obtain possession of
client funds, such as by serving as trustees, even thought the client's
assets are held by an independent qualified custodian. The release also
indicated that the Commission has directed the staff to evaluate the
impact of the rule on advisers and their clients. In particular, the SEC
staff has been directed to conduct a review following the first round of
surprise examinations and provide the Commission with the results of the
review, along with any recommendations. I have noticed the recent press
discussing potentially significant auditing costs that advisers serving as
trustees may have to pay for their custodial clients. 16 In order that we may be fully informed as to
the impact of this aspect of the rule, I encourage you to collect
information and to relay any pertinent information to the staff.
While I supported the adoption of the amendments to the custody rule, I
stated at the time that it was not enough. As this audience knows well,
the amendments were prompted by the revelation of the Madoff Ponzi scheme.
I felt that our action did not go far enough because it did not address
Madoff's actions as a broker-dealer. It's important to recognize that the
Madoff Ponzi scheme lasted for decades potentially starting in the 1980s
and for much of that time Madoff was registered only as a broker-dealer.
The victims lost money from discretionary, commission-only brokerage
accounts. It was only in 2006 that Madoff registered as an investment
adviser.
Thus, even if the rule had been in effect, it would not have applied to
the Madoff broker-dealer and the rule would not have prevented much of the
harm that Madoff did. Moreover, you need to remember that because
investment advisers are required to maintain their clients' assets with
qualified custodians, such as banks and broker-dealers, very few advisers
actually hold physical custody of client assets.
Accordingly, tightening the rules applicable to investment advisers
without assessing and strengthening the underlying broker-dealer rules is
not enough. To that end, I have urged the SEC staff to move quickly toward
developing proposals to strengthen the broker-dealer framework. I hope to
see the staff's proposal in the near future.
Reducing the Temptation of Advisers to Misuse Political
Contributions
As I alluded to earlier, the Commission has also re-proposed a rule to
limit the ability of investment advisers to make political contributions
in order to be chosen to manage public pension fund money. In other words,
this rule is intended to reform the pay-to-play system that has been
documented far too often.
The pension fund business is substantial. State and municipal pension
plans hold over $2.3 trillion of assets and represent one-third of all
U.S. pension assets. These plans are typically administered and managed by
elected officials who also have the responsibility of selecting the
investment advisers who oversee the plans. Obviously, these plans pay
significant advisory fees to investment advisers, making the management of
these plans highly desirable business. Advisers compete fiercely to win
this business and, for the most part, compete fairly based on their
qualifications.
The concern behind the proposal is that some advisers and elected
officials are engaging in pay-to play conduct where advisers make
political contributions to elected public officials who oversee public
pensions in order to be chosen to manage some of the pension business.
This type of conduct distorts the marketplace and is incredibly hard to
police. The proposed rule is the Commission's attempt to ensure that
advisers compete for pension plan business on a level playing field and
that they fulfill their fiduciary obligations and put the interests of the
plan beneficiaries above all others.
To crystallize if an adviser wins business because it has "paid" in
order to "play," there are serious doubts as to whether the most qualified
adviser was selected for the job. After all, in such a case, the adviser
selection process would not appear to be based on merit and qualification.
If the best person was not selected for the job, the plan could suffer
inferior management that may lead to greater losses. The plan may also be
paying higher fees because the adviser may be trying to recoup its
political contributions or because the contract negotiations were not
exactly arms-length.
It is important to note that the proposed rule, while regulating
investment advisers, would not reach the conduct of the elected officials
who serve as public pension plan trustees. These individuals engage in
serious conflicts of interest when they accept political contributions
from those who do business with the plan. I applaud the state and local
authorities who have taken steps to prohibit pay-to-play activity and I
encourage more to do the same.
Revisions to Form ADV, Part II
Lastly, let me say a word about Form ADV. As those in this room know,
Form ADV is the core disclosure document for every registered adviser. In
particular, Part II of Form ADV is the disclosure document provided
to clients and includes key information including the services provided,
the applicable fees, conflicts of interests, and other specified
information. Part II is the primary document by which investors receive
the information they need to decide whether to hire an adviser.
Unfortunately, the current form is sadly antiquated and a modern day
adviser's services may not correspond well to the limited number of
options on the form. As a result, the resulting disclosure may not
describe the adviser's business or conflicts in a way that investors can
readily understand.
The need to update Part II has been clear for over a decade. In April
2000, the Commission proposed comprehensive amendments to Part I and II of
Form ADV; but although the Commission adopted the amendments with respect
to Part I, the amendments to Part II did not see the light of day. Then,
in March of 2008, the Commission re-proposed various amendments with the
aim of providing clients and prospective clients with plain English
disclosure of the business practices, conflicts of interest, and
background of investment advisers and their advisory personnel.17 It is expected that the Commission will soon
revisit Form ADV.
While there are many aspects of the amendments that merit discussion, I
want to focus on one the brochure supplement. Currently, investors
receive information about executives of the advisory firm but little to
none about the educational background or disciplinary history of the
advisory personnel sitting across the table. The Form ADV proposals, in
2000 and 2008, proposed a brochure supplement to provide investors much
needed information in real time. The supplement would contain information
as to the qualifications of the advisory personnel who will be providing
the investor with the personalized investment advice.
I believe that clients would benefit greatly from the information to be
conveyed through the proposed supplement particularly where the advisory
personnel has a disciplinary history. I know this particular proposal
generated robust comment and I look forward to the staff's
recommendations.
Conclusion
The regulatory landscape is changing, and its future state is
uncertain. As investment advisers, you have a critical role to play in any
regulatory improvements for advisers. Investors place their trust in you
to act as their fiduciaries in managing their investments, but they also
need you to bring your experience and expertise to the discussion of
strengthening industry regulation.
In my role as an SEC Commissioner, I will support strengthening the
regulatory framework governing investment advisers, and I will work to
ensure that the proposals provide smart, effective regulation without
diminishing investor protections.
Thank you for the opportunity to speak with you today.
Endnotes
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