Continued: Advisors Fiduciary Duty Under Attack

By opening the door for RIAs to legally introduce conflicts of interest into their practices, the whole RIA space runs the risk of falling prey to the Market for Lemons economic phenomenon, says Benjamin Edwards, associate professor of law at the University of Nevada’s law school in Las Vegas.

Market for Lemons is a foundational work of Nobel Prize-winning economic research that demonstrates how, in a market for used cars, when consumers have no way to determine the quality of the vehicles, they discount the price for all vehicles they buy, to account for the risk of buying a lemon.

"As this happens, it drives down the quality of the goods in that marketplace to the point where all you have left is lemons," Edwards says. "If people can't distinguish between good advice and bad advice, you will gradually see bad advice take over the market."

The SEC's position on this subject springs from a fundamental misunderstanding of the limits of disclosure's effectiveness, Edwards says. "The SEC tends to fetishize disclosure because it's so important for public companies, [but] nothing like that can operate in the financial advisor space ⁠— it's a misplaced disclosure fetish."

When it comes to public company regulation — a core responsibility of the commission — large, well-funded industry players such as mutual fund companies, hedge funds and research giants like Morningstar minutely dissect disclosures to derive valuable insights. Many investors then buy products and services, often guided by insights gleaned from those disclosures, Edwards says.

But wealth management is a different beast. Disclosures given to clients are unlikely to face the level of scrutiny and expertise conducted by research firms and mutual fund companies. When the SEC leaves the analysis to retail investors — who, even if they had the time to read through volumes of disclosures, lack the background to understand them — the value of any transparency evaporates, Edwards says.

The SEC has been blinkered before about the impacts of its rule-making, says Dave Yeske, co-founder of RIA Yeske Buie in San Francisco.

WHEN THE FPA TOOK ON THE SEC
That's why the FPA sued the SEC in 2004, after the commission proposed an exception to the Investment Advisers Act for brokers. For a number of years, the exception allowed brokerages to receive fees for offering financial advice on retirement accounts despite the fact that they were not fiduciaries, says Yeske, who was chairman of FPA’s national board at the time.

The SEC move was well-intended, he thinks, surmising that commissioners thought it would reduce brokers' tendency to churn client accounts for higher commissions.

But they overlooked different ways the 
exception enabled brokers to self-deal in those accounts, according to Yeske, such as selling clients in-house products for high commissions. A federal appeals court overturned the SEC’s exemption for brokers in 200 financial planning. 

Edwards says he expects to see legal challenges to the SEC's new regulation, in much the same way that the brokerage industry killed the Department of Labor's fiduciary rule by challenging it in court.

The SEC has already faced a bevy of criticism. AARP lambasted the commission, saying the rule-making "weakens the interpretation of the Investment Advisers Act, undercutting decades of accepted practice."
Yeske wonders, "Who the hell ever thought we'd ever see the Investment Advisers Act under such assault?"