Brokers as Fiduciaries
‘The Cat in the Hat’ Revisited

The Proposed Legislation

Spooked by the market meltdown of 2008-09, the U.S. Government in the spring of 2009 embarked on an ambitious overhaul of our financial system.  In June the Obama administration released a Financial Regulatory Reform Plan which included a proposal  to “establish a fiduciary duty for broker-dealers offering investment advice and harmonize the regulation of investment advisers and broker-dealers.”
The Plan announced that “The SEC should be given new tools to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers.”
The Plan theorized as follows:

“Retail investors are often confused about the differences between investment advisers and broker dealers. Meanwhile, the distinction is no longer meaningful between disinterested investment adviser and a broker who acts as an agent for an investor; the current laws and regulations are based on antiquated distinctions between the two types of financial professionals that date back to the early 20th century. Brokers are allowed to give ‘incidental advice’ in the course of their business, and yet retail investors rely on a trusted relationship that is often not matched by the legal responsibility of the securities broker. In general, a broker-dealer’s relationship with a customer is not legally a fiduciary relationship, while an investment adviser is legally its customer’s fiduciary…Standards of care for all broker-dealers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to aligning the legal framework with investment advisers.”  (Emphasis supplied).

FINRA Chairman and Chief Executive Richard Ketchum hailed the proposal, announcing that “FINRA is uniquely positioned to build an oversight program that ensures investment advisers are properly examined and their customers are adequately protected.”

However, FINRA’s plans have not yet been realized. Instead, on December 2, 2009, after extensive hearings, House Financial Services Committee Chairman Barney Frank proposed H.R. 4173. Section 7103 of that Bill, entitled “Establishment of a Fiduciary Duty for Brokers, Dealers and Investment Advisers, and Harmonization of Regulation” proposes an amendment to Section 15 of the Securities Exchange Act of 1934 (regulating broker-dealers), directing the SEC to

“…promulgate rules to provide that, with respect to a broker or dealer, when providing personalized investment advice about securities to a retail customer (and such other customers as the Commission may by rule provide), the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an investment adviser under the Investment Advisers Act of 1940. The receipt of compensation based on commission or other standard compensation for the sale of securities shall not, in and of itself, be considered a violation of such standard applied  to a broker or dealer.”

The Bill goes on to place the enforcement authority with respect to the new standards squarely in the hands of the SEC.

The Frank Bill was modified and passed 223-202 on December 11, 2009, referred to the Senate as the “Wall Street Reform and Consumer Protection Act of 2009.”

Meanwhile, on November 10, 2009, Senator Dodd, Chairman of the Senate Banking Committee, introduced a “discussion draft” of a financial reform bill, including the establishment of a Financial Institutions Regulatory Administration and a Consumer Financial Protection Agency, regulatory elements substantially tougher than those included in the House bill. When questioned by reporters, Senator Dodd remarked: “This is not at time for timidity.” Shortly thereafter he announced that he would not run again.

Section 913 of the Dodd “discussion draft” proposes that Section 202(a) (11) of the Investment Advisers Act be amended to remove from the definition and exemption for

“(C)  Any broker or dealer whose performance of such services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.”

This approach did, however, leave untouched the main definition which brings under regulation

“…any person who, for compensation, engages in the business of advising others…as to the value of securities or as to the advisability of investing in, purchasing or selling securities…” (emphasis supplied)

As of this writing, attempts to reach a bipartisan agreement in the Senate Banking Committee over this legislation have broken down, chiefly over the powers of the new agencies. Senator Dodd publicly accused the financial industry of deploying “an army of lobbyists whose only mission is to kill the common-sense financial reforms we have been working so hard to achieve.”  The “broker fiduciary” provision may be dropped altogether in favor of a study  to develop rules to address the problem. Realizing  this, the Consumer Federation of America (CFA), North American Securities Adminstrators Association, Inc. (NASAA), AARP and Fund for Democracy all jumped  into the fray, blasting both the SEC and FINRA for back-tracking on the measure and, instead, supporting the “study.” Barbara Roper, Director of CFA, actually accused FINRA of secretly lobbying against the provision, a charge denied by Mr. Ketchum

Not only is the Dodd proposal inconsistent on its face. Strangely enough, I do not believe that any of this legislation has addressed the issue of state regulation of investment advisers, which under the Uniform Securities Act still continues to exempt broker dealers from registration. And there is the  additional puzzle as to who is intended to be regulated. Today, advisers with less than $25 million under management must register with the states. Some of the congressional proposals include increasing that limit to $100 million, which would add immeasurably to the confusion.  

The fate of the “fiduciary” reform proposal in the Senate is now uncertain. Senate Banking Committee chairman Christopher Dodd, D-Conn., is expected to introduce new financial reform legislation this week that excludes applying a fiduciary standard to brokers offering investment advice.
The provision was circulated two weeks ago by Sen. Tim Johnson, D-S.D., a Banking Committee member. Rather than classifying certain brokers as registered investment advisers, Mr. Johnson's proposal would require the Securities and Exchange Commission to conduct a study of regulatory standards for brokers and advisers, then propose rules on the issue.
Scrapping the fiduciary requirement will only hurt investors, said Knut A. Rostad, chairman of The Committee for the Fiduciary Standard, a group formed last year to promote higher standards for financial advisers. “Studying this issue is a straw man,” Mr. Rostad said. “There has been so much study that has been done over the past 15 years that the SEC has become a think tank on the issue of fiduciary issues. But the industry needs to explain why these investor protections should not be afforded to their customers.”

What is a “Fiduciary?”

 The concept of a “fiduciary” derives from trust law and is based on the latin word “fides” or “faith.”  Simply put, a “fiduciary” is a person in the legal position of putting the interests of another person (usually the “beneficiary”) before his own. A person who is a “fiduciary” has a duty of loyalty to the other person’s interests.  A person who is a “fiduciary” has a  duty to deal with the matters entrusted to him or her with the same degree of care that he or she would devote to his or her own affairs. This includes a duty to avoid conflicts of interest, fully disclose, etc.   

Strangely enough, the Investment Advisors Act does not come right out and state that every registered adviser has a “fiduciary duty” to his or her client. Section 206 talks about avoidance of “any device, scheme or artifice to defraud a client” or to engage in any transaction, practice or course of business “which operates as a fraud or deceit upon any client…”  And the SEC, over the years in its rule making, has similarly avoided any broad-based rules that an adviser has a “fiduciary duty” to his or her client, preferring instead to couch its very specific behavioral and record-keeping precepts with the preliminary statement in each rule that failure to abide constitutes a “fraudulent, deceptive and manipulative act, practice or course of business.”     

Nonetheless, the SEC in its enforcement actions and, as supported by many court decisions, has uniformly taken the position that an investment adviser has a “fiduciary duty” to its clients. Not only this, but the SEC pronouncements and the laws and regulations of many states set out a “fiduciary duty” for any person, including a broker-dealer, who has discretionary authority over the customer’s account. And legal cases and arbitrations also recognize the “shingle theory” under which a broker-dealer or representative “holding out” the promise of investment advice as a regular part of its business may be held to a “fiduciary” standard with respect to customers.    

While the “bright lines” of “fiduciary duty” have not always been clearly drawn, to date in the financial services industry, it is fair to say that the designation of “fiduciary” has almost always been attendant upon some formally established relationship, under which the “fiduciary” is acting as a designated trustee or by law such as an ERISA plan administrator or a person holding a limited power of attorney to trade a customer’s account, or a publicly announced regular program of providing investment advice for compensation.  

The presently proposed legislation, if adopted in its current form, now anoints every broker-dealer (and by extension, every registered representative) with “fiduciary” obligations to the clients should any investment advice be provided, whether or not compensated solely by commissions and whether or not there is any formal arrangement to provide investment advice.

Seemingly ignored in all this legislative frenzy is the simple proposition that broker-dealers buy and sell securities for profit. Contrary to the language of the Financial Regulatory Reform Plan, a broker is not a person “who acts as an agent for an investor.”  Like all salesmen, registered representatives are agents of their broker dealer, trained to sell the customer something, restrained by the strictures of “suitability” and “full disclosure.” The advice they give is – and always will be – colored by this imperative. Anointing these enthusiastic promoters with the “fiduciary” mantle is no less ridiculous than shoe-horning every car salesman into a dispassionate evaluation of his competitor’s product before even recommending his own. So much for the auto industry!

The underlying and totally naïve assumption for this piece of legislation is that securities product, unlike any other product on the face of this earth, doesn’t need sales people. Indeed, sales people are to be feared. Investors are much better off if they seek out and pay people to tell them what is best to buy. The best products for a particular investor will – well – just magically appear in the marketplace, all ready for the taking. A share of stock is not just like a house or a car. A share of stock is not a product, it is an “investment experience.”  Like a medical procedure, it is something to be personally crafted for the individual consumer, etc. People should be able to choose stock brokers the way they choose doctors, by the quality of the “investment experience” they deliver. Never mind the quality of the product. 
  
The crafters of the Investment Advisers Act of 1940 and the Uniform Securities Act recognized that broker-dealers could not function as such without providing investment advice as part of their business. This was the basis of the two-fold legislative solution: (a) exempt broker-dealers as such and (b) require registration of all persons (including broker-dealers) who made investment advice a part of their regular business. Broker-dealers whose advice was “incidental” to their practice did not need to register.

Why on earth the sachems, from Obama on down, chose to ignore these simple rules now in place (and totally enforceable) in favor of something muddy, gooey and unworkable is beyond me. We are evidently bound to do something – anything – to create a positive stir. “The current laws and regulations are based on antiquated distinctions between the two types of financial professionals that date back to the early 20th century.”  Hey, if it’s antiquated, just throw it out!

What’s Next?

The legislative moves in Congress have an eerie resemblance to the 1957 Classis “Cat in the Hat” story by Dr. Suess (1).  Like the cat Congress appears at the door and begins insanely piling on regulation after regulation in a hysterical effort to gain acceptance,  re-election (and dominance). Representatives and Senators are out-doing on another in loudly professing fidelity to the public interest. Forgotten (for the moment) are the practicalities of applying to one distinct industry (the broker-dealer community) a set of regulations appropriate only to another (investment advice and management). Perhaps, like the cat, this “fiduciary” proposal will disappear in the legislative morass. Or be swallowed up in some similarly unworkable compromise.

These populist enthusiasms have swallowed up for the moment a basic legislative tenet: You just can’t legislate morality. Trying to cure Bernie Madoff by decreeing that “everybody is now a fiduciary” will only drive the crooks to another venue where they will continue to practice their nefarious craft. The law of unintended consequences decrees that, if this legislation is enacted as proposed, detailed knowledge about securities product will now become more inaccessible than ever to the public, due to broker fears of liability for providing investment advice without registration.    

So what should a broker-dealer do?  Sit tight and do nothing? Register as an adviser and  force every registered rep into a Series 65 or 66? 

From my perspective, the best thing to do at this point is to engage in a careful assessment of the effects of this proposed legislation on your business. Will it be a major change or only a minor annoyance? What are the minimum steps that could be taken to be in compliance? What insurance and structural changes should be made? Are there any steps that you could take now anyway, given the changes  taking place in the business?  And – do you have your “ear close to the ground” to pick up the changes in time to plan in a prudent fashion?

Regulation is, fortunately or not, the unavoidable companion to our business. To survive and adapt in it, therefore, is not only necessary, it is essential. As a wise French philosopher once remarked: “Plus ca change, plus c’est la meme chose.” 
 
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(1) In Dr Suess’ first book featuring the character (The Cat in the Hat, 1957), the Cat brings a cheerful, exotic and exuberant form of chaos to a household of two young kids one rainy day while their mother leaves them unattended. Bringing with him two creatures appropriately named Thing One and Thing Two, the Cat performs all sorts of wacky tricks ( The Cat at one point balances a cup, some milk, a cake, three books, the Fish, a rake, a toy boat, a toy man, a red fan, and his umbrella while he's on a ball to the chagrin of the goldfish). to amuse the children, with mixed results. The Cat's antics are vainly opposed by the family pet, a sapient and articulate goldfish. The children (Sally and her older brother, who serves as the narrator) ultimately prove exemplary latchkey children, capturing the Things and bringing the Cat under control. To make up for the chaos he has caused, he cleans up the house on his way out, disappearing a second before the mother arrives.
  

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