More On Legal & Compliancefrom The Advisor's Professional Library
- RIAs and Customer Identification Just as RIAs owe a duty to diligently protect their clients privacy and guard against theft, firms also play a vital role in customer identification. Although RIAs are not subject to an anti-money laundering rule, securities regulators expect advisors to address these issues in their policies and procedures.
- Preventing and Dealing with Client Complaints Although the SEC has not provided specific guidance on how client complaints should be handled, a firms policies and procedures should provide clear direction how to do so, as neglecting complaints can exacerbate a bad situation.
Raising capital by going public can be a boon to a financial services firm, its officers or executives and shareholders, and, of course creating capital is the American way. But what is the impact on individual investor customers or clients when their financial services firm is publicly traded? Is the client experience different at a privately held firm than at a publicly traded one?
For broker-dealers that are publicly traded, the balance is complex: for the company to grow, clients and customers must feel that their interests are being served; however, deals must be done, and products and securities sold. How would this change if the SEC concludes, after the current study on this subject, that brokers who provide advice must put clients' interests first?
A Delicate Balance of Interests
Does the added pressure to constantly grow revenues and add to shareholder value mean that a public broker-dealer or investment advisor is at more at odds with investor interests than a private broker-dealer would be? How does a public broker-dealer align shareholder interests and investors’ interests? In other words, does the pressure of a public company to always grow revenues for shareholders change the BD-RIA's (registered investment advisor’s) relationship with customers or clients?
Former Fed Vice Chairman Alan S. Blinder (left) pointed to his views about this issue in an e-mail reply to these questions on Thursday. Dr. Blinder is now the Gordon S. Rentschler Memorial Professor of Economics and Public Policy at Princeton University. In a forthcoming article, “It’s Broke, Let’s Fix It: Rethinking Financial Regulation,” to be published inDecember in the International Journal of Central Banking, he writes about the connection between sales, traders and executive compensation and risk-taking.
“Just like the traders and sales personnel who work for them, top executives of corporate financial institutions derive the lion’s share of their compensation from bonuses that are normally linked to the firm’s annual profits,” Blinder states in the article. “They, too, get rich in the fat years and pass the losses on to shareholders in the lean years. So they, too, rationally want to go for broke.”
Blinder notes in his article that the U.S. Treasury Dept. recommended in its June 2009 “Financial Regulatory Reform” white paper that the Fed provide guidance to financial services firms to “align executive compensation practices of financial firms with long-term shareholder value, and to prevent compensation practices from providing incentives that could threaten the safety and soundness of supervised institutions.”
Of course, Blinder articulates in his article a much broader sense of financial reforms than the simple question I pose about loyalties to clients and loyalties to shareholders, but it is related. He continues in his paper that, “The Fed’s guidance gave particular attention, by way of example, to clawbacks, to risk-adjusting incentive pay, and to reducing the sensitivity of pay to short-term performance.” In encouraging pay adjusted for longer-term performance, Blinder includes as potentially useful, the “say on pay” provisions, which give shareholders a voice and a vote on CEO pay—which was also enacted as part of Dodd-Frank.” But, Blinder remains “a bit skeptical that government can legislate compensation practices effectively.”
When Reps or Advisors Are Affiliated, Not Employees
In the case of a public BD, what about corporate officers' duty of loyalty to shareholders, employee-reps' loyalty to the firm, and because, In the case of LPL, a BD-RIA, in which most reps or investment advisors are affiliates and not employees, does their duty to customers/ clients change when the firm changes from privately to publicly owned?
First let me state that I am in no way picking on LPL—an independent industry leader. Last Thursday, Philip Palaveev, president of Fusion Advisor Network and a frequent contributor to www.AdvisorOne.com, noted in an interview that “LPL has kind of been the torchbearer in many directions in the industry. Because of their presence, today advisors have the ability to choose better broker-dealers, lower transaction costs for their clients and more affiliation models.”
“Investors in a fiduciary business are bound by fiduciary law as much as any investors in business are bound by law. They are entitled to demand maximization of their business profits but only within the constraints of fiduciary rules owed to customers,” said Tamar Frankel, a professor of law at the Boston University School of Law, via e-mail. “Pressure of investors to increase revenues is not much different from self interest of management to increase bonuses. But some professionals, such as lawyers and physicians, may not bring in non-professionals as owners, and one of the reasons is the concern about pressures (the other, confidentiality of the clients),” she continues.
In the unique case of LPL, in which most registered reps are not employees, but independent-contractor brokers (and sometimes also RIAs), Frankel added: “Reps that are not employees but affiliates have a direct duty to the people they serve—investors. They have no duty to the investors of the firm with whom they are affiliated, except the contractual relationship.”
On the other hand, in the case of agents, such as employees of a public insurance company, Frankel says, “If they are agents they owe a fiduciary duty to the corporation-principal—but not to the investors of the principal.”
Frankel adds: “Because investment banks receive more money from their investors they are able to earn more and divide the profits or lose more in which case the losses are born by the investors. This is where the pressure is. Once awareness by regulators is highlighted, disclosure and examinations may prevent a slippery slope.”
“When an investment firm goes public it can raise conflicts of interest that are similar to those seen in the mutual fund industry,” Arthur Laby, associate professor at Rutgers-Camden School of Law, said in an interview on Thursday. “So if an investment firm is public, as you know, it has a duty to its shareholders to make money, to enhance value, which is often accomplished by raising fees to its clients or possibly even cutting back or changing client services.
“On the other hand,” Laby adds, “the firm obviously has a duty, and in some cases a fiduciary duty, to its investor clients to charge a reasonable fee and to provide a high level of service. Needless to say, those two goals can contradict. This is one reason why the Investment Company Act of 1940 states that the advisor of a fund has a fiduciary duty to the fund with respect to compensation, to the fees that the fund pays the advisor to manage the fund. So the conflict that you raise is not new; it’s endemic, I think, to the industry. Congress recognized it in 1940 and even dealt with it rather specifically in the Investment Company Act.”
But Which Loyalty Comes First?
In terms of loyalty to clients and loyalty to shareholders, if an advisor is an RIA, with fiduciary duty to clients, but works for a public firm—which duty of fiduciary loyalty would come first? “This is a very difficult question,” Laby says, “but I think the rep’s primary duty flows to the individual client of that rep. That’s right. But that said, the rep is always going to have in the back of its mind the ongoing obligation that any firm has to enhance shareholder value, and it’s that kind of background obligation, if you will, that really raises a serious conflict, and one that Congress recognized in 1940.”
“This is not to say that the conflicts cannot be managed,” Laby added in a follow-up e-mail, “and advisory firms may have sound reasons for going public—but the attendant conflicts must be managed by paying close attention not only to the bottom line, but also to the duties owed to clients in both the short term and the long term.”
Obviously, there is the additional wrinkle that the SEC is currently studying the gaps in regulation between BDs and RIAs, and whether the fiduciary standard of care should be extended to brokers who provide advice to individual investors. They are to report to Congress in January and may issue rules after that.