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Fiduciary Duty

 

Investing can be complicated, technical, time-consuming, and, for many, not very interesting. As a result, many individuals seek the guidance of experienced and trustworthy financial professionals.

 

But whom can we trust? Whom can we feel comfortable and confident with our hard-earned assets, personal information, and financial futures? On whom can we rely to put our interests first?

Expectation and the law

 

There are two sides to the trust coin that are completely distinct, but often confused. First, there is expectation. We approach every commercial transaction with some notion about the other party and the extent to which our interests align. For instance, we may fairly expect our local grocer to sell only fresh, safe, and accurately labeled products. But we would not necessarily expect him to put our interests ahead of his, all or even most of the time. We understand that he is in business to make a profit, and it would be naive to expect him to put our interests first when, for instance, he sets a price for fresh produce. Nor would we expect him to reveal the price he paid the wholesaler or the other inner workings of his business.

 

Our expectation of trust of the grocer is a work in progress, built over time through experience. In general, we expect to be treated in a way that earns our repeat business. In other transactions, our expectation of trust may be higher or lower. We always hope for good treatment from the mechanic, carpenter, and car dealer, but we recognize that these and other vendors have their own interests that will almost always come first. In most business relationships we keep our expectations pretty low, knowing our greatest protections are care and skepticism. That is, let the buyer beware.

On the flip side of expectation is legal responsibility. The grocer can be held liable if he knowingly sells tainted meat or produce. The carpenter can be held responsible for causing damage to property. “Lemon laws” provide some recourse against buying a car with incurable problems. But beyond these simple protections, sellers of products and services are rarely required by law to put the interests of their customers ahead of their own.

Investing is different


Trust in the financial services arena is ruled by the same two-sided coin — what we expect and what the law requires. We expect good treatment from our financial advisors. We know trust and honesty are essential to create financial plans and portfolios that serve our financial and family interests. We expect advisors to suggest sound investments that align with our needs, time horizon, and comfort with risk. Our expectations of financial professionals are relatively high; in general, we view financial advisors as worthy of our trust.

 

On the legal side of the coin is fiduciary duty. Fiduciary duty is a legal duty of care, loyalty, honesty, and good faith. As SEC Commissioner Luis Aguilar described in a speech to the Investment Advisers Association Annual Conference on May 7, 2009,

“… A fiduciary has an affirmative obligation to put a client’s interests above his or her own. As a result, a fiduciary acts in the best interests of the client, even if it means putting a client’s interest above his own. …A fiduciary standard…is an affirmative obligation of loyalty and care that continues through the life of the relationship between the adviser and the client, and it controls all aspects of their relationship. It is not a check-the-box standard that only periodically applies.”

 

To a far greater extent than in most businesses, investment advisors are legally bound to put the interests of clients ahead of their own. This means, among other things:
 

  • Selecting investments based on client needs, not on compensation or career success for the advisor

 

  • Disclosing any markups on transactions for client accounts

 

  • Revealing any existing or potential conflicts of interest

 

  • Disclosing any sources of compensation that could influence the guidance of the advisor

 

  • Transparency in all dealings, guidance, and decisions


These are fundamental protections — similar to those that apply to doctors, lawyers, and CPAs — that validate the expectation of trust we bestow on financial professionals. They are true legal obligations, not mere ethical standards or industry guidelines. Violations can mean the end of a career and other penalties.

An important distinction


Fiduciary duty means that advisors are obligated by law to protect investor interests. However, not all financial professionals are bound by fiduciary duty. Registered Investment Advisors (RIAs) are. But broker-dealers typically are not. Broker-dealers serve clients, but work for their employers.

 

Broker-dealers (Brokerage Firms) are not required by law to recommend investments that are in the best interest of clients. Instead, they must meet a much lower standard — suitability. A recommended investment must be suitable for the investor, generally meaning only that the levels of risk and sophistication are appropriate.

 

The suitability standard allows brokers to pursue their own interests without disclosing those interests. Brokers are free to, for example, recommend mutual funds that earn commissions or bonuses for themselves, or sell bonds from the brokerage’s in-house inventory at undisclosed markups. In making a recommendation, a broker is not required to disclose the compensation he or she may receive, or discuss that other similar suitable, or better, investments may be available at lower prices. He or she is not required to seek out on behalf of their clients investments with low transaction or management fees.

 

Compared to fiduciary duty, suitability is a lower bar. Because of this important distinction between fiduciaries and brokers — a distinction unknown or unclear to many investors — many brokers include this language on account agreements and promotional materials:

 

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

 

One of the regulatory reforms under consideration to close the gap between advisors and brokers is to require brokers to adhere to a fiduciary standard, but at this time, no such requirement applies.

No surprises


To be sure, a suitability standard is acceptable for many investors, and does not preclude a broker from providing sound guidance and earning a high level of client trust. However, every investor should fully understand the legal boundaries within which a financial professional operates.

And by the same token, a professional designation alone should never merit blind trust. Before working with any financial professional, investors should exercise thorough due diligence — ask questions, review resumes, and talk to other clients. And remember that an expectation of trust and legal duty are two different sides of the same coin — connected but distinct.

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