A group of institutional investors is calling on the House of Representatives to oppose the Financial Choice Act saying it will undercut shareholder rights.The Council of Institutional Investors, an advocacy group, sent a letter to every House member Wednesday urging them to oppose the bill. It was signed by 53 pensions, unions and other institutions that collectively hold more than $4 trillion in assets.
“The Choice act threatens fundamental investor protections that keep U.S. markets safe, fair and vibrant,” said Amy Borrus, deputy director at CII. “It’s like taking seatbelts out of cars, it’s just too risky.”
We join with the Council of Institutional Investors in strongly opposing the falsely named “CHOICE” Act, which would eliminate critical shareholder rights and market responses that ensure the integrity of our financial markets. The proposal would sharply reduce the number of shareholder proposals and shareholder oversight on ceo pay, restrict the ability of independent proxy advisory firms to provide essential information and guidance on matters of corporate governance, and entrench underperforming and overpaid executives. It has been less than a decade since the financial meltdown and Congress, fueled by corporate political contributions, is trying to get rid of some of the reforms that restored the credibility of our financial markets.
Three Principles to Protect Investors and Strengthen Capital Markets
As Congress and the administration consider revamping key aspects of America’s financial regulatory system, CII urges policymakers to uphold and enhance critical protections for investors.
Painful reminders of the massive failures of oversight—by regulators and corporate boards—that contributed to the financial crisis of 2008 are with us still. The market meltdown cost millions of Americans their jobs and homes, and devastated their retirement savings. Robust reforms have helped to restore investor confidence in the integrity of the marketplace. That trust must not be undermined.
That’s why CII believes that any future financial reforms should uphold three principles that foster fair, stable and vibrant markets:
- Protect fundamental shareholder rights
- Promote effective disclosure and reliable financial reporting
- Safeguard the independence of the Securities and Exchange Commission (SEC)
The House Financial Choice Act, however, would weaken critical shareholder rights that investors need to hold management and boards of public companies accountable, and that foster trust in the integrity of the U.S. capital markets. CII has outlined its concerns in detail in recent comment letters here and here, in a Member Toolkit and below on this page.
1. Protect fundamental shareholder rights
Robust shareholder rights ensure that investors are treated fairly and equitably, that management and boards are accountable to owners and that market participants have confidence in the integrity of capital markets.
Strong public company boards of directors are the first line of defense for shareholders. The board has a fiduciary duty to see that senior managers run the company in the long-term interest of its owners. But holding directors accountable to shareholders is inherently challenging in today’s public companies, where equity ownership is dispersed among thousands of owners. Balanced rules ensure that shareholders have fundamental safeguards, including a level playing field in director elections, a meaningful vote and effective tools to engage management and the board.
- Shareholder proposals are essential tools for investors, individually and collectively, to express their views to management and boards on major governance and other issues. The vast majority of these votes are strictly advisory; even if they pass, boards can choose whether to act on them.
However, the major U.S. House bill to roll back financial regulation would sharply increase the regulatory hurdle for shareholder proposals. The legislation reportedly would require any shareholder wishing to put a proposal on a public company ballot to own at least 1 percent of the company’s stock for a minimum of three years. That would raise the stock ownership threshold for filing a proposal at Apple, the largest market cap company, to $7 billion. This radical change could effectively shut out shareholder proposals. Congress should not micro-manage the shareholder proposal process, which the SEC has overseen well for decades, and especially not through draconian restrictions on filers. Read more…
- The House bill would prohibit the SEC from finalizing a proposed rule to allow shareowners to freely vote for the board candidates they favor in a contested election for board seats. The SEC’s proposal for universal proxies would give shareholders voting by proxy (the vast majority of investors) the same voting options as shareholders who vote in person: freedom of choice to vote for the specific combination of director nominees they believe best serves their interests. Congress should not block SEC action on this critical mechanism for holding directors accountable to the shareholders they are elected to represent. And the SEC should adopt its proposed rule as soon as possible. Read more…
- Shareholders should have the power to remove directors in uncontested elections, too, if they think the directors are doing a poor job. That is why CII supports a strong majority vote standard in director elections, rather than a plurality standard that permits boards to ignore the owners’ wishes when the majority of owners oppose directors standing for re-election. At the very least, there should be clarity about the vote standard the company uses. Too often, shareholders are in the dark about how votes for director are counted. The SEC should finalize its proposal to require companies to provide clear disclosure in proxy statements of the voting standard used in uncontested director elections. Read more…
- The 2010 Dodd-Frank Act’s requirement that public companies offer shareholders a periodic advisory vote on executive compensation (“say on pay”) has been a winning game-changer for companies and their shareholders. Say-on-pay votes enable shareholders, individually and collectively, to express their views about CEO pay. They have sparked improved communication between boards and shareholders, and greater understanding among investors about corporate strategy and how pay incentives drive the strategy.
While say-on-pay votes are strictly advisory and most pass by wide margins, they have led many board compensation committees to improve pay-for-performance incentives in executive compensation. Shareholders overwhelmingly support annual say-on-pay votes.
The House bill would require companies to hold say-on-pay votes only when there is an ill-defined “material change” to executive compensation. Congress should preserve the requirement that companies hold regular say-on-pay votes and the option for this important vote to occur annually. Read more…
Support fair rules for “clawbacks” of unearned executive compensation.
- Dodd-Frank’s requirement that companies recover (claw back) incentive-based compensation from executives when a material error results in a financial restatement is simply fair pay for fair play. Executives who reap additional pay for “hitting the numbers” should not be rewarded when they fail to hit the numbers. Congress should preserve this important shareholder protection.
- Independent research helps investors cast informed proxy votes. But access to independent research is threatened by a proposed legislative provision that could drive up the cost of voting responsibly–and possibly drive proxy advisory firms out of business.
Proxy advisory firms play a vital and necessary role in assisting pension funds and other institutional investors in carrying out their fiduciary duty to vote proxies in the best interest of plan participants and clients. Many investors purchase research from proxy advisory firms but vote according to their own guidelines.
The House bill would give companies an incentive to try to delay publication of proxy advisor reports as long as possible, increasing costs to advisory firms and their investor clients. Congress should not interfere with the right of investors to purchase independent proxy research. Read more…
2. Promote effective disclosure and reliable financial reporting
Investors and other market participants depend on prompt, transparent disclosure of important corporate financial information. High-quality, timely disclosure gives investors a full picture of a company’s businesses and helps investors price risk. But some observers have proposed drastic cuts in corporate reporting requirements for public companies.
Support disclosure requirements that investors need to make informed investment and voting decisions.
- Investors are the primary users of financial reporting information, and they do not view “information overload” as a problem. A CFA survey of investors found that 80 percent of respondents did not think reducing the volume of financial statement disclosure was important. Investors are more concerned with obtaining meaningful information. While eliminating disclosure overlap makes sense, regulators should focus on protecting investors—the owners of public companies—when considering appeals for reduced disclosure. Congress and the SEC should balance corporate demands for less disclosure with investors’ need for effective disclosure.
- Hedging by executives undercuts pay incentives. Equity granted as a long-term incentive is supposed to be at risk; hedging insulates executives from risk. It also severs alignment with long-term shareholders. That’s why CII policies call on public companies to bar executives from hedging company stock. At a minimum, shareholders should be able to know if and how executives are hedging, because hedging weakens alignment of executive pay with long-term shareholder value.
Dodd-Frank’s requirement that companies disclose their policies on company-stock hedging by executives would give investors a better understanding of who is allowed to hedge and how. But Congress should let the SEC adopt its proposed hedging disclosure rule, not gut requirements for disclosure of hedging.
3. Safeguard the independence of the SEC
Sufficient, stable and independent SEC funding is critical to ensuring the integrity of the U.S. capital markets.
Support full funding for the SEC.
- While reducing the federal deficit and burdens on American taxpayers are vitally important, the SEC needs appropriate resources to fulfill its mission: protecting investors; maintaining fair, orderly and efficient markets; and facilitating capital formation.
Funding the SEC does not increase the federal deficit or cost taxpayers any money. Its funding is fully offset by transaction fees from self-regulatory organizations. The SEC is the only independent federal agency that is tasked explicitly with protecting investors. Congress should give the SEC the resources it needs to police the markets effectively.
- Flexible rulemaking authority helps keep the SEC nimble and responsive to changing market needs. But the House bill would heap additional, unnecessary reviews on the SEC that would hamstring its rulemaking capacity and undermine its ability to fulfill its mission. The SEC would do little else but evaluate its rules.
Shareholders are no fans of unneeded regulation. But the SEC already performs cost-benefit analyses on proposed rules, as numerous laws require (including the Administrative Procedure Act, the Paperwork Reduction Act of 1980, the Small Business Regulatory Enforcement Fairness Act of 1996 and the Regulatory Flexibility Act). While some costs of proposed rules can be estimated reliably, the benefits of regulation are often difficult to measure. Congress should not shackle the SEC with excessive cost-benefit analysis requirements.
- The right of shareholders to elect directors to represent them is a fundamental right of share ownership. That right is especially critical when there is a contest for board seats. Contested elections are pivotal events for companies and for shareholders, since board seats, and in some cases, board control, are at stake.
- In contested director elections, management and the dissident shareholder who is running competing candidates should provide shareholders with proxy cards that list all director nominees. Such “universal proxy” cards would guarantee that all shareholders are able to choose among all nominees to vote for the specific combination of nominees that they prefer, regardless of which slate they are on.
- But that is not what happens now in contested elections at U.S. companies. Shareholders can choose any combination of nominees only if they vote in person at the meeting. For many retail and institutional investors, however, attending shareholder meetings is prohibitively costly and time-consuming. The vast majority of shareholders vote by marking proxy cards. And shareholders voting by proxy when there is contest for board seats generally can only vote either management’s card or the dissident’s card. They cannot “split their ticket” and vote for some nominees from each side.
- Mandatory universal proxy cards for all contested elections would guarantee that shareholders are able to choose from among all board nominees, regardless of whether they vote in person or by proxy.
- Opponents of universal proxy cards contend their use would encourage more proxy contests or favor dissidents. But there is no compelling evidence for either assumption.
- The SEC’s universal proxy proposal does not eliminate the substantial cost and risk associated with waging a dissident campaign. Legal, administrative and solicitation expenses required for a dissident to wage a proxy contest can run to six or seven figures. Furthermore, the SEC proposal requires dissidents to solicit shareholders representing at least a majority of outstanding votes.
- A Harvard study found that universal proxy cards in general favor neither management nor dissidents. Perceptions vary about which side benefits more, and those perceptions depend on contest-specific circumstances. Companies and dissidents have been on both sides of this issue. Tessera Technologies sought universal cards in its 2013 contest with dissident Starboard Value, as did Shutterfly in its 2015 proxy fight with Marathon Partners, but the companies were rebuffed. When dissidents sought universal proxy cards at Target in 2009 (Pershing Square) and DuPont in 2015 (Trian Fund Management), the companies declined. Parties in contests rarely request universal proxy cards because they assume the other side will refuse. The only clear “winner” from universal proxy cards is the investor.
- Claims that universal proxy cards would empower special interests do not hold up, either. Ultimately, board seats would go to nominees who receive the most votes.
- Shareholder proposals are an essential tool for investors, individually and collectively, to express their views to management and boards on major governance and other issues.
- The vast majority of shareholder proposals are strictly advisory; even if they pass, companies can choose whether to act on them.
- Shareholder proposals have encouraged many companies to adopt enhanced governance policies that today are viewed widely as best practice. For example, electing directors by majority vote, a radical idea a decade ago when shareholders pressed for it in proposals, is now the norm at 90% of large-cap U.S. companies.
- The CHOICE Act would require a shareholder wishing to put a proposal on a company’s annual meeting ballot to own at least 1% of the stock for three years (the current threshold is $2,000 worth of stock for one year). That would raise the ownership threshold to file a shareholder proposal at Apple, for example, to $7.5 billion. At Wells Fargo, the threshold to file would be $2.6 billion. Even the largest pension funds would not be able to file shareholder proposals.
- Current SEC rules require a shareholder to refile a proposal only if it has received at least 3 percent of the vote on its first submission, 6 percent on the second and 10 percent on the third. The House bill would raise those thresholds to 6 percent, 15 percent and 30 percent, respectively.
- Those hurdles would also knock out many shareholder proposals. The percentage of proposals since 2000 that are estimated to fall below those thresholds are 13.32 percent, 31.5 percent, and 50.14 percent, respectively
- Critics contend that shareholder proposals are a growing burden on companies. But the number of shareholder proposals has not climbed significantly. In recent years, it has vacillated from a high of 1,126 in 2009 to a low of 691 in 2011.
- What has changed is that support for shareholder proposals has grown and represents a significant proportion of investors.
- In 2016, 61 percent of proposals that came to a vote received at least 25 percent support from shareholders, up from 31 percent in 2000 (source: ISS Voting Analytics).
- The proportion of proposals that win the support of a majority of shareholders has risen, too. In 2016, 21 percent of proposals received a majority of votes cast, up from 15 percent in 2000 (source: ISS Voting Analytics).
- The SEC oversees a robust appeals process that allows companies to exclude proposals from the proxy card that do not meet certain procedural and/or substantive hurdles. SEC staff has a well-earned reputation for deliberating fairly. In 2013-2015, companies challenged nearly one-third of shareholder proposals and about half were omitted from the proxy.
- Companies complain about the burden of costs “imposed” by shareholder proposals. But incurring those costs is largely their choice; it is the cost of trying to exclude the proposal from the proxy. The cost to put a proposal on the proxy ballot is de minimus.
- A periodic advisory vote on executive compensation (“say on pay”) is an essential tool for investors, individually and collectively, to express their views on a matter that goes to the heart of corporate governance and performance. It is important for boards and their compensation committees to frame pay decisions around long-term shareholder interest, and not simply respond in a vacuum to pay demands of senior managers.
- The 2010 Dodd-Frank Act requires public companies to offer shareholders say-on-pay votes annually, every other year or every three years. Most companies hold say-on-pay votes annually, which CII and most institutional investors prefer.
- But lthe Financial CHOICE Act includes a provision that would require public companies to hold advisory votes on executive compensation only when there is a “material change” to executive compensation.
- A 12-year global study found significant benefits from say on pay. Following adoption of say-on-pay laws in various markets, the link between CEO pay and firm performance increased, especially at companies with poor pay practices and weak governance. Say on pay also coincided with reduced disparity between CEO compensation and the pay of other top executives, a factor associated with higher firm valuation.
- Say-on-pay votes have been a catalyst for discussion between U.S. boards and shareholders, leading to greater investor understanding of company strategy and how pay incentives drive the strategy. Growing comfort in engaging on pay is leading to more discussion between companies and investors on a range of other issues.
- Since 2011, when say-on-pay became mandatory at U.S. public companies, boards have been eliminating club memberships, tax gross-ups and other executive perks. They have also strengthened links between executive compensation and corporate performance.
- Say-on-pay votes usually are not controversial, and shareholders generally have been deferential to board compensation committees, except where shareholders clearly see a problem. Each year since 2011, more than 97 percent of say-on-pay proposals win majority support of shareholders.
- Eliminating say-on-pay votes would prompt more investors to vote against corporate directors at companies with troublesome pay practices, because they would have no other mechanism by which to signal their disapproval.
- Proposed legislation would require proxy advisory firms to give companies advance copies of their recommendations and elements of their research and to resolve corporate complaints about errors prior to voting. It would also force proxy advisory firms to hire an ombudsman to address issues companies raise.
- The new regulatory scheme would pressure proxy advisors to accede to management’s recommendations to minimize delays and added costs, reducing the value of the research to investors. Moreover, the scheme might inhibit proxy advisors from even issuing research and recommendations where the subject company invokes the process and does not confirm its agreement with the resolution of issues raised.
- It would also narrow the already-limited window for investors to cast thousands of votes during the spring proxy season.
- It would create new barriers to entry, including yet-to-be determined registration qualification standards to be set by the SEC, in what has been a low-margin industry with few competitors, and potentially drive some proxy advisory firms out of business
- Solutions already exist to address significant errors in proxy advisors’ reports:
- Companies can quickly offer corrections to proxy advisor reports and communicate them to the marketplace via a regulatory filing in addition to the error correction processes undertaken by the proxy advisors themselves.
- Proxy advisors do revise reports to correct material errors as well as to include any new information that is material. Critically, we understand that the leading providers communicate that information to clients immediately in the form of an alert to subscribers.
- Market discipline is the ultimate backstop: advisory firms that make too many errors risk reputational damage and the loss of investor clients.
- The proposed regulatory scheme is based on the false premise that proxy advisory firms dictate proxy voting results. There is no compelling empirical evidence to support that assumption; moreover, academic literature suggests otherwise
- Many pension funds and other institutional investors buy and review proxy advisors’ research and recommendations, often buying research and recommendations from multiple providers, but vote according to their own guidelines.
- For example, in 2016, Institutional Shareholder Services (ISS), the largest proxy advisory firm, recommended against say-on-pay proposals at 12 percent of Russell 3000 companies. Yet just 1.7 percent of those proposals received less than majority support from shareholders.
- Similarly, while ISS opposed the election of 6.5 percent of director-nominees in the 2016 proxy season, just 0.2 percent failed to garner majority support.
VEA Vice Chair Nell Minow appeared on the Motley Fool Money podcast to discuss Donald Trump, financial “reform” and attempts to roll back investor protections, and the Oscars.
ValueEdge Advisors Vice Chair Nell Minow is quoted in this story about a possible proposed change to Dodd-Frank that would make it easier for companies to hide accounting problems from their investors, creditors, and suppliers.
The sweeping package to reform the Dodd-Frank bank reform law introduced in Congress has a provision that would curtail the reporting of accounting problems from about a third of issuers.
Rep. Jeb Hensarling, the Texas Republican who chairs the House Financial Services Committee, has suggested modifications to his legislation introduced last September, according to a memo leaked last week to journalists, that would uproot Dodd-Frank to raise the limit for companies to comply with the requirement for an outside auditor’s opinion on a company’s internal controls over financial reporting, or ICFR.
That requirement was originally mandated by Section 404(b) of the Sarbanes-Oxley Act of 2002. In the memo, referred to by several new outlets who obtained a copy as Choice 2.0, Hensarling doubles the permanent exemption threshold from the original bill of last September, to $500 million in market capitalization from $250 million. The current exemption is $75 million. In Hensarling’s legislation, the exemption was also extended to depository institutions with less than $1 billion in assets.
Nell Minow, a corporate governance expert and the vice chairwoman of ValueEdge Advisors, told MarketWatch, “This is an outrage. It isn’t just that investors and consumers will not have this information; the more significant problem is that knowing it will not be public, boards will think they do not have to investigate and make corrections.”
The Dodd-Frank exemption threshold of $75 million “is a perfectly acceptable number for establishing materiality,” said Minow. “Raising it allows companies to ignore significant problems until they become too big to fix.”
Corporations are happily preparing their wishlists for getting rid of consumer and employee protections under the new administration and the Republican-controlled Congress and Senate. Look for them to be disguised as “reform,” as pointed out in this piece from Adam J. Levitin in American Banker.
The financial services industry is pushing hard for Congress to change the single director Consumer Financial Protection Bureau into a multimember commission under the guise of “good government.” Let there be no mistake what this is really about: the proposal for a commission structure is a backdoor attack on the very existence of the CFPB as an agency.The financial services industry doesn’t have the courage to attack the CFPB, an immensely popular agency, directly. So instead, the strategy is to try to render it ineffective by changing it from a single-director structure to a five-member commission.
Donald Trump has tapped a longtime critic of heavy regulation to flesh out his new administration’s plans for remaking the financial rule book, including the potential dismantling of much of the Dodd-Frank financial overhaul.
U.S. House Republicans advanced legislation to undo Congress’s response to the 2008 financial crisis after Democrats forced quick action on the measure that they decried as toxic.Financial Services Committee Chairman Jeb Hensarling’s bill, which he said will spur economic growth and end bank bailouts, will move to the House floor after a 30-26 vote in an acrimonious committee markup on Tuesday. The Financial Choice Act is the Texas Republican’s plan for replacing the six-year-old Dodd-Frank Act.
“This bill is so bad that it simply cannot be fixed,” Representative Maxine Waters, the panel’s ranking Democrat, said in a statement before the vote. “It’s clear that this is a rushed, partisan messaging tool, though why anyone would want to push legislation to deregulate Wall Street at a time like this is beyond me.”Even with committee approval, the legislation isn’t expected to get a vote on the House floor. Many Republicans aren’t anxious to take a position that can be portrayed as giving support to the financial industry, especially in the weeks leading up to an election.
Scrapping Dodd-Frank may be even less popular after Wells Fargo & Co. set off a renewed backlash against banks in Washington when it agreed last week to pay $185 million in fines for allegedly opening deposit and credit-card accounts without customers’ approval.
By stripping people of any meaningful way to hold companies accountable for fraud or abuse, forced arbitration grants Wall Street an effective license to steal from consumers to pad its bottom line.
But the era of the “rip-off clause” may soon come to an end — at least in consumer finance. When Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, legislators specifically addressed the growing harm of forced arbitration. In addition to creating a new consumer watchdog in the Consumer Financial Protection Bureau (CFPB), Dodd-Frank tasked the agency with studying the impact of forced arbitration in the financial marketplace. If it found evidence of harm to consumers, the agency was specifically instructed to restrict or ban the practice.
Last year, the CFPB completed the most comprehensive study of arbitration ever done, and the data showed very clearly that forced arbitration favors companies and wipes out consumer claims. The agency then moved to fulfill its mandate by proposing a new federal rule to rein in this increasingly widespread practice. Americans for Financial Reform (AFR) and Public Citizen recently partnered to step up a joint campaign to take on forced arbitration, working with a broad coalition of organizations to build support for the CFPB’s rule-making by raising public awareness of rip-off clauses and the way they work across a range of industries, products and services. In just the last few months, public attention on forced arbitration has expanded rapidly.
A New York Times investigation last fall brought significant attention to veterans, students and consumers harmed by rip-off clauses. More recently, Roger Ailes’s move to push Gretchen Carlson’s allegations of sexual harassment into arbitration has reignited national interest in the inherent secrecy and injustice of forced arbitration.This week marked another milestone in this fight: an unprecedented level of public engagement on forced arbitration as the comment period for the CFPB rule came to a close on Monday.In a joint comment letter, 281 consumer, civil rights, labor and small business organizations registered strong support for the CFPB to move forward with its proposal. Led by AFR and Public Citizen, the letter was signed by national powerhouses advocating for consumer protections, civil rights, labor, women’s rights and small business, along with state and local groups from 42 states and the District of Columbia. Many of these organizations also submitted separate comment letters highlighting specific issues and perspectives.
A new report from the Roosevelt Institute shows that the hidden costs of our financial services imposed as much as $22.7 TRILLLION of unjustified costs on our economy between 1990-2023.
Gerald Epstein and Juan Antonio Montecino measured:
three components: (1) rents, or excess profits; (2) misallocation costs, or the price of diverting resources away from non-financial activities; and (3) crisis costs, meaning the cost of the 2008 financial crisis.
Even if you take out the costs of the 2008 financial meltdown, the numbers are staggering.
First, we estimate the rents obtained by the financial sector. Through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities, bankers receive excess pay and profits for the services they provide to customers. By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers. We estimate that the total cost of financial rents amounted to $3.6 trillion–$4.2 trillion between 1990 and 2005.
Second are misallocation costs. Speculative finance does not just grab a bigger slice of the pie; its structure and activities are often destructive, meaning it also shrinks the size of the economic pie by reducing growth. This is most obvious in the case of the financial crisis, but speculative finance harms the economy on a daily basis. It does this by growing too large, utilizing too many skilled and productive workers, imposing short-term orientations on
businesses, and starving some businesses and households of needed credit. We estimate that the cost of misallocating human and financial resources amounted to $2.6 trillion–$3.9 trillion between 1990 and 2005. Adding rent and misallocation costs, we show that, even without taking into account the financial crisis, the financial system cost between $6.3 trillion and $8.2 trillion more than the benefits it provided during the period 1990–2005.
We are long overdue for an Uber-like disruptive force, though the financial services industry will spend hundreds of millions of shareholder dollars to prevent it.
VEA Vice Chair Nell Minow interviewed Stephen Davis, Jon Lukomnik, and David Pitt-Watson on their new books, What They Do With Your Money: How the Financial System Fails Us and How to Fix It. Reminiscent of the 1940 classic Where Are the Customers’ Yachts?, this is a reasoned but devastating takedown of the skewing of the financial services industry to divert customers’ money for valueless layers of “experts” and “compliance.”
What They Do With Your Money is a thoughtful, meticulously documented, and downright infuriating indictment of the American financial services industry, which not only takes much more in fees from investors than their counterparts in other countries but hides those fees so that people who are relying on employer-sponsored pension funds, 401(k)s, and other investments cannot tell how much of their money is being siphoned off. The subtitle of the book is How the Financial System Fails Us and How to Fix It, and it ends on a hopeful note.
In an interview, authors Stephen Davis, Jon Lukomnik, and David Pitt-Watson explained the 16 layers and 100 different fees that erode the pensions of American workers and the changes in social media and technology that could reroute those returns back to employees and investors.
Why do you say that worker savings have become a “virtual ATM for the financial industry?”
Understandably, we have allowed experts to manage our nest eggs—but the number of agents between us and our investments has grown exponentially and each takes a fee or extracts a cost. Yes, there are money management fees which most of us see, but also marketing fees (12B-1 fees), custodial fees, transfer agent fees, sub-transfer agent fees, custodial fees, sub-custodial fees, audit fees, mutual fund board fees, valuation agent fees, proxy advisory fees, trading costs, broker fees, administration fees… the list goes on and on. It sometimes takes as many as 16 different agents—each extracting fees or adding costs—to shepherd our money from an account to an investment. And while some of those fees are disclosed, many are not, so that the average investor really doesn’t appreciate how much the financial industry siphons. Stealth costs can climb enough to knock 50% off the total that a typical worker would have on retirement without those fees and costs.
We have seen a series of post-crash and post-scandal reform efforts over the past 30 years — what has been effective and what has failed?
The Enron scandal begat the Sarbanes-Oxley Act, and the financial crisis begat the Dodd-Frank Act. In each case reforms from Washington added some constructive safeguards. But they have amounted to Band-Aids rather than comprehensive treatment for market ills. Experts disagree about whether the benefits have been worth the cost when companies have to comply with thousands of pages of new regulations. But one thing is certain: When it comes to fixes, policymakers have had a blind spot about financial agents. The biggest hidden failure in today’s financial system is that there is almost no effective oversight of our financial agents. The main law addressing the issue (the Employee Retirement Income Security Act, or ERISA) is 42 years old; it was written for retirement conditions that no longer exist. For instance, we have far fewer workers compared to retirees; people live a lot longer, so they need more money to draw on; and traditional pension plans have given way to 401(k)-style plans with far more risk and higher fees.
Gridlock in Washington has put a brake on efforts to update law and regulation. Recently the US Department of Labor required investment advisors to put client interests ahead of other commercial interests – and the industry is suing to block that rule, and the Congress is trying to overturn it, largely on partisan grounds. That’s a shame, because if the partisan gridlock would loosen enough for a rational discussion, much could be accomplished. For example, a reform package could oblige retirement plans to disclose the equivalent of a nutrition statement, so that consumers can learn in plain language whether their agents are configured to act in their best interests, how many agents there are, how they get paid and how much that reduces potential earnings. Legislation could require retirement savings plans to feature skilled, independent boards that police fees, conflicts of interest, and policies of investment funds. Finally, laws could mandate that financial agents abide by fiduciary duties that put the client first.
The interesting thing about that package of reforms is that they are systemic; designed to allow the market to work by adding information, expertise and clear accountability. They are not the type of “do this, don’t do that” regulations to which the industry objects and, which, we contend, have unintended consequences and don’t work that well in the first place. Consider this: There are now about 100,000 more compliance officers in finance than there were before the financial crisis. They monitor a virtual Hammurabi’s code of very specific compliance-type regulation. But few think that the financial sector works better because of this. But if we made the process transparent, made accountability explicit, made fiduciary obligation extend throughout the chain of intermediaries, we could lighten up on the amount of spot regulation.
How has the shift from defined benefit pension plans to defined contribution plans affected retirement benefits? How has it affected shareholder oversight of corporate direction? The overall economy?
Defined contribution plans were conceived as a supplement to pension plans, not a substitute for them. As the principal vehicle for retirement savings, they fall well short of needs. Fees are higher, and returns are lower, than traditional defined benefit or hybrid collective savings plans. Savers shoulder excessive risk, and even those who are supposedly sophisticated are shown to make poor choices. No wonder that the US faces a worsening savings crisis, with the typical American nearing retirement with inadequate income to meet basic living expenses.
But it is even worse than that. The shift to 401(k)s has ballooned the power of mutual funds, and the business model of mutual funds is trading-oriented rather than long-term investment oriented. Studies show they too often act short term – in general they turn over their portfolios every year — which in turn compels companies to act short term to match their investors’ time frame. While some fund families, such as Blackrock, Vanguard, State Street and TIAA, have grown more responsible as owners of shares, some have not. To take one case, in 2012 a large mutual fund spent an estimated $138 million promoting its brand as a champion of clients, but at the same time employed a single person to actually do that advocacy, by managing voting shares at more than 10,000 portfolio companies worldwide. If holders of vast blocks of US stock act in our name in this way, it short-circuits the genius of free enterprise—that owners watch the store. The result is an underpowered type of capitalism in which managers, not owners, make fundamental strategic business decisions.
A number of politicians have recommended a legal standard for boards and executives that is measured by stakeholder benefits. What would that change?
We think this is a distraction. In the real world, managing a company means balancing the demands/risks/opportunities of innumerable groups and time frames. But our legal system makes some of those risks more equal than others. So, for example, financials are audited and filed with the SEC, but companies feel free to omit or segregate into a separate statement the ways in which they address so-called environmental, social and governance, or ESG, factors, when, in today’s world, these are fundamental risks and opportunities. Even when there is SEC guidance requiring disclosure of these risks, as there is on climate change, it is honored in the breech, with boilerplate, non-differentiated disclosure. And the SEC has sat by silently while its own guidance is ignored.
So, the first step is for the SEC to start enforcing its own guidance. The second and more important step is for boards, managements, regulators and investors to stop seeing ESG issues as somehow different from other risks and opportunities companies face. Human capital management, climate change, supply chain management, and a host of other ESG issues are now known to have financial consequences. Why would an investor voluntarily assume the risk of ignoring them? Why would a company take on unnecessary risk by omitting them from strategic calculations? Standards should clarify that factors relevant to value, whether conventionally measured or not, should be integrated into statements to allow investors and others to get a more accurate profile of a company. Disclosure of relevant risks is the law. Making it clear that disclosure applies to both short- and long-term risks and opportunities would help investors more accurately assess the danger to, and potential of, portfolio companies.
How many intermediaries are there between an employee and the stock he or she owns in a retirement plan?
As noted above, one study counted 16. That may be low. The Transparency Task Force in the UK has detailed more than 100 fees. While the regulatory regime in the UK and the US are different, we would not be surprised to see such a list here.
What do you think of binding arbitration agreements in contracts between investors and money managers?
Arbitration, like a court proceeding, has its advantages and disadvantages. The great advantage of arbitration is that is flexible, and the parties can agree to the procedure and the arbitrators, customizing the process and tribunal to their specific needs. But that means there needs to be equal knowledge and power in deciding on where, how, and before whom to arbitrate between the parties signing the contract. That may the case for large investing institutions, but it is virtually never the case for consumer investors. Therefore, we believe the courts are better served to protect investor interests. Granted, the sophisticated and monied will always have an advantage, however a court’s procedures and a judge’s discretion can lessen those advantages.
To deny retail or unsophisticated investors a court hearing based upon a fine print paragraph buried in the back of a multi-page legal document we believe is wrong.
The business community is currently suing to stop a new rule that would require them to put the interests of their customers ahead of their own. Why does that matter?
Investment advisors should put the interests of client investors ahead of their firm’s commercial interests. That way individuals seeking investment help can know if the advice they get is truly going to be best for them, or if it is being offered because a broker is being paid on the side. Financial service companies are fighting the measure through Congressional allies and court action, using the argument that the action would curb financial advice. In fact, the new fiduciary duty standard could curb excessive fees going from individuals to those financial companies. And while it might end some types of advice, the chances are that type of advice isn’t very good for the investors, since it’s being influenced by the promoters of a financial product.
Large institutional investors – the CalPERS and Harvard endowments of the world – usually mandate by contract that their advisors are fiduciaries, which is the legal way of saying that their advisors must put their interests first. Individuals don’t have the power to do so. They can fend for themselves and get that contract language. This battle is about some parts of the financial community trying to deny fiduciary protection to small investors who generally do not have the leverage to get fiduciary obligation put into a contract.
Even from the industry point of view, we find the industry’s position on this short-sighted. At a time when the financial system is under attack, we need to build up trust. Opposing the fiduciary rule does the opposite. Instead, the industry ought to be proposing a grand bargain: Embrace fiduciary obligation and real transparency so that the market can work the way it’s supposed to. In return, let’s simplify the exponential amount of “spot” regulation that has created 100,000 new compliance officers since the global finance crisis, and which many think does not work as well as it should.
But the industry today seems to be opposing systemic fixes. Cynics would say that Wall Street has figured out how to pass on the cost of those compliance officers, and has identified the loopholes in the myriad of spot regulations that have been passed. We prefer to think that the industry – our industry – is being short-sighted and will come around to embracing a systemic fix in time.
Why do Americans pay so much more in fees for managing their retirement money than people in other countries like the Netherlands?
The US in the past three decades has migrated away from collective pension savings to individual accounts in which citizens, if they are lucky enough to have a plan at all, shoulder nearly all risks when they save for retirement. In effect, we are sold financial products, instead of buying retirement plans. Studies show that the 401(k)-style system comes at a high cost compared to the type of collective plans available in the Netherlands. Plus, thanks to better governance of savings arrangements there, plans feature fewer intermediaries between the saver and the investment and fewer distortions caused by conflicts of interest.
One other thing that generally flies under the radar. After you retire, the Dutch system features simple, low-cost annuities, compared to the type of very complicated, high-cost annuities you can buy here. So, while a typical retiree in the Netherlands will retire with 50% more in assets than will a similarly-situated retiree here, if the Dutch and the American buy annuities to provide income in retirement, the Dutch retiree will be able to live on 79% more than the American retiree.
You have some intriguing ideas about the use of social media and technology to provide more transparency and oversight for investors. What do you think is most promising?
Take the example of Buycott, a free app launched in 2013, which aims to help consumers align their values with their purchasing. The first question it asks is: “Have you ever wondered whether the money you spend ends up funding causes you oppose?” You can scan a product at a store to see if the company that produced it is involved in any ethical campaign you support.
Now, let’s imagine a smartphone tool that asks a parallel question: “Have you ever wondered whether the money you save ends up funding causes you oppose?” It could compare pension or 401(k) plans, providing you with a picture of how accountable each is, how fees compare, and how well or poorly they align with what you believe. That’s a gap just waiting to be filled.
FinTech approaches hold other promise. Today, those with a 401(k) plan can easily summon an online page filled with latest data on holdings, transactions, and stock prices. But what’s conspicuously missing are real-time updates on how funds you own have voted in your name at portfolio companies on key issues such as CEO pay, or engaged in your name with boards on climate change. Funds don’t offer a ready description of how they are governed, or precisely how much in fees is subtracted. It isn’t technically difficult to do. They just need pressure from their savers to do it.
In many ways, San Francisco is attacking New York, by which we mean that technology firms are trying to disrupt the financial system. There are payment systems – think PayPal and Apple pay – and there is now retirement advice from the so-called “robo-advisors”. They have reduced the cost of portfolio construction advice materially, sometimes to zero. So, technology has the potential to reduce costs and improve services. On the other hand, the history of technology in finance is that it either gets regulated, co-opted or bought by the existing financial services firms. But perhaps this time is different. We don’t know. It should be fascinating to watch it play out.