Financial Services Regulation

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Unravelled: Would you like best interests with that? Conflicted remuneration, American style

7 March 2016

Written by Senior Associate Stephanie Malon and Senior Regulatory Counsel Michael Mathieson

Last month, we were fortunate enough to host Barney Frank, co-architect of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, to discuss financial regulation reform.

Coincidentally, a couple of weeks later, we were treated to a presentation on US financial regulation reforms by a US lawyer, David W. Powell, at the annual superannuation lawyers' conference. Powell's presentation focussed on US efforts to expand 'fiduciary' duties for financial advisers, including those advising on Individual Retirement Accounts. IRAs now constitute a large chunk of US retirement savings, with US$7.3 trillion held in IRAs in 2015.

There are some interesting comparisons to be made between the proposed US rules and existing Australian financial advice laws. But perhaps most interesting of all is the proposed 'best interest contract exemption'. Before reading on, take a moment to ponder those four words, and what they might mean. We come back to them a little later.

A short history

Loopholes in US legislation mean that many financial advisers aren't caught by existing rules that apply to 'fiduciaries'.

Back in 2010, the US Department of Labor proposed revisions which would have extended these rules to those advising on IRAs. Amid the political wrangling of 2010, the revisions were eventually withdrawn. But come 2015 (and with President Barack Obama edging towards the end of his presidency), there was renewed political will to press ahead with reform:

Today, I'm calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It's a very simple principle: You want to give financial advice, you've got to put your client's interests first.
President Barack Obama, 23 February 2015

The Department of Labor obliged, by releasing draft regulations which would subject those advising on IRAs (amongst other products) to the rules that apply to 'fiduciaries', and would, as a result, prohibit them from receiving payments creating conflicts of interest – what we would call conflicted remuneration.

A very interesting exemption

Alongside these draft regulations, the Department of Labor also released the proposed 'best interest contract exemption' referred to earlier. This rather curious exemption would allow financial advisers to receive 'otherwise prohibited compensation' (including compensation that varies based on the investment recommendations made, and compensation from third parties received in connection with the advice provided), if certain conditions are met.

The conditions require the financial advice firm and the individual adviser to enter into a written contract with the client which includes:

  • A commitment to 'providing advice in the client's best interests': The firm and adviser must act with the care, skill, prudence and diligence that a prudent person would exercise in the circumstances and they must avoid making misleading statements about fees and conflicts of interest.
  • A warranty that the firm has adopted policies and procedures designed to mitigate conflicts of interest: The firm must warrant that it has identified material conflicts of interest and compensation structures that would encourage individual advisers to make recommendations that are not in clients' best interests. It must also warrant that it has adopted measures to mitigate any risks to consumers from conflicts of interest.
  • Clear and prominent disclosure of conflicts of interest: The contract must also direct the consumer to a webpage disclosing the compensation arrangements applying to the adviser and their firm and make customers aware of their right to full information about the fees charged.
Commentary from an Australian perspective

The obvious comment is this – if these are the things that a financial adviser must undertake to do, in order to be able to receive a commission, the ordinary rules concerning 'fiduciaries' cannot be a very demanding set of rules.

You might think having policies and procedures designed to mitigate conflicts of interest might be a minimum precondition to participating in the financial advice market. The Australian Parliament evidently thought so in 2001 when it included such a requirement in the core obligations of an Australian financial services licensee.

You might think the same way about clear and prominent disclosure of conflicts of interest. If you have a conflict of interest and you don't say so in your FSG or SoA, you are very likely to have a problem.

And then there is the requirement to provide advice in the client's best interests. This is where the comparison with the position under FoFA is most interesting. The US position appears to be that you will only have to act in the client's best interests if you want to receive a commission (and how about the inherent tension that arises there!). FoFA gives you no such choice.

FoFA requires a financial adviser who provides personal advice to a retail client to do so in the client's best interests. The ban on conflicted remuneration was introduced precisely because no-one believed that the best interests requirement would, on its own, be enough to bring about the necessary changes to the way advice is provided. So the best interests requirement is not optional, as it appears to be in the US.

Of course, all this begs the question as to what 'best interests' means, both here and in the US. Under FoFA, it means very little – and certainly nothing like what the general law fiduciary obligation means. Further, many advisers are perfectly happy not to receive a commission so long as they can receive an asset-based ongoing adviser service fee, invariably paid by the product issuer (but with the client's 'clear consent'). In the US, the requirement appears to focus on 'care, skill, prudence and diligence' – suggesting this may be more than just of case of how best to pronounce 'tomato'.

So, perhaps we shouldn't view the proposed 'best interest contract exemption' as an odd curiosity or as the by-product of what has no doubt been intense lobbying from commercial interests. Perhaps we can reflect on the best interests duty under FoFA, and on the client-given benefits exception to conflicted remuneration, and ask ourselves how we would go about explaining them to an American – and whether we might feel a bit sheepish in doing so.

Other articles in this edition of Unravelled

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Dodd Frank – promoting financial stability and other purposes
The Dodd Frank Act is a bit like the US financial system it is trying to regulate – vast, complex and hard to wade through. It creates a bunch of new regulators on top of what was already a pretty solid cast and gives them wide-ranging powers. They can not only set capital and liquidity requirements for banks and make rules about what they can and cannot do, but they can also shut down or sell off parts of their businesses. But are these regulators smart enough or well enough resourced to identify the risks? Read more>>

Transparency and Accountability – and not just for Wall Street
The regulatory law repercussions of the GFC remain endlessly fascinating. As an example, take the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010. It runs to 848 pages. Title VII addresses, perhaps optimistically, 'Wall Street Transparency and Accountability'. My favourite provision is section 716, headed 'Prohibition Against Federal Government Bailouts of Swaps Entities'. This heading suggests that, if there is ever another AIG, it can't be bailed out. Too-big-to-fail solved by legislative prohibition. If only it was that easy. Read more>>

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