SEC's Broker-RIA Fiduciary Comment Deadline Near: OPINION Column

By Kate McBride

August 27, 2010 at 08:00 PM

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The public comment period for the SEC's study of whether brokers should have to put investors' interests first will end August 30. As the SEC continues a six-month study of extending the fiduciary standard to broker-dealer (BD) reps who provide advice to individual investors, it has pledged a transparent process and requested comments from the public. This is commendable.

Comments are pouring in; through August 22, there have been 1538 comments posted on the SEC's Web site. To add yours, here is the comment link.

The Level of Knowledge Is Not Equal

Fiduciary duty to clients is a critically important issue because as the investment world has become more complex, individual investors do not–and cannot ever reasonably be expected to–have the same level of knowledge of complex financial issues that their advisor has.

Would a doctor's recommendation fall into a "buyer beware" category? Of course not! And, no lay person could reasonably be expected to prescribe medicine for or conduct surgery on himself or herself–it would be ridiculous–and dangerous. We rely on the fiduciary duty of a doctor, lawyer or accountant because these are professions that require a high level of specialized knowledge, just as financial services does. We entrust these professionals with our wellbeing and they must to put our interests first.

This uneven level of knowledge is the reason that individual investors must be able to trust that their advisor is a fiduciary, with the individual's best interest as their legal duty. It is the same as if one was a guardian, entrusted with the wellbeing of a minor child, or an elderly person deemed no longer able to make an informed decision. The individual (with less knowledge) entrusts their assets to the professional, to paraphrase Boston University fiduciary scholar, Tamar Frankel. Also of crucial note: most investors don't understand the basis on which they deal with "financial advisors." They do not suspect that they may be entrusting their wealth to someone who, under suitability, is not required to put the customer's interests first.

To be sure, there are many reps who are fiduciaries when advising on retirement assets or when they have discretion. And there are many who want to practice as fiduciaries. I am by no means picking on brokers. It is the legal structure that is at issue here. Why not back them up professionals giving advice with the legal structure that makes it clear that where there is advice there is fiduciary duty?

In The White House Blog on May 5, called "The Good Guys," White House Communications Director Dan Pfeiffer put it like this: in a list of financial reforms the White House was watching, he highlighted "a few simple, straightforward

improvements that would further strengthen an already strong bill and really help American families. We'll call them the "Good Guys". Let's hope they prevail over the 'Lobbyist Loopholes' as the debate moves forward." In his list of 10 reforms, the fiduciary standard for investment advice was the number-one issue.

"Investment Advice by Any Other Name. Today, investment advisors have a fiduciary duty to their clients – that is, they are legally obligated to act in their client's best interest. But brokers offering investment advice have no such obligation. Why does that make sense? Well… it doesn't. If you're a retiree managing your savings, or a family saving for college, you should be able to trust that the person giving you investment advice has your best interests at heart -whether that person is called a broker or an investment advisor. It's that simple," Pfeiffer said in the blog.

Formerly: A Clear Line Between Sales and Advice

At issue: the 'suitability' standard versus the 'fiduciary' standard of conduct toward investors. Investment advisors must adhere to the fiduciary standard: in addition to always control and disclose all costs to the investor, the Committee for the Fiduciary Standard (of which I'm a member) has developed Five Core Fiduciary Principles:

o Put the client's best interests first

o Act with prudence; that is, with the skill, care, diligence and good judgment of a professional

o Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts

o Avoid conflicts of interest

o Fully disclose and fairly manage, in the client's favor, any unavoidable conflicts

Clarity in Titles and Roles

When brokers simply bought and sold securities for customers and titles were such that everyone could tell they were dealing with a salesperson–advice wasn't part of the equation. Since advice is now a big part of the sales process for many brokers, most of whom call themselves advisors, the actions of brokers and investment advisors look the same for many investors. This is a big deal. In practice, the advisory function looks like a duck. It walks like a duck. But one is a duck and one is not. When titles contain the words advisor, counselor, or consultant, they convey a duty of loyalty, not a sales function.

These words are very important and no matter what the outcome of the SEC's study and rulemaking, titles need to be clarified and defined. Anyone who uses a title that conveys prudence, competence, authority and loyalty should be required to act under the highest standard of loyalty–and that is fiduciary duty. This includes the title of wealth manager, private banker–and many others.

Brokers who do not want to advise–but rather to sell–should be permitted to do that, in a fully disclosed way, with a sales title that in no way conveys that an individual is dealing with an advisor.

The Evolution of Banks Since the Repeal of Glass-Steagall

Another issue is the evolution of banks–including the private banking/wealth management arms of most banks–from acting with fiduciary duty toward clients to being brokers under suitability. Clients (now customers) for the most part are shocked to find out that the people who are advising them on their investments at a bank they

may have been dealing with for years–or generations–are no longer fiduciaries. (I am not speaking of trust departments here, of course.) There may be exceptions. But that is a problem. How is an individual investor to discern the difference? Disclosures are not anywhere near enough. The relationship must be clear. Currently it is not.

Product distributors attach layers of fees onto products that reps who "advise" customers on a suitability basis are often not even aware of. Certainly the customers are not fully aware of them either. I am not a lawyer, but wouldn't common sense say that the entire cost (firm and rep compensation) is material, and not disclosing that, clearly and fully, is misleading?

Comments to the SEC on Fiduciary Duty for Brokers

Some of the form-like letters to the SEC's request for comment area on this fiduciary study have offered misinformation about the fiduciary standard that I'd like to clarify:

Comment: Fiduciary duty is a "lowest cost" standard. The fiduciary standard is not a "lowest cost" standard–but costs do need to be controlled and part of the fiduciary process includes not wasting client's money and disclosing all compensation to firm and advisor, to the client. That said, if a client solution is a costlier one, it can be recommended but advisors must document the reasons why this extra cost is justified. That is only fair dealing (and fair dealing is part of the suitability standard).

Comment: "The suitability standard governing broker-dealers and registered representatives is a robust and heavily enforced standard."

FINRA's glossary defines 'suitability' this way: "A suitability violation occurs when and investment made by a broker is inconsistent with the investor's objectives, and the broker knows or should know the investment is inappropriate." Under suitability, if the investor needs, say, a stock fund, and there is a choice among those funds that pays more to the broker and firm, a broker can sell that security–regardless of cost to the investor–and meet the suitability standard. But as that cost comes out of the investor's pocket, it is not necessarily in the best interest of the customer; the higher cost comes out of the investor's pocket, and ongoing high costs affect investment performance.

Suitability is not as high a duty to investors as fiduciary duty. It does not require investors' interests be put first, or avoidance of conflicts, or disclosure of all costs. It doesn't require that the professional act with prudence, diversify assets or document all actions and decisions. While there are certainly many rules that govern suitability conduct, the fiduciary standard is the highest standard under the law. When getting advice, investors should be provided with the highest form of loyalty–fiduciary duty.

Comment: "The fiduciary standard looks back and enforces breaches retroactively through SEC enforcement or private lawsuits. The suitability standard looks forward and tries to prevent harm to consumers through ongoing and frequent FINRA and broker-dealer audits and compliance processes."

Sorry, that "looks back" statement is simply not true. The fiduciary standard is not a look back standard, it is a process where decisions are prudently made and recommended in the best interest of the client–what's backward looking about that?

Conflicts are disclosed and avoided and when they can't be avoided they are managed in the client's favor. Everything is documented. When this process is followed, liability decreases, not increases.

If the comment writer is speaking of looking back at performance–that is absolutely not the case with a fiduciary duty. However, if a higher cost product is recommended and performance suffers…the investor could have an issue. The reasons for the selection of that product over others should have been well-documented. Performance is related to cost. If there were lower cost products available, then maybe there is an issue with the selection process.

Comment: Fiduciary duty for brokers "would reduce product choice for investors."

This is may be my favorite piece of misinformation from the bank/broker/insurance lobby. From a SIFMA meeting I attended on July 15, the day that the reforms bill was signed, I can unequivocally say that it is not investors' choice of product that brokers are worried about reducing. It is that brokers' choice to sell the highest-cost alternatives could be curtailed. At this meeting, it was said that many smaller BDs would not be able to survive if they couldn't sell "alternative products" that paid them a very high commissions.

I have only one comment here: if that's your business model, to sell the highest commission products to individual investors, then perhaps you must revisit that model. By and large the brokers who do a great job are not dependent on those products. If that's what sustains your model maybe it is best if you find an alternate model.

Comment: "It will cost investors more" to deal with fiduciary advisors than it does with brokers.

Oh, come on. We all know that if the full amount of costs at a broker was disclosed to the investor that is absolutely not the case. At this point, BD customers see a commission but don't typically get a complete, clear cost disclosure of what the firm

makes as well, as they must from an investment advisor. On that basis, it is easy to look like the costs are lower at a broker, when in fact they would not be.

This is just some of the misinformation that is circulating. I will write more about this next week. In the meantime, get your comments in to the SEC; here is the link, on this issue that is fundamentally important to all American investors by Monday, August 30.

Perhaps this comment to the SEC from attorney Steven Caruso should be the last word today:

"As Chairman Schapiro recently noted in her July 27, 2010 speech before the Center for Capital Markets Competitiveness in Washington, D.C., in recognition of the primary and central importance of investor protection, a uniform fiduciary standard that requires broker-dealers and investment advisors to both place the interests of their customers first and foremost, above all else, is not just common sense, but it is a standard that would promote both market efficiencies and capital preservation – concepts that are critical to investors especially given the recent economic events that have transpired over the course of the past few years.

Simply put, if the financial services industry is going to regain the confidence of investors and restore the integrity that used to be the hallmark of our capital markets, the Commission can no longer allow investors to be subject to different standards of care that are predicated solely on the title that appears on the proverbial business cards of their financial representatives – whether that title is broker, adviser, consultant or otherwise.

To the contrary, I would submit that the standard of care should be predicated on doing what is right for investors and that the most logical standard of care, for actually doing what is right, would be to impose a fiduciary standard on all financial representatives.

Nothing more is needed and nothing less should be acceptable."

Comments? Please send them to [email protected]. Kate McBride, AIF^(R), is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.

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