Speech by SEC Commissioner:
A Shared Responsibility: Preserving the Fiduciary Standard
by
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
IA Compliance Best Practices Summit 2010
Renaissance Hotel
Washington, D.C.
March 26, 2010
Thank you for that generous introduction. I'm very pleased to be here at the IA Compliance Best Practices Summit 2010. As is customary, I want to make clear that the views I express today are my own, and they do not necessarily reflect the views of the Commission, other Commissioners, or the staff.
I'm particularly pleased to be here today because during my career I've done what many of you do on a day-to-day basis. I've been a securities practitioner for over 30 years, working for both the buy and sell side of the industry. And for almost a decade, I served as the general counsel and head of compliance of a large global asset manager. During my time there, I also served as the president of an affiliated broker-dealer and headed the company's Latin American operations. These varied roles have provided me with a broad understanding of the industry and the compliance challenges you face. As a former head of compliance, I know that your jobs are not easy.
As you are no doubt aware, the investment adviser industry in the United States has seen tremendous growth in recent years — from 6,650 registered advisers managing approximately $18 trillion in 1999, to nearly 11,500 registered advisers managing approximately $33 trillion as of January 2010. And these numbers include only advisers who have registered with the SEC. Many additional advisers are either registered with the states or are not required to register with anyone, such as most managers of hedge funds and other private pools of capital.
Even these large numbers, however, do not fully capture the influence of investment advisers in the lives of Americans. Millions of Americans rely heavily on advisers for their financial wellbeing. With so much depending on the advisory industry, it is incumbent on all of us — the SEC as the industry's regulator and you as the compliance experts — to make sure that investors are protected.
Recent events have deeply shaken investor confidence, and we all need to work hard to return to the bedrock principle that the capital markets should be known for their integrity and their fairness. Today, with increasingly complex investment opportunities available and more investors relying on advisers, the need for this integrity and fairness is greater than ever.
Today, in addition to sharing my views on the importance of the fiduciary standard, I'll discuss the importance of that standard as a foundation for effective compliance oversight. Also, I'll discuss the SEC's oversight of investment advisers and how the SEC's examination program can be improved.
The fiduciary standard — a fundamental investor protection
Those of us who have served in the advisory industry know that the fiduciary relationship between an investment adviser and his or her client is a fundamental investor protection. It is an affirmative obligation that continues throughout the relationship between adviser and client and controls all aspects of their dealings. The Supreme Court has recognized that the Investment Advisers Act "establishes 'federal fiduciary standards' to govern the conduct of investment advisers"1 and that "the Act's legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations."2 Simply put, the fiduciary duty is the foundation of the Investment Advisers Act.
As fiduciaries, investment advisers owe their clients an "affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation to 'employ reasonable care to avoid misleading'" [their] clients.3 Accordingly, investment advisers are required to serve the interests of their clients with undivided loyalty. An adviser that has a material conflict of interest must either refrain from acting upon that conflict, or it must fully disclose all material facts relating to that conflict, and obtain the informed consent of its clients, before acting.4 In addition, an investment adviser has the duty to seek best execution,5 to make suitable recommendations,6 and to have a reasonable basis for the investment advice that is provided to clients.7
It is only natural that the relationship between an investment adviser and a client requires the utmost fidelity. When a client entrusts funds to an adviser, the client is often saving for the down payment on a first house, for a child's college education, or for a financially secure retirement. Such goals frame the most important passages in most peoples' lives. Accordingly, acting as a fiduciary is a profound responsibility.
In fulfilling your roles as fiduciaries there are some key questions that need to be asked. For example: Is your firm acting in the clients' best interests? Does your firm always put the clients' interests above its own? Has your firm avoided conflicts of interests in giving investment advice? If not, has your firm identified and disclosed all conflicts of interests it may have as to the client? And, if you were the client, knowing all that you know from within the adviser, would you still answer the first four questions the same way? If these questions can not be answered in the affirmative, you are headed toward trouble.
I especially want to focus your attention on conflicts of interest. In my decades of practice, I have often been asked whether an adviser could or could not do something — generally, something profitable — consistent with the clients' best interests. Usually, the answer is clear when you first put yourself in the client's shoes and then ask whether the proposed course of action is best for the client. Most often when people struggle with whether a particular action is consistent with a fiduciary duty, it's because there is some benefit to the adviser that seems out of the ordinary. Moreover, the client is usually not aware of the benefit to the adviser. In other words, it's likely that they have a conflict of interest. The willingness to identify and address such conflicts of interest is crucial to acting as a fiduciary.
In some cases, disclosing the conflict and obtaining the client's consent can appropriately address a conflict, but it's important to remember that not just any disclosure will suffice. Even if the client consents, the fiduciary duty has not been met unless the disclosure is honest, conspicuous, and complete. The disclosure must be one that allows the client to fully understand the conflict and the relationship of that conflict to the advice. There can be no holding back. As the celebrated jurist Benjamin Cardozo once opined: "Many forms of conduct permissible in a workaday world for those acting at arm's length are forbidden to those bound by fiduciary ties. . . . Not honesty alone, but punctilio of an honor the most sensitive, is then the standard of behavior."8
Efforts to expand, or undermine, the fiduciary duty
The fiduciary standard has served advisory clients well for many years, and I believe that it should be the governing standard whenever investment advice is provided. If you are giving advice to an investor, regardless of the title on the business card, you should always be bound to do so in the best interests of the client. While the scope of service may vary between clients, the standards of loyalty and care in providing that service should not. You simply cannot be three-quarters of a fiduciary.
As you know, there has been a lot of discussion about the appropriateness of imposing a single standard on all of the various professionals that provide investment advice. Most of the discussion has involved the benefits of aligning the standard so that advisory clients of broker-dealers and investment advisers receive the same standard of care. And clearly, it makes sense for investors to expect that all securities professionals providing them with advice would be subject to the same obligations.
For the last several years, I've been listening to the ongoing debate about what standard should be applied. While many of the standards I have heard proposed are referred to as "fiduciary" standards, these standards do not offer the same robust protection as the fiduciary standard that currently applies to investment advisers. In truth, there is only one fiduciary standard, and it means an affirmative obligation to act in the best interests of the client and to put a client's interests above one's own.
Accordingly, it was heartening last year to see that the Obama Administration in its White Paper on Financial Regulatory Reform explicitly stated that the standard of care for broker-dealers who provide investment advice should be raised to the fiduciary standard applied to investment advisers. This was followed by provisions in both the Wall Street Reform and Consumer Protection Act (the "House Bill") and the initial draft of the Restoring American Financial Stability Act (the "Senate Bill") that would have extended to broker-dealers the traditional fiduciary standard applicable to investment advisers.
Of the two legislative proposals, the initial draft of the Senate Bill was significantly stronger. It would simply have eliminated the distinction between broker-dealers and investment advisers when providing investment advice. By comparison, the House Bill would instead require that the Commission promulgate rules to subject broker-dealers providing "personalized investment advice about securities to a retail customer" to the standard of conduct in the Investment Advisers Act. In other words, the House Bill would not apply the same standard to all brokers who provide advice — but rather only to those providing personalized services to retail customers. This language limits the application of the fiduciary standard and excludes many investors from its protection.
The Senate Bill, however, has abandoned its strong position in the face of determined lobbying by the insurance and brokerage industries. The revised version that was voted out of the Senate Banking Committee on March 22nd has eliminated the provision applying the fiduciary standard to brokers who provide investment advice. It would, instead, require a one-year study by the SEC concerning the effectiveness of existing standards for "providing personalized investment advice and recommendations about securities to retail customers."
This potential retreat from requiring a fiduciary standard for all who provide investment advice concerns me for several reasons. First, I see no need to study the appropriate obligation for investment advisers. We already have a strong, workable standard that has done its job successfully for decades, and I would not support any attempt to weaken it. Second, as with the House Bill, I question why the protection of the fiduciary standard should be limited to "retail" customers. It is readily apparent from recent Commission enforcement cases involving auction rate securities that all investors, including institutional investors, need the protection of the fiduciary standard. Third, I question why the study, as well as the reach of the House Bill, should be limited to "personalized services." This qualification would narrow the range of clients that would be protected by the fiduciary standard, and I fear that it may become a loophole that would make it easy to avoid putting clients first.
Finally, I don't believe that we need a study to conclude that investor protection requires that broker-dealers providing investment advice be subject to fiduciary duties. I think that question has long ago been asked and answered.
As you follow this legislative development, I would ask that you listen carefully to how various proposals would seek to rationalize the standard for similar services between investment advisers and broker-dealers. There are those who believe that the calls for "harmonization" sound very much like code for imposing broker-dealer standards on advisers, not the other way around. We all need to remain vigilant to make sure that investors who receive advice do so from intermediaries that are held to the high standards of care and loyalty embodied in the existing fiduciary standard under the Investment Advisers Act.
The SEC's role in strengthening observance of the fiduciary standard
In addition to ensuring that the fiduciary standard is preserved in any legislation, the Commission, of course, must work to ensure that the fiduciary standard is consistently observed in the industry. No standard, not even the fiduciary standard, has teeth unless it is properly implemented and enforced. One of the ways by which the SEC monitors the application of the fiduciary standard is through inspections and examinations conducted by the Office of Compliance Inspections and Examinations ("OCIE"). And, for most of you, OCIE is your primary point of interaction with the SEC. Thus, I would like to speak for a few minutes about how OCIE is changing.
Strengthening examination resources
The importance of the OCIE's staff work can not be overstated. At the SEC, the examination program is crucial to the success of the agency's mission and integral to both our regulatory and enforcement responsibilities. Although I have spoken before about the need to reinvigorate our inspection and enforcement teams, that need has never been greater than it is today. Clearly, OCIE has been seriously challenged over the last decade — a time during which the number of regulated entities grew significantly, while OCIE faced declining staff and budgets.9 However, efforts are underway to turn this around, and more should be done. The Commission should take steps to strengthen our examination resources, improve OCIE's coordination with other divisions and offices within the agency, and remove self-imposed restrictions governing how OCIE's resources are deployed in the field.
There is no doubt that, to strengthen our examination resources, the number of examiners needs to grow. And I am pleased that we expect to have budget authority to increase this number by 61 in 2010 and 100 in 2011. Although these numbers are still small compared to the number of regulated entities to be overseen, it is a move in the right direction. Furthermore, as we hire, it is my expectation that we will actively look for professionals who will bring valuable new perspectives and skills to complement those of our existing examiners. Even as we add new expertise, it will also be important to have a renewed focus on keeping the skills of experienced staff current through additional training. In other words, we need to benefit from the best of both worlds — fresh ideas and recent industry experience combined with hard-earned regulatory expertise.
In addition, as part of a new focus on identifying and addressing risks, OCIE will also benefit by coordinating more closely with other Divisions and Offices within the agency, drawing on their expertise and sharing its own. This collaboration will not only strengthen OCIE's examinations and inspections, but it will inform and enhance the Commission's initiatives across the agency, including rulemaking initiatives.
Perhaps most important of all, it is imperative to remove the handcuffs from OCIE. For example, historically, OCIE was able to make voluntary inquiries of unregulated entities when the information would be relevant and helpful to our oversight and investor protection mission. This is a situation that the Commission commonly confronts when an unregulated entity operates side-by-side with a regulated entity, with extensive business dealings between the two. Naturally, under such circumstances, a comprehensive inspection of the regulated entity would lead to questions about the unregulated entity, and OCIE would pose those questions and ask to see relevant records. These inquiries by OCIE successfully led to significant enforcement actions to halt on-going fraud.
In 2007, however, this practice was altered, severely curtailing its usefulness. Internal policies were imposed on the staff that strictly limited OCIE's ability to ask questions of unregulated entities. Now, inquiries into potential frauds, such as Ponzi schemes, may be off limits. Further, even when inquiries are permitted, additional administrative procedures have been imposed, such as requiring the staff to obtain high-level authorization before an inquiry can proceed. The danger, of course, is that by the time all these hurdles have been cleared, it may be too late to protect investor funds.
These needless restrictions need to be removed. We have challenges enough in regulating a vast industry without hampering our own efforts by adopting ill-advised procedures. With these restrictions removed, the staff would no longer be subject to pointless micromanagement in following-up evidence of ongoing fraud.
Even after these initial steps are taken, I believe that more needs to be done to empower OCIE. To that end, I support legislative action to clarify and expand the SEC's examination authority to include entities that should be registered under the securities laws, entities that have recently withdrawn from registration, and relevant records of certain associated persons of registered entities.
Under current law, OCIE may be unable to conduct an examination of a boiler room or a Ponzi scheme simply because the relevant entity has unlawfully failed to register with the SEC. In other words, fraudsters can use one violation of the securities laws to try to hide another. In other situations firms have withdrawn their registration as soon as OCIE begins an examination. Still others have claimed that relevant records were the property of an unregistered affiliate, even though the registered and unregistered entities shared the same office space, officers, employees, records, and business. In all of these situations, under current law, examiners can be stymied as fraudsters are able to manipulate the jurisdictional boundary between regulated and unregulated entities. Clearly, this needs to change.
Enhancing surveillance
As it strengthens its examination program, the Commission should also take another important step to strengthen its oversight of the securities markets — and that is establishing a consolidated audit trail. I've been a strong advocate of such a project. As I travel the country and speak with investors, many are shocked to learn that the outdated system now in place does not give the SEC the capability to oversee, in real time, activity within and across securities markets.
Under the current system, the exchanges and FINRA operate separate audit trails to track information about orders and executions in their respective markets. This system has significant limitations that hinder the Commission's ability to analyze market activity. The information is not comprehensive, it is not consistent across markets, it is not available in real time, and it is cumbersome for the Commission staff to access. The new system would be designed to address these issues.
Under the new system, every order would be assigned a unique identifier, and each market participant that touches the order would capture and immediately send critical information to a central repository. Each step in the life cycle of an order — from inception through modification, routing, execution, and settlement — would be documented and preserved in a uniform manner. Even the beneficial ownership of the customer behind the order would be captured. As a result, the Commission and the SROs would at last have access to the data required to conduct effective surveillance across markets and to detect, analyze, and sanction even sophisticated trading violations.
Obtaining adequate resources
All of the SEC efforts and all of the proposals that I've described have one aim — and that is to strengthen the Commission's ability to protect investors. In order to be truly effective, however, we simply need greater resources. As I have consistently advocated, the single most transformational act that Congress could undertake is to allow the SEC to be self-funded. Unlike almost every other financial regulator, the SEC remains without a stable funding stream. Self-funding would enable the SEC to set multi-year budgets and respond promptly to drastically changing markets, while also maintaining appropriate staffing.
For example, while the number of registered investment advisers has increased over the past five years by 33%, from 8,623 to 11,500, the staff dedicated to examining advisers and mutual funds has decreased over the same period by 13%, from 489 to 425. As a result, the Commission can examine only a fraction of the advisers and fund complexes each year. Self-funding would allow us to have the resources to keep up with the growth in the industry. Accordingly, I am pleased that the latest version of the Senate Bill would make self-funding a reality, and I look forward to that day.
Conclusion
As I conclude, let me reiterate the importance of your role. As compliance officers, you are uniquely positioned in your firms to spot trouble on the horizon, so your role in our capital markets is vital. Perhaps more than anyone, you are able to gauge the likelihood and the magnitude of risks that may be lurking in the company. By creating an active and robust compliance culture — one that does not wait for problems to arise — but actively searches for them, you not only protect your employer from liability, but you also help your firm meet its obligations as a fiduciary.
The regulatory landscape is changing, and its future state remains unknowable. But whatever the specific regulations may be in the future, the way forward, both for you and for the SEC itself, flows from principles that do not change. For the SEC, that principle is investor protection. For you, it is the fiduciary relationship that your firms have with their clients. If we all keep our eyes fixed on those guiding principles, we will not stray far from the right path.
In my role as an SEC Commissioner, I will support strengthening the regulatory framework governing investment advisers, working to ensure that the proposals provide smart, effective regulation without diminishing investor protections.
Thank you for the opportunity to speak with you today.
Endnotes
http://www.sec.gov/news/speech/2010/spch032610laa.htm
