September 6, 2004
Dear SEC Commissioners:
I am Bob Veres, a financial consumer, writer and concerned citizen who has closely observed the financial services industry for the past 23 years. In particular, I have seen a new profession arise in our midst, a profession which fits the description but perhaps not the intent of the 1940 Act which the SEC was created to administer-- and which, perhaps more than anything else in the SECs regulatory purview, creates a need for interpretation of the Act with little direct guidance handed down from the visionaries who created it.
As you know, the Act was created primarily to guide and control what was then a nascent profession of institutional investment professionals, people who today would be described as fund managers and managers of endowments, and investment advisers to the very wealthiest segment of the general public. The creators of the Act appear not to have envisioned that investment advisory services would eventually be provided to a mass consumer audience. Nor did they envision that it would commonly, routinely be paired with more comprehensive advice of which investment advice is a strong subset--what we today call financial planning.
This lack of foresight is certainly understandable who among us CAN predict the future with any accuracy?, but it is also inconvenient in the present circumstance. Before I start offering my own comments and recommendations, I want to make sure that you know that I understand that--and, I think, so too do the parties involved in this discussion, the wirehouse organizations on one hand, and the financial planning profession on the other. Both of them look to you for guidance for very different reasons, and I think in the final analysis, it is those reasons, those agendas, which should be your best clue as to how to proceed in interpreting the Act into our present age.
Over the last 23 years, I have watched the financial planning profession do something which may be unique among professions: evolve ever higher standards of consumer protection, without being required to do so by any outside regulatory body. In the early 1980s, when I first became involved with the profession as a magazine editor, the typical financial planner was unambiguously a salesperson, a producer in the parlance of the time. Planners were not overly finicky about what they sold the products of the day were selected according to the size of the commissions they generated, and sometimes it was argued that diamonds and shares of diamond portfolios were not securities and therefore not required to be registered with the SEC or the state securities commissioner. Later in the decade, limited partnership investments were sold with more scrutiny of their commission structures than their merits to investors.
I could give you a detailed description of the evolution from those unhappy days to these, but the bottom line is really all that is necessary to know. And the bottom line is that gradually, a little at a time, sales activities were recognized to be not in the best interests of clients and customers, and were deemphasized in favor of advice and service. A growing number of planning professionals have set aside commission revenues in favor of fees, putting forth the argument that commissions carry an inevitable conflict of interest, greater than the conflicts associated with a fee-only compensation structure. Over that time, advisors have gradually begun to voluntarily embrace the concept of acting in a fiduciary role with clients. Along this journey, literally thousands of advisors decided that it was too much of a conflict to work for and represent a large financial services firm which promoted in-house investment products or which insisted that the loyalty of their brokers be to their bottom line rather than the bottom lines of the consuming public.
Let me repeat the most astonishing part of this story: that this evolution toward increasing consumer-friendliness was accomplished without outside regulatory pressure. It has been voluntary. And this evolution is continuing, and I expect it to continue unless acted on by an outside force, until the financial planning profession is virtually 100 fiduciary in its relationship to its customers, and upholds standards which are only given lip-service in other areas of the marketplace.
Over these years, I have also watched an interesting evolution of the larger wirehouse organizations--those firms whose attorneys are arguing the other side of the so-called Merrill Lynch Rule. When I started watching them 23 years ago, it seemed to me that their business model was founded on intractible conflicts of interest. They manufactured and managed investment products, and they also recommended investment products to the public--and, by a coincidence that I think you will have no trouble explaining, a high percentage of the investment products they recommended to the public were manufactured and managed in-house.
These firms also bought and sold investments for their own company account, and also recommended investments for their customers. Who got the best advice in these transactions? When an attractively-priced investment was presented to the firm, did it call its customers first?
These firms also took companies public, and, at the same time, made recommendations to the public on which IPO shares they should purchase. After agreeing to sell a certain number of shares on behalf of the company going public, could they then cast a skeptical eye on the offering when making recommendations to consumers?
Over the last 23 years, the evolution of the larger Wall Street firms has not, interestingly enough, taken the same path as that of the smaller investment advisers that we sometimes call financial planners. In fact, the Wall Street firms have, over these two decades and more, been unwilling to give up ANY of these manifest conflicts to their ability to give unbiased consumer-friendly advice to the public.
Instead, their evolution has been a bit more sly. Over these years, the people once called brokers have been renamed advisers and counselors, words chosen with care, words which do not suggest that there is a sales role or conflicts behind the advice offered to the public. I doubt very much that anybody reading this is unclear why these firms chose to rename their representatives. History has shown- and a careful reading of the 1940 Act confirms--that consumers prefer conflict-free advice to advice from people who have multiple agendas. Consumers put more trust in a fiduciary than in a salesperson. If the salesperson can somehow masquerade as a fiduciary, as an investment adviser, then the doors of trust are opened to people who are then able to act on their conflicts of interest and make recommendations and execute transactions that benefit everybody but the customer.
It is, in short, very good business to have salespeople rather than fiduciaries, but have the salespeople seem like fiduciaries to the general public.
We need hardly look at ancient history to see why consumers tend to gravitate toward fiduciary advisers. The recent scandals that you at the SEC are still cleaning up, where purportedly independent analysts were openly acknowledging their sales role when competing for year-end bonuses, where companies have offered sales rewards for recommending in-house products, where IPO shares were mispriced and then given away to favored customers in exchange for higher commissions can the movement of money from the company going public to the back pocket of the investment bank be any more transparent?, the sales of annuities and life insurance products as retirement plans--these all testify to the wisdom of that consumer who seeks out impartial fiduciary advice.
And so, today, you are required to interpret the 1940 Act and the specific broker dealer exemption that is laid out in it, which states that the term Investment Adviser does not include or apply to any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.
I think that you, as the guardian of the spirit and the letter of the Investment Advisers Act of 1940, have several issues to consider. The first, of course, is the letter of the regulation. Looking at todays large broker-dealer organization, and the way in which these organizations do business in todays marketplace, the question before you seems to be: Are the investment advisory services offered by these firms solely incidental to the conduct of their business? and Do they receive special compensation that pertains directly to the provision of investment advice?
The key issue, I believe, lies in how you define the terms solely incidental and special compensation. I would argue that the larger Wall Street firms have actually conceded the solely incidental issue everywhere but in their arguments before the Commission, and will simply point to their advertising, which I see at all hours of the day and night. Any reasonable assessment of the marketing messages put out by the firms who argue that they should remain exempt from RIA registration will show, not a focus on the excellence of their investment products, but on the excellence of the advice of their counselors. It is the same with their collateral literature, which inevitably focuses on the financial consultant, rather than the in-house products they recommend. In many cases, the first step in a relationship with a brokerage firm is the creation of a financial plan, with generic recommendations. A cynic might suggest that this is a well-crafted ploy to make the relationship look as much as possible like the opening of a relationship with a fiduciary, so that trust can be established in order to facilitate the sale of products to a less-wary consumer. But even a less-cynical observer can see that the provision of advice has become a centerpiece of the broker-customer relationship. There is nothing whatsoever incidental about it.
And what about special compensation? I think it is sensible to argue that the original creators of the 1940 Act were responding to their own environment, where brokers were paid trading commissions if the customer found their investment recommendations persuasive, while asset manager/investment advisers received ongoing management fees. The distinction that was once clear has now become remarkably fuzzy. Brokers are routinely compensated by asset management fees, as a percentage of the overall portfolio, exactly as investment advisers were compensated in the era when the 1940s Act was written and promulgated. Surely the original authors of the document would not have hesitated to call this special compensation. Otherwise, how on Earth would you distinguish between the compensation normally paid to investment advisers and to brokers?
I would argue--and AM arguing--that the current wirehouse activities fail the exemption test on both counts. A careful interpetation of the wording of the Investment Advisers Act of 1940 cannot help but conclude that the larger wirehouse organizations have placed investment advice at the heart of the great majority of their customer relationships, and that many of their brokers-cum counselors are compensated in ways that clearly fall into the area where brokerage activities end and investment advisory activities begin.
By this important standard, I submit that the wirehouse firms should be required to register as Registered Investment Advisers under the 1940 Act, immediately and without qualification.
The second issue to consider is the spirit of the regulation. What was the intent of the original writers of the Act, and how would we uphold their intent in todays marketplace?
This, I think, is not a complicated discussion. The authors of the Act were clearly attempting to protect the public by creating new and definitive standards of conduct, with appropriate penalties for those who abuse the public trust. They must have intended that all who hold themselves out as providing investment advice to the public, as their primary stock in trade, would be covered by the Act. Otherwise why create it in the first place?
Beyond this, however, is a more encompassing issue. Over the last 23 years, we have watched a substantial group of investment advisers embrace the spirit of the 1940 Act and the consumer protection is at its core. Those are the people who are asking you, today, to allow them to compete on equal terms with rivals who pose as them but who are not them, who continue to embrace conflicts, whose nefarious consumer-unfriendly activities reemerge with some degree of regularity on the business pages of the nations newspapers, whose agenda is to blur the distinction between fiduciary and broker.
The situation in the marketplace is, I think, very clear. You have a group of advisers who have embraced their consumer protection role in increasing numbers and with increasing enthusiasm, who are asking you now to apply the fiduciary standard to anyone who represents him/herself as an investment adviser or provider of advice. And you have a group of larger firms who have attempted to blur the distinction between these emerging consumer advocates and their own continued attachment to conflicts of interest, who are asking you to allow them to evade fiduciary responsibilities so their renamed consultants and advisers can pose as equally trustworthy providers of advice.
The investment advisers who have registered with the SEC ask nothing more than for you to apply the rules equally to all parties. If you deny them this consideration, then you are sending them--and the public--the clear message that consumer protection is somehow less important than the business interests of large financial services organizations.
The right decision, I would suggest, is to rescind the Merrill Lynch Rule in its entirety. As a financial consumer, on behalf of all of my kind, I ask you to make the right decision.