Establishing a fiduciary duty for broker-dealers that offer investment advice and harmonizing the regulation of investment advisers and broker-dealers is now a goal of the Obama administration.
To reach that goal, promulgated in the proposed Investor Protection Act of 2009, the Securities and Exchange Commission would be given new tools “to increase fairness for investors,” as the administration explained in its white paper, “A New Foundation: Rebuilding Financial Supervision and Regulation.”
The SEC will face a challenge. The terms “fiduciary duty” and “fiduciary standard” aren't universally understood or agreed upon, even among those involved in shaping the new scope of financial regulation.
In my experience, fiduciary duties and standards can cover a wide range of expectations and behaviors. In fact, in some cases, consumers may be best off not being covered by a fiduciary standard.
I will explain that in a moment, but first let me detail what a fiduciary standard really means and clarify for those governed by regulation the exact level of responsibility that will be expected.
Simply replacing the existing broker suitability standard with a generic fiduciary standard, as set forth by the SEC for registered investment advisers, does little to introduce the type of reform needed to truly inform consumers of what behavior should be expected from their investment service providers.
High-level fee-only professional financial advisers know that the words “fiduciary” and “sales” should never be used in the same sentence. A fiduciary should never “sell” anything to a customer; he or she may only make purchases for the portfolio, standing in the client's place.
In essence, the fiduciary is the purchaser of investments and should not be the product provider. This concept must be understood by anyone attempting to establish fiduciary standards in the investment realm.
In my experience as a bank fiduciary risk manager, I observed that the level of fiduciary obligation ascribed to an RIA under SEC regulations isn't quite as stringent as the obligations of a bank acting in a fiduciary capacity as either trustee or investment agent when investing a trust's or client's assets.
The bank trust regulations rely heavily on trust common law where the Duty of Loyalty is paramount and requires the fiduciary to act “solely in the interests” of the client, and not merely in the “client's best interests.”
In other words, the trustee's fiduciary standard requires that when investing client assets, the trustee must consider only the interests of the client(s) and not those of the trustee, its affiliates, its employees or any third parties, even if their own interests align with the client's.
A specific example of the differences in the level of “fiduciariness” (if we can coin such a word) under bank regulations versus SEC regulations for RIAs is demonstrated by the degree of disclosure required of each for conflicts of interest.
For example, a corporate trustee can't use the services of an affiliated broker without client consent or statutory exemption by the governing state. An RIA simply needs to make disclosure in its Form ADV and isn't required by the SEC to obtain positive client consent to relieve many acts of self-dealing.
The use of an affiliated broker is a common double dip in the RIA world for larger advisers and is permissible under SEC rules. Thus the adviser's broker affiliate can earn commissions on the very trades initiated by the adviser, who also earns a portfolio management fee.
Such a double dip could induce the adviser to trade more frequently for the benefit of the firm, especially where the adviser is dual-hatted and also acts as the broker. Even if the RIA takes steps to prohibit the employee from receiving commissions on these trades, the firm or its affiliate obtains a benefit and is engaged in self-dealing. (More stringent rules often apply when the adviser is managing mutual funds and assets of a retirement plan governed by the Employee Retirement Income Security Act of 1974 than if he or she were managing individual client portfolios.)
Conflicts of interest or self-dealing by a trustee can be mitigated only by statute, or by express client consent, after all relevant facts are disclosed. Some conflicts are never acceptable.
The SEC should raise its RIA standard to a true fiduciary standard and prohibit use of affiliated brokers or at the very least, require the transactions to be done with no profit to the affiliate. It should also require express client consent for all acts of self-dealing, and not simply disclosure in Form ADV.
Finally, it should prohibit certain acts of self-dealing that are already prohibited in the trust world, such as buying or selling an asset to/from a client portfolio, borrowing from a client's portfolio, and other egregious behavior. These are the type of true fiduciary standards that RIAs should follow, and the SEC should up its game on this point.
A broker can't comply with this high fiduciary standard while simultaneously providing any type of investment advice that leads to income derived from those very recommendations. That model is the very antithesis of acting solely in the interests of another.
I would suggest that any policy body reviewing the suitability and fiduciary standards consult with the experienced personnel in the asset management group of the Office of the Comptroller of the Currency, the trust unit of the Office of Thrift Supervision and the trust exam specialists at the Federal Deposit Insurance Corp.
“Harmonizing” the broker world with the adviser world would have to result in a restructuring of the models because a true, high fiduciary standard is at odds with the adviser regulations, as well as the broker model. Perhaps consumers will be best served if investment professionals were in one of three camps.
The first group would be advisers who are held to the highest fiduciary standards such as those of a trustee, not merely the SEC fiduciary standard of “best interests,” but one in which the adviser solely represents the interests of the client as discussed above. Positive client consent would be required (absent statutory authority) for all self-dealing.
The second camp would be brokers who sell products, clearly disclosing to the consumer that they aren't fiduciaries and don't represent solely client interests, and that they get paid based on commissions from products or securities sold. This is somewhat equivalent to insurance agents who represent their firms, make commissions and don't have a fiduciary obligation to customers.
The third camp would be the broker order-taker who isn't authorized to give any advice, isn't permitted to push products and is relieved of any duty to establish suitability. This level of broker is paid a salary by his or her firm and not a commission, and has no obligations to the consumer other than to follow their instructions for trade execution in a prompt and fair manner.
Online brokerages generally fall into this category. Such a category of investment service would actually provide regulatory relief to those discount brokers who don't sell any product, yet are expected to gather asset and income information from consumers in order to ascertain whether the individual is qualified to buy certain types of assets (options, futures, etc.).
If the service provider isn't permitted to present or sell products to sway the consumer, why should we care what the consumer decides to buy?
In a free society, the consumer should have the ability to choose how to spend his or her money. We ask more invasive questions and require more financial information from a person who opens a $5,000 brokerage account than we do from someone who spends $40,000 to buy a car.
Consumers who simply want trade execution should be able to hire a broker to execute those trades without the broker being required to delve into their personal finances.
This may at first appear contrary to the administration's push for more consumer protection, but in the absence of sale motivations there is less need for expensive -regulatory requirements that burden firms and deny choice to consumers.
Implementing distinctions be-tween types of investment professions won't work without regulations governing the nomenclatures used by firms and their employees, along with public education about the differences. Nomenclatures have long contributed to consumer confusion.
I suspect that the majority of those on Capitol Hill can't ex-plain the difference between a broker and an adviser.
In fact, if one looks at a broker's business card, he or she is likely to be referred to as any one of a number of titles that may include the word “adviser” in them — investment adviser, client adviser, portfolio adviser — while there is nothing that reveals whether the investment professional is an SEC-registered adviser, a state-registered adviser, a broker or a crook who doesn't bother to register at all.
None of these descriptions are consistently used to tell a consumer how the investment professional is compensated nor what the consumer can expect with respect to the level of the investment professional's fiduciary duty.
We must alleviate this confusion for consumers by eliminating references to commissioned brokers as “advisers” or “financial planners” or other terms leading a consumer to think that the service provider has some duty to act only in their interests. The terminology used to refer to a professional can conjure up different expectations among different people, which is why a simple explanation of how the professional is paid, along with discontinuing titles that imply a fiduciary standard where none exists, is so crucial to avoiding misperceptions.
Public education is essential. The consumer must be told how the service provider is paid so he or she can understand the service pro-vider's motivations.
Just as consumers generally know that an optometrist provides eyeglasses but doesn't perform eye surgery, which is the specialty of the ophthalmologist, consumers can be educated over time on the differences among investment professionals.
I advocate requiring that at the time a brokerage account is opened or an investment adviser is engaged, and annually thereafter, the customer be provided with a clear, short disclosure that explains how the professional and his or her firm is paid — whether by upfront or trailing commissions, fees for assets under management, product placement fees, etc.
The practice of burying language in a Form ADV or a multipage disclosure doesn't suffice. A better approach is a simple plain-English sentence or two in bold-face, 12-point type that says something like: “Your broker is paid based on commissions charged for each transaction in your account.”
Financial planners also deserve attention, as financial planning is unregulated and the Washington-based Certified Financial Planner Board of Standards Inc. has no sanctioning authority. The fiduciary standard outlined by the CFP Board, just like the RIA fiduciary standard, also lacks a stipulation that clients must consent to self-dealing and conflicts of interest.
It does takes a big step by requiring disclosure about compensation and conflicts, but the resulting forms are wordy and unlikely to be read by most consumers.
Although many planners also are registered advisers, brokers or insurance agents, and thus theoretically under the supervision of some regulator, anyone can call himself a financial planner. Financial planning is a different service than that provided by advisers and brokers, which means that more rigor is needed in designing qualifications that a person presenting himself or herself as a planner must possess.
Planners also should be held to a higher fiduciary standard than advisers. No compensation from products should be permitted.
The bottom line is that a true fiduciary standard isn't required of RIAs. In addition, it isn't feasible, and in fact contradictory, to hold a securities broker to such a standard.
Those calling for such a standard, whether the SEC, individual commissioners or the administration, need to first understand what that term entails and then define and use terminology that matches the new expectations proposed for brokers. Consumers deserve to know what is meant by a fiduciary standard and the differences be-tween service providers.
Janice J. Sackley, a bank fiduciary risk manager and consultant, is a member of the Stockbridge, Ga.-based Fiduciary and Investment Risk Managers Association. She is based in Kalamazoo, Mich., and can be reached at email@example.com.