Sparks fly over ‘hat-switching’ provision

As if the debate over fiduciary standards wasn’t heated enough, a one-sentence provision buried in the sweeping financial services reform legislation passed by the House this month has once again pitted investment adviser groups against brokerage groups.

The legislation, if enacted, would require the Securities and Exchange Commission to write rules establishing a fiduciary duty for brokers providing investment advice that would be in line with the standard governing advisers. The provision, however, adds a qualifier — brokers would be held to a fiduciary standard when offering advice, but they could carry out that advice under the lower suitability standard. That standard allows brokers to sell products from their inventory, among other things.

The so-called hat-switching provision — dubbed the “Schwab amendment” because it’s intended to protect discount brokerages from liability — is supported by brokerage groups, which argue it’s needed to accommodate customers who need advice only for specific transactions.

Advisory and consumer groups, however, claim the bill essentially renders the fiduciary requirement useless. For them, the provision is leading to new worries that fiduciary standards for advisers will be weakened in a final financial services reform package.

“We’re definitely concerned that [the provision] could fall short of a single standard for brokers and advisers that meets the current [Investment Advisers Act of 1940] standard,” said Dan Barry, director of government affairs for the Financial Planning Association.

Advisers groups want all brokers and advisers to be governed by the “40 Act, which requires that they put the client’s interests before their own.

“The language is over-broad and certainly leaves the door open to a hat-switching kind of scenario,” said Marilyn Mohrman-Gillis, managing director of public policy at the Certified Financial Planner Board of Standards Inc.

She argued that once a fiduciary relationship is established, it should not be breached. “Once you have a fiduciary relationship with the client, you are a fiduciary. The duties for that client remain duties.”

Nancy Hradsky, special-projects manager for the National Association of Personal Financial Advisors, which opposes the provision, argued that the provision is unnecessary to protect discount brokerages, because their clients generally understand that an adviser is working with them only on a particular sale. “When you’re giving very short-term advice and there isn’t the expectation to follow the fiduciary relationship, that’s OK,” she said.

But for brokers who work with clients on a continuing basis, the distinction is going to get “fuzzy,” Ms. Hradsky said.

If consumers continue to call brokers asking for advice, it may not be clear to them whether the broker is acting in their best interests as a fiduciary or acting as a salesman, she said.

The hat-switching provision should not be necessary, said David Tittsworth, executive director and executive vice president of the Investment Adviser Association, which represents advisory firms regulated by the Securities and Exchange Commission. “Not all advisory relationships contemplate continuous and ongoing advice.”

Discount-brokerage giant Charles Schwab & Co. Inc., however, argues that the provision is needed.

“Many investors look to companies like ours for validation at the moment of transaction, and under the legislation, investors will be assured that these initial investment recommendations must be made in their best interests,” Schwab spokeswoman Alison Wertheim wrote in an e-mail.

“However, after the advice interaction, many investors neither want nor need — nor care to pay for — the ongoing service that [registered investment advisers] provide,” she wrote. “The provision is an important addition to preserve investor choice — whether to purchase full fiduciary and discretionary investment services, which tend to be more expensive, or to maintain a non-discretionary account at a brokerage firm which might provide occasional advice for a reasonable commission.”

The language is meant to address “a standard that is dependent upon the nature of the relationship,” Securities Industry and Financial Markets Association spokesman Andrew DeSouza wrote in an e-mail. The language is necessary to “recognize the different types of relationships, based on [the] business model, financial professionals have with their clients.”

Industry and consumer lobbyists are now focusing their attention on the Senate, which has begun considering draft legislation introduced last month by Banking Committee Chairman Christopher Dodd, D-Conn.

The Senate draft would require all brokers giving advice to register as investment advisers, an approach that is favored by advisory and consumer groups, and opposed by brokers and insurers. Advisers are concerned that broker groups may be able to persuade some members of the Banking Committee to include the so-called Schwab amendment.

The issue of whether brokers should be obliged to fulfill fiduciary duties to clients if they give transactional advice is likely to be addressed in the Senate bill, said Barbara Roper, director of consumer affairs for the Consumer Federation of America.

“I would certainly hope that it’s not the same language,” she said. “It should be narrowly written so that it only deals with that issue and doesn’t open the door to a situation where a broker could claim that they’re a fiduciary only when they do investment planning, for example, and not when they sell the products to implement the plan.”

But broker and insurance groups are pushing for legislation more like the House bill, including the Schwab amendment. Key members of the Senate Banking Committee have split into bipartisan pairs to thrash out a compromise on their legislation, which is expected to be acted on by the Senate early next year.

That could make it easier for brokers and insurers to move the Senate in their direction, since Republicans are likely to favor ways to allow the brokerage industry to conduct business in the usual way.

The Schwab provision would not result in switching hats, argued David Leifer, associate general counsel of the American Council of Life Insurers. Under an approach similar to the House legislation, “consumers would be assured that whoever they were dealing with owed them the same standard of conduct,” he said. “We would be looking for the same thing in the Senate.”

E-mail Sara Hansard at [email protected].