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Speech by SEC Commissioner:
Protecting Investors by Requiring that Advice-Givers Stay True to the Fiduciary Framework


Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

Investment Adviser Association Annual Conference
Chicago, Illinois
April 29, 2010

Thank you for that kind introduction. It is my pleasure to be able to join you today for the 2010 Investment Adviser Association Annual Conference. At the outset, I want to make clear that the views I express today are my own, and do not necessarily reflect the views of the Commission, other Commissioners, or the staff.

Just last year, I stood before you and discussed the clear need for regulatory reform. Today, it looks like legislation may literally be weeks away. And while I have concerns about various provisions, overall it is a positive development for the American public and all who invest in our capital markets. The legislation is expected to bring greater transparency to hedge funds and over-the-counter derivatives. Further, it creates both a stronger framework to monitor potential systemic risk and a resolution process if a "too big to fail" institution actually fails. Published reports are carefully scrutinizing every detail of possible passage as we wait to see what the ultimate legislation will look like. As the legislation continues on its way and is amended before final passage, I will continue to be a staunch advocate for regulatory reform that is oriented towards investors.

By this I mean, that I am supportive of regulatory reform legislation that would strengthen the investor protection regime that currently exists and that results in enhanced protections and flexible authority to regulate an unforeseeable future. This should not become an opportunity to roll back long-held investor protections or create opportunities for regulatory arbitrage.

Today, I am going to concentrate my remarks on the following:

  • Congress should mandate that all providers of investment advice should be fiduciaries;

  • I am going to discuss a snapshot of certain of the current proposals in Congress; and

  • I will urge the SEC to move forward in rectifying previous regulatory inaction.

All Investment Advice-Givers Should Be Fiduciaries

I would like to take you back in time to the passage of another piece of historic legislation, the Investment Advisers Act of 1940. The Advisers Act and its companion legislation, the Investment Company Act of 1940, resulted from a comprehensive congressionally-mandated study conducted by the SEC of investment companies, investment counsel, and investment advisory services. Ultimately, the report concluded that the activities of investment advisers and advisory services "patently present various problems which usually accompany the handling of large liquid funds of the public."1 The SEC's report stressed the need to improve the professionalism of the industry, both by eliminating tipsters and other scam artists and by emphasizing the importance of unbiased advice, which spokespersons for investment counsel saw as distinguishing their profession from investment bankers and brokers.2 The general objective "was to protect the public and investors against malpractices by persons paid for advising others about securities."3

The report stressed that a significant problem in the industry was the existence, either consciously or, more likely, unconsciously, of a prejudice by advisers in favor of their own financial interests. Reading through the volumes of the SEC report, the evidence is clear that whenever advice to a client resulted in a financial benefit to the advice-giver — over and above the fee —it was feared that the resulting advice might be tainted. Even more importantly, as cited by the Supreme Court, SEC staff rejected an early market discipline argument by recognizing that "a significant part of the problem was not the existence of a deliberate intent to obtain a financial advantage, but rather the existence subconsciously of a prejudice in favor of one's own financial interests."4 Consequently, the Advisers Act required advice-givers, as fiduciaries, to bear the burden of providing disinterested advice and being able to prove it.

As stated by the Supreme Court, "[t]he Investment Advisers Act of 1940 thus reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested."5 Best of all, Congress and the Court placed the burden for providing disinterested advice and eliminating or disclosing conflicts squarely where it belonged, in the hands of the advice-giver. This places the obligation in the hands of those responsible for upholding their fiduciary duties rather than unfairly and unrealistically burdening investors to discern conflicts and incentives — an often impossible task.

Flash forward from the 1930s to the events of the last two years, and an array of examples will come to mind demonstrating the role that advice tainted by conflicts of interest played in harming investors and harming market integrity. Tainted advice led investors to invest billions of dollars in auction rate securities because brokers told them they were safe investments.6 Conflicts of interest at credit rating agencies contributed to AAA ratings on products that turned out to be worthless.7 Clearly, the concerns giving rise to the Advisers Act are even more relevant today. We need to restore the clear and strong rules that protect investors and, more than ever, we need to ensure that investment advice is disinterested.

Recently, in the context of an enforcement case, our own Director of the Division of Enforcement, Robert Khuzami, summed up the harm succinctly when he stated, "The product was new and complex but the deception and conflicts are old and simple."8 The events of the last two years have underscored an age old truth that financial products and technologies will continually change but the potential for deception and conflicts endure.

Lack of a Fiduciary Duty Leads to Real Investor Harm

An issue that illustrates this is the discussion around extending the fiduciary duty that underlies the investment adviser regulatory framework to broker-dealers who provide investment advice. This is the ultimate investor protection issue — because the harm to investors is real if broker-dealers giving advice are not held to the fiduciary standard and fail to put their client's interests before their own.

The fiduciary standard has served advisory clients well for many years and it should be the governing standard whenever investment advice is provided. If you are giving investment 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.

Currently broker-dealers are providing investment advice without any requirement that they serve as fiduciaries. In other words, broker-dealers are being permitted to end-run the Advisers Act. While brokers are required by current law to make certain disclosures about securities that are offered to investors, they are not required to make disclosures about certain of their own conflicts of interest. As a consequence, investors are susceptible to receiving tainted advice from broker-dealers and they will have no way of knowing that the advice was tainted by an undisclosed conflict.

Because broker-dealers are not fiduciaries, investors are not required to be informed of possible conflicts that may affect the advice they receive. For example, investors may not be told that the representative sitting across from them may receive undisclosed compensation from the investment option he or she just recommended. Since many broker-dealers aggressively market themselves as "financial advisers," investors have a difficult time distinguishing them from investment advisers. As a result of this confusion, they will fail to understand that the broker-dealer, unlike an investment adviser, is not required to place their interests first.

The danger is not simply that investors are unable to distinguish between broker-dealers and investment advisers; it is that both entities are providing investment advice to investors with dramatically different consequences. Although often marketed in the same way, the investment advice that investors receive from broker-dealers does not come with the same protections as advice received from investment advisers.

The Advisers Act has been designed to empower investors and provide them with the information that they need to evaluate conflicts and decide whether to enter into or continue an advisory relationship. Broker-dealers who are giving advice are not doing so within this investor-focused fiduciary framework. As the noted expert, Tamar Frankel stated,

That is the difference between suitability standards and fiduciary standards. The disclosure made under suitability standards is about what is being sold and not who sells it. That is why the time has come to change the law. The salesperson's temptation is too great when investors trust them, and disaster is too painful if the investors cease to trust all salespersons, and choose to avoid the financial markets altogether.9

The fiduciary standard guards against the inherent bias that arises when the broker-dealer is focusing on selling a product, rather than focusing only on what is best for a client. Permitting broker-dealers to provide investment advice without requiring them to act as fiduciaries is to permit a practice that undercuts the core principles of the Advisers Acts and leaves investors vulnerable to the same abuses described in the 1930s.

Landscape of Legislative Proposals

As we look at the landscape of legislative proposals, I have to first reiterate what I said here last year. There is only one true fiduciary standard, and it means an affirmative obligation to act in the best interests of the client and to put the 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 state 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") 10 and the initial draft of the Restoring American Financial Stability Act (the "Senate Bill")11 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 universal 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."

I continue to have concerns about this retreat from requiring a fiduciary standard for all who provide investment advice. First, I see no need to study the effectiveness of existing obligations for investment advisers. We already have a strong, workable standard that has been in use 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 — such as the 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 an additional study to conclude that protection of investors requires that broker-dealers providing investment advice be subject to fiduciary duties. I think that question has long ago been asked and answered. We need to remain vigilant to make sure that investors who receive advice do so from intermediaries held to the high standards of care and loyalty embodied in the existing fiduciary standard under the Investment Advisers Act.

SEC is the Regulator of the Investment Adviser Industry

As regulatory reform moves forward and the Commission evaluates its priorities, we must recognize that strong laws and rules are only one component of an effective regulatory framework. These laws and rules must also be accompanied by robust examination and enforcement oversight. That brings me to the SEC's Office of Compliance Inspections and Examinations (OCIE).

I have previously spoken about the need to reinvigorate the SEC's examination and inspections program — by increasing our examination resources, adding to the skills and experience of our staff, and removing handcuffs imposed by ill-advised internal SEC policies. I've also discussed the need for legislative action to clarify and expand the SEC's examination authority to include, among other things, 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.12

As I also mentioned last year,13 there is no doubt that OCIE's examination resources need to be strengthened. 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, we can examine only a fraction of the advisers and fund complexes each year.

In order to address this problem, as well as others, the SEC must be adequately resourced. As I have been consistently advocating, 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 consistent funding stream. Self-funding would enable the SEC to set multi-year budgets and respond promptly to our dynamic capital markets, while also maintaining appropriate staffing. Self-funding would allow us to have the resources to keep up with the growth in the industry.

Accordingly, I am pleased to report that the most recent version of the Senate Bill would make self-funding a reality. Of course, the legislative process is on-going and the results are far from predictable. I know that the Investment Adviser Association has been a strong proponent of self-funding for the SEC every time this issue has been seriously considered. I thank you for being willing to speak frankly on the issue and thank you in advance for the work to come.

Beyond the resource issue, there is another structural change that the legislation would trigger. There is a provision in the Senate Bill that would, in essence, disband OCIE as it currently exists. The Senate Bill provides that the exam staff would be redeployed from the stand alone Inspections and Examinations Unit to the Divisions of Trading and Markets and Investment Management.

The proposed redeployment takes us back in time. In 1995, Chairman Arthur Levitt created OCIE for the express purpose of consolidating examination resources to better utilize them to protect investors.14 One of the criticisms of OCIE, as well as of the entire SEC, is that it is too fragmented and does not utilize expertise across the agency. I am concerned that creating specialized groups of examiners at a time when the industry has numerous dual registrants is to ignore the reality of those we regulate. Moreover, since 1995, the services provided by broker-dealers and by investment advisers have increasingly come to resemble each other,15 undercutting the argument that separate examination staff is appropriate.

While I am sympathetic to the need to integrate our examination function more deeply into the workings of our rule-making and programmatic divisions, I fear that this redeployment may have the opposite effect. The resulting fragmented oversight could make it harder for the SEC staff to detect and prevent wrongdoing.

Furthermore, and of the greatest concern to me, by legislatively mandating separate and fragmented inspection and examination programs, the SEC would lose the flexibility to make future determinations of how best to oversee the industry. In a dynamic industry that is continually evolving, and increasingly consolidating, it is necessary for the SEC to be in a position to determine the most effective means to fulfill its responsibilities. We should not have our hands tied as to what may be the best way to provide effective oversight, either now or in the future. I hope that the members of the Senate rethink this provision.

Rectifying Regulatory Inaction

Even as the legislative process winds its way forward, the Commission continues to be active on a scale few can remember. Before I discuss three initiatives that directly impact the investment advisers' fiduciary framework, I would like to talk about the cost of regulatory inaction. Much is written about the fear of too much regulation. However, since I became a Commissioner, I have been struck by the opposite, the cost of regulatory inaction. Thus, in the mix of priorities, I believe it is important for the Commission to take on initiatives to rectify investor harm resulting from regulatory inaction. The events of the last several years have demonstrated the cost of regulatory inaction. I would like to highlight two initiatives that would significantly improve the adviser fiduciary framework — and that have been languishing for decades.

For example, in 1999, the Commission proposed pay-to-play rules to prevent the exact conduct that we have been confronting in states across this country. These rules were not adopted and, in the decade since, significant assets have been inappropriately allocated, and public confidence in investment advisers and public pension funds across this country has been shaken. If the rule had been adopted in 1999, would we be facing pay-to-play scandals of this magnitude? It's doubtful.

Similarly, amendments to the core disclosure document of the adviser's regulatory framework, the Form ADV Part II have languished. Initially proposed in 2000 but not adopted, the Commission re-proposed these amendments in 2008 but, again, failed to adopt them. This is a core disclosure document that is antiquated and the Commission should prioritize the adoption of these amendments.

Before I discuss these proposals in greater detail, I want to touch on a custody initiative that is still to come.

The Need to Strengthen Custodial Practices to Protect Investors and Their Assets

Last December, the Commission adopted amendments to various rules to strengthen safeguards to protect clients' assets controlled by investment advisers. This action was intended to protect against the misappropriation of client funds by advisers who serve as custodians and hold on to, or have control over, their client's assets. These advisers are now subject to annual examinations by an independent auditor: a "surprise exam" to verify client assets, and a review of internal custody controls. I know there have been implementation issues with this rule and I know that the industry has been working closely with our staff to insure compliance.

I would like to highlight one issue related to the recent revision to the investment adviser custody rule. The Commission's adopting release made it clear that this rule had the potential to disproportionately impact small advisers who have the authority to obtain possession of client funds, such as by serving as trustees, even thought the client's assets are held by an independent qualified custodian. The release also indicated that the Commission has directed the staff to evaluate the impact of the rule on advisers and their clients. In particular, the SEC staff has been directed to conduct a review following the first round of surprise examinations and provide the Commission with the results of the review, along with any recommendations. I have noticed the recent press discussing potentially significant auditing costs that advisers serving as trustees may have to pay for their custodial clients. 16 In order that we may be fully informed as to the impact of this aspect of the rule, I encourage you to collect information and to relay any pertinent information to the staff.

While I supported the adoption of the amendments to the custody rule, I stated at the time that it was not enough. As this audience knows well, the amendments were prompted by the revelation of the Madoff Ponzi scheme. I felt that our action did not go far enough because it did not address Madoff's actions as a broker-dealer. It's important to recognize that the Madoff Ponzi scheme lasted for decades — potentially starting in the 1980s — and for much of that time Madoff was registered only as a broker-dealer. The victims lost money from discretionary, commission-only brokerage accounts. It was only in 2006 that Madoff registered as an investment adviser.

Thus, even if the rule had been in effect, it would not have applied to the Madoff broker-dealer and the rule would not have prevented much of the harm that Madoff did. Moreover, you need to remember that because investment advisers are required to maintain their clients' assets with qualified custodians, such as banks and broker-dealers, very few advisers actually hold physical custody of client assets.

Accordingly, tightening the rules applicable to investment advisers without assessing and strengthening the underlying broker-dealer rules is not enough. To that end, I have urged the SEC staff to move quickly toward developing proposals to strengthen the broker-dealer framework. I hope to see the staff's proposal in the near future.

Reducing the Temptation of Advisers to Misuse Political Contributions

As I alluded to earlier, the Commission has also re-proposed a rule to limit the ability of investment advisers to make political contributions in order to be chosen to manage public pension fund money. In other words, this rule is intended to reform the pay-to-play system that has been documented far too often.

The pension fund business is substantial. State and municipal pension plans hold over $2.3 trillion of assets and represent one-third of all U.S. pension assets. These plans are typically administered and managed by elected officials who also have the responsibility of selecting the investment advisers who oversee the plans. Obviously, these plans pay significant advisory fees to investment advisers, making the management of these plans highly desirable business. Advisers compete fiercely to win this business — and, for the most part, compete fairly based on their qualifications.

The concern behind the proposal is that some advisers and elected officials are engaging in pay-to play conduct — where advisers make political contributions to elected public officials who oversee public pensions in order to be chosen to manage some of the pension business. This type of conduct distorts the marketplace and is incredibly hard to police. The proposed rule is the Commission's attempt to ensure that advisers compete for pension plan business on a level playing field and that they fulfill their fiduciary obligations and put the interests of the plan beneficiaries above all others.

To crystallize — if an adviser wins business because it has "paid" in order to "play," there are serious doubts as to whether the most qualified adviser was selected for the job. After all, in such a case, the adviser selection process would not appear to be based on merit and qualification. If the best person was not selected for the job, the plan could suffer inferior management that may lead to greater losses. The plan may also be paying higher fees because the adviser may be trying to recoup its political contributions or because the contract negotiations were not exactly arms-length.

It is important to note that the proposed rule, while regulating investment advisers, would not reach the conduct of the elected officials who serve as public pension plan trustees. These individuals engage in serious conflicts of interest when they accept political contributions from those who do business with the plan. I applaud the state and local authorities who have taken steps to prohibit pay-to-play activity and I encourage more to do the same.

Revisions to Form ADV, Part II

Lastly, let me say a word about Form ADV. As those in this room know, Form ADV is the core disclosure document for every registered adviser. In particular, Part II of Form ADV is the disclosure document provided to clients and includes key information including the services provided, the applicable fees, conflicts of interests, and other specified information. Part II is the primary document by which investors receive the information they need to decide whether to hire an adviser. Unfortunately, the current form is sadly antiquated and a modern day adviser's services may not correspond well to the limited number of options on the form. As a result, the resulting disclosure may not describe the adviser's business or conflicts in a way that investors can readily understand.

The need to update Part II has been clear for over a decade. In April 2000, the Commission proposed comprehensive amendments to Part I and II of Form ADV; but although the Commission adopted the amendments with respect to Part I, the amendments to Part II did not see the light of day. Then, in March of 2008, the Commission re-proposed various amendments with the aim of providing clients and prospective clients with plain English disclosure of the business practices, conflicts of interest, and background of investment advisers and their advisory personnel.17 It is expected that the Commission will soon revisit Form ADV.

While there are many aspects of the amendments that merit discussion, I want to focus on one — the brochure supplement. Currently, investors receive information about executives of the advisory firm but little to none about the educational background or disciplinary history of the advisory personnel sitting across the table. The Form ADV proposals, in 2000 and 2008, proposed a brochure supplement to provide investors much needed information in real time. The supplement would contain information as to the qualifications of the advisory personnel who will be providing the investor with the personalized investment advice.

I believe that clients would benefit greatly from the information to be conveyed through the proposed supplement — particularly where the advisory personnel has a disciplinary history. I know this particular proposal generated robust comment and I look forward to the staff's recommendations.


The regulatory landscape is changing, and its future state is uncertain. As investment advisers, you have a critical role to play in any regulatory improvements for advisers. Investors place their trust in you to act as their fiduciaries in managing their investments, but they also need you to bring your experience and expertise to the discussion of strengthening industry regulation.

In my role as an SEC Commissioner, I will support strengthening the regulatory framework governing investment advisers, and I will work to ensure that the proposals provide smart, effective regulation without diminishing investor protections.

Thank you for the opportunity to speak with you today.




Modified: 04/29/2010