On The 75th Birthday Of The 1940 Act, A Reminder Of The F-Word's Power

09/02/2015 05:33 pm ET Updated Sep 02, 2016

September is here and there is no better season to celebrate the F word: F, in this case, for the fiduciary standard.

For one thing, the month of September has just launched. The Institute for the Fiduciary Standard has christened this first month of fall Fiduciary September, in an effort to advance the spirit of the fiduciary standard both among industry practitioners and regulators. For another, the Department of Labor recently vowed to push through an initiative it proposed in April that would mandate a fiduciary standard for brokers who get paid to provide individualized retirement advice--with a few exceptions.

This year also marks the 75th birthday of the Investment Advisers Act of 1940, the very body of law that brought the fiduciary standard to bear on the investment advisory industry.

"I submit to you that the one clear impact [of the Investment Advisers Act of 1940] has been to shape the culture of advisers," says Tamar Frankel, an authority on fiduciary law, an author and a professor of law at Boston University. "Advisory services may be a business, but there are things that are engrained in those who do business in this area. They are concerned about giving an effective advice. They worry about conflicts of interest. Their culture says: 'Here we do not engage in conflicts.'"

Anyone who follows the industry even casually knows that 75 years later, the fiduciary standard is still a matter of considerable debate. The question concerns whether and to what extent broker-dealers who offer investment advice to clients should be subject to the 1940 Act and the fiduciary standard it helped establish. So long as these brokers are not paid for the advice they offer, they are not currently held to the F word--even if they are providing advice on retirement accounts or any other accounts.

But the reality is that investors trust brokers who provide investment advice, in part because these brokers present themselves as trusted advisers, Frankel argues. If instead, the broker is primarily selling the client a product, and getting paid by the product provider to do so, are these clients being exposed to abuse?

"Variable compensation arrangements - where a broker is paid one amount for recommending Product A, and a different amount for Product B - create an inherent conflict of interest that can impair the objectivity of advice given to an investor. Investment advisers registered under the Investment Advisers Act of 1940 - RIAs -- are not allowed to engage in such conflicts, which allows for more impartial advice for investors," says Skip Schweiss, TD Ameritrade Institutional's managing director of advisor advocacy and industry affairs.

Under the Department of Labor proposal, all those offering advice on retirement accounts would have to offer impartial advice, put their clients' interest first, and could not accept payments that created conflicts of interest--but again, there are exceptions--the most sweeping of which is the "best interest contract exemption," which would permit a broker to accept commissions from a product purveyor and to share in revenue generated by mutual fund companies who sell their funds through the broker as long as this information were disclosed to the client. Critics argue that this simply shifts the burden to clients, requiring them to become more educated, rather than requiring brokers to avoid conflicts of interest.

"Unfortunately, this language still represents a loophole for conflicts--a true fiduciary advisor seeks to avoid conflicts first and foremost," says Michael Zeuner, managing partner at WE Family Offices. "Even under the proposed regulations, 'caveat investor' will still be important. By asking two important questions when evaluating an advisor's investment recommendation: who's interests are you representing (mine or your firm's) and how are you getting paid, an investor can get more clarity into whether an agenda, other than their own, may be at play."

The problem is that the broker-advisers are supposed to be the experts, and most individual investors cannot judge the merchandise, says Frankel. "With a large retiree population that is not expert in finance and depends on savings for its livelihood, the issue of brokers' duties has become increasingly serious."

The Investment Advisers Act of 1940 and the Investment Company Act of 1940 were created by Congress to protect investors from abuse of trust. If that trust is once again abused, the financial intermediation and advisory businesses may not survive.

"The birthday of the Acts should be used to revive the memories of their birth pains," says Frankel. "We should remember that the Acts rose from the ashes of the securities markets [left by the 1929 stock market crash]. Thus, at moments of high exuberance we should never forget how and why these Acts was passed."