Clark At Large

In his response to my January 8 blog, Jay Martin raises an interesting issue about whether a fiduciary standard can or should be applied to securities sales. He writes: “I, for one, am thoroughly confused how sales can or should be fiduciary.”

The implication here is that it shouldn’t be, and I couldn’t agree more. But then he goes on to imply that the standard of “caveat emptor” is sufficient to protect financial consumers in sales situations, and that’s where I have to respectfully disagree.

“Buyer beware” works great in situations where the consumer is an equal party to the transaction and—and this is the important part—understands the nature of the relationship: that the salesperson is trying to sell a car, a cell phone, a putter, an upgrade to a suite, etc. However, when it comes to securities “sales” we all know that’s not the case (whether we admit it or not).

In my own recurring straw poll of asking people over the years, including “sophisticated” investors, lawyers, business executives, high-net-worth folks, and so on, if they think their broker has a fiduciary duty to put their interests first, not one has ever answered “No, they don’t.”

That’s no accident. Since I started covering advisors, Wall Street has spent billions of advertising dollars suggesting, implying, or inferring that what you get from brokers is investment advice. Over those same years, in response to various regulatory initiatives or proposals, the industry has as much as admitted that if they had to fully disclosure the nature of the sales relationship, it would affect sales.

That should be our first clue that something’s amiss. For caveat emptor to work in a consumer securities transaction, the consumer should be made aware that “their” broker neither works for them nor has any duty to act in their best interest. But when brokers, or other “financial advisors,” cross over the sales line into giving advice, that’s when a fiduciary duty should apply to the relationship.

What constitutes advice? Financial planning industry leader Harold Evensky recently defined it the clearest, simplest, most elegant way that I’ve ever heard, using what Harold calls the “you” standard: When a broker or any other kind of “advisor” tells a client “here’s what you should do:” buy a mutual fund, sell a stock, hedge a position, etc., that’s advice. If you simply give them product information, that’s sales.

“But if we do that,” I hear brokers and insurance agents across the country crying, “no one will buy anything.” Maybe that’s our second red flag.

In the comments that he’s posted to this blog (for example, in this blog posting , Steve Winks raises some important issues that warrant further discussion. I’ve known Steve since he was a due diligence officer at a financial planning B/D in Atlanta in the ‘80s, and in more recent years I’ve heard him articulate his analysis of the implications for a fiduciary duty, much of which he’s been kind enough to share with us in his postings.

Steve does an excellent job of capturing the concerns that I’ve heard many registered reps express about the impending financial services regulation, particularly regarding the extension of a fiduciary duty to all financial advisors. Steve, like the many RRs he’s worked with over the years, comes from a brokerage environment, in which FINRA and then the B/Ds’ compliance departments lay down clear, concrete rules for the activities of their reps: which Series licenses they have to hold to conduct specific types of business, what disclosures they need to make to their clients, how to determine which products are suitable for which clients, and even what they can say about those products, etc. etc. Virtually every aspect of an RR’s business day is covered by some rule or regulation for the appropriate conduct.

As you can imagine, such a tightly controlled working environment also creates an overall sense of comfort and safety: play by the rules and no matter what happens to your clients’ portfolios, or what claims they might make against you, you and your firm won’t be held responsible. That’s not to say registered reps don’t care about the well-being of their clients—most of the RRs that I know do care. It’s a system that enables them to sell financial products secure in the knowledge that they’ve done what they’re supposed to do, and no one can say otherwise, regardless of the ultimate outcome of any transaction. Who would want to give that up?

Unfortunately, it’s also a system that’s based on an illusion. For should a registered reps’ actions ever be called into question, the matter isn’t resolved by a jury of laypeople, or even an elected judge—it’s referred to a securities industry arbitration panel, whose job is to determine whether the rep in question broke the rules, not whether the client was treated fairly. These securities industry rules—the ones that create such a comfortable safe harbor for registered reps everywhere—are never called into question. The rules themselves are never subjected to a judicial review of whether the client’s rights or interests were violated.

I don’t have any factual basis for this, but it’s my suspicion that if arbitration cases went instead to a real court of law, the brokers would lose a lot more of those cases. And that, if you read between the lines of Steve Winks’ postings, is what RRs are really afraid of. Steve attempts to solve this problem by calling for “hundreds of rules and regulations” that would recreate the current rules-based system to tell advisors exactly what they need to do. But it doesn’t work that way in the real world: most of us don’t have a set of rules we abide by. We have principles that we live by, that mostly boil down to “do the right thing:” don’t steal, don’t cheat, do what you say you’ll do, and don’t kill or maim. It’s not really that complicated. If a true fiduciary duty is imposed on all advisors, they’ll be subject for the first time to all the judgment calls that the rest of us make every day. Scary? I’m sure. The end of civilization as we know it? Probably not.

Much is being made of SEC Chair Mary Schapiro’s testimony in front of the Financial Crisis Inquiry Board on January 14 regarding her comments about the reregulation of financial advisors. About a fiduciary duty for advisors, Ms. Schapiro said: “When investors receive similar services from similar financial service providers, it is critical that the service providers be subject to a uniform fiduciary standard of conduct that is at least as strong as exists under the Investment Advisers Act [of 1940], and equivalent regulatory requirements, regardless of the label attached to the service providers.”

To be fair, her remarks do sound a lot like the position that I and other observers have been advocating, namely, that simply eliminating the “broker exemption” to the ’40 Act, would greatly benefit the public. Without that exemption, brokers would have to register as investment advisors, and become subject to all the obligations that RIAs currently have, including a fiduciary duty to their clients. This would indeed be the most beneficial advance in protection for financial consumers in 70 years.

But don’t be fooled: Just because a quick read of Ms. Schapiro’s remarks sounds like a win for consumers doesn’t make it so. To my mind, the most important part of her testimony comes in those three little words: “receive similar services.” In other words, brokers should be regulated as RIAs “when they give advice,” and conversely, not held to an RIA standard when they don’t.

This is, not surprisingly, hauntingly similar to the position of SIFMA and FINRA: brokers should be subject to a fiduciary duty “when they give advice.” That will lead to great parsing of  when brokers actually give “advice” and, if the brokerage industry has its way, will lead to brokers sometimes having and sometimes not having a fiduciary duty to the same clients. This, of course, is hard to distinguish for the current state of affairs in the brokerage world, because it is exactly the same—business as usual. When brokers give you advice, they have a duty to put a client’s interests first. But when they implement that advice by selling a high-priced, and/or heavily loaded, and/or proprietary, and/or mediocre product, they have no such duty.

A genuine fiduciary standard would require financial advisors to always put the clients’ interests first. Anything less is a sham. Unfortunately, Ms. Shapiro, like the rest of the securities industry, doesn’t seem to be on board with the highest level of financial consumer protection.