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Stockbrokers, Registered Investment Advisors, and the Fiduciary Standard

Background | Articles | Research & Studies | 3 Strikes - Advisor Warning Signs

Gary Karz, CFA
Host of InvestorHome
Founder, Proficient Investment Management, LLC



     On January 22, 2010 the SEC issued it's report in response to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The SEC's mandate was to resolve differences between the suitability standard that Stockbrokers (aka Registered Representatives) are held to and the fiduciary standard that Registered Investment Advisors (RIAs) are held to. The report continued a debate that has gone on for decades (for instance, see Can You Trust Your Broker? from BusinessWeek - 2/20/95).

     Elizabeth Ody wrote a thought provoking summary of the then pending SEC decision in the December issue of Kiplinger's. She directly asked the question Whose Advice Can You Trust? in the title and notes in the subtitle "The feds want to level the playing field between brokers and advisors. It may not make a difference." Her article begs the question of whether we should expect the SEC's decision to resolve the current issues. One critical issue revolves around the current situation whereby Stockbrokers can have two hats (one broker hat and one advisor hat). The standard they must meet depends on which hat they wear. Stockbrokers are relatively easy to identify because they are required by law to identify themselves with the phrase “Securities offered through (firm name).”

     When Stockbrokers are not providing financial advice, they can wear the broker hat. By providing products that are suitable, but possibly not in the client's best interest, Stockbrokers are often placed in situations which create conflicts of interest with those clients. Research (cited below) consistently finds that investors are confused regarding current regulations and standards for investment professionals, mistakenly believe investment professionals have their best interests in mind, and the industry takes advantage of the environment to make more money from investors. Troubling research findings include the following.

     There is a long list of reasons why investors should be on guard regarding interaction with a Stockbroker given the gap between the suitability and fiduciary standards. In particular, when a stockbroker moves from one firm to another the stockbroker may have entered into an agreement with the new firm that pays them upfront out of future earnings they are expected to generate from their clients. How often does that happen? According to InvestmentNews At least 206 teams of advisers — managing a total of $68.3 billion in client assets — moved to another company or created a new firm in 2010. They keep a running list of Advisers on the Move including Assets Under Management and Trailing Twelve Months "production." We know that the SEC is evaluating these agreements and appears to be imminently planning to issue new rules to prevent abuse (see articles below). See also 3 Strikes - Advisor Warning Signs.

     Sadly, what you are unlikely to hear in articles about Stockbrokers switching firms is how the client portfolios of those Stockbrokers performed. The focus is generally on how much money the Stockbrokers made for themselves and their firms, which by definition comes out of their clients' returns. Another potential problem the SEC is evaluating is the question of whether Advisors that move have an incentive to boost their "production" just prior to the move to get a stronger package.

     How much is it worth to the brokerage industry to not have to meet a fiduciary standard? Since many of the brokers are public companies, we can actually get a good estimate from the analysts at some of those brokerage firms that are trained in making those kind of financial projections. There is one estimate in Trusted Adviser or Stock Pusher? Finance Bill May Not Settle It from the NYTimes (3/3/2010), which includes this very telling note - "Guy Moszkowski, a securities industry analyst at Bank of America Merrill Lynch, said that the impact of a fiduciary standard was hard to determine because it would depend on how tightly the rules were interpreted. But he said it could cost a firm like Morgan Stanley Smith Barney as much as $300 million, or about 6 to 7 percent of this year’s expected earnings, if the rules were tightly defined." So if you extrapolate to other public brokerage firms, it's easy to speculate that the brokerage industry makes $billions annually and brokers themselves make $billions more taking advantage of their option to sell their clients higher cost "suitable" products that may no be in their clients best interest.


Research and Studies

The primary reason to create a fiduciary rule is not to head off major scandals, it’s to stop the daily nickel-and-diming that costs investors millions of dollars a year. Pending SEC action, investors should take advice only from a broker or planner willing to be a fiduciary.
Jane Bryant Quinn in Will the SEC Force Your Broker to Behave? from Moneywatch (1/26/2011)

At the beginning of the last century, Americans rightly demanded that those who provide their health care meet the highest educational standards. But a decade into the 21st century, American investors have yet to demand the same from those who give them advice about their money. Indeed, standards are hardly high. To sell financial products, a person has only to pass a two-hour exam that covers basic investment products and laws. There are no educational requirements to become a financial adviser—not even a college degree. . . It’s time to take the next series of steps to improve the intellectual standards of practitioners in our industry and transform the typical financial adviser from one with a sales product in mind to one with a particular investor’s portfolio in mind.
Lane Steinberger in Looking for Abraham Flexner: Today’s investors must demand higher standards from their financial advisers from CFA Magazine Nov-Dec 2010 (or here)

The depressing fact of the matter is that federal and state governments do not regulate brokers in the same way they do other professionals. For example, the law does not consider brokers to be fiduciaries, as are practitioners of other learned professionals. This arcane term refers to a professional's duty to put a client's interests first. Accountants, lawyers, bankers, and doctors all have fiduciary responsibility to clients and patients, as do investment advisors. Somehow the brokerage industry dodged this bullet.
William J. Bernstein in The Investor's Manifesto

Brokers have never enjoyed the purest of reputations in our popular imagination. From the corruptible Bud Fox of Wall Street to the manipulative bond salesmen of Liar's Poker, the people whose job it is to push investments out the door and into investors' arms have often been depicted as morally elastic. After all, brokers are ultimately salespeople who are generally compensated by commission and whose primary loyalty is to their employers . . . You wouldn't go to a doctor who earns a commission on every prescription he writes. Why treat your finances with any less respect.
Elizabeth Ody in Whose advice can you trust? from Kiplinger's (December 2010)

While we are on the subject of minimizing costs, we need to warn you to beware of stockbrokers. Brokers have one priority: to make a good income for themselves. That's why they do what they do the way they do it. The stockbroker's real job is not to make money for you but to make money from you. Of course, brokers tend to be nice, friendly, and personally enjoyable for one major reason: Being friendly enables them to get more business. So don't get confused. Your broker is your broker-period.
Burton Malkiel and Charles Ellis in The Elements of Investing

The sad thing is that there can be no legislation against stupidity.
Fred Schwed Jr. in Where Are The Customer’s Yachts?

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