Although the SEC’s report in January 2011 recommended that broker-dealers be subject to the same fiduciary standard as RIAs, the bar has not been raised to that level yet. For now, only RIAs are held to the fiduciary standard, not broker-dealers. In 1963, the U.S. Supreme Court ruled that Section 206 of the Investment Advisers Act imposes a fiduciary duty on RIAs. Securities Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), was the Supreme Court’s first interpretation of the Investment Advisers Act. To this day, the case is cited frequently by lower courts and the SEC in enforcement actions.
A fiduciary obligation is one that goes beyond the suitability standard typically owed by registered representatives of broker-dealer firms to their clients. The relationship between an RIA and the firm’s clients is built on the premise that the investment advisor will always do the right thing for the person or entity receiving advice. It is a special relationship that does not exist between most businesses providing services to their customers. In June of 2009, a group of investment industry leaders formed The Committee for the Fiduciary Standard and called on Congress to adopt an authentic fiduciary standard. This committee put forth a list of five core principles of the fiduciary standard to help individual investors make the distinction between an investment advisor’s fiduciary standard and a broker’s suitability standard (Figure 8-1).
Figure 8-1. Five Core Principles Esatblished by the Committee for the Fiduciary Standard
Put the client’s best interest first
Act with prudence, that is, with the skill, care, diligence and good judgement of a professional
Do not mislead clients—provide conspicuous, full and fair disclosure of all important facts
Avoid conflicts of interest
Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts
More information about the Committee for the Fiduciary Standard can be found at
Although IARs might recognize that they owe a fiduciary duty to clients, they might not be cognizant of the potential ramifications which may arise from that special relationship. IARs, especially if their background is in the insurance-industry, may not be accustomed to disclosing all risks faced by clients and the commissions that will be paid. IARs do not always realize that failing to fulfill their fiduciary obligations can result in serious consequences ranging from regulatory sanctions to a lawsuit. Even if that failure was not intentional, IARs and their firms may still face legal, financial, and regulatory consequences.
Breaching that fiduciary duty is the most serious transgression that an RIA can commit, and this can seriously impair an RIA’s ability to attract clients. When clients have a negative experience with an investment advisor, the bad news usually travels quickly. Few people will entrust their assets to someone with a bruised reputation, and the firm is likely to receive fewer referrals.
The SEC and state securities regulators often issue press releases when litigation is brought against an RIA for violating the Investment Advisers Act. Local newspapers often carry the story, and it’s likely to live forever on the Internet. Prospective clients will read about it when they conduct an Internet search of the RIA before hiring the firm.
Even if allegations against an RIA are not well-publicized, established and prospective clients will learn about them by reading the firm’s Form ADV. On Form ADV, RIAs must make full disclosure of legal and disciplinary events such as:
- criminal or civil actions against the firm or a management person;
- violations of an investment-related statute or regulation; and
- violations of certain self-regulatory organization’s rules.
A breach of fiduciary duty by an RIA or IAR is likely to trigger regulatory scrutiny for years to come. Because of those previous mistakes, the firm will most likely be viewed as a higher risk. Consequently, the RIA is very likely to receive more frequent visits from securities examiners.
If there are clear-cut violations of the fiduciary obligations owed to clients, the SEC may refer the matter to the Division of Enforcement. This referral will happen quickly if the SEC believes that clients’ funds or securities are at risk.
Benefits of a Uniform Fiduciary Standard
As mentioned previously, the SEC recommended that a uniform fiduciary standard be applied to broker-dealers and RIAs. A uniform fiduciary standard, as well as related disclosure requirements, may offer several benefits:
- Increased investor protection
- Heightened investor awareness
- Flexibility to accommodate different existing business models and fee arrangements
- Preservation of investor choice
- Continued access to existing products and services
The most important benefit is that investors receive investment advice in their best interest, regardless of whether it is offered by a broker-dealer or RIA. Many investors are unaware of the duty owed by the person giving them advice. They do not know if the individual owes a fiduciary duty or need only recommend suitable investments.
The Meaning of Fiduciary Duty
Fiduciary duty encompasses much more than just being honest and avoiding negligence. RIAs owe an affirmative duty of loyalty, which means an advisor must always put the client’s interests first. The fiduciary duty owed by an RIA includes all of the following obligations and more.
- only give disinterested advice;
- provide thorough written disclosures of potential or actual conflicts of interest in the RIA’s Form ADV and advisory agreement;
- keep information strictly confidential; and
- refrain from fraud and other types of misconduct.
Cherry-picking is a classic example of a breach of fiduciary duty. In a typical case, the RIA allocates profitable trades to its own account while losing trades are allocated to the client. On September 9, 2008, the SEC charged an investment advisor in Rye, New York, with cherry-picking. The SEC’s civil complaint alleged that from April 2003 through October 2005, the advisor cherry-picked profitable trades for his own account resulting in harm to his clients and unjust enrichment for the RIA. The advisor orchestrated this cherry-picking scheme by buying securities during the day in one single account. He waited until later in the day to allocate those purchases after seeing which securities appreciated in value.
Fiduciary duty encompasses many obligations. It may include the duty to pursue class action lawsuits on behalf of clients. When voting proxies, an RIA must always act in the best interest of its clients.
Among other fiduciary obligations, RIAs owe a duty to obtain best execution of a client’s securities transactions if they recommend the broker to be used. RIAs must disclose any outside business activities that might present a conflict of interest. As we will discuss later, RIAs may only recommend suitable investments.
In numerous deficiency letters, the SEC has told RIAs that they have a fiduciary duty to establish a process for responding to emergencies, contingencies, and disasters. This plan should address issues such as:
- where employees will meet and work if offices are destroyed or severely damaged;
- how employees can be contacted;
- how clients, regulators, suppliers and service providers can be contracted; and
- who will manage clients’ assets if a key member of the firm dies or becomes disabled.
In the most extreme cases, IARs may face criminal charges for breaching their fiduciary duty. These prosecutions may be brought if an advisor commits fraud or misappropriates clients’ funds. The SEC only has the authority to seek civil sanctions against an RIA. The most serious violations of securities laws are prosecuted by the Justice Department.
The Big Picture
In an ideal world, financial advisors would always do the right thing for their clients instead of acting in their own self-interest. Unfortunately, there are too many instances where investors are exploited by financial professionals they trust. There have been many well-publicized cases of affinity fraud where financial professionals prey upon investors who share their religious or ethnic identity. The financial advisor uses that religious or ethnic connection to gain the investor’s trust.
The good news is that an effective and thorough compliance program can help RIAs to avoid breaching their fiduciary duty. Rule 206(4)-7 under the Investment Advisers Act requires SEC-registered advisors to implement and audit their policies and procedures. Robust policies and procedures, if followed, can help RIAs live up to their obligation as fiduciaries.
Rule 204A-1 under the Investment Advisers Act, better known as the Code of Ethics Rule, reinforces the fiduciary principles that govern the conduct of advisory firms and their personnel. As we will see in Code of Ethics Rule, adhering to these principles will help advisors avoid breaching their fiduciary duty and the severe consequences that are likely to follow. In the accompanying release to the Code of Ethics rule, the SEC said, “The rule and rule amendments are designed to promote compliance with fiduciary standards by advisers and their personnel.”
In that release, the SEC took note of the severe consequences that flow from a breach of fiduciary duty. The SEC said:
“Rule 204A-1 will benefit investment advisers by renewing their attention to their fiduciary and other legal obligations, and by increasing their vigilance against inappropriate behavior by employees. This may have the effect of diminishing the likelihood that their firms will be embroiled in securities violations, Commission enforcement actions, and private litigation. For an adviser, the potential costs associated with a securities law violation may consist of much more than merely the fines or other penalties levied by the Commission or civil liability. The reputation of an adviser may be significantly tarnished, resulting in lost clients. Advisers may be denied eligibility to advise funds. In addition, advisers could be precluded from serving in other capacities.”
These serious repercussions should make every RIA and IAR conscious of their fiduciary obligations. The adopting release for the Code of Ethics Rule can be found at:
The good news is that owing a fiduciary obligation can help win over clients. According to a TD Ameritrade Institutional survey released on October 17, 2011, the top reason why investors choose to work with independent RIAs is that they are required, as fiduciaries, to offer advice that is in the best interests of clients.
In addition, investors are often encouraged to choose an RIA by financial journalists, because they are fiduciaries. In an article published in the Sun-Sentinel on November 27, 2011, Reuters columnist, Linda Stern, called the fiduciary standard “a superior one.” Stern wrote that a fiduciary is legally bound to put your interests above her own.” While living up to that standard is difficult, the benefits to RIAs and clients are worth the effort.