fi360 Blog

Fiduciary Links: A new year, the Fiscal Cliff averted, and the “temporary” principal trading lives on

Welcome to the first Fiduciary Links of 2013! We hope all of our readers enjoyed the holidays and are looking forward to another great year on the fi360 Blog.

>>>> The big news today on a short week is, of course, the deal reached to avert the Fiscal Cliff. Late last night, The American Taxpayer Relief Act of 2012 was finally passed by both the Senate and House. The move resolves much of the uncertainty regarding what the tax rates will look like for the coming year. The White House site has both a write up of the deal, as well as a fact sheet summarizing many of the details. Retirement plans figured prominently in the deal, which includes a provision to allow traditional 401(k) plans to be more easily converted into a Roth plan. In September, fi360 conducted a webinar on the Fiscal Cliff and what it means for advisors, a recording of which is available on our website.

>>>>The SEC made final its rule to extend the temporary principal trading rule for an additional two years. The rule permits broker-dealer representatives to conduct principal trades with non-discretionary advisory clients under certain circumstances. Fi360 had submitted comment to the SEC in opposition of the rule extension and was, in fact, the only commenter to be in opposition to the rule. Please read InvestmentNews’s coverage for more details.

Fiduciary Links: Season's Greetings

Proxy Advisors and Your Fiduciary Responsibility

In 2003, the SEC adopted Advisers Act Rule 206(4)-6, which requires registered investment advisers to adopt and implement written proxy voting policies and procedures, designed to avoid conflicts of interest that an investment adviser may encounter when voting proxies on behalf of its clients.  The adopting release for this Rule (SEC Rel No IA-2106) stated that: “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”  Following the adoption of the Rule, the SEC Staff granted no-action letters to two proxy voting advisory firms (“proxy advisors”) that described methods by which proxy advisors could demonstrate their independence from issuers with whom the proxy advisors did business.  (Egan-Jones Proxy Services, May 27, 2004; Institutional Shareholder Services, September, 15, 2004)  In a recent speech, former SEC chairman Harvey Pitt urged that these two no-action letters be withdrawn.  Pitt maintained that the letters have fostered the belief that many investment managers effectively outsource their proxy voting responsibilities.  While Pitt maintains that a portfolio manager who makes such a delegation breaches its fiduciary obligation, he believes “the Commission will be hard-pressed to go after people who outsource their votes” so long as the no-action letters are outstanding.

Pitt’s speech again raises the simmering issue of the power of proxy advisors and the propriety of the delegation of proxy voting decisions by investment advisers.  Although the ultimate effect of the Rule and the no-action letters may have been to avoid conflicts of interest affecting investment advisers who have direct relations with issuers, in many cases the cure may be worse than the illness. 

Fiduciary Links: Answering your questions on conflicts of interest and risk governance.

>>>>Two weeks ago fi360 hosted a webinar, “A fiduciary approach to conflicts of interest and risk governance.” During the session our two speakers, Mr. Blaine Aikin and Mr. Byron Bowman, spoke about conflicts of interest, risk governance, fulfilling fiduciary duties. In particular, Mr. Bowman spoke on the current focus the SEC is placing on conflicts. A recording of the webinar and the slides are now available for download on our website.

Mr. Aikin and Mr. Bowman were able to answer quite a few questions from attendees, though there were some questions that weren’t able to be addressed in the time available. Mr. Bowman has answered the remaining questions below, which we present in the following Q&A:

Q:  In the case of dually-registered advisors, is disclosure of conflicts of interest a fiduciary requirement? Or is it enough to simply switch between the “two hats”?

Byron:  It is not uncommon for RIAs to also be registered representatives of broker-dealers, often in order to be able to offer variable annuities or other insurance-related products to their clients.  There is often confusion in the minds of both the advisor and the client as to the responsibility of the advisor to deal with conflicts of interest when dually-registered.  While a registered representative is bound by its broker-dealer’s suitability requirements, an RIA may be subject to a fiduciary duty under state law if the RIA has investment discretion over the entire account.  In that situation, the RIA should make full disclosure and obtain the client’s consent before placing a product in the account through the RIA’s broker-dealer.  Many RIAs would seek to control this conflict by waiving their fee in an amount sufficient to offset any commission that the RIA would earn from the transaction.

Q:  Do structured investment products always run the risk of conflicts of interest? I haven't yet seen one where the conflict of interest does not seem to be built into the product.

Byron:  “Always” is a loaded word.  Certainly, many—if not most—structured products have some conflicts of interest inherent in their structure.  For this reason, it is crucial for an advisor considering such a product for a client to closely read the offering circular and be able to explain any conflicts of interest to the client.

Q:  How is the trading desk as a profit center reconciled with the fiduciary duty to manage cost on behalf of the client?

Byron:  An advisor is under a duty to obtain “best execution” for its clients; however, best execution may consist of a broad number of practices, including not only cost, but research and trade management.  Section 28(e) of the Securities Exchange Act of 1934, as amended, permits fiduciaries to take into consideration these factors when placing trades with brokers.  As a practical matter, an advisor should not refrain from using an affiliated trading desk solely because the desk operates as a profit center.  However, the advisor should, as a matter of practice, (1) be able to evidence that the affiliated trading desk provides execution on a basis at least as beneficial to the customer as other competing brokers—considering all of the factors, (2) disclose the potential conflict to the client prior to using the affiliated trading desk, and (3) obtain the client’s consent before placing trades with the affiliated desk.  An advisor choosing to use an affiliated trading desk should expect to be asked to provide regulatory examiners with evidence that the affiliated trading desk provides competitive execution; furthermore, the advisor should not be surprised if institutional or other sophisticated investors also request to review such information before consenting to the use of the affiliated desk. 

Solving a Retirement Crisis: It's as Simple as 123(4)

>>>>In California and elsewhere the retirement planning industry is beginning to wake up to a new “defined benefit” plan for low- to middle-income workers or, as a legislative aide, Greg Hayes, describes it, an “IRA in an insurance wrap.”  The concept, if California S.B. 1234 overcomes not insignificant financial and legal hurdles, promises to upend conventional thinking over the utility of 401(k)-type plans for the private-sector workforce. 

It also may create a shift in thinking about fiduciary responsibilities of the employers that sponsor plans.   

Signed into law on Sept. 28 by Gov. Jerry Brown, the concept was inspired by the aunt of bill sponsor State Sen. Kevin de León.  His aunt still works as a maid in her 70s and without any retirement savings.  Almost simplistic in concept, the program would require employers to automatically enroll the state’s 6.3 million private-sector workers who have no retirement coverage.  Companies with fewer than five employees are exempt.  Unlike IRAs, however, investment decisions for the retirement fund would be made by the investment board managing the program, not the individual participants.  Workers could opt-out, although they would be re-enrolled every two years unless they again opt out.  Companies that fail to enroll eligible employees would be fined up to $750 per employee.  The state of California and employers participating in the program would not be liable for investment results.

Formally known as the California Secure Choice Retirement Savings Trust Act, the program would not cover public sector employees, railway workers or those covered by a Taft-Hartley pension plan.  Private sector employers also could opt out by using vendors, mainly the Fidelitys and Prudentials of the retirement world, who wish to participate in the state’s Retirement Investments Clearinghouse.  Vendors and their financial advisors to the plans and to participants would be covered by existing law.

Before the Secure Choice program can get underway, the new Investment Board for the Secure Choice program must be appointed and undertake a feasibility study on costs and other issues.  The Investment Board would comprise of a mix of state officials and private sector representatives who would serve without pay and be appointed by the Governor and Assembly.  Another hurdle facing the Investment Board is to secure approval for favorable tax treatment from the Internal Revenue Service and a waiver from the U.S. Department of Labor from  ERISA.  This means the new savings program is still several years from going into effect, according to Hayes, adding that Assembly representatives had already met in Washington last month with the IRS and DOL to discuss the matter.

While the Investment Board is not explicitly required to act in a fiduciary capacity, there are  expectations that it will, based on the language in the bill and precedent in common law.

Fiduciary Links: Challenges Facing Advisors in Retirement Planning

>>>>In a 2012 generational research study, it was apparent that many employees are not optimistic about their ability to achieve income replacement for retirement. A recent report issued  by Financial Finesse explored perspectives and habits impacting the financial behaviors for age groups divided into: Millennials (younger than 30), Generation X (ages 30 to 44), Late Boomers (ages 45 to 54), and Early Boomers’ (ages 55 to 64).   

The research report data indicated that, with respect to retirement plan participation, between 83-95% of employees contribute to a retirement plan at work (95% for both late and early boomers).  However, for a variety of reasons outlined in the report, few respondents felt they were on track to replace 80% of pre-retirement income ― 25% of early boomers and only 15-18% in other age groups. Respondents cited factors such as lack of investment knowledge, debt repayment, or college savings for their children that are preventing them from being on track to replace income in retirement. 

The statistics concerning how respondents view their own ability to save for retirement may signal potential problems down the road.  Another contributing factor is the possibility that the government reduces the amount that can be contributed into a tax-deferred retirement plan ― a course of action that may thwart efforts to enhance retirement preparedness. There is a troubling precedent for this set by the major overhaul in 1986, which is blamed for limiting tax-deferred savings and causing pension plans to be terminated. Broad-based tax reform as part of a fiscal cliff solution could include such measures.

The American Society of Pension Professionals & Actuaries (ASPPA), concerned that the budget crisis and tax reform in Washington may severely impact worker contributions to 401(k) plans, instituted  a program called  Save My 401k Campaign to deter Congress from impacting the deductions in connection with pension savings or imposing limitations on pension contributions. At least one proposal, put forth by Simpson-Bowles, already aimed to cut retirement plan deductions by 60%  according to Brian Graff, Executive Director and Chief Executive Officer of ASPPA. 

Congress should be cautious when instituting reforms that impact retirement savings, lest they try to solve one problem by making another problem, the retirement readiness of American workers, worse.

>>>>DECEMBER WEBINAR: Tuesday, Dec. 11, the webinar "A Fiduciary Approach to Conflicts of Interest and Risk Governance" will be help from 4-5 p.m. ET. Please join featured presenters Blaine Aikin And Byron Bowman for a one hour discussion on the focus the SEC is currently placing on conflicts of interest, and what fiduciaries can do to mitigate this risk. Live attendance at the session will be reported for one hour of continuing education for the CFP® certification, AIF® and AIFA® designations. Space is limited. Register for the event here.

Now on to the rest of the best links of the week:

Fiduciary Links: FINRA to Consider Recruitment Compensation Disclosure Rule

>>>>The FINRA Board of Governors meets on Thursday. On the list of rulemaking items for discussion is a proposal to require brokers to disclose recruiting bonuses received for moving to a new firm. Unsurprisingly, this has quickly elicited a response from both sides of the argument. The InvestmentNews coverage of the argument includes a quote from a recruiter who feels this is going beyond the line of what is relevant to customers and a quote from an attorney who feels the proposal is justified, given the comprehensive disclosures required from RIA firms. IN headhunter blogger, Danny Sarch, says that, new regulation or not, advisors would be better suited being forthcoming about compensation than not. In any case, this sure looks like yet another signal that FINRA is migrating closer to fiduciary-like requirements in areas such as transparency.

>>>>In October, we alerted our readers to the new “Top 10 Operational Risks” series on the SEI website. That series has reached its conclusion and the entire book is now available for download. This is a good, hands-on resource that is valuable for any advisor to reference and we recommend you check it out.

>>>>DECEMBER WEBINAR: Tuesday, Dec. 11, the webinar "A Fiduciary Approach to Conflicts of Interest and Risk Governance" will be help from 4-5 p.m. ET. Please join featured presenters Blaine Aikin And Byron Bowman for a one hour discussion on the focus the SEC is currently placing on conflicts of interest, and what fiduciaries can do to mitigate this risk. Live attendance at the session will be reported for one hour of continuing education for the CFP® certification, AIF® and AIFA® designations. Space is limited. Register for the event here.

Now on to the rest of the best links of the week:

Whither the SEC?

The rulemaking pipeline at the SEC remains clogged with the requirements of the Dodd-Frank Act (32 rules adopted, 63 left to go, according to DavisPolk), and there are no signs of things letting up. In fact, it may only get worse.  The DC Court of Appeals’ insistence on substantive cost-benefit analysis to support new rules—and the increasing reluctance of certain Commissioners to act without such analysis—threatens to slow the rulemaking process down even more than it has been.

Two main thrusts of enforcement activities—insider trading and Ponzi schemes—are likely to continue.  The investigation into Knight Capital that came to light recently may represent a new attempt by the SEC to get its arms around the practices—and malpractices—of high-frequency trading.  Enforcement actions in this area could enable the SEC to establish certain “rules of the road” without the time and effort necessary for rulemaking.

Fiduciary Links: Some Thoughts on Chairman Schapiro's Tenure

>>>>The SEC announced today that Chairman Mary Schapiro will be stepping down from her position effective on December 14, 2012. It had long been speculated that she would be leaving the SEC sometime after the elections. Later in the day, the White House released confirmation that Commissioner Elisse Walter would be replacing her.

Fi360 would like to express its best wishes to Ms. Schapiro in her future plans. While we would have liked to have seen the SEC propose a strong, uniform fiduciary rule on her watch, we strongly commend her stewardship in navigating the SEC through a major financial crisis and numerous SEC oversight hearings.  Chairman Schapiro was handed a difficult task in 2009 – perhaps the most challenging since the Great Depression –and performed the job admirably. We look forward to continuing to work with the SEC under Ms. Walter’s leadership to ensure that all investors receive the enhanced protection of a strong fiduciary standard.

>>>>Fiduciary Duty: ”Conflicts of interest are the single greatest obstacle to fulfilling fiduciary duty,” writes Blaine in his latest Fiduciary Corner column in InvestmentNews. As long as temptations exist, there will be instances of fiduciaries who make decisions for their own benefit at the expense of those they are charged to serve.

Blaine’s column this month was inspired by a speech by the SEC’s director of the Office of Compliance Inspections and Examinations Carlo V. di Florio in which di Florio explains the SEC’s focus on conflicts for guiding their enforcement strategy. Di Florio states that experience has taught the SEC that “conflicts of interest, when not eliminated or properly mitigated, are a leading indicator of significant regulatory issues for individual firms, and sometimes even systemic risk for the entire financial system.”

>>>>FINRA and SRO UPDATE: FINRA was on the offensive again regarding an SRO structure for investment advisers, as Executive Vice President of Regulatory Policy Thomas M. Selman made remarks to the Investment Program Association’s Fall Conference defending the SRO model and attacking what he termed “two internally inconsistent objections” regarding SROs: 1) that they are captive to the industry and 2) that they are insensitive to their industry. This caused a reaction from David Tittsworth, the executive director of the Investment Advisers Association, who pointed to FINRA’s lack of transparency and Congressional accountability in his case against the broker oversight organization.

You can view fi360’s position against an SRO for advisers and against FINRA as adviser oversight in our comments to the bill that was introduced and later abandoned by the House earlier this year that would have authorized the creation of one or more SROs for advisers.

Now on to the rest of the best links of the week:

Fiduciary Links: Considering the Money Market Fight & 'Fiduciary' Debate

>>>> Money Market Fight Resumes A battle royale is brewing between the obscure but powerful Financial Stability Oversight Council (FSOC) and the mutual fund industry over money market funds.  While the Investment Company Institute and U.S. Chamber of Commerce can claim credit for halting SEC Chairman Mary Schapiro’s campaign to reform the $2.6 trillion money market industry, Section 120 of the Dodd-Frank Act allows FSOC to essentially override any action (or inaction) of a single federal regulator, which in this case is the SEC and the first exercise of FSOC’s authority under Section 120.  Schapiro is a willing partner to this initiative, given the reluctance of her fellow SEC commissioners to propose any new reforms to money market funds after the Prime Reserve Fund ‘broke the buck’ during the 2008 crisis.

FSOC, which is comprised of all the major federal financial regulators, on Nov. 13 proposed three potential changes to the regulation of money market funds: 1) floating NAV; 2) a stable NAV with a capital buffer capped at 1 percent of the fund’s value, in addition to delayed investor redemptions to avoid “runs;” or 3) a stable NAV with a higher 3 percent capital buffer dependent on other measures, such as greater diversification to reduce risk.  It is seeking comment over the next 60 days on the proposals.

While FSOC’s action may simply be a lever to induce the SEC to act – as some members of FSOC suggest, including Treasury Secretary Tim Geithner, it also sets the stage for the ICI and Chamber to square up for the first time against a whole host of regulators – the Fed, Treasury, and other federal regulators – not just the SEC.  While no one has yet mentioned a lawsuit in the D.C. federal appeals court, one can almost hear Eugene Scalia, who has taken on many of the administrative cases against the SEC, sharpening his legal scalpel in the back room.

Investment fiduciaries who assume money market funds are a safe harbor from future financial storms should carefully follow this battle to its conclusion.

>>>> DOL Fiduciary Rule.  Speaking of lawsuits, the SEC general counsel’s office and recently hired economists will probably take extensive notes when the Department of Labor releases its revised version of a new fiduciary definition early next year.  Similar to the controversy around the SEC’s proposed standard – which still has not seen the light of day – the DOL proposal will likely go to court over its cost-benefit analysis.  In a 2011 case over an SEC proxy access rule, Business Roundtable v. SEC, the rule was vacated due to what the court considered to be an insufficient analysis of its costs.  Assistant Labor Secretary Phyllis Borzi, however, promises a more robust economic analysis that would outline the costs to industry and benefits to plan participants.

At a time when the DOL is also reporting continued problems with valuation of certain assets in multiple employer plans, it seems clear that the DOL is moving forward full steam, damn the legal torpedoes while the SEC continues to flounder in its rulemaking on fiduciary matters.