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Business News/ Opinion / Online-views/  Who can investors trust in the US?
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Who can investors trust in the US?

Who can investors trust in the US?

Shyamal Banerjee/MintPremium

Shyamal Banerjee/Mint

An investment transaction is, if you think of it, a remarkable act of trust. You turn over what could well be a large chunk of your life’s savings to a comparative stranger, who knows far more than you about the investment’s potential upside and risk. No one would ever take such a chance unless they believed their adviser was trustworthy. And in the US, one reason many Americans trust their adviser is that they believe the law forbids him from taking advantage of them.

Shyamal Banerjee/Mint

That fact bears repeating. Even in the wake of the global financial crisis; even after Bernard Madoff stole $50 billion from trusting investors; even after the average American investor has gone a full decade without a positive return on capital, most Americans get their advice from a professional who is allowed to put his interests ahead of theirs without telling them he is doing so.

Recent reforms in US financial oversight—specifically, the 2010 law known as Dodd-Frank—have dragged this issue into the sunlight. Now Washington is locked in hot debate over how to bring investors’ true legal protection in line with what they expect. At the heart of the debate is a classic tension, as old as regulation. Most ordinary people don’t know enough about investing to act in their own best interests. Regulators want to protect citizens from this ignorance; providers want to exploit it for profit.

In many areas of English common law—the basis of much American law—a code known as the “fiduciary standard" makes the financial professional responsible for protecting citizens from their ignorance. The idea is that people in certain positions of trust should be required to act selflessly on their client’s behalf.

In English common law the concept dates back to the 14th century. It is written into current American law in the 70-year-old investment advisers Act, which says that an investment adviser must act solely in the interest of the client, even if that interest is in conflict with the adviser’s own financial interest. Most American financial planners and money managers are governed by this law and thus adhere to the fiduciary standard.

But the fiduciary standard doesn’t apply to all professionals, whom an American investor may reasonably regard as investment advisers. Stockbrokers and insurance salespeople, for example, are held to a far less stringent measure: Basically, they cannot commit fraud or sell investments that are blatantly unsuitable for the client. Otherwise, anything goes.

When the relevant laws were written in the 1933 and 1940, stockbrokers were regarded as mere order takers, while investment advisers were regarded as personal counsellors. Today, that distinction has disappeared. Most brokers represent themselves as trustworthy investment experts and offer advice liberally. The result, says Barbara Roper, director of the investor protection division, Consumer Federation of America, is confusion and vulnerability. “Trusting in their adviser’s expertise and integrity, many investors generally do exactly what he recommends, without researching or second-guessing," she says. “In short, they act as if their broker is required to act in their best interests even though he is not."

The Securities and Exchange Commission (SEC)—the regulator charged by Dodd Frank with sorting out the confusion—declared last year that brokers and investment advisers should be held to a uniform fiduciary standard. Almost everyone agrees that a single standard is the only solution, and the commission has said it would issue rules early this year.

But as you look closer, it’s clear that the fiduciary standard can’t stretch to cover everyone. Brokers almost always work on commission. If you buy a mutual fund from a broker, for example, he will typically keep 5% or so of your investment as compensation. The conflict of interest is obvious—the broker has an incentive to recommend investments with the highest possible commissions. More money for him, less for you.

A true fiduciary would instead recommend comparable investments with no commission, of which there are many. And in fact, most American investment advisers do just that. Instead of commission, they take a percentage of their clients’ investment portfolio—typically 1%—as an annual fee. The fiduciary’s interests and the client’s are thus aligned: The more the portfolio grows, the more both prosper.

But regulators, bowing to reality and lobbying pressure, have promised that under the new uniform standard fiduciaries would be able take commissions. Whatever rules the SEC issues, SEC chairman Mary Schapiro has declared, will be “business-model neutral". In other words, the uniform standard will not require stockbrokers to fundamentally change how they do business.

How can this be done? The SEC is leaning towards allowing people to meet the fiduciary standard not by eliminating conflict of interests with their clients, but by simply disclosing them. As former commissioner Harvey Pitt explained at a conference on fiduciary standards last week, “An adviser would have to say, in effect, ‘I’m paid by commission, and I’m recommending this investment, which would pay me this much money, even though there are cheaper alternatives’."

There are plenty of problems with this. The first is actually getting brokers to do it. (Another former SEC commissioner, Arthur Levitt, responded to Pitt’s example by saying, “I’ve been a broker. I know how they think. And a broker would never say that to a customer.") The SEC could require the disclosure to be written, but written disclosures tend to be written in legal jargon and presented in dense impenetrable type blocks. (When was the last time you read an online “terms of use" agreement?) As Elizabeth Warren, founding director of the Consumer Financial Protection Board, put it, “Most financial disclosure screams, ‘Don’t read me!’"

What appears to be about to happen is that US regulators are going to abandon a 70-year-old standard (or a 750-year-old standard, depending on how you count) that made fiduciaries responsible for their trustworthy behaviour. In its place could be a uniform standard that allows fiduciaries to behave however they want as long as they admit to their behaviour in advance. “If you water down the standard we’ve got to accommodate commission-based advisers," says financial planner Harold Evensky. “You get the worst of both worlds."

Investor advocates are hoping that SEC’s rules won’t be as bad as that. They could at least demand extremely clear disclosure and outlaw certain actions even with disclosure. Otherwise the new standard could be the ultimate regulatory irony: An effort that was designed to make advisers more trustworthy and investors less confused, and does exactly the opposite.

Eric Schurenberg is the editor of Inc.com, and former editor of Money.

We welcome your comments at mintmoney@livemint.com

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Published: 08 Feb 2012, 07:50 PM IST
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