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The Tangled Web of 'Uniform Fiduciary Standards'

Although an SEC study concludes that a uniform standard is necessary, it is sparse on the details.

Judith A. Hasenauer, 03/03/2011

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

We have written in the past about the future of fiduciary standards being implemented by the SEC in response to the requirements imposed by the Dodd-Frank Act. The SEC has finally released its long-awaited study to Congress that pretty clearly indicates that some form of "uniform" fiduciary standards will eventually be applied to stock brokers and investment advisors. Although the SEC study concludes that a uniform standard is necessary, it is sparse on the details. It is particularly difficult to ascertain any clear understanding of what we think of as the distinction between a "Fiduciary" (with a capital "F") and a "fiduciary" (with a lower case "f"). Most stock brokers earn their living from commissions. The majority of investment advisors earn theirs from fees. In this difference in compensation lies the primary distinction between a "Fiduciary" and a "fiduciary."

The distinction between a fiduciary with a capital "F" and one with a lower case "f" (this is our characterization--it is not official in any way), is the difference between one who owes his principal or client somewhat of a duty of trust and fair treatment and one who owes a complete duty of trust that includes a prohibition against profiting from transactions with the client. The courts have long held that stock brokers have some sort of a fiduciary relationship with their clients (fiduciary with a lower case "f"). The cases seem to reach the conclusion that a stock broker owes his client a duty for fair dealing which involves not taking unfair advantage of the relationship. This lower case "f" duty has not resulted in a prohibition against payment of commissions. It has also not meant that a stock broker has the same degree of duty that is owed by a trustee or lawyer (or maybe even an investment advisor) to the client. The type of fiduciary duty owed by a trustee or lawyer includes a prohibition against profiting personally from any situation that should inure to the client. It is probably unlikely that the receipt of a commission on a transaction on behalf of the client would be consistent with such a fiduciary duty.

It is the use of the term "uniform" in the SEC study that causes us concern. Certainly, the SEC could adopt regulations that would enable a stock broker to receive reasonable commissions on transactions completed for a client without violating the fiduciary duty owed to the client. However, it seems likely that any such commissions would require full and complete disclosure to the client and might even be required to be "reasonable" taking into consideration the services rendered. Federal securities laws (the Securities Exchange Act of 1934) already permits the SEC and FINRA to enact rules that require stock brokers to make no recommendations to their clients regarding purchase or sale of securities unless such a recommendation is "suitable" to the client's needs. Implementation of a fiduciary standard is more stringent that the current suitability rules.

The Investment Company Act of 1940, in Section 36, already imposes quite stringent fiduciary requirements on investment advisors to regulated investment companies. This fiduciary requirement has been interpreted to limit fees charged by an investment advisor to a "reasonable" amount and to prohibit utilizing any fees charged by such an investment advisor for other than advisory activities. Thus, it took special rules to be adopted by the SEC to permit charges against investment company assets for sales activities (Rule 12b-1). Over the years there has been a great amount of litigation against investment advisors alleging unreasonable charges against investment company assets. Moreover, "unreasonable" charges against investment company assets have not been able to be resolved by disclosure. If they are "unreasonable," they are in violation of an investment advisor's fiduciary duty to the mutual fund. Could such a standard be a part of the "uniform" standards that will be implemented by the SEC?

Conceptually, it is difficult to reconcile such an absolute standard with the concept of selling something to a client. Certainly, stock brokerage firms that merely accept orders for stock transactions are probably in a better position than are the more traditional brokerage firms that engage in sales campaigns. Those customers who do not awake in the morning with the thought "I need to buy some securities today," are motivated by a salesperson creating the demand in their minds. This is even more of the case with sales of variable annuities and variable life insurance. It is doubtful if anyone awakes in the morning with the thought that they should buy insurance before the end of the day. Insurance is not bought, it is sold. Yet, people need insurance, whether they recognize the need or not.

If the "uniform" fiduciary standards, when they are adopted, require stock brokers and sellers of variable insurance products to disclose the exact total amount of compensation and limit such compensation to that which is "reasonable," there will be profound changes to the way in which investing is done in this country. While it is admirable to want to "protect" consumers, if such protection extends to killing sales of investment products, nothing will have been accomplished except to destroy the capital markets in this country.

We have, for many years, reminded the young lawyers who have worked for us that it is possible to protect the client right into bankruptcy. Businesses have to sell their products. In order to do so, salespeople must be compensated. Likewise, free markets have the absolute requirement that risk is inherent. If there is no risk, there is no reward. If some form of a "uniform" fiduciary standard implies that stockbrokers and investment advisors must guarantee a risk-free investment environment, then the free market disappears. Likewise, if stock brokers and investment advisors cannot be compensated for their services, there will be no market, free of otherwise.

It is obvious that some form of enhanced fiduciary standard is on the horizon. We can but hope that it will be rational and not destroy the very system that it is supposed to enhance.

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