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. As a result, regulators have never required brokers to act as fiduciaries -- that is, to act in the undiluted best interest of their customers.
That was all well and good so long as broker-client relationships were largely limited to executing buy and sell orders -- which they were, for much of the 20th century -- and as long as any advice brokers gave to clients was incidental to those duties. But over time, brokers' roles have expanded to overlap those of an entirely different group: registered investment advisers (RIAs), who are paid to provide investment advice and who, according to federal law, do have a fiduciary responsibility to act in their clients' undivided best interests. Indeed, a growing number of brokers earn their keep in the same way that many advisers do -- by charging clients a percentage of the assets they manage. And many advisers still accept sales commissions for some or all of their compensation.
A 2008 report published by the RAND Institute for Civil Justice said that most investors find brokers "indistinguishable" from RIAs. And a 2010 survey sponsored by several industry groups found that two-thirds of investors surveyed mistakenly believe that brokers are required to put their clients' interests first.
Now federal regulators are considering rewriting the rules to put an end to this confusion. The Securities and Exchange Commission is studying the issue and will announce its conclusions in January. There's a good chance that the SEC will finally decide to impose a fiduciary standard on brokers, requiring them to place their clients' interests ahead of their own.
Raising the Bar
At first glance, the idea of a fiduciary duty sounds warm, fuzzy and unassailable. At its core lie both the concept of trust -- a client entrusts an adviser with his or her finances, just as you entrust your health to your doctor -- and the notion that a fiduciary should make his personal interests secondary to those of his clients.
Currently, brokers need only demonstrate that the investments they recommend are "suitable" for their customers. Suggesting penny stocks for an 80-year-old widow would almost certainly flunk the suitability test. So would recommending an investment that locks up money for ten years to a couple who soon plan to buy a house.
To meet the suitability standard, brokers must make reasonable inquiries into the financial situation, tax status and investment objectives of their customers. But brokers are not required to subordinate their own interests -- specifically, how much they're being compensated. "Legally, a fiduciary duty is a higher standard than suitability," says David Tittsworth, executive director of the Investment Adviser Association, a trade group for RIAs.
It sounds like a no-brainer, right? "I don't believe you can go wrong if you're putting the client's interests first," says Kevin Keller, president of the Certified Financial Planner Board of Standards.
The trouble is, it's difficult to pinpoint specific ways in which a fiduciary standard would improve the advice brokers provide. Some advocates say that if brokers were required to meet the fiduciary standard, they would have to recommend the best investments for their clients, rather than merely suitable investments, because they would be required to take their clients' best interests to heart.
That is, at least in theory, the standard to which advisers are currently held. "The vast majority of RIAs -- 99% of them -- are trying to follow the spirit of the law," including the spirit of this "best" standard, says Adam Bold, founder of the Mutual Fund Store, a network of adviser franchises.
But it doesn't seem to be an enforceable standard. "I have never seen any case law defining the difference between 'suitable' and 'best,'" says Nelson Ebaugh, a Houston-based securities lawyer. He says that if an investor sued his or her adviser, arguing that the adviser recommended a product that was suitable but not the best, "it would be considered frivolous."
Most claims against advisers are settled through private arbitration, the details of which aren't made public. So it's impossible to know for certain whether any investors have ever successfully made such a claim. But Scott Shewan, president of the Public Investors Arbitration Bar Association, an organization of lawyers who represent investors in arbitration cases, agrees that any difference between "best" and "suitable" is so nebulous that it would be impossible to resolve in a legal proceeding. "I don't think you can hold a broker to a 'best' standard," he says.
Ironically, brokers are already subject to an elaborate oversight system, which aims to ensure that they follow both the spirit and the letter of the suitability standard, in addition to the requirement that they "deal fairly" with clients. All broker-dealer firms enforce their own internal oversight systems. Typically, a firm is visited by either the SEC or Finra, the brokerage industry's self-regulatory agency, once every two years. Individual states provide another layer of scrutiny. By comparison, registered investment advisers are regulated by either the SEC or their home state, but not both.
Mischief still happens. Brokerage customers are not permitted to sue brokers; instead, they must go through arbitration. In 2009, customers filed 7,137 arbitration cases against their brokers. As of the end of August, 3,778 cases had been filed so far for 2010. Comparable statistics for advisers aren't available.
A fiduciary standard applied to brokers wouldn't get to the heart of the matter because it wouldn't abolish a broker's ability to charge a sales commission. If the SEC does set a fiduciary standard for brokers, Congress has directed that accepting a commission should not, in itself, count as a violation of a broker's fiduciary duty. And it wouldn't be a violation if his or her firm offers only in-house products with high fees, as long as the broker tells clients that they are being offered a limited range of investments.
That gets us more or less back to where we started. Some brokers could still be pressured to recommend high-fee products that don't really serve their clients' best interests. Many investors might not be told that they may be better off buying a low-cost index fund than an expensive product managed by the broker's own firm. Nor, in all likelihood, would many customers be told that they shouldn't be investing at all because of their financial circumstances. "As long as customers are dealing with someone who's getting a piece of the transaction, they won't get advice as good as if they were dealing with someone who earns a fee for their service," says Tom Posey, a Houston financial planner.
On balance, however, extending the fiduciary standard would be a plus for investors, if only because brokers would be required to clearly explain conflicts -- for example, when they receive a commission from the sale of a product.
If, for instance, a broker has two equally suitable products on hand, but one would earn him a higher commission than the other, he would have to explain as much to the client before making a recommendation. In that situation, "the investor needs to determine whether the financial incentive might be clouding the broker's judgment," says David Cosgrove, a St. Louis-based securities lawyer.
Even this isn't foolproof. Congress has stipulated that any fiduciary standard adopted for brokers will not require them to act in that role round the clock, but only when they are providing financial advice. In other words, a fiduciary duty will be a hat that brokers can don or doff, depending on which service they're performing. Any new rule should ensure that this flexibility doesn't give brokers a pass if they fail to fess up about conflicts of interest, including commissions, at all times, for all products they sell.
Whatever the SEC decides, it doesn't relieve you of the responsibility to do your homework when choosing an adviser (see 6 Steps to Finding a Great Adviser). If you are looking for someone to execute your transactions, using a broker may be just the ticket. But if you're seeking financial advice, you should think carefully about your adviser's incentives. You wouldn't go to a doctor who earns a commission on every prescription he writes. Why treat your finances with any less respect?