Preliminary Solicitation of Public Comments: Fiduciary Conduct Standard for Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives

June 24, 2019 – Concerned.Citizen.In.MA@gmail.com

Subject: Comment on Fiduciary Conduct Standard
From: Concerned.Citizen.In.MA@gmail.com

Dear Secretary Galvin,

This is in response to your request for comments on the "Fiduciary Conduct Standard for Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives".

I believe this proposal is good start, with admirable goals. However, without the elimination of adverse incentives, this is a half-measure at best. If you allow financial advisers to take commissions and other incentives from product sellers, then of course they will be influenced, whether they believe they are or not. You can't legislate human nature.

It is not possible to solve this problem until we address the root cause of the issue: Eliminate conflicts of interest. Ban kickbacks.

This is not revolutionary. There is a lot of precedent for this.

How other countries and industries have solved this problem

1) Other countries, such as the UK, the Netherlands, Denmark, Norway, Finland, Australia, and India, have banned conflicted-remuneration for financial products. They forbid any type of compensation, either monetary or non-monetary, that might bias the adviser's advice. These countries believe that such compensation is tantamount to fraud. Financial advisers are still paid for their services, but the fees are structured so that they do not influence the advice provided.

2) Under the Federal Anti-Kickback law, physicians and other healthcare providers are prohibited from receiving any type of kickback for the referral of a Medicare of Medicaid patient. Violation of this law is considered a felony.

But in the financial industry, kickbacks are not felonies – they are accepted practice.

Until we eliminate the causes of bad financial advice – kickbacks and other conflicts of interest -- and thereby hold financial advisers to the standards of other professionals, investors will continue to be harmed.

Why commissions are harmful

Why do commissions matter? How much do they influence advisers' advice?

• The Harvard Business School researched this question and came to the conclusion: a LOT. They found that insurance agents who earned commissions recommended appropriate products only 9% of the time. In the other 91%, they recommended investment-linked products that were dramatically more expensive. http://www.hbs.edu/faculty/Publication%20Files/12-055_f474d8ef-ec12-480f-9a0d-532e9667635e.pdf
• A study in Germany compared the investment returns of people who chose their own investments, versus those who got professional advice from an adviser. They found that advised accounts had average lower net returns and inferior risk-return tradeoffs, even after controlling for investor characteristics. They concluded that financial advisers were systematically recommending unsuitable products to their clients in order to boost their own commissions. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1360440
• Sendhil Mullainathan of Harvard and colleagues from M.I.T. and the University of Hamburg sent "mystery shoppers" to visit financial advisers. They found that advisers mostly recommended investment strategies that fit their own financial interests. http://www.nber.org/papers/w17929
• A study by Susan Christoffersen of the University of Toronto and colleagues from the University of Virginia and the University of Pennsylvania, found that investment advisers directed more of their clients' money to funds that shared the upfront fees with them. Returns of these funds were poor, compared with alternatives. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1393289

Further, the research of behavioral economists shows unequivocally that people's actions are influenced by incentives, even when they themselves don't know it. If one investment pays the adviser $5000, while another investment pays the adviser $100, of course the adviser is going to be influenced.

It simply is not possible to be paid on commission and preferably represent a client's interest. It doesn't matter if the person has a "fiduciary" label or not -- if it comes down to their interests versus their client's, you can be sure theirs will come out on top.

We cannot legislate how people respond to incentives. Rather, we must regulate the incentives themselves.

Why a fiduciary standard would be unenforceable

If we move forward with a uniform fiduciary standard, how would we enforce it?

First, the investor has to actually figure out that there's a problem, which is extremely hard to do -- most advisory clients are unsophisticated and don't know how their portfolio is performing compared to the market, apart from what their adviser tells them. Very few people will actually figure out when fiduciary duty has been breached.

Of note: in the Well Fargo scandal where the bank opened 3.5M fraudulent accounts, fewer than 1% of the affected people actually filed complaints. And this case was much more straightforward than breach of fiduciary duty. Complaint rates are low because most defrauded people do not know they have been defrauded.

Second, assuming the investor does figure it out, what recourse does he/she have? Investors are locked out of the courts due to mandatory binding arbitration. The arbitration forum is controlled by the financial industry itself, so how can an investor hope to get a fair hearing? Moreover, the adviser can always say that he/she thought the investment was the best choice for the client, and it is very difficult to disprove this.

Third, regulatory enforcement is nearly nonexistent for the fiduciary standard we already have for RIAs. The MA Securities Division only brings about a dozen enforcement actions per year, among more than 27,000 broker/dealers and investment advisers registered in the state. And only a minority of these enforcement actions are for breach of fiduciary duty.

I asked the Securities Division why they do not crack down on the egregious investments being sold by fiduciary RIAs to elderly customers – investments that are sure-losses for consumers while offering huge kickbacks to financial advisers. They told me that breach of fiduciary duty is hard to prove, so they tend to avoid these cases. The Securities Division itself doesn't believe it can enforce a fiduciary standard.

So what good is this regulation to investors?

We need a law that is enforceable, especially when most advisers themselves won't be aware of how their incentives are causing bad advice. It is very difficult to prove that an adviser did not act in a customer's best interest. But if we had a no-kickback law, it would be much easier to prove if an adviser took remuneration that could bias their advice.

How it could be instead

Other countries prohibit financial advisers from taking commissions or other compensation that might bias their advice. They understand that the only way to ensure unbiased advice is to eliminate the incentives that cause that bias. MA citizens deserve the same protections.

In Australia, they combine their best-interest requirement with a ban on conflicted remuneration. Here are some excerpts of the law, https://asic.gov.au/regulatory-resources/find-a-document/regulatory-guides/rg-246-conflicted-and-other-banned-remuneration/:

The conflicted and other banned remuneration provisions primarily aim to more closely align the interests of those who provide advice with the interests of their clients, and improve the quality of advice these clients receive.

A significant conflict of interest for financial advisers occurs when they are remunerated by product manufacturers for a client acting on a recommendation to invest in their financial product … These payments place financial advisers in the role of both broker and expert adviser, with the potentially competing objectives of maximising remuneration via product sales and providing professional, strategic financial advice that serves clients' interests … Evidence to the committee strongly suggested that the current disclosure requirements had not been an effective tool for managing conflicts of interest.

[Conflicted remuneration, defined as follows, is banned]:

Conflicted remuneration is any benefit given to an AFS licensee or its representatives that provide advice to clients that, because of the nature of the benefit or the circumstances in which it is given, could reasonably be expected to influence: (a) the choice of financial product recommended to clients by the licensee or its representatives; or (b) the advice given to clients by the licensee or its representatives.

If we are serious about investor protection, then we should follow the lead of other countries and ban the conflicts of interest that cause bad advice.

As another example, in healthcare, doctors are supposed to act in their patients' best interests. But the government recognizes that's not enough, so we have the federal Anti-Kickback Statute, which prohibits the exchange of remuneration for referrals for services. In other words, no kickbacks.

According to the Health and Human Services government website, http://oig.hhs.gov/compliance/physician-education/01laws.asp:

The AKS is a criminal law that prohibits the knowing and willful payment of "remuneration" to induce or reward patient referrals or the generation of business involving any item or service payable by the Federal health care programs… In the Federal health care programs, paying for referrals is a crime.

Why is it a crime for physicians to accept remuneration intended to influence their advice, but we consider it perfectly acceptable for financial advisers to accept remuneration intended to influence their advice? This does not make any sense. Let's hold financial advisers to the same standards as other professions.

As a physician, you are an attractive target for kickback schemes because you can be a source of referrals for fellow physicians or other health care providers and suppliers. You decide what drugs your patients use, which specialists they see, and what health care services and supplies they receive.

Similarly, financial advisers are an attractive target for kickback schemes because they are a source of referrals for various types of investment products. As trusted advisers/fiduciaries, they help their clients decide what stocks, bonds, mutual funds, structured products, annuities, and other financial products to buy.

Kickbacks in health care can lead to:

• Overutilization
• Increased program costs
• Corruption of medical decisionmaking
• Patient steering
• Unfair competition

Similarly, kickbacks in financial services can lead to:

• Purchase of inappropriate investment products
• Increased risk of loss
• Corruption of financial decisionmaking
• Investor steering
• Unfair competition

All of the reasons for banning kickbacks in healthcare apply to financial advisers as well.

Furthermore, we need a law that is enforceable. The AKS goes on to say:

The Government does not need to prove patient harm or financial loss to the programs to show that a physician violated the AKS. A physician can be guilty of violating the AKS even if the physician actually rendered the service and the service was medically necessary. Taking money or gifts from a drug or device company or a durable medical equipment (DME) supplier is not justified by the argument that you would have prescribed that drug or ordered that wheelchair even without a kickback.

Similarly, an investor should not need to prove harm to show that an investment adviser violated an anti-kickback law. Taking money or gifts from a seller of financial products would not justified by the argument that you would have recommended those products even without a kickback. THAT would be enforceable.

Healthcare has done this. The financial industry can do it as well.

Myths

The financial industry will claim that banning commissions for financial products would limit the availability of affordable advice for consumers. This is a myth perpetrated by the financial industry to protect their own financial interests.

First of all, commission-based advice is anything but affordable. The fees are hidden so consumers have no idea what they are paying, but hidden does not equal affordable. See, for example: http://www.nytimes.com/2015/03/04/business/americans-arent-saving-enough-for-retirement-but-one-change-could-help.html, which discusses how taking advice from a conflicted adviser could cost you 40% of your savings over a lifetime. That's affordable?

No one needs conflict-ridden advice, no matter how cheap it appears to be. It is like hiring a thief to guard your home. The thief may not charge any direct fees for his services, but you will pay ten times over by what he takes from your home.

In addition, the best insight about what would happen if we banned commissions comes from the countries that have already done it -- and in these countries, consumers are doing just fine. New services have come to market to offer low cost advice – services similar to Wealthfront, Betterment, Future Advisor, etc., which are very low cost and provide much better advice than most conflicted advisers. Consumers in these countries are not lacking affordable advice at all.

In short, there is no free lunch. There is nothing about the commission-based model that magically allows advisers to provide "affordable advice". Advisers are going to get paid one way or another, and consumers are going to pay for it. So the question is: should advisers get paid via obscure and hidden fees, so that the consumer never really knows what he/she is paying and cannot trust the advice received? Or should advisers get paid via upfront fees, so that the consumer knows exactly what he/she is paying and can trust the advice received? That is the question.

I should note that some people advocate disclosure as a solution, but disclosure is not the answer. According to Dan Ariely, professor of behavioral economics at Duke:

Disclosure doesn't seem to help. Several studies have shown that when professionals disclose their conflicts of interest, this only makes the problem worse. This is because two things happen after disclosure: first, those hearing the disclosure don't entirely know what to make of it and second, the discloser feels morally liberated and free to act even more in his self-interest.

Disclosure has not – and will not – solve this problem. We need to make these practices illegal.

Summary

I appreciate all that you are doing for investor protection. Toward that end, I encourage you to pass a meaningful, enforceable regulation that will make a real difference to consumers. Let us address the root cause of the problem and pass a law to eliminate kickbacks and conflicts of interest for financial advisers.

It's time we take bold steps to stop the incentives that cause financial advisers' predatory and corrupt practices.

To close, I'd like to quote Edward Jewell-Tait, head of private banking at Credit Suisse in Australia, http://www.smh.com.au/business/credit-suisse-boss-edward-jewelltait-slams-commissions-for-financial-advisers-20140921-10k0s6.html:

I think it is simply not possible both to provide advice and sell products at the same time and problems inevitably arise when advisers are incentivised to give particular advice. You simply can't have inducements. You can't have a situation where people are paid commissions on the products they sell at the same time as giving advice.

Mr. Jewell-Tait, a banker, does not believe it is possible to be a fiduciary when you have conflicts of interest. Let us not fool ourselves into thinking this is possible either.

Thank you for considering.