Regulators can’t be bullied by brokerage firms

The fight over whether financial advisers should have to give honest advice in a customer’s best interest continues, with industry lobbyists urging states not to adopt financial disclosure requirements of their own but instead deferring to standards being developed by the Securities and Exchange Commission.

With national consumer groups deeply skeptical about the SEC’s proposed regulations, the outcome stands to be significant for residents of Nevada and other states that are considering their own requirements.

Testifying before a House subcommittee, Barbara Roper, director of investor protection for the Consumer Federation of America, explained her concerns. Although the SEC’s rules are titled “Regulation Best Interest,” Roper explained that the draft regulation does “not create an unambiguous obligation for brokers to do what is best for their customers.” Instead, the regulation allows financial services companies to mostly do what they want so long as they disclose in some relatively obscure documents that they may act against their customer’s interests in certain circumstances.

Customers hearing terms like “best interest” may not understand that they’ll need to read the fine print to see when a financial services firm will deviate from that expectation.

Consider the recent $125 million settlement the SEC extracted from many Wall Street firms because clients “were steered into higher-cost mutual funds without being clearly told about cheaper versions.” In the SEC’s view, clients will be on “fair” notice about these practices so long as these firms put something in their fine print. 

Resolving similar issues, the SEC extracted a $260 million-plus settlement from JP Morgan for failing “to disclose that they preferred to invest client money in firm-managed mutual funds and hedge funds.”

Frustrated with federal inaction and the failure of the Department of Labor’s fiduciary rule, states have begun to move ahead to tackle conflicted financial advice on their own. 

Nevada moved first in 2017 when the Legislature imposed a fiduciary duty on stockbrokers operating in the state. Now that the draft regulations have emerged, industry members have begun making the usual threats and working to keep other states from following Nevada’s lead.

At its core, the fight hinges on how we tell people how the world works. Industry prefers the status quo, where a small-print disclosure reveals that conflicts may exist and an adviser may receive compensation from the issuer when their customers invest.

Paperwork, often delivered at or after the sale, may enable more sophisticated investors to calculate what they actually paid.

Unsurprisingly, the current approach effectively leaves investors in the dark. One recent study found that about half of investors in their 60s and 70s either don’t know what they pay for financial advice or wrongly assume that it’s free. 

Nevada’s draft regulations would fix this problem. Consider a pitch from a financial adviser about to reap a fat 7 percent commission for convincing an investor to put $100,000 into a variable annuity. Under Nevada’s draft regulations, the adviser must actually tell the investor that the adviser has 7,000 reasons to tilt the investor toward that decision.

Predictably, industry members have pulled out the stops to stop reform. Morgan Stanley, Wells Fargo, Charles Schwab and TD Ameritrade even threatened to stop offering brokerage services in Nevada if regulators don’t give them the changes they demand.

Regulators should not fear these threats to stop foisting overly complex, high-fee products on customers.

One study found that particular structured equity products Morgan Stanley marketed and sold to customers were so “overpriced at their initial offerings that they have expected returns less than the riskless rate.” It also found that certain complex products were consistent with the theory that banks designed them “to exploit investors’ misunderstandings of financial markets.”

If these brokerage operations just stops giving advice to people, many investors might be better off. 

One audit study sent investors with well-diversified, low-fee portfolios in to meet with commission-compensated stockbrokers. The auditors walked out with portfolios tilted toward actively managed funds charging higher fees. 

Another study looked at whether investors would be better off without the assistance of brokers in selecting retirement funds. It also found that “broker recommendations lead to higher annual fees” and “lower risk-adjusted returns.”

To be sure, investor protections should not be so extensive that investors cannot afford high-quality financial advice.

Although Nevada’s draft regulations may make it more difficult for particular players to operate, that does not mean investors will not be able to get decent advice. New financial technology firms make it easier every day for companies to deliver quality advice at a low cost.

Benjamin Edwards is an associate professor of law at the Boyd School of Law at UNLV.