On fiduciary matters, the SEC should think more like a trust company & less like a bank – Carosa

Eminent fiduciary commentator and well-respected ERISA attorney Fred Reish believes if the DOL opts not to appeal the 5th circuit decision to vacate its fiduciary rule, the rule is as good as dead (see “Exclusive Interview: Fred Reish says DOL ‘Conflicted’ Over Conflict-of-Interest Rule Appeal,” FiduciaryNews.com, April 17, 2018). However, he says, “while the particulars” may have been killed, the principles are not necessarily dead.

Indeed, the forum shifts from the DOL to the SEC.

If you thought the DOL had an impossible task of crafting a rule that protected all business models, consider the conflicts within the SEC.

The SEC is charged with not only protecting investors, but also with maintaining the sanctity of the capital markets. Those two opposing elements butt heads in a most inglorious fashion.

In some cases, there’s absolutely no way to serve both masters simultaneously.

Why try?

If it’s seeking a model for regulatory spaghetti code, the SEC need look no further than the banking industry. Banks can find themselves overseen by any one of three separate regulators – and that’s only on the Federal level (for those keeping score at home, they are the Federal Deposit Insurance Corporation, the Federal Reserve Board, and the Office of the Comptroller of the Currency). In fact, banks are so over regulated, for generations they acted as whipping boys for every political fad out there.

But let’s not bother going there. Let’s focus on the inherent conflict between customers and shareholders.

Shareholders demand corporate profits (either through capital gains or dividend income). Those profits come at the expense of customers. Sandwiched in between these dueling interests stands the liquidity mandate, a regulatory requirement to keep the bank solvent.

See how confusing it gets?

Somehow, though, the banking industry has demonstrated historical success in separating the demands of the shareholders from the demands of the customers, all while keeping the regulators happy. (OK, well, at least since the Securities Laws during the era of Glass-Steagall.) This is an important fact. Here’s why. The bank had two kinds of customers: Trust clients and retail customers.

What’s the different between the trust side of the business and the demand deposit side of the business? The former’s assets are separate from the bank’s assets, while the latter’s assets become the bank’s assets. In other words, retail customers assume a risk that trust customers never see.

Trust customers are protected under a fiduciary umbrella built upon centuries of case law.

Over that time, the wall between the self-interest of the trustee and the best-interest of the trust beneficiary has grown to a solid thickness. It’s all based on the concept (and enforcement of) the ban on prohibited transactions.

In rare cases, given appropriate disclosure and no mitigating circumstances, self-dealing transactions can occur. Even when a trustor specifically writes such imprudent direction into the original trust, a court can strike it down if the beneficiaries prove they were harmed. And courts have appeared to have very little tolerance when it comes to beneficiaries not having things done in their best interest.

None of these protections seem to exist in the discussions involving the so-called “fiduciary standard,” whether we’re talking about the DOL or the SEC variety. Instead, we see a lot of “disclosure” being thrown around, as if that’s the panacea for not acting in anyone’s best interest. The best trust departments would never tolerate this. Chances are, neither would the court of trust law.

Now, nothing says the SEC must take the same tack as the typical trust department. More so, a case can be (and has been) made that, with all the many regulatory hats worn by the SEC, it cannot afford to act as one-dimensionally as a trust department.

But, maybe it should think like a bank. A bank that also has a trust department. It can deal with its demand deposit retail customers as it wishes, but for its fiduciary clients, the bar is set much higher.

Why can’t the SEC have two sets of rules, one for each class of investors – those who delegate their decision-making to a third party (i.e., a fiduciary relationship) and those who merely buy research ideas but make their own decisions (i.e., a brokerage relationship).

This isn’t a fiduciary rule. It’s a trust rule.