The Hidden Trading Costs of Diversification, the Demise of Brokers Fiduciary Duties, and the Legalization of Brokers’ Fraud

Posted in: Business Law

Trading costs are usually not the first issue on which investors focus. Understandably, they typically focus on the chance and promise of gain—and not simply net gain, but securities price gain. This focus may present a problem, especially when it relates to long-term savings. In some cases, the aggregated small trading costs offset or even exceed small returns over a long period of time and the amount of this difference may sometimes be a surprisingly large surprising amount.

Moreover, these trading costs are oblivious to the transaction, whether it is purchasing securities that might produce returns, or selling securities, which might reduce risk of loss. In both cases, and regardless of happy or unhappy results, the investor always bears the transaction.

At first glance, this allocation of costs might make sense. After all, the person performing the services of trading (the broker) is entitled to be paid, like every person who performs a service or makes a sale. However, is it truly necessary or equitable that the broker be compensated for every transaction?

The trading in indexes presents a similar question. The Wall Street Journal published an article entitled: “Your Fund Fees Might Still Vary More Than They Should—Especially on Index Funds.” How can small charges add up to significant losses? One way is in pools of investments each of which carries a small charge. Second, changes may be encased in trading in such pools carrying charges in the pools themselves. The trades are not shown separately, and neither is the cost.

These costs are relatively small. Or are they? A long term investment can magnify even a very small transaction cost. Losing the return on $1 for 20 years may be a surprisingly high cost, particularly if the $1 is charged often, with every unknown trade (embedded in the index).

Yet, there seems to be no legal requirement to disclose embedded fees. Let us focus on the absence of this requirement. By scrutinizing this omission, perhaps we should demand a change in our own approach to regulation in this area.

The demand for specificity in the law is an invitation to corruption. We as a society find unacceptable the idea that whatever action or intention is not specifically prohibited is permissible (except in the area of criminal law). We are free country, right? Wrong. People in a country are not that free to manipulate and defraud. Yet, that is how the Department of Labor Rule, which was negotiated for years, reached 1,000 pages before a court invalidated it. What did those pages include? The details of the details of the details of what brokers may not say to their clients. The rest they may say!

The Wells Fargo story provides two examples of corruption produced by a literal “dictionary approach.”

Brokers were rewarded for opening “new accounts” and risked being fired if they did not. Notably, under a literal interpretation of the term “new account,” opening a new account for an existing client constituted opening a “new account.” However, opening a new account for an existing client and charging the client for the opening of the new account is cheating the client. It is fraud.

Wells Fargo charged its clients for the opening of these subsequent accounts, despite that they already had one account and did not need additional accounts. Yet many of the clients were unaware of the charges associated with opening the additional accounts. Was Wells Fargo’s action legal? It abided by the literal meaning of “new accounts.” But by true law it was despicable fraud.

Consider this second example of literal interpretations of law leading to unfair and wrong results. Opening an account in the name of one’s 12-year-old daughter and putting 15 cents into the account violates no rule. It is indeed a new account. However, this action is cheating the bank. The bank will not benefit from the account and will lose the cost of opening the account. Even so, some managers of the bank used this literal definition to engage in this behavior.

In both cases, the employer banks rewarded conduct that was literally account opening but in fact fraud.

If a law does not specifically regulate every possibility, shade, and intonation, of any activity, that does not mean that such uncovered possibility is permissible. Let us examine the purpose of our laws.

The purpose of securities laws is to enforce trustworthiness and reliability on experts. They should not and do not make permissible the manipulation of non-experts (i.e., investors). No rule can cover all nuanced possibilities, but all laws have an overriding purpose. The interpretation of vague rules must relate to and be consistent with their main purpose. In this case it should relate to the duties to ensure justifiable trust in the financial service givers not freedom of these service givers to defraud those who entrust them with their money.

So what is the solution? The law alone may not be the most effective one. Nor are hundreds of detailed rules a solution. Regulators seem to conduct long negotiations that result in literal “dictionary” solutions and thus permit bad actors to defraud. But perhaps some brokers have seen the light. The Oxford Portfolio Review highlighted “The Nation’s Best—and Fastest Growing—Discount Broker,” which enables customers to trade for a nickel a share and where the investment advisers focus on the cost of trading in serving their clients.

To be sure, the clients do not understand the trading of stock, but they are far more likely to understand the cost of trading. It is not surprising that brokers have long fought against disclosing their charging costs in dollars rather than as a percentage of the price. Indeed, for most of us 2.41% of $26.45 is harder to imagine in concrete terms than 50 cents. Let the price of trading be as simple as possible and let the brokers and advisers give fiduciary advice—professional and legally principled and based on trustworthiness, not calculated to evade a dictionary definition and cheat the investor.

As a fiduciary, a broker is subject to two main duties: (i) the duty of loyalty, that is avoiding conflicts of interest; and (ii) the duty of care, that is, having and exercising expertise. In a relatively recent time there arose another duty: to act in the “best interests” of the client. This third duty sounds good and benevolent, but it is not. First, the best interest eliminates (by superseding) the duty of care and the duty of loyalty. The focus is not on the fiduciary’s services and honesty but on the results of the fiduciary’s services. This definition effects two significant changes. We no longer examine the broker’s expertise or the honesty. They are irrelevant under the best interest duty. Instead we focus on the results of the service. Here we will have the task of finding for each client the client’s best interests! No rule can ever adequately describe with any particularity what “best interest” means. Interests of the client depend on age, health, education, wealth, position, marriage happiness, to name a few. “Best interest” requires to: inquire and define the situation for each and every client a broker has or had. This type of rule invites definitional and factual inquiries for decades. After all, the investors are not the same, and the entire generation of investors changes continuously. “Best interests” has erased the generation-long test of a fiduciary. Avoid looking and examining the behavior of the trusted broker. Look at what he or she offered and sold the investor and determine whether the products were in the client’s best interests. Interestingly, the Securities and Exchange Commission’s rule has added a weak conflict of interest. The “best interest” was not enough even after the 400-page rule.

What will the future hold? Perhaps a few brokers and few sophisticated clients will find each other. Both exist in the markets. If they match and succeed, others might follow. The market might resolve what the law is failing to correct. There are enough strong and honest leaders to return to the roots and carry voluntarily: a duty of care-expertise and a duty of loyalty-avoiding conflict of interest.

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