On Advice

Are brokers really ready to be fiduciaries?

There are plenty of legal risks and compliance pitfalls facing the securities industry following June 9, the official start date for the DOL fiduciary rule

Jun 1, 2017 @ 11:20 am

By Bruce Kelly

The Department of Labor's fiduciary rule for retirement accounts will take effect Friday, and advisers and their broker-dealers better get ready for a new wave of risk: lawsuits and legal complaints by investors who believe they have been harmed by an adviser's recommendations or choice of investment.

The Big Daddy of liability facing firms, the best-interest contract exemption, does not kick in until Jan.1. The BICE is a provision of the fiduciary rule that will give investors the right to bring class-action litigation against financial firms.

Brokerage firms are extremely fearful about potential litigation and the cost of lawsuits brought due to the BICE. Some have gone as far as eliminating sales of products that charge a commission to clients with retirement accounts in order to remove any whiff of conflict of interest.

But there are still plenty of less pronounced legal risks and compliance pitfalls facing the securities industry between Friday's official start date for the DOL fiduciary rule, and January, industry observers said.

A firm's business risk is, at the moment, greatly reduced because the BICE has yet to take hold, said John Rooney, managing principal with Commonwealth Financial Network.

That doesn't mean, however, the door is completely shut to its legal responsibilities under the new rule, Mr. Rooney said.

"The adviser needs to meet the terms of the rule's impartial conduct standard at the very least. If the adviser is not charging reasonable compensation or not making recommendations that are in the client's best interest, the broker-dealer is opening itself up to liability."

To bring readers up to speed, the DOL's impartial conduct standards "are formal obligations to serve clients' best interests, to charge only reasonable compensation and to avoid misleading statements," according to InvestmentNews' blog, Fiduciary Corner, by Blaine Aikin. "These standards should be reflected in each advisory firm's compliance manual."

This concept sounds simple, but is antithetical to the way many advisers, mostly brokers who consider themselves salesman, have been doing business for years, if not decades. Can a salesman, who lives for commissions, become a fiduciary overnight, as the calendar inevitably flips from June 8 to June 9? The answer is no.

At bottom-tier firms, compliance manuals are created so they can be handed to regulators when they visit the office; they are not intended to be read.

Broker-dealers like Commonwealth Financial for decades have been evolving into businesses that operate as fiduciaries. In the run-up to the credit crisis of 2007 and 2008, Commonwealth's advisers did not sell billions of dollars of fraudulent private placements that other IBDs sold, which turned out to be Ponzi schemes, irreparably harming clients and causing many of those firms to fold due to crushing legal costs.

Unlike many IBDs, Commonwealth invests in its own internal team to perform due diligence on nontraded real estate investment trusts and other high-risk products. Some other firms farm out the diligence on illiquid products and rely on due diligence reports paid for by the product's own sponsor, a clear conflict of interest that will only draw more attention from the regulators under the new fiduciary rule.

After Friday, "broker-dealers have to demonstrate best interests, or why they chose the funds," said Denise Valentine, a senior analyst at Aite Group. "They have to show care and prudence and why they matched the investor to those funds. They have to show reasonable compensation and that they have made no misleading statements."

Andrew Stoltmann, a plaintiff's attorney and president-elect of the Public Investors Arbitration Bar Association, said the biggest legal target on the backs of all brokerage firms after this week will be IRA rollovers.

"Historically, that has been the biggest saliva-inducing asset that financial advisers want to get their hands on," he said. "That's where probably 85% of the financial chicanery and breaches of a fiduciary duty would take place."

When rollovers occur, unscrupulous brokers have jammed investors into proprietary house funds or high-fee and commission products such as variable annuities and nontraded real estate investment trusts, Mr. Stoltmann said. "That has created most of the problems for investors after the credit crisis and the Great Recession."

The new fiduciary rule clearly benefits investors, he said. "The brokerage industry would vehemently deny this, but there is no question that long term, we will see less litigation and arbitration claims because of the fiduciary rule. It will force firms to clean up toxic practices that have gotten them into so much trouble in the past 30 years."

The securities industry is littered with firms housing advisers who do not operate in their clients' best interests, as Mr. Stoltmann points out. It is preposterous to think that those advisers will become fiduciaries overnight.


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