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"Creating A Suitable Standard: Why Brokers Should Be Fiduciaries" by Nicholas M. Herubin


Creating a Suitable Standard: Why Brokers should be Fiduciaries

Nicholas M. Herubin

I. Introduction

For the average investor, making sense of the financial world is a daunting task. The financial products available to ordinary people are constantly becoming more complex. See, e.g., These Financial Products are too Complex for the Average Joe, INVESTOPEDIA, Nov. 13, 2009 (describing some of the complex products available to the public and providing investors with techniques to evaluate investments). There is a seemingly endless amount of information available to consider before making an informed decision. See, e.g., Financial Navigating in the Current Economy: Ten Things to Consider Before You Make Investing Decisions, SECURITIES AND EXCHANGE COMM'N (providing investors with a list of factors to consider before selecting a particular investment). At the same time, a decreasing number of Americans will be able to rely on a defined benefit retirement plan. Barbara A. Butrica, Howard M. Iams, Karen E. Smith & Eric J. Toder, The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Income of Baby Boomers, SOCIAL SECURITY ADMIN. (2009)(describing the "steadily declining" number of Americans covered by a defined benefit plan). This means that individual investors have to make serious decisions that will shape their financial wellbeing for the rest of their lives. Id.

For many, guidance from a financial professional is a critical part of that decision making process. TIAA-CREF Survey, available at https://www.tiaa-cref.org/public/about/press/about_us/releases/articles/pressrelease436.html. These professionals act as intermediaries between the investing public and the financial world. Many people go to the local office of a brokerage firm and hire a financial professional to help them choose investments that will help them pay for their children's college education or eventually retire.

Most investors likely assume that the professional they hire is looking out for their best interests. At many firms and with many brokers, that is likely the case. However, under the current regulatory regime, most financial professionals owe surprisingly few legal obligations to their customers. The current regulations do not go far enough to ensure that investors are getting unbiased advice from professionals acting without conflicts of interest. Expanding the fiduciary standard to brokers is a necessary step to provide adequate protection for retail investors.

II. The Fiduciary Standard & Financial Professionals

A fiduciary relationship creates an obligation for a person to act in the best interests of another person. BLACK'S LAW DICTIONARY (9th ed., 2009), fiduciary (defining fiduciary as "a person who is required to act for the benefit of another person..."). It sets extremely high standards of behavior for the fiduciary. In the context of a financial professional and a client, a fiduciary duty provides clients with a high level of protection from misconduct by the professional. The advisor must put the client's best interests first and avoid conflicts of interest. SeeInvestment Advisors Act § 206(3). The advisor must act with prudence, which requires acting with the care, skill, and diligence of a professional. Five Core Principles, COMM. FOR THE FIDUCIARY STANDARD, http://www.thefiduciarystandard.org/about-us. Finally, the advisor must never actively mislead the client. Investment Advisors Act § 206(1).

The fiduciary duty aligns the interests of the advisor with those of the client in a powerful way. It creates a relationship similar to that of a lawyer and a client or a doctor and a patient. Importantly, if a dispute arises between a customer and a financial professional with a fiduciary relationship, the burden is on the financial professional to show that he or she actually acted in the customer's best interest. See Why is the fiduciary standard vital?, COMM. FOR THE FIDUCIARY STANDARD, http://www.thefiduciarystandard.org/about-us. In the case of a non-fiduciary financial professional, the burden is on the customer to show that the professional acted improperly. Id.

Under federal securities laws, "investment advisors" registered under the Investment Advisors Act of 1940 owe their customers a fiduciary duty. Investment Advisors Act § 206. Broker-dealers do not. Investment Advisors Act § 206. While this may seem like semantics, it is the reason why most retail investors do not have a fiduciary relationship with the men and women giving them investment advice.

III. The Investing Public's Misconceptions

This is a serious problem because investors tend to believe that the financial professionals they hire are obligated to act in their best interests. Yet, studies show that most investors do not actually understand what legal duties their financial professionals owe to them. In 2010, a study asked 1,319 American investors who they believed owed them a fiduciary duty. INFORGROUP/ORC, U.S. INVESTORS AND THE FIDUCIARY STANDARD: A NATIONAL OPINION SURVEY (2010), available at http://www.thereformedbroker.com/wp-content/uploads/2010/09/stockbroker-advisory-survey.pdf. The results show that there is widespread confusion. More than 75% of those polled incorrectly believed that financial advisors and planners owe fiduciary duties to their clients. Id. Two out of three believed that stockbrokers have a fiduciary duty and 60% think investment advisors are the same as stockbrokers. Id. Over half believed that insurance agents owe customers a fiduciary duty. Id.

Several factors make it difficult for the average investor to understand who owes him or her a fiduciary duty. First, consider the fact that a single institution or even a single employee can act in multiple capacities. Take, for instance, an ordinary trip to a bank branch. It can actually become quite complex. A customer would start by dealing with a teller (a transaction that would be well-protected up to $250,000 by the Federal Deposit Insurance Corporation). See Who is the FDIC?, FEDERAL DEPOSIT INSURANCE CORP., http://www.fdic.gov/about/learn/symbol/. If the teller sees that the customer has a lot of money in a low-interest account, the teller might refer the customer to a broker sitting at a desk right across the branch. See, e.g., Bank Tellers , OCCUPATIONAL OUTLOOK HANDBOOK, http://www.umsl.edu/services/govdocs/ooh20002001/120.htm (describing as a job duty of tellers learning about the bank's "various financial products and services the bank offers, so they can briefly explain them to customers and refer interested customers to appropriate specialized sales personnel"). The broker would likely work for the bank's broker-dealer subsidiary. ANJALI KUMAR, THE REGULATION OF NON-BANK FINANCIAL INSTITUTIONS, 20 (1997).

Thus, to customers, it is not necessarily obvious that in a few short steps they are leaving the insured, highly regulated banking world and entering much riskier territory. That type of rapid transition within one financial entity complicates customers' perception of who is handling their money.

In addition, the variety of titles firms give to their employees adds to the confusion. "Broker", "financial planner", "financial advisor" and "wealth manager" are all synonymous with the securities law term of art "broker." Difference Between Brokers and Investment Advisors, BROWN WEALTH MGMT., Dec. 12, 2012. The different terminology from one brokerage to another makes it more confusing for investors.

Barbara Roper, the director of Investor Protection at the Consumer Federation of America, has said, "The lack of understanding is not because investors are stupid. It's because the policy itself is stupid." Mark Schoeff, Most Investors Think Brokers are Fiduciaries, Survey Says, INVESTMENT NEWS, Sept. 15, 2010. Retail investors by definition are not financial professionals. They lead busy lives beyond trying to figure out who owes them a fiduciary duty and who does not. Concern about the legal obligations of stockbrokers seems rather likely to fall behind matters like work, mortgage payments, and kids on the average person's list of concerns. Add to that the fact that the term "fiduciary duty" is, as the New York Times puts it, "a term so dry that your eyes may be glazing over as you read this." Tara Siegal Bernard, Will You Be My Fiduciary?, N.Y. TIMES BUCKS BLOG, Feb. 16, 2010. Without knowing the legal mechanics of the relationship, the typical investor reasonably believes that the person on the other end has the investor's best interests in mind. Unfortunately, that is not necessarily the case.

IV. Broker Conflicts of Interest

In many instances, it would be better for investors to think of their brokers more like a salesperson than a disinterested advisor helping them select smart investments. Brokers' training often focuses more on sales tactics rather than choosing financial products tailored to a particular customer's needs. Tara Siegel Bernard, Trusted Advisor or Stock Pusher?, N.Y. TIMES, Mar. 3, 2010, at B1. As one former Merrill Lynch broker said, "I learned a lot about being a good salesman at Merrill. The amount of training I sat through to properly evaluate investment opportunities was almost non-existent relative to the training I got on how to sell them." Id. Brokers know that making sales is a key part of their job description.

Once a customer hires a broker, the obligations of the broker are remarkably limited. Financial Industry Regulatory Authority ("FINRA") Rule 2111 requires that a broker "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer." FINRA Rule 2111.

The "suitability" requirement is a logical rule, but not a particularly high standard. It functions somewhat like a "rational basis" test for brokers: as long as there is plausibly a legitimate reason for the recommendation, the broker has met the standard. Trusted Advisor or Stock Pusher?, supra, at B1. One financial planner told The New York Times, "Under suitability, advisors would willy-nilly buy and sell investments that were the flavor of the month and make some infinitesimal case that they were somehow appropriate without worrying." Id. In addition, the suitability rule only applies when a broker is "recommending" a product to a customer. See FINRA Rule 2111. It does not create any duty for the broker to talk a customer out of an investment the investor thinks of, regardless of how clear it may be to the broker that the investment is a bad idea. Frequently Asked Questions: FINRA Rule 2111, FINRA. "The suitability rule applies only to recommended securities and investment strategies involving securities...". Id. Therefore, by avoiding making a "recommendation", the broker can avoid the suitability rule altogether. Id.

There are other FINRA broker rules to protect customers, but they provide only a minimal layer of protection. For example, brokers cannot "churn" their clients' accounts. FINRA Conduct Rule IM-2310-2. "Churning" refers to selling and purchasing securities repeatedly to generate brokers' fees for the trades. Churning, INVESTOPEDIA, http://www.investopedia.com/terms/c/churning.asp. Brokers also must get the "best execution" when executing a trade on a customer's behalf. FINRA Regulatory Notice 12-13. This means that a broker must get the customer the best price for a customers' trade in a short timeframe. Best Execution , INVESTOPEDIA, http://www.investopedia.com/terms/b/bestexecution.asp. Beyond these, however, there are very few rules in place to protect investors who are dealing with a non-fiduciary financial professional.

This creates a problem because there is widespread potential for broker conflicts of interest. One of the most obvious conflicts of interest can arise when a broker's pay is on a per-transaction basis rather than a fee for managing investors' assets. The broker's interest then becomes maximizing the number of transactions rather than giving quality advice. Christopher Traver Robinson, Biased Advice , 60 EMORY L. J. 653, 675 (2011) (discussing how brokers can become incentivized to trade frequently and generate fees). While the rules against churning prevent extreme cases of excessive trading, brokers with this type of fee arrangement still have a strong incentive to produce a high number of trades. Id.

Another conflict that can arise for brokers is the opportunity to steer clients towards products that will maximize their own fees. Robert A. Prentice, Moral Equilibrium: Stock Brokers and the Limits of Disclosure , 2011 WIS. L. REV. 1059, 1062 (2011). This can be very profitable for brokers because the amount of fees earned can vary widely from one product to another. For example, brokers generally receive a two-to-three percent commission for investing a customer in a mutual fund. How Investors Get Into Trouble with Annuities, SHEPHERD SMITH EDWARDS & KANTAS LLP, http://www.stockbroker-fraud.com/lawyer-attorney-1136040.html. When they sell a customer an annuity, however, the commission can be as high as ten percent. Id. This can be a huge difference for the broker but does not necessarily reflect the underlying value of the product to the customer.

Regardless of the brokers' fees, as long as a financial product meets the minimal suitability threshold, the broker has no obligation to offer the customer any less costly options. Oftentimes, this can create incentives for brokers to recommend financial products that make little sense for customers. For instance, some brokers have sold clients variable annuities (a tax-deferred product) to put in their 401(k) (a tax-deferred account). Alina Tugend, Pick a Planner Who Can Spell Fiduciary , N.Y. TIMES, Apr. 28, 2008, at G5. The double tax deferral would be useless for the client but the sale would produce a large commission for the broker.

There is also pressure on brokers to sell customers "proprietary products". Find the Right Financial Advisor , INVESTOPEDIA, http://www.investopedia.com/articles/pf/07/rightadvisor.asp. These are the brokerage firm's own financial products. Id. For instance, ABC Brokerage invests a client's money in ABC Mutual Fund. These transactions tend to be very profitable for financial institutions because the entire investment stays in-house. Id. However, they may or may not be the best investment for a particular customer.

Similar to proprietary products, large brokerage firms often have arrangements with outside mutual fund companies called "revenue sharing." Id. The mutual fund pays the brokerage in order to be on a list of "preferred" mutual funds. Id. This creates a conflict between the customer's best interest and the mutual fund paying for the brokerage's stamp of approval. Some firms disclose these agreements on their websites or in paper at the time of the transaction. Ron Lieber, The High (and hidden) Costs of Your 401(k), N.Y. TIMES, June 10, 2011, at B1. Yet that leaves the customer in the odd position of trying to determine whether the brokerage's arrangement with a mutual fund is enough of a conflict of interest to forgo the purchase of the mutual fund.

These are just a few common examples of the types of conflicts of interest that can arise in a broker-customer relationship. Since brokers have no fiduciary duty, they are free to act in their own best interest when there is a conflict. As long as the broker can meet the minimal suitability standard, there is nothing stopping him or her from maximizing profits at the expense of the customer. See Prentice, supra , at 1068 (2011).

V. Recent Developments and Looking Ahead

There have been efforts to go beyond disclosure and actually expand the fiduciary duty to include brokers. The Obama administration attempted to include a heightened standard for brokers in the Dodd-Frank Act. The new rule would have created a duty "to act solely in the interest of the customer or client without regard to the financial or other interests of the broker, dealer or investment advisor providing the advice." Press Release, U.S. Dep't of the Treasury, Additional Improvements to Financial Markets Regulation (July 10, 2009), http://www.treasury.gov/press-center/press-releases/Documents/tg205071009.pdf. In the end, however, Congress did not enact the rule and the Securities and Exchange Commission ("SEC") was directed to merely devise a plan for better disclosures from brokers. Dodd-Frank, Pub. L. No. 111-203 §913 (g). It is still unclear whether this heightened standard will ever be applied.

Surprisingly, there are signs that individual brokers and even some large brokerage firms are not entirely opposed to a fiduciary standard. The brokerage firm TD Ameritrade provides financial support to the Committee for the Fiduciary Standard, a group that advocates for expanding the fiduciary standard. See About Us , COMM. FOR THE FIDUCIARY STANDARD, http://www.thefiduciarystandard.org/about-us ("This year the Committee is proud to recognize TD Ameritrade Institutional, a firm that has spoken out for the fiduciary standard for many years, as a financial supporter of the Committee."). One survey indicates that over half of brokers support an expanded fiduciary standard. A poll of about 900 brokers taken in 2009 by the Committee for the Fiduciary Standard showed that 53% believe that "all financial professionals who give investment and financial advice should be required to meet the fiduciary standard." Thomas Coyle, Poll Indicates Broker Support for Fiduciary Standard , WALL STREET J. WEALTH MANAGER BLOG, Dec. 2, 2009. Only 23% said they were opposed. Id. This would seem to suggest that brokers think that a fiduciary standard would not significantly damage their business. It also shows that most brokers recognize the potential for conflicts and would welcome attempts to avoid them.

However, support within the industry is by no means universal. Some firms and industry groups are vehemently opposed to expanding the fiduciary standard. The Securities Industry and Financial Markets Association ("SIFMA") opposed the Dodd-Frank proposal. SIFMA claimed that the rule would "ultimately harm investors by raising the cost of saving." Position: Fiduciary Standard, SECURITIES INDUSTRY AND FINANCIAL MARKETS ASS'N, http://www.sifma.org/issues/private-client/fiduciary-standard/position/. Instead, SIFMA suggested its own standard, a watered-down definition of "fiduciary" that would take the place of the definition in the Investment Advisors' Act. See id. In addition, groups lobbying on behalf of insurance brokers have put up a particularly strong fight against expanding the fiduciary duty. When the change was proposed as part of Dodd-Frank, they were "apoplectic." Tara Siegel Bernard, Struggling Over a Rule for Brokers , N.Y. TIMES, Feb. 15, 2010, at B1. Observers suggest that this is likely because insurance brokers would have to disclose the huge fees they receive from selling certain products, especially variable annuities. Id.

Critics of the change have raised concerns about an increase in regulations and costs to brokerage firms if brokers were held to a fiduciary standard. Any estimate of the cost of the new rule is necessarily imprecise but it seems likely that there would be some loss of profits for brokerages. It could create a lot more work for brokers and would require them to steer clients towards less profitable products. It also seems possible that the cost of financial advice could go up if brokers were fiduciaries. One analyst who covers the securities industry says that big firms could stand to lose as much as 7% of their revenue. Id. To a firm like Morgan Stanley Smith Barney, that could mean as much as $300 million annually. Id. Yet an increase in costs is not a compelling argument against requiring brokers to act in their customers' best interests. If anything, it highlights how much profit brokerages apparently derive from transactions that are not in their customers' best interests.

Today, two trends are creating the need for stricter regulation of brokers. First, the stakes for individual investors are higher than ever. Most employees can no longer rely on a professionally managed pension plan to fund retirement. This means that people have to make more of their own investment decisions. The second trend is the increasing complexity of the financial markets. Years ago, an investor was likely to do fairly well with a portfolio of blue chip American companies. Today, there are many more products to consider: exchange traded funds, mutual funds, annuities, etc. There are also new factors to consider in diversifying (i.e. emerging markets). These two developments make it more important than ever that average investors have access to quality financial guidance. This means unbiased, personalized advice from a professional free from conflicts of interest. The best way to ensure that is to expand the fiduciary duty to brokers.

Perhaps the SEC or Congress will put a broker fiduciary duty in place eventually. There is also the potential for FINRA, the industry self-regulatory organization, to require its members to meet the fiduciary standard. However, unless the rule changes, the responsibility will remain with investors to educate themselves and be aware of whether their broker is truly acting in their best interests.

Nicholas Herubin is a graduate of Albany Law School Class of 2013. While at Albany Law, he worked at the school's Securities Arbitration Clinic, learning about the serious issues facing ordinary investors. He was also a member of the Albany Government Law Review and had an article published about New York State's economic development programs. He would like to thank Professors Joan Stearns Johnsen, James Redwood, and Christine Sgarlata Chung for their help with learning about securities and financial regulation.

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This page contains a single entry from the blog posted on November 12, 2013 9:02 PM.

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