Are Investment Advisors & Broker-Dealers, Fiduciaries?

On January 3, 2008, the Securities & Exchange Commission issued a Press Release, entitled "SEC Publishes Text of RAND Report on Investment Adviser, Broker-Dealer Industries". The referenced study explored industry and investor perspectives on customer relationships with financial service providers.

The Report prepared under contract by the RAND Corporation, in part, studied the "fiduciary" role or obligations of an investment adviser or a broker-dealer licensed by the SEC towards a customer/client.

The Securities and Exchange Commission has received and posted on its Web site the text of the RAND Corporation's final report on practices in the investment adviser and broker-dealer industries.

"The Commission has been anxious to receive RAND's study of the investment adviser and broker-dealer industries, and the nature of their relationships with customers. The report will assist the Commission's efforts to update our regulations to improve investor protections in today's new marketplace," said SEC Chairman Christopher Cox.

"Our staff is now studying the report and the potential regulatory implications of its findings."

RAND produced the report under contract with the Securities and Exchange Commission. The report is the product of more than a year of empirical study and analysis. * * * [Link inserted.]

The controversial nature of the topic and the genesis of this Rand Report are revealed in the last paragraph of that Press Release:

Following a March 2007 Court of Appeals decision that overturned a 2005 SEC rule permitting non-adviser broker-dealers to charge fees to investors based on account size, the SEC and RAND agreed that RAND would deliver its final, peer-reviewed report in pre-publication format on Dec. 31, 2007, three months earlier than the contract had originally required.

The text of the posted report is final and has been peer-reviewed. Neither the data nor the analysis on which it is based will change. The fully formatted, publication version of RAND's final report is due by March 25, 2008.

The RAND Report (IA/BD), 12/07 (PDF, 219 pages, 12 MB) is available online.

Issuance of the Report was noted on January 3, 2008, by The Registered Rep, which is targeted at professional investment advisers, in a posting entitled "SEC's RAND Study Released":

The SEC released the results of the RAND study today, which examined two issues: how broker/dealers and investment advisors market and provide products and services to investors, and how investors understand the differences between investment advisors and broker/dealers.

The RAND study paints a picture of today’s brokerage and investment advisory firms as shape-shifters, “taking many different forms, and offering a multitude of products and services,” leading to confusion among the retail investing public, especially when it comes to differences between the legal duties of investment advisors versus brokers. * * *

The article noted an initial criticism of the Report by the Financial Planners Association -- the plaintiff which brought the litigation that resulted in the Court of Appeal's reversal on March 4, 2007, of the SEC's prior rulemaking:

Duane Thompson, group director of advocacy for the FPA, says he commends the SEC and RAND for their thorough work, but he was “under-whelmed,” by the results of survey.

Thompson says “the tricky part of this whole issue really isn’t addressed in the study itself because RAND wasn’t charged with making policy recommendations. The $64,000 question is: Whose set of rules should advisors and brokers operate under?”

According to Thompson, the study basically states that advisors and brokers are doing the same thing, and investors really don’t understand the differences in the titles they use.

“You can look at the cup as half empty or half full,” he continues. “Most investors say their happy with their advisor and that should come as no surprise. Most advisors are honest and do a good job, whether they’re affiliated with a broker or an investment advisor. But our concern is that you should play by the same rules if you’re doing the same thing.” * * *

That article also noted the limited effect of the RAND Report and the discussion yet to come:

What will the SEC do with Rand’s findings?

The FPA’s Thompson says it is still early to tell, but he predicts “a huge cat fight” over the next 12 months.

“My sense is that the SEC is going to use the study to create a new regulatory structure or at least seriously consider a new regulatory structure for brokers and advisors who provide retail advice,” he says.

According to Thompson, the FPA would like to see a roundtable (similar to the SEC-hosted 12b-1 fee roundtable in June 2007), to get the industry and consumer groups to talk about the issue before the SEC takes action. * * *

MarketWatch (a Dow-Jones service) reviewed the Report in its article by Alistair Barr, posted on January 3, 2007, entitled "Investment advisers, brokers blurred, Rand says". It noted that "[d]istinctions between the two main types of financial professional have blurred in recent years and customers don't understand the different fiduciary duties of the people helping them invest * * *." [Emphasis added.]

An investment adviser gives advice to others about what securities to buy and sell. A broker executes trades for clients, while dealers trade for their own accounts.

The distinctions are important because these financial professionals have different responsibilities under various federal regulations, the report commissioned by the Securities and Exchange Commission said.

But as financial markets have become more complex this decade, these important distinctions have become blurred, Rand said Thursday.

"Current laws and regulations are based on distinctions between the two types of financial professionals that date back to the early 20th century and ... these distinctions appear to be eroding today," the Rand report concluded.

"Investors do not operate with a clear understanding of the different functions and fiduciary responsibilities of their financial professionals." * * *

Investment News published a commentary on January 7, 2008, by Diahann W. Lassus, entitled "SEC to continue assault on fiduciary protection in 2008, which criticized the SEC's past position exempting broker-dealers from fiduciary duties and its apparent continued reluctance to do so:

Despite the U.S. Court of Appeals' recent rebuke of the SEC in Financial Planning Association vs. Securities and Exchange Commission, the regulator appears ready to continue to reduce the fiduciary protections afforded by the Investment Advisers Act of 1940 to consumers of investment services. [Link added.]

First, there is the "two hats" special rule proposed by the SEC in September that would permit a dual registrant to act with the same client/consumer both as a fiduciary on investment advisory accounts and not as a fiduciary with respect to brokerage advisory accounts.

It is obvious that consumers of investment services neither understand nor are able to discern the dual registrant's status as he or she switches between being a fiduciary, or otherwise having to act in the consumer's best interest, to being a product salesperson.

The plain language of the Advisers Act has an exception for persons and their relationships, not accounts.

"Two hats," if enacted, would open the door to the use of "bait and switch" activities, which none of us wants to see.

The SEC also appears ready to continue 12b-1 fees in 2008, with only minor modifications.

What's the difference between a 12b-1 fee, deducted by the mutual fund company and paid to the broker-dealer firm, and a fee-based brokerage account? Nothing.

And this reminds me of an old maxim taught to all lawyers in law school — "you cannot do indirectly what you cannot do directly." In other words, "if it walks like a duck ..."

The SEC seems ready to pursue a course that is clearly not in the best interests of the consumer * * *.

What does FPA want?

The FPA's leadership expressed support for a universal fiduciary standard of conduct, under the law, for all financial planners.

The "Focus on Fiduciary" campaign of Arlington Heights, Ill.-based National Association of Personal Financial Advisors continues to enlighten consumers. * * *

That Campaign was the subject of a prior PA EE&F Law Blog posting, "NAPFA Unveils "Fiduciary" Campaign & Website" (05/04/07), when the National Association of Personal Financial Advisors unveiled its new website "Focus on Fiduciary".

That movement "aims to educate Americans about the need for financial professionals to hold themselves to a fiduciary standard."

In its proposed rulemaking, I suggest that the SEC also determine, definitively, whether the term is properly spelled "advisors" (according to the FPA) or "advisers" (according to RAND).