The SEC recently announced its “kinda fiduciary”proposal, allegedly to provide investors with protection against abusive marketing strategies used by the investment industry. Interestingly, the SEC choose not to use the term “fiduciary” in announcing its proposal, instead referring to new “Best Interest” (BI) proposal. The issue did not go unnoticed.
While various post and articles have been written regarding the BI proposal, two articles written by leading ERISA attorney Fred Reish provided very informative and insightful analyses comparing the BI proposal to the terms of the DOL’s recent fiduciary rule and its Best Interest Contract Exemption (BICE). I would strongly recommend that anyone in either the investment or ERISA industries take the time to read Mr. Reish’s articles.
One of the most common criticisms of the SEC’s BI proposal is the noticeable lack of any definition of “best interests.” Mr. Reish addressed the issue by referring to the DOL rule’s definition of “best interests.” Under the DOL rule, “best interests” was defined as follows:
Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. (emphasis added)
At some point, the SEC is going to have to address the issue of the definition of “best interest” under their “fiduciary” proposal. Commons sense would suggest that the easiest and most effective option would be to adopt the DOL rule’s definition of “best interests.” If, as expected, the DOL chooses to adopt the SEC’s eventual “fiduciary rule, this would obviously make the transition easier for the DOL, plan sponsors and plan participants..
The DOL’s definition of “best interest” would also further the alleged purpose of the SEC’s BI proposal – protecting investors. I’ve highlighted two sections of the DOL’s definition to illustrate how their inclusion in the DOL’s rule provides the fiduciary protection that investors need.
The United States Supreme Court recently stated that in matters involving fiduciary law, the Court often looks to the Restatement of Trusts (Restatement) for guidance. The Restatement (Third) of Trusts emphasizes two basic fiduciary duties – the duty to be cost-conscious and cost-efficient (Section 88), and the duty to be prudent (Section 90, aka “The Prudent Investor Rule”). The first part of the DOL rule is a direct quote from Section 90’s definition of the fiduciary duty of prudence.
Section 78 of the Restatement discusses a fiduciary’s duty of loyalty. Once again, the DOL rule’s language essentially tracks the Restatement’s language.
If the SEC is sincere in adopting a fiduciary standard, then the similarity in langauge between the Restatement and the DOL’s rule makes adoption of the DOL’s rule definition of “best interests” the simple and obvious solution for defining “best interests” under the SEC’s BI proposal.
I’m guessing that that is not going to happen for two reasons. I am records as stating that the SEC does not actually want to adopt, in fact cannot adopt, a true, meaningful fiduciary standard for two basic reasons. First, many SEC commissioners look to Wall Street for employment after their SEC terms end. A true fiduciary standard is not something the investment industry wants.
Why? Because Wall Street and the investment industry know that their current business model cannot comply with a true fiduciary standard, especially once based on the Restatement’s stringent standards.
For example, the investment industry relies heavily on the sale of actively managed mutual funds to individual investors and pension plans/participants. The two most noticeable aspects of actively managed mutual funds is their consistent underperformance and excessive fees when compared to comparable index funds.
Comment h(2) addresses the cost-efficiency issues involved with actively managed mutual funds, noting that such funds often involve higher costs and risk than comparable index funds. As a result, the Restatement cautions that actively managed funds should not be recommended or used in investment accounts unless “realistically evaluated return expectations” will compensate an investor for the actively managed fund’s additional costs and risks.
Simply put, this is a hurdle that most actively managed funds simply cannot meet. The most recent S&P Indices Versus Active report stated that 86.72 percent of actively managed domestic equity funds failed to outperform their appropriate benchmark. My own experience in performing forensic analyses on actively managed mutual funds using my metric, the Active Management Value Ratio™ (AMVR), has consistently shown that actively managed funds are not cost-efficient, in many cases even before their front-end load- adjusted and/or risk-adjusted returns are factored in.
Bottom line, the investment industry cannot effectively do business under their current business models if a meaningful fiduciary standard is imposed on them. that’s exactly why the industry fought so hard against the DOL’s proposed fiduciary rule and will fight against the SEC’s BI proposal if the SEC attempts to adopt similar fiduciary guidelines.
So I would suggest that they key to the SEC’s whole BI proposal is whether they balk in any way at adopting the DOL rule’s “best interest” definition. It’s there for the taking and perfectly describes the concept of “best interests” for investors. If the SEC balks in any way in adopting the DOL’s definition, then everyone will immediately see the BI proposal for what it is, a ruse and an accommodation to Wall Street and the investment industry. In the words of the great philosopher Judge Judy, “don’t pee on my leg and tell me it’s raining.”
Happy Memorial Day!
The Prudent Investment Fiduciary Rules 