The Other Securities Regulator: A Case Study in Regulatory Damage

Anita K. Krug is D. Wayne and Anne Gittinger Professor of Law at the University of Washington School of Law. This post is based on a recent article by Professor Krug, forthcoming in the Tulane Law Review.

In 2016, regulators approved a new rule that imposes fiduciary obligations on broker-dealers and their personnel in connection with the investment advisory services they provide to their customers. The rule is among the most controversial ever adopted in the securities realm—a remarkable fact given that the agency with primary regulatory authority over the U.S. securities markets, the U.S. Securities and Exchange Commission, was not the adopting agency. Rather, the so-called “fiduciary rule” is the product of the Department of Labor, the agency charged with, among other things, administering the Employee Retirement Income Security Act of 1974, or ERISA.

The heart of the controversy surrounding the rule stems from the effect of its fiduciary requirement, which is to prohibit securities brokers from receiving transaction-based compensation, such as the commissions brokers receive when acting as agent in securities transactions (including “12b-1 fees” paid by mutual funds). Although the DOL provided an exception to these strictures, in the form of the “Best Interest Contract” (BIC) exemption, the leeway that the exemption affords does little to alleviate the rule’s impact. In addition to imposing onerous burdens—detailed disclosures and contractual provisions, among other things—on securities brokers relying on the BIC exemption, it does not modify the fiduciary rule’s core requirement that brokers act in their customers’ best interests. As a result, a broker cannot recommend a security as to which she will receive higher compensation as compared with that received as to other securities, unless the difference is the product of neutral considerations.

The upshot is that many securities brokers have been forced to change the way they operate, with some moving to asset-based compensation arrangements, in which, on a periodic basis, they are paid a certain percentage of the assets as to which they provide advice. To be sure, transaction-based compensation could incentivize brokers to recommend more securities transactions than might be optimal or to recommend a particular product based on the size of the commission associated with the product. However, asset-based compensation structures have their own difficulties, in that they may incentivize brokers to recommend too few transactions, on the basis that they will receive the asset-based fees regardless of how much effort they expend on behalf of their customers. In addition, in the aggregate, asset-based fees are generally higher than transaction-based fees, a product of the fact that the latter are merely sporadic, paid only when a customer executes a trade.

Nevertheless, in the context of the fiduciary rule, the battle between the two types of fee structures does not end in a tie. Rather, by way of its transformation of securities brokers’ relationships with their customers, the rule potentially harms investors in an important way. This harm begins with the fact that the fiduciary rule effectively pressures securities brokers to reduce, to the extent possible, the aggregate fees that their customers must pay for advisory and investment services, to stanch the anticipated loss of customers concerned about paying higher advisory fees. The most straightforward way for brokers to do that is to recommend lower-cost investment products, such as ETFs and passively-managed mutual funds. For those brokers opting to rely on the BIC exemption, moreover, this trend is bolstered by the fact that the exemption permits class-action lawsuits against brokers for alleged breaches of their fiduciary duties—allegations that arguably are more likely the higher the fees that customers pay. Finally, to the extent the DOL evaluates a broker’s compliance with her fiduciary responsibilities in part based on the amount of those fees, maintaining low fees is a reasonable way for brokers to avoid regulatory scrutiny.

Although many investment professionals, academics, and commentators have extolled the benefits of passive investing, the push to passivity assumes that all investors have the same investment needs—contrary to the longstanding notion that investment advice, by definition, is advice that is tailored to particular investors’ specific objectives and circumstances. A corollary of the passivity push is the assumption that investors’ investment needs can be satisfied through placing assets in a passive strategy—despite the fact that actively managed strategies remain critical for achieving well-diversified portfolios. More important for securities regulatory purposes, however, is the that, by funneling investors into the same types of investment products with the same strategies and the same general outcomes, the fiduciary rule effectively renders investment advice and fiduciary obligations irrelevant. After all, if all investors have the same investment needs and objectives, then there is really no personalization or tailoring to do. Ultimately, then, by constricting most retirement investors’ participation in the securities markets, the fiduciary rule widens the gap, in terms of investment opportunities and performance, these investors and their “sophisticated” counterparts, who generally do not turn to brokers for investment advice.

The DOL’s failure in adopting the rule is a product of doctrinal factors. First, the rule is inconsistent with U.S. securities regulation’s foundational principle of neutrality—the notion that the laws and rules governing the securities markets should not be biased for or against particular productive activities but, rather, should seek to ensure that investors are fully informed about the risks of whatever activities they pursue. In adopting the fiduciary rule, by contrast, the DOL effectively endorsed a particular mode of retirement investing, regardless of whether it serves investors’ best interests. Second, the rule ignores securities regulation’s signal challenge, which is to mitigate conflicts of interest while recognizing that some conflicts should not be abolished completely. That is, certain limited conflicts of interests may actually help to align brokers’ interests with those of their customers. Yet, in its effort to eliminate all conflicts of interests that may influence the advice that securities brokers provide, the DOL eschewed this pragmatic approach and, instead, sent brokers searching for an alternative but equally-effective business model that ultimately could not be found.

With the fiduciary rule, the DOL sought to protect retirement investors by constraining the decisionmaking of the professionals on whom these investors have relied for advice. Although the Department’s goals are laudable, there are better ways to protect retirement investors—ways that take account of the doctrinal factors that, for better or worse, are foundational in the U.S. system of securities regulation. Perhaps the best answer—which many observers have supported—is to leave rulemaking on securities professionals’ fiduciary obligations to the SEC, an agency that itself has been the target of much criticism but that nevertheless has gotten some things right.

The complete article is available for download here.

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