INVESTOR CONFUSION EXISTS OVER FEE-BASED ADVICE OFFERINGS
In the financial world today, there are basically two types of advice available to investors: that given by stockbrokers, and that given by Registered Investment Advisers (RIAs). Unfortunately, most investors don’t know the difference between these two kinds of advice.
In fact, most aren’t even aware a difference exists. In a recent survey:
- 54% of investors believed both stockbrokers and independent RIAs have a responsibility to act in their best interests.*
- 74% of investors did not understand the different obligations required of RIAs and stockbrokers. Unlike stockbrokers, RIAs have an obligation to act in an investor’s best interests in all aspects of the financial relationship.*
- 79% said they would rather work with an investment adviser if they knew advisors provided greater investor protection than stockbrokers.* The truth is, there’s considerable confusion in the investment community regarding financial advice and
the people who dispense it. The following questions and answers aim to sort out some of the confusion, and to help you find advice you can trust.
WHY DOES THIS CONFUSION EXIST?
Historically, brokerage firms could offer investment advice only if that advice was “solely incidental” to their brokerage business, and only if they did not receive “special compensation” for the investment advice. The SEC interpreted these provisions narrowly
until 1999, when it issued a proposal allowing brokerage firms to offer fee-based accounts without registering as investment advisers.
The SEC also issued a controversial “no-action” position, allowing brokerages to take advantage of the proposal before it was finalized. In 2004, the Financial Planning Association (FPA) sued the SEC for allowing the “no-action” position to continue without taking final
action after hundreds of comments were submitted in opposition to the proposal. The SEC then reopened the comment process, and on April 6, 2005, it announced it was adopting a final rule similar to its 1999 proposal.
In 2007, the FPA ultimately received a successful outcome. In the ruling, Judge Judith Rogers and Judge Brett Kavanaugh noted that the SEC exceeded its authority by exempting brokerage firms that charge asset-based fees from registration under the Advisers
Act.
Ironically, then, when the FPA won its lawsuit against the SEC and had the broker-dealer exemption rule vacated, these definitions of what does and does not constitute “solely incidental” advice were thrown out along with it, due to the lack of any severability
provisions in the rule that might have allowed the court to reject some parts of the rule but not others. As a result, interpretations of the ’40 Act reverting to the prior-and-now-still-current status where the “solely incidental” provision remains substantially unenforced,
despite an even-more-dramatic expansion of financial planning into brokerage firms.
So perhaps it’s time for the FPA to re-assert itself in lobbying, not around proposing new fiduciary rules or a uniform fiduciary duty, but simply to push the SEC to promulgate updated rules and actually enforce the “solely incidental” clause of the ’40 Act as written today.
In other words, perhaps all we need to ensure that consumers receive financial planning subject to a fiduciary duty is for the SEC to recognize again – as it did once already – that the delivery of financial planning services itself expands the scope of advice beyond being “solely incidental” to brokerage services, and enforce those rules accordingly.
HOW ARE INVESTMENT ADVISERS DIFFERENT THAN STOCKBROKERS?
Some of these key differences follow:
- Investment advisers have a fiduciary duty to act in the best interests of their clients at all times. Brokerage firms generally are not fiduciaries to their customers and therefore may not make decisions that are solely in their customers’ best interests.
- Investment advisers provide their clients with a Form ADV that describes exactly how the investment adviser does business and obtains the client’s consent to any conflicts of interest that might exist with the investment advisor’s business. Brokerage
firms are not required to provide customers with any comparable type of disclosure. - Investment advisers cannot trade with their clients as principal except in extremely limited circumstances. Brokerage firms often earn significant profits by trading as principal with their customers.
- Investment advisers charge clients a fee negotiated in advance and cannot earn any other profits from their clients without the clients’ prior consent. Most investment advisers are paid an asset-based fee, so their interests are aligned with their clients.
- Brokerage firms’ revenues may increase even if the customers’ assets shrink. ♦ Investment advisers manage money in the best interests of their clients. They do not engage in business activities like investment banking or underwriting, which brokerage firms do. These other businesses may cause a brokerage firm’s interest or attention to focus on other areas of the firm outside of their retail brokerage business and customers.
WHAT ARE THE ADVANTAGES OF WORKING WITH AN INDEPENDENT REGISTERED INVESTMENT ADVISER OVER A STOCKBROKER?
RIAs are held to a higher standard than stockbrokers when it comes to putting investors’ interests first and doing the right thing for their clients’ investments. Independent RIAs have a fiduciary duty to their clients, which means they must:
- Act in the best interest of their client
- Identify and monitor illiquid securities
- Employ fair market valuation procedures where appropriate
- Observe procedures regarding the allocation of investment opportunities, including new issues and the aggregation of orders
- Have policies regarding affiliated broker-dealers and maintenance of brokerage accounts
- Disclose all conflicts of interest
- Have policies on use of brokerage commissions for research
- Have policies regarding directed brokerage, including step-out trades and payment for order flow
- Abide by a code of ethics
Stockbrokers are held to suitability obligations on the part of their broker-dealer when making
recommendations:
- Reasonable Basis Suitability — the broker-dealer must believe that the recommended security is suitable for any investor
- Customer-Specific Suitability — the broker-dealer must believe that its recommendation is suitable for that particular investor