"The Subtle Influence: Conflicts of Interest in Financial Planning by Frank C. Bearden, Ph. D. is a book that will change your financial advising practice. It will ease your mind, lower your level of stress and better prepare you forwhatever the regulators choose to impose on financial advisors. You will be a better, more confident advisor.

This book should be read and absorbed by all advisors, RIAs, Registered Representatives, Broker/Dealers and all of those charged with providing unconflicted advice and professional judgment. It brings the sometimes elusive concept of fiduciary into something to which we all can strive."

-Ben G. Baldwin, CFP®, ChFC, CLU, MSM, MSFS Noted Author, Speaker, Educator

Through detailed case studies, you will determine how to evaluate and respond to conflicts of interest so that your integrity is never called into question. Discover practical solutions that you can implement right away.

Conflicts of interest continue to wreck the careers of many professionals, and they also contributed to the recent financial crisis that devastated so many individuals and companies. Ensure that you survive and succeed with The Subtle Influence: Conflicts of Interest in Financial Planning.

"Conflicts of interest are a core component of discussions regarding client-plannerrelationships and fiduciary responsibility in the financial services industry. Dr. Bearden discusses such conflicts in a clear, straightforward manner, and his usage of client scenarios effectively adds color to ethicalgray areas. Dr. Bearden’s book is required reading for those advisors who aspire to maintain long-lasting client relationships and who want to interact with clients in a transparent, ethical, and mutually productive manner."

-Dr. Jesse B. Arman, ChFC,Vice President, Academic AffairsCollege for Financial Planning

The Subtle Influence

Conflicts of Interest in Financial PlanningBy FRANK C. BEARDEN

iUniverse, Inc.

Copyright © 2010 Frank C. Bearden, PhD.
All right reserved.
ISBN: 978-1-4502-3338-5

Contents

Preface...........................................................................viiChapter 1 Introduction: Are Conflicts of Interest a Big Deal?.....................1Chapter 2 Serving Up Damage to Professional Judgment..............................23Chapter 3 What Happened?..........................................................37Chapter 4 Naming the Problem......................................................48Chapter 5 Conflicts That Are Not Conflicts Of Interest............................63Chapter 6 The Appearance of a Conflict of Interest................................77Chapter 7 Conflicts of Interests Outside Of Practice..............................88Chapter 8 Conflicts of Interests within Practice..................................106Chapter 9 Indications of Their Presence...........................................125Chapter 10 Remedies...............................................................138Chapter 11 Suggestions on Practice Policy.........................................154References........................................................................159Index.............................................................................171

Chapter One

Introduction: Are Conflicts of Interest a Big Deal?

Conflicts of Interest in General

As this introduction is being written in early June of 2009, the United States is slowly emerging from what has been termed by Jack Healy in the New York Times as "the worst financial crisis since the Great Depression" (Healy, June 4, 2009). The analytical work as to the reasons for the crisis is still in process, but some of the broad contributing factors are assumed to be the issuance of large numbers of subprime mortgages, the drop in housing prices, defaults and foreclosures of the mortgages, and the run on capital for commercial and investment banks and other large financial institutions, not necessarily in that order. Because a significant part of the damage can be attributed to the general subject of this book (Strier, 2008), the event seems an appropriate place to begin a discussion of conflicts of interest. What follows is a discussion of some of the more significant factors at work in what occurred, to uncover the subtle role played by a major conflict of interest.

The Subprime Mortgage Crisis Sold and resold.

In the recent past, subprime mortgages in the U.S. began being issued on a large scale to persons with low credit scores, little credit history, or other credit impairments. In 1996, $96.8 billion of subprime mortgages were originated and in 2006 the total rose to approximately $600 billion (Coval, Jurek, & Stafford, 2009). The issuing organizations of subprime mortgages sold these loans to investment banking firms to receive fresh capital to lend again. The investment bankers then structured these loans into what can be loosely categorized as collateralized debt obligations or CDOs, to sell to institutional investors such as commercial and investment banks, hedge funds, pension plans, and insurance companies. The investment banks sought ratings on credit quality by credit rating services such as Moody's, Standard & Poors, and Fitch to facilitate the sales. The rating services were paid for their work by the investment bankers. The rating services also regularly provided these CDOs with high level, investment grade ratings that reflected little default risk, similar to the ratings for high quality bonds (Strier, 2008). Between 2005 and 2007, approximately 80 percent of the subprime mortgages were in CDOs given AAA ratings (Kim, 2008).

In fact, the subprime mortgages that were a major part of the collateral in the CDOs were of low credit quality (Coval, Jurek, & Stafford, 2009). The default rate for CDOs with investment grade ratings was significantly higher than that for similar ratings given to corporate bonds. Corporate bonds receiving Moody's lowest investment grade rating of Baa between 1983 and 2005 had a default rate over 5 year periods of 2.2 percent, while CDOs for the same period defaulted at a rate of 24 percent (Calomiris & Mason, August 24, 2007).

Highly rated CDOs had a distinct advantage over similarly rated bonds in that they had higher rates of return (David & Goldstein, June 18, 2007) which was a primary reason for their popularity. In 2006 the issuance of CDOs in the United States was $312 billion, a 102 percent increase from 2005, also a record year (Thompson, Callahan, O'Toole, & Rajendra, 2007). Had the CDOs been rated as somewhat speculative, their placement with institutional investors would have been on a much lower scale.

As CDOs grew in popularity, the revenue generated by credit rating services in their work with investment bankers grew significantly. Moody's revenue for the fourth quarter of 2007 rose 86 percent, and revenue for the year rose 24 percent. CDOs accounted for 44 percent of the revenue (Strier, 2008). In addition, credit rating organizations also provided consulting services to the investment bankers for the CDOs they later rated. These services included how to structure the debt products to receive higher ratings. Consulting on CDO type products accounted for 40 percent of Moody's revenue in 2006 (Levitt, Sept. 7, 2007).

Defaults begin.

With CDOs backed by subprime mortgages in place on a large scale in the portfolios of large commercial and investment banks, insurance companies, and hedge funds, the subprime mortgages began to default. The defaults occurred due to the interaction of a few distinct factors. A good place to begin reviewing these factors is with the characteristics of subprime loans. The structure of subprime loans was a major contributor to rising defaults. The majority of subprime mortgages originated from 2003-2007 were designed with a fixed rate of interest for two or three years and then an adjustable rate tied to a measure of market interest rates. These were known as short-term hybrids. Typically interest rates rose two or more percentage points after the initial period. Through mid-year of 2008, delinquencies on adjustable-rate mortgages rose to over 29 percent, while fixed-rate mortgage rates rose to 9 percent (Mayer, Pence, & Sherlund, 2009).

Lowered standards of credit worthiness also were a significant contributor to defaults. Median loan-to-value ratios increased from 90 percent in 2003 to 100 percent for originations in 2005 and 2007. Subprime loans with a second lien increased from 7 percent in 2003 to 28 percent in 2006. Subprime loans with the highest loan-to-value ratios at origination from 2005-2007 had the highest rates of default. Loans with little or no documentation of income or assets also contributed to the rising default rate. These subprime loans increased from 32 percent of the subprime loans originated in 2003 to 38 percent in 2007. From 2003 to 2008 serious delinquencies of subprime loans with little or no documentation rose from 5 percent to over 25 percent, while fully documented loans rose from 5 percent to approximately 20 percent (Mayer, Pence, & Sherlund, 2009).

The combination of subprime mortgages structured with adjustable rates and lowered credit worthy standards produced a loan portfolio with inherent vulnerability to changes in the larger economy. Two such economic changes that brought out this vulnerability in the loans were the price of housing and mortgage interest rates. Prior to 2005, increases in housing prices, low rates of interest and low unemployment encouraged the growth of subprime lending. In 2005, the increase in housing prices began to slow. By 2007, housing prices were actually in decline in areas of the United States, falling an average annual rate of 10 percent from mid-2006 until mid-2008 (Mayer, Pence, & Sherlund, 2009).

Falling housing prices had the following effects on mortgage holders: The subprime mortgagors who put little or no down payment on their homes, incurred negative equity with falling prices. So when they had financial difficulties, they may have opted for default as their only choice (Foote, Gerardi, and Willen, 2008; Gerardi, Lehnert, Sherlund, and Willen, forthcoming; Sherlund, 2008). Owners with positive equity had an additional choice when encountering financial difficulty. They were more likely to refinance or sell their homes than go through default and foreclosure. Even if the mortgagor could not afford the mortgage, selling the house was more profitable than foreclosure (Mayer, Pence, & Sherlund, 2009).

Upward interest rate movement provided the catalyst for the defaults described above. Interest rates were low in 2003 until mid-2004, rising almost 2 percent from then until mid-2006, as measured by the London Interbank Offered Rate (LIBOR). A fully indexed rate in a subprime mortgage would have increased from 8 to 11.5 percent. This translated to a 25 percent increase for a mortgagor whose two or three year level rate changed to an adjustable rate. The mortgagor would have experienced an approximately $250.00 payment increase on a loan of $150,000. This level of increase could and apparently did produce financial difficulty for many mortgage holders (Mayer, Pence, & Sherlund, 2009).

The vulnerability of subprime loans due to structure and lowered creditworthy standards positioned this debt as operable only in optimal conditions. The changes brought by dropping housing prices and rising interest rates interacted with the vulnerability to produce historically high default rates (Mayer, Pence, & Sherlund, 2009).

And the markets responded.

The market value of CDOs began to drop due to growing subprime defaults and commercial banks were soon seeking large sums of capital to restore their capital requirements. Investment banks also suffered, as Lehman Brothers declared bankruptcy, Bear Stearns was sold to Morgan Stanley, and Merrill Lynch was sold to Bank of America. The federal government approved $700 billion in the Troubled Assets Relief Program to help failing commercial banks and other large financial institutions (Lengell, March 30, 2009).

A key factor in these events was the high credit ratings given to the CDOs by the credit rating services, reflecting investments with low default risk and higher returns than other investments of the same rating. This encouraged the impressive scope of the issuance and purchase of CDOs. The credit ratings given to these investments were a direct function of the professional judgment of the credit rating agencies. That judgment was flawed, as evidenced by the default experience of CDOs compared with the default experience of other similarly rated debt instruments such as corporate bonds (Calomiris & Mason, August 24, 2007). The flawed judgment occurred concurrently with significantly increased revenues from CDO rating and consulting business by the credit rating services, which leads to the conclusion that a relationship existed between the two (Strier, 2008). The credit rating agencies had a conflict of interest with their investment bank clients that impaired the raters' professional judgment. The flawed judgment could well have arisen from reduced objectivity due to the prospect of additional revenues. Had the resultant ratings of the credit ratings reflected the true speculative nature of the investments involved, their appeal would have been much less and the incidence of these CDOs in institutional investor accounts would have been much lower. The lower incidence would have lowered the impact of subprime defaults. In summary, a conflict of interest held by the credit rating agencies was a significant contributor to the current financial crisis (Strier, 2008).

Conflicts of Interest in Financial Planning

The prior few pages provide evidence of the importance of conflicts of interest in general, especially in light of the damage they can and will generate. This book is about conflicts of interest in the practice of financial planning, so we have to look elsewhere for evidence of the importance of the issue within this context. In reviewing the financial planning landscape, we will consider some recent and not so recent statements about conflicts of interest in financial planning from a diverse group of credible sources: a respected financial planning credential granting organization, the largest financial planning professional organization and a sister organization, a state regulatory agency, the media, and a well-known financial planning professional.

First, let's consider two significant recent activities by the Certified Financial Planner Board of Standards. The CFP Board's Standards of Professional Conduct was adopted by the Certified Financial Planner Board of Standards to regulate the professional principles and behavior of all persons that are certified to use the CFP(r) mark. The CFP Board's Standards of Professional Conduct was revised May 31, 2007, took effect July 1, 2008, and was enforceable for CFP(r) professionals January 1, 2009. Within the CFP Board's Standards of Professional Conduct the "Code of Ethics and Professional Responsibility" establishes the principles and standards of practice (CFP Board, 2009, p. 6). Principle 4 is entitled "Fairness" and has a clear stipulation regarding conflicts of interest: "Fairness: Be fair and reasonable in all professional relationships. Disclose conflicts of interest" (CFP Board, 2009, p. 6).

The "Rules of Conduct" section (within CFP Board's Standards of Professional Conduct) specifies professional behavior required to uphold the principles and standards of the "Code of Ethics and Professional Responsibility." Rule 2 addresses "Information Disclosed to Prospective Clients and Clients" (CFP Board, 2009, p. 8), and Rule 2.2b stipulates that a CFP(r) certificant must disclose:

A general summary of likely conflicts of interest between the client and the certificant, the certificant's employer or any affiliates or third parties, including, but not limited to, information about any familial, contractual or agency relationship of the certificant or the certificant's employer that has a potential to materially affect the relationship. (CFP Board, 2009, p. 10)

In conjunction with the revision of the CFP Board's Standards of Professional Conduct, with provisions directly addressing conflicts of interest, the CFP Board of Standards has been actively promoting the use of the fiduciary standard for all financial professionals who offer broad-based financial advice. On December 8, 2008, the CFP board, the Financial Planning Association(r), and the National Association of Personal Financial Advisors announced joint involvement in the Financial Planning Coalition, seeking regulatory reform through legislation to assure that financial planning services are provided with fiduciary accountability and transparency (CFP Board, Public Policy and Advocacy section, 2009, para. 1-3). Among the principle concerns by the CFP Board and Financial Planning Coalition is the necessity that pending legislation adequately addresses measures to regulate conflicts of interest among those providing financial planning services (CFP Board, letter to House Committee on Financial Services, November 2, 2009).

A third milestone event occurred on March 20, 2007, underscoring again the importance of conflicts of interest within financial planning. The United States Court of Appeals for the District of Columbia granted the petition of the Financial Planning Association (FPA) in their lawsuit against the Securities and Exchange Commission. The SEC's final rule exempting broker-dealers from the requirements of the Investment Advisors Act of 1940 was overturned. The FPA contended that a professional who functions as a registered investment advisor-RIA, or an RIA representative-must be subject to the Advisors Act, and two provisions in particular: putting clients first using the fiduciary standard of service, and disclosing conflicts of interest prior to accepting an engagement (FPA, 2007). The FPA filed this suit, in part, because many financial planners provide investment advice and are RIAs or RIA representatives (Churchill, 2007).

Going back a little further in time, on March 2, 2006, the Financial Planning Association of Australia (FPA Australia) announced the adoption of the FPA principles to manage conflicts of interest. The principles are part of the FPA Australia's ongoing efforts to help members achieve high professional standards and effectively manage conflicts of interest (FPA Australia, 2006).

The emphasis on disclosing conflicts of interest by the CFP Board and the emphasis placed on conflicts of interest in recent actions by the FPA and the FPA Australia underscore their significance in financial planning practice. Now let's consider an incident involving a state regulatory agency described in the New Hampshire Bureau of Securities Regulations, July 12, 2005. The state securities regulators settled a complaint against a major financial planning firm regarding inadequately disclosed conflicts of interest. The Bureau charged that the planning firm had failed to properly warn clients of material conflicts of interest including higher commissions on firm-managed mutual funds than similarly styled and performing funds available from unaffiliated money managers. The planning firm settled, agreeing to a large fine and restitution to any harmed investors; in addition, the firm agreed to retain an independent consultant to review practices related to the use of proprietary mutual funds (New Hampshire Securities Regulation, July 12, 2005).

(Continues...)

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