In “SEC Smackdown” [WealthWise, May 2007], I wrote about a federal appeal court’s rejection of an SEC policy known as the “Merrill-Lynch Rule,” which allowed the large brokerage firms to pass their salespeople off as “investment advisers” without imposing the legal requirement to act as fiduciaries toward their clients. The issue is back in the public eye again. Earlier this year, the Obama Administration announced it wants all who provide investment advice to be regulated by a single regulator. Would that single regulator apply a fiduciary standard?
What exactly is a “fiduciary standard” and why does it matter to investors? A fiduciary obligation exists when a client places trust, confidence and reliance on the adviser to exercise his or her discretion and expertise in acting for the client. Some hallmarks of a fiduciary standard are:
• A fiduciary may not act in any manner adverse or contrary to the interests of the client, or act for his or her own benefit in relation to the subject matter.
• The client is entitled to the best efforts of the fiduciary on his or her behalf and the fiduciary must exercise all of the skill, care and diligence at his or her disposal when acting on behalf of the client.
• A person acting in a fiduciary capacity is held to a high standard of honesty and full disclosure toward the client and must not obtain a personal benefit at the expense of the client.
Traditionally, broker/dealers and their representatives, commonly called “reps,” have been held to a much more lax standard known as the “suitability” standard, under which a rep and his or her firm can only be disciplined for placing a client in an inappropriate or unsuitable investment. Here’s an example of how a suitability standard differs from a fiduciary one.
Under a suitability standard, reps, even those who call themselves “advisers” or “consultants” can, without fear of discipline, recommend that a client purchase a mutual fund for which the rep gets credit toward the rep’s compensation even when the performance of that fund is clearly inferior to other similar funds for which the rep gets no credit. A fiduciary standard would require full disclosure of the additional compensation (or health insurance, or special vacations) reps will receive if they meet sales goals for financial products offered by certain favored promoters, including the rep’s boss.
A universal standard of care?
Last March, the trade group known as the Securities Industry and Financial Markets Association (SIFMA), representing the large broker/dealers, testified before Congress on the need for broker-dealers and investment advisers to be held to a “universal standard of care,” saying this would enhance investor protection and reduce “inefficiencies.” SIFMA spokesman Tim Ryan complained the term “fiduciary” had “different definitions and prohibitions under different federal laws, and at the state level, as well,” and referred to the concept of fiduciary as part of an “obsolete regulatory scheme.”
Obviously, SIFMA wanted to avoid hindering the sales efforts of broker/dealer reps by having to meet the disclosure requirements of the fiduciary standard. As expected, the Financial Planning Association, the plaintiff that successfully challenged the SEC’s Merrill-Lynch Rule, urged the opposite: All who give investment advice should be held to a real fiduciary standard. State regulators echoed the call.
Personally, I’ve never had any difficulty understanding what being a fiduciary requires of me, whether I’m serving as an investment adviser regulated under the federal Investment Adviser Act of 1940, or as a practicing attorney and member of the State Bar. The law requires me to act with the utmost good faith in the best interest of my clients.
The problem for SIFMA’s members is that imposing these expectations on its member broker/dealers and their reps will change dramatically the way they do business—and, in particular, how they get paid.
A change of heart?
In July, SIFMA issued a press release announcing that its Private Client Group Steering Committee unanimously supported a new federal fiduciary standard applicable to broker/dealers and investment advisers. FPA’s president immediately lauded SIFMA for taking an important first step by the broader financial services industry to adapt its old business model to new realities. At least SIFMA is now able to use the word “fiduciary” without choking, an important first step, indeed.
Despite SIFMA’s apparent change of heart, there remain significant efforts to water down a “universal” fiduciary standard. For example, the House Financial Services Committee is considering language that would require broker reps to comport with a fiduciary standard only “when providing personalized investment advice,” raising the specter of “hat-switching,” for example, “Now I’m no longer providing personalized advice, so I can sell you products covered only by the suitability standard.” Also, as it’s now written, language in the legislation that calls for standards “at least as high” as those found in the Investment Adviser Act of 1940 appears only in the parts of the legislation relating to those advisers, implying that the standards applicable to broker/dealers and their reps can be lower.
Another more serious threat to a real fiduciary standard in the pending legislation now before the House Committee is a de facto transfer of regulatory authority to FINRA, the “self-regulatory organization” of broker/dealers. FINRA’s members have historically opposed applying a fiduciary standard to their reps. Should an organization of firms for whom a fiduciary standard has been anathema and to whose business model that standard poses a severe threat now get to make the rules for investment advisers? Putting the FINRA fox in charge of the henhouse would be a dramatic setback for consumer protection.
The jury is still out on whether current efforts to “reform” the financial services industry will be a step forward or backward for investors.
