Back in 2007, in what can best be described as a classic “David versus Goliath” victory, the Financial Planning Association won a lawsuit against the Securities and Exchange Commission preventing it from expanding the “broker exemption” to the Investment Adviser Act of 1940 to cover the management of client portfolios. As you hopefully know, the broker exemption exempts brokers from the fiduciary duty of investment advisors when their advice is “usual and incidental to the sale of securities.”
In 2005, the SEC tried to broaden the exemption to allow brokers to provide advice that isn’t necessarily in their clients’ best interest. Two years later, the U.S. Court of Appeals for the Washington district ruled in favor of the FPA’s challenge in what was widely hailed as a victory not only for the FPA, but for all retail investors, whose consumer protections have been consistently eroded by the SEC almost since the passage of the ’40 Act.
But was it really a victory? With the benefit of eight years of hindsight, it’s hard to believe that any of us can honestly answer “yes.” Consequently, our experience with the FPA lawsuit stands as both the rationale for the Institute for the Fiduciary Standard’s “Best Practices for Fiduciary Advisers,” which were released Sept. 30 — and a warning about the application of those standards.
Today, brokers who manage assets (who appear to be the vast majority) have a fiduciary duty to their clients when they offer advice about what changes to make in their clients’ investment portfolios. But, thanks to the brokerage exemption, they have no such requirement to advise in their clients’ best interests when selling them the assets to put into those portfolios.
Consequently, brokers truthfully can claim that yes, they do have a fiduciary duty to their clients, and then sell investment products that do not meet that standard of protection. (I have personally heard many brokers make just such a claim.) Yet as study after study has shown, not one client in a thousand understands the implications of the part-time fiduciary standard. But we understand it: The net result of the FPA’s “victory” was to strengthen brokers’ sales pitches, while enabling them to avoid acting in their clients’ best interests when creating their portfolios.
Ironically, had the SEC won the lawsuit, the fate of retail investors would be arguably better. It’s true that if they’d won, brokers wouldn’t have a fiduciary duty for either their investment advice or their portfolio recommendations. However, there wouldn’t be any ambiguity about brokers’ standard of care: They would never have to put their clients’ interests ahead of their own or their BDs’. While most investors would probably continue to believe their broker does have to put their interests first, independent RIAs would be able to tell prospective clients otherwise — and work to get that message out via the media.
Would investors really be better off under this hypothetical scenario? They’d at least have a chance of understanding the standard of care that their broker is legally obligated — and not obligated — to provide. To my mind, that chance is pretty slim in the current “sometimes I’m your fiduciary and sometimes I’m not” situation. To most folks, that’s just plain confusing. As Knut Rostad, president of the IFFS, put it, “Investors shouldn’t need a lawyer to understand what their broker is required to do for them.”
SEC ‘Eroding’ Client Protections
Of course, the FPA’s victory isn’t the only reason that investors are confused these days about brokers’ standards. As Rostad detailed last year in the Institute’s white paper, “Conflicts of Interest and the Duty of Loyalty at the SEC,” during the past 10 years or so, the SEC has been actively eroding the ’40 Act fiduciary standard that applies part-time to brokers. The commission has done this by morphing both a fiduciary’s duty to avoid conflicts and to act in the client’s best interest into simple disclosure (see “An SEC Broker Fiduciary Standard May Undermine the ’40 Act,”Investment Advisor, May 2015).
In that paper, Rostad concluded that at the SEC today, “conflicts are no longer viewed as inherently inconsistent with objective advice […]. The ‘new normal’ is that conflicts are OK.”