The Conflicted Advice Problem: A Response to Conflicts & Capital Allocation

Abstract

Professor Benjamin Edwards’ Conflicts & Capital Allocation is a timely piece that examines the far-reaching consequences of commission-based compensation for financial advisors. In the article, Professor Edwards convincingly demonstrates that commission-based compensation creates structural conflicts of interest for financial advisors who sell their clients financial products that generate higher commissions for the advisor but do not maximize the client’s wealth. But, as Professor Edwards argues, the effect of financial advisors’ compensation-related conflicts extends beyond retail investment clients and into the financial markets, causing systemic capital misallocation. The potential macro-level harm that arises from conflicted investment advice thus requires an effective response. To this end, Professor Edwards puts forward a straightforward, bright-line proposal: a prohibition on commission-based compensation for financial advisors. As Professor Edwards asserts: “[b]anning commission compensation for personalized financial advice will better align financial advisor incentives with their clients’ interest and improve capital allocation.” He further opines that a complete prohibition on commissions is the most efficient way to minimize and avoid the harms that accompany a commission-based compensation structure.

Compensation-related conflicts of interest are common in the financial markets beyond financial advisors and retail investors. Credit rating agencies, for example, are paid by the issuers whose debt they are rating, which may incentivize them to inflate ratings in order to attract more ratings opportunities. Similarly, directors set their own compensation for serving on a corporation’s board, which allows them to potentially maximize their earnings at the expense of the corporation and its shareholders. Indeed, one need look no further than the ongoing scandal that currently embroils Wells Fargo regarding fraudulent accounts that the bank’s employees created in order to meet their quotas. In each example, the compensation structure is innately conflicted, has been viewed as a primary impetus for related scandals, and has resulted in many of the ills identified in Conflicts and Capital Allocation. However, despite the innate and unavoidable issues that accompany commission-based compensation, the structure seems to be here with us to stay, at least in the short- to medium-term. Thus, in this Response, I consider recent efforts to implement one of the alternatives to commission-based compensation that Professor Edwards raises — namely, the imposition of fiduciary duties or a fiduciary-like standard on financial advisors.

Fiduciary obligations developed as part of the law of equity, specifically in instances in which a person was expected to act as a “trustee” because of her relationship of trust and confidence with another. A fiduciary is one who is granted authority to manage the affairs of the principal and, therefore, is entrusted to further the principal’s best interest in her actions and decisions. Thus, integral to fiduciary obligations is the expectation that the fiduciary act: (i) loyally by eschewing or disclosing conflicts of interest; (ii) with care by acting deliberatively in decision-making; and (iii) with candor by disclosing all material and relevant information to the principal. Recently, there has been legislative and regulatory interest in harmonizing the standards of conduct applicable to all financial advisors, bringing them closer to a fiduciary(-like) standard. The first salvo in the battle to impose fiduciary obligations on financial advisors came from the Department of Labor (“DOL”), which implemented the “Fiduciary Rule” pursuant to its authority under the Employee Retirement Income Security Act (“ERISA”). And, after the Fiduciary Rule failed to come to fruition, the Securities Exchange Commission (“SEC”) proposed Regulation Best Interest to impose a best interest standard on broker-dealers. Both are efforts aimed at reducing the problem of conflicted advice, enhancing investor protection, and minimizing investor confusion. Yet, as this Response demonstrates, the problem of conflicted investment advice is intractable and persists despite these regulatory proposals.

This Response focuses on these recent efforts to “fiduciarize” or otherwise heighten the standard of conduct applicable to financial advisors and analyzes whether and to what extent the proposed fiduciary(-like) standards minimize the conflicted advice problem. As regulators and industry actors attempt to tackle the innate conflicts of interest that arise in the investor-financial advisor relationship through the imposition of fiduciary(-like) duties, it is necessary to analyze the potential implications of these proposals.

This brief Response first analyzes the applicable legal framework that governs the conduct of financial advisors in providing investment advice to retail customers. The Response highlights the muddled and uneven state of affairs with respect to different types of financial advisors to demonstrate the confusion that retail investors face. Next, it discusses the short-lived and nowdefunct DOL Fiduciary Rule and the SEC’s recently proposed rule, Regulation Best Interest. Before concluding, this Response analyzes the implications, both positive and negative, of these proposals for retail investors.

Keywords: Conflicts, Capital Allocation, Investment, Investment Advisers, Fiduciary Duties, Investor Protection