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"Federal" versus "Authentic" Fiduciary Duty

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In testimony before

SIFMA’s testimony states that “the central imperative of a fiduciary is putting investors’ interests first. A fiduciary should also act with good professional judgment, and avoid conflicts of interest, if possible, or otherwise effectively manage conflicts through clear disclosure and, as appropriate, investor consent.” It sounds good, at first glance, but it falls far short of the authentic fiduciary duty that applies to investment advisors.

Then it becomes clearer why: they appear to think that they are already acting as fiduciaries under the commercial standard. Nothing could be further from the truth. SIFMA says: “We note that broker-dealers are already subject to and operate under many core fiduciary principles, including the following which are memorialized under current FINRA rules: just and equitable principles of trade; suitability of recommendations; best execution of transactions; fair and balanced disclosure to investors; supervision; and training.”

On that list, only “best execution” is a fiduciary characteristic shared with investment advisors who are bound by an “authentic” fiduciary standard, which encompasses the “five core fiduciary principles,” according to The Committee for the Fiduciary Standard:

? Put the client’s best interests first;

? Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;

? Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;

? Avoid conflicts of interest; and

? Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.

SIFMA’s testimony is crafted to make it look as though it is promoting an actual fiduciary standard of conduct for its members–B/Ds and registered representatives. However, when one looks at the testimony, the hearing itself, news reports and a Wealth Manager Webinar on October 7 with Kevin Carroll and Knut A. Rostad, it is clear that there is little fiduciary conduct in their interpretation of their “federal fiduciary standard.” This editor is a member of The Committee for the Fiduciary Standard.

Kevin Carroll is a managing director and associate general counsel at SIFMA–the Securities Industry and Financial Markets Association. He is the staff advisor to SIFMA’s Litigation Advisory, Arbitration, and Private Client Legal Committees. Carroll was an assistant director in the Enforcement Department of NASD, now FINRA, before he joined SIFMA.

Knut A. Rostad is the regulatory and compliance officer at the RIA Rembert Pendleton Jackson (RPJ), and chairman of The Committee for the Fiduciary Standard. As a contributing editor to Wealth Manager, Rostad writes the Regulatory Reason blog.

No one questions the fact that the functions of investment advisors and broker/dealer registered representatives have in some very important ways become identical. Both routinely give financial and investment advice to clients. What is still different, however, is that investment advisors are regulated by the Securities and Exchange Commission and the Investment Advisers act of 1940, while broker/dealers and registered reps are regulated under The Securities Exchange Act of 1934 and a self-regulatory organization, FINRA–the Financial Industry Regulatory Authority.

What’s more: titles have merged, with both B/D registered representatives and investment advisors often calling themselves financial advisors or counselors or consultants. Those titles confuse investors, especially since there is typically no reference to a broker/dealer’s sales function–indeed, it specifically sounds as if the broker’s function is an advisory one.

And, perhaps most important: according to the SEC’s Rand Report–its study of “Investor and Industry Perspectives on Investment Advisers and Broker-Dealers,” investors typically assume that the advice they get from a registered rep., or an investment advisor is coming from a person who must put their client’s interests first–but only the investment advisor is, by law, held to the fiduciary standard, requiring them to put investors’ interests first.

Now I am not picking on broker/dealer registered representatives here. I was one, long ago, (and then a trader and then an advisor), and I understand that many registered representatives hold themselves to a higher standard than the suitability standard, and put their client’s interests first as a practice. But a broker holding oneself to a higher standard than suitability, without regulation and/or law backing that up, does not give the investor the protections afforded by the current investment advisor’s fiduciary duty.

No one is saying that broker/dealers should be eliminated–not by a long shot–or that compensation must be in the form of a fee. The important distinction here is that, if broker/dealers are not going to label a salesperson a salesperson, but they are going to give advice in the identical role as an investment advisor, then by law and/or regulation, the advice givers should be regulated in the identical way–and, many will say, by the same regulator. It follows then, that since there is already established, centuries-old law regulating fiduciary conduct–the conduct that governs investment advisors now–that this should be the standard that governs advice from registered representatives as well.

A path to fiduciary

Yes, there are many practical aspects to consider on the path to fiduciary duty to clients by broker/dealers: compensation; principal trading; proprietary products; self-directed brokerage; capital raising activities, among others. However these and more are being actively discussed, in detail, at the regulatory and legislative levels, and from what I have heard firsthand in these discussions, these challenges can be resolved.

I find it helpful to look back at how centuries of fiduciary law were interpreted by the Supreme Court in perhaps the most important case governing fiduciary conduct by investment advisors since the Investment Advisers Act of 1940. Here is link to the full Supreme Court opinion, with a long excerpt below:

Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., et al. Supreme Court of the United States 375 U.S. 180 (1963):

“The Investment Advisers Act of 1940 was the last in a series of Acts designed to eliminate certain abuses in the securities industry, abuses which were found to have contributed to the stock market crash of 1929 and the depression of the 1930′s.7 It was preceded by the Securities Act of 1933,8 the Securities Exchange Act of 1934,9 the Public Utility Holding Company Act of 1935,10 the Trust Indenture Act of 1939,11 and the Investment Company Act of 1940.12 A fundamental purpose, common to these statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry.13 As we recently said in a related context, “It requires but little appreciation . . . of what happened in this country during the 1920′s and 1930′s to realize how essential it is that the highest ethical standards prevail” in every facet of the securities industry. Silver v. New York Stock Exchange, 373 U.S. 341, 366.

The Public Utility Holding Company Act of 1935 “authorized and directed” the Securities and Exchange Commission “to make a study of the functions and activities of investment trusts and investment companies . . . .”14 Pursuant to this mandate, the Commission made an exhaustive study and report which included consideration of investment counsel and investment advisory services.15 This aspect of the study and report culminated in the Investment Advisers Act of 1940.

The report reflects the attitude — shared by investment advisers and the Commission — that investment advisers could not “completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.”16 The report stressed that affiliations by investment advisers with investment bankers, or corporations might be “an impediment to a disinterested, objective, or critical attitude toward an investment by clients . . . .”17

This concern was not limited to deliberate or conscious impediments to objectivity. Both the advisers and the Commission were well aware that whenever advice to a client might result in financial benefit to the adviser — other than the fee for his advice — “that advice to a client might in some way be tinged with that pecuniary interest [whether consciously or] subconsciously motivated . . . .”18 The report quoted one leading investment adviser who said that he “would put the emphasis . . . on subconscious” motivation in such situations.19 It quoted a member of the Commission staff who suggested that a significant part of the problem was not the existence of a “deliberate intent” to obtain a financial advantage, but rather the existence “subconsciously [of] a prejudice” in favor of one’s own financial interests.20 The report incorporated the Code of Ethics and Standards of Practice of one of the leading investment counsel associations, which contained the following canon:

“[An investment adviser] should continuously occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious; he should scrupulously avoid any affiliation, or any act, which subjects his position to challenge in this respect.”21 (Emphasis added.)

Other canons appended to the report announced the following guiding principles: that compensation for investment advice “should consist exclusively of direct charges to clients for services rendered”;22 that the adviser should devote his time “exclusively to the performance” of his advisory function;23 that he should not “share in profits” of his clients;24 and that he should not “directly or indirectly engage in any activity which may jeopardize [his] ability to render unbiased investment advice.”25 These canons were adopted “to the end that the quality of services to be rendered by investment counselors may measure up to the high standards which the public has a right to expect and to demand.”26

One activity specifically mentioned and condemned by investment advisers who testified before the Commission was “trading by investment counselors for their own account in securities in which their clients were interested . . . .“27

This study and report — authorized and directed by statute28 — culminated in the preparation and introduction by Senator Wagner of the bill which, with some changes, became the Investment Advisers Act of 1940.29 In its “declaration of policy” the original bill stated that

“Upon the basis of facts disclosed by the record and report of the Securities and Exchange Commission . . . it is hereby declared that the national public interest and the interest of investors are adversely affected — . . . (4) when the business of investment advisers is so conducted as to defraud or mislead investors, or to enable such advisers to relieve themselves of their fiduciary obligations to their clients. “It is hereby declared that the policy and purposes of this title, in accordance with which the provisions of this title shall be interpreted, are to mitigate and, so far as is presently practicable to eliminate the abuses enumerated in this section.” S. 3580, 76th Cong., 3d Sess., ? 202.

Hearings were then held before Committees of both Houses of Congress.30 In describing their profession, leading investment advisers emphasized their relationship of “trust and confidence” with their clients31 and the importance of “strict limitation of [their right] to buy and sell securities in the normal way if there is any chance at all that to do so might seem to operate against the interests of clients and the public.” The president of the Investment Counsel Association of America, the leading investment counsel association, testified that the32

“two fundamental principles upon which the pioneers in this new profession undertook to meet the growing need for unbiased investment information and guidance were, first, that they would limit their efforts and activities to the study of investment problems from the investor’s standpoint, not engaging in any other activity, such as security selling or brokerage, which might directly or indirectly bias their investment judgment; and, second, that their remuneration for this work would consist solely of definite, professional fees fully disclosed in advance.”33

Although certain changes were made in the bill following the hearings,34 there is nothing to indicate an intent to alter the fundamental purposes of the legislation. The broad proscription against “any . . . practice . . . which operates . . . as a fraud or deceit upon any client or prospective client” remained in the bill from beginning to end. And the Committee Reports indicate a desire to preserve “the personalized character of the services of investment advisers,”35 and to eliminate conflicts of interest between the investment adviser and the clients36 as safeguards both to “unsophisticated investors” and to “bona fide investment counsel.”37 The Investment Advisers Act of 1940 thus reflects a congressional recognition “of the delicate fiduciary nature of an investment advisory relationship,”38 as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to render advice which was not disinterested. It would defeat the manifest purpose of the Investment Advisers Act of 1940 for us to hold, therefore, that Congress, in empowering the courts to enjoin any practice which operates “as a fraud or deceit,” intended to require proof of intent to injure and actual injury to clients.

This conclusion moreover, is not in derogation of the common law of fraud, as the District Court and the majority of the Court of Appeals suggested. To the contrary, it finds support in the process by which the courts have adapted the common law of fraud to the commercial transactions of our society. It is true that at common law intent and injury have been deemed essential elements in a damage suit between parties to an arm’s-length transaction.39 But this is not such an action.40

This is a suit for a preliminary injunction in which the relief sought is, as the dissenting judges below characterized it, the “mild prophylactic,” 306 F.2d, at 613, of requiring a fiduciary to disclose to his clients, not all his security holdings, but only his dealings in recommended securities just before and after the issuance of his recommendations.

The content of common-law fraud has not remained static as the courts below seem to have assumed. It has varied, for example, with the nature of the relief sought, the relationship between the parties, and the merchandise in issue. It is not necessary in a suit for equitable or prophylactic relief to establish all the elements required in a suit for monetary damages.

“Law had come to regard fraud . . . as primarily a tort, and hedged about with stringent requirements, the chief of which was a strong moral, or rather immoral element, while equity regarded it, as it had all along regarded it, as a conveniently comprehensive word for the expression of a lapse from the high standard of conscientiousness that it exacted from any party occupying a certain contractual or fiduciary relation towards another party.”41

“Fraud has a broader meaning in equity [than at law] and intention to defraud or to misrepresent is not a necessary element.”42

“Fraud indeed, in the sense of a court of equity properly includes all acts, omissions and concealments which involve a breach of legal or equitable duty, trust, or confidence, justly reposed, and are injurious to another, or by which an undue and unconscientious advantage is taken of another.”43

Nor is it necessary in a suit against a fiduciary, which Congress recognized the investment adviser to be, to establish all the elements required in a suit against a party to an arm’s-length transaction.”

If that’s not a “federal” mandate that supports the current “authentic” fiduciary standard of care that is embraced by investment advisors, I don’t know what is. Why would that not apply to all who provide advice to individual investors?

Comments? Please send them to [email protected]. Kate McBride is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.