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Protecting the Salesmen

It's always interesting when you see someone announce some really interesting data from interesting research, and then make it clear they have no idea what it means. Such is the case from a really interesting study by the Institute for the Fiduciary Standard, conducted in November.

It was a logical avenue to pursue. Institute founder/CEO Knut Rostad has seen hundreds of comment letters from independent broker-dealers claiming that the Department of Labor fiduciary initiative is simply unworkable, burdensome and an initiative that should be delayed, scrapped, put off until the SEC has taken its own fiduciary action (which, as I've said elsewhere in this issue, seems to be on track to happen roughly the same time the Earth crashes into the Sun), and (my favorite) an initiative that would, if enacted, force the broker-dealers to throw up their hands and abandon all customers who aren't wealthy.

Apparently the independent BDs didn't consult their advisors and reps about any of this. The Institute asked dually-registered advisors (it annoyingly insists on call them “brokers,” but the great majority of them seem to be financial planners and SEC-registered RIAs) whether it is reasonable to disclose conflicts of interest, as the DOL rule would require. They said yes by a 76%-10% margin. They were asked whether it was reasonable to adopt policies that would minimize conflicts of interest. Yes again, this time by a 60%-18% margin. Is acknowledging fiduciary status in writing reasonable? Yes, but by a narrower 47%-33% margin.

I wish the Institute had asked whether, if the DOL initiative passes, the dually-registered advisors planned to drop all customers below the $1 million AUM threshold, as their BD executives insist, but I think we all know the answer to that.

Rostad and the Institute wonder why the broker-dealer management teams believe their own reps and advisors are incapable of meeting a best interest standard. But the obvious answer is that the broker-dealers aren't choosing their lobbying positions with an eye toward their most ethical, fiduciary RIAs. When they lobby for or against a regulatory initiative, their primary concern is to protect the small percentage of commission-based sales agents who generate a disproportionate share of a BD's overall revenue.

A dually-registered advisor with a fiduciary mindset is very marginally profitable to the BD. They do what's right for their clients, including minimizing the trading and other costs, and they negotiate their back office arrangements not just for their own benefit, but also for the benefit of their clients. When the broker-dealer starts pushing shoddy products like non-traded REITs or high-commission annuities-which generate a lot of BD revenue directly (via overrides) and indirectly (these companies pay generously for booths and speaking engagements at the top producer conferences)-the mainstream dually-registered advisor simply switches the channel.

The small percentage of the field force who churn out sales of non-traded REITs, high-commission annuities and other exotic products are sorely threatened by tighter regulation like the DOL fiduciary initiative-and that threat is felt directly by the BD. Imagine if one of these top sales producers signs a fiduciary oath, and then loads up a client portfolio with junk. You might think this would never happen in the ERISA world, but one of the points the Financial Services Institute (the independent BD trade organization) has made against DOL rulemaking is that the new rules would effectively snuff out the sales of non-traded REITs to qualified plans and IRAs. Wouldn't THAT be a terrible outcome!

So now the customers of the sales producers are sitting on investments which, sooner or later, will reveal themselves to have been very lucrative for two out of the three parties in the sales transaction. The bust occurs, and the first thing the buyer of the toxic junk is going to give to his attorney is the fiduciary oath the sales guy signed. Is it any wonder that the broker-dealer is threatened by the very idea of a fiduciary standard? Restitution alone would cost hundreds of millions of dollars-out of the coffers of a low-margin business.

The question that the Institute should be asking is: why are the independent broker-dealer management teams spending all their lobbying efforts to protect the relatively small number of sales agents in their field forces? The answer is: that's where their profits are coming from.

And this tells us something important. The rank-and-file dually-registered advisors are (or should be) embarrassed by the lobbying positions of their broker-dealers. So far, the general public hasn't made the connection between their local planning office and the FSI telling the world that a fiduciary standard is a great idea so long as it's dumbed down to a FINRA sales standard. But sooner or later, as the marketplace becomes more competitive, these finer points are going to be made by the fee-only advisors down the street.

And I think we all know that eventually there is going to be a big scandal involving non-traded REIT sales activities, big losses by innocent investors, and a lot of publicity around lawsuits that will draw client attention to that little disclosure at the bottom of a lot of websites: securities transacted through [name of independent BD named in a $10 billion class-action lawsuit for unsuitable sales].

The Institute for Fiduciary Standard poll represents a mild rebuke from dually-registered advisors to the BD executive teams who decide how to spend their lobbying dollars. Those advisors undoubtedly knew the “right” answers from the FSI standpoint, but they chose to provide contradictory responses that give aid and comfort to the opposing team's lobbyists. They can't be happy with the assumption that they couldn't live under a fiduciary mindset, especially when they're already registered with the SEC as RIAs or IARs and have built their careers by following it.

When the excrement makes full contact with the fan, they are going to be even less happy with the reputational risk that the BDs willingly took on, and passed on, to the silent majority of ethical dually-registered advisors. It will be interesting to see what happens next.