• / Free eNewsletters & Magazine
  • / My Account
Home>Practice Management>Fiduciary Focus>Broker-Dealers and Other Non-Fiduciaries as Fiduciaries?

Related Content

  1. Videos
  2. Articles
  1. Benz: How Small Changes Can Bridge a Retirement Shortfall

    Bundled together, small tweaks can help investors get their portfolios ready for retirement, says Morningstar's Christine Benz in this special one-hour presentation.

  2. Create a Lean, Mean Tax-Efficient Machine

    Morningstar's Christine Benz discusses how to improve your take-home return by reducing the drag of unnecessary tax exposure.

  3. How to Make the Most of Your 401 (k )

    In this special presentation, get the answers to key questions about the quality of your plan, whether your savings are on track with your goals, how to allocate assets, and what to do with assets when you leave your job.

  4. 7 Habits of Successful Investors

    Special presentation: Learn how 'cheaping out,' building in discipline, and other simple steps help successful investors get it done.

Broker-Dealers and Other Non-Fiduciaries as Fiduciaries?

There's a regulatory wrestling match going on in Washington.

W. Scott Simon, 09/03/2009

I normally don't worry too much about legislative and regulatory proposals concerning the financial-services industry for two reasons. First, most such proposals eventually fall by the wayside. Second, I can't influence their outcome anyway. I thought, nonetheless, that it might be interesting this month to explore one of these proposals that is shaping up as a truly monumental wrestling match between the executive branch of the federal government and the mighty special interest groups whose members can be impacted so heavily by it.

This match has now commenced with the proposed Investor Protection Act of 2009 and the Department of Treasury white paper titled "Financial Regulatory Reform, a New Foundation: Rebuilding Financial Supervision and Regulation." Part of this proposal, in which the Obama administration is effectively pitted against the broker-dealer industry, seeks to (1) subject broker-dealers providing investment advice to their clients to a fiduciary standard and (2) "harmonize" the regulation of broker-dealers and registered investment advisors by replacing the suitability standard that now governs broker-dealers with the fiduciary standard that now governs registered investment advisors.

In a nutshell, the two-pronged goal of the administration is to turn broker-dealers into fiduciaries and then subject them to the same fiduciary standard that governs registered investment advisors. The great uncertainty of this titanic struggle, of course, will be whether broker-dealers will actually be turned into fiduciaries and, even if they are, what kind of fiduciary standard they will actually have to meet.

Note that Treasury's white paper speaks to individual investors, not participants in qualified retirement plans governed by the Employee Retirement Income Security Act of 1974. It's likely, though, that if Treasury's proposal is adopted it will govern the conduct of broker-dealers in their relations with participants (and their beneficiaries) in retirement plans such as 401(k) plans. Given that (conditional) likelihood, my discussion in this month's column is focused on retirement plans.

A Bit of History
The SEC was established by Congress in 1934 to, among other things, regulate the nation's stock market. Part of the responsibility of the SEC is to administer a number of laws that govern the securities industry, including the Securities Exchange Act of 1934, which regulates broker-dealers, and the Investment Advisers Act of 1940, which regulates registered investment advisors.

The World of (Fiduciary) Registered Investment Advisors
Section 202(a)(11) of the 1940 Act defines an "investment adviser (as it was spelled in the Act)"--i.e., an RIA as well as the investment advisor representatives of an RIA--as: "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. "

Surprisingly, the word "fiduciary" doesn't appear in the text of the 1940 Act. If there was ever any doubt, though, the U.S. Supreme Court made clear in SEC v. Capital Gains Research Bureau, Inc. (375 U.S. 180 (1963)) that the 1940 Act "reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship, as well as a congressional intent to eliminate, or at least expose, all conflicts of interest which might incline an investment adviser--consciously or unconsciously--to render advice which was not disinterested." Further, an RIA owes its clients a duty of "utmost good faith, and full and fair disclosure of all material facts" as well as an affirmative obligation "to employ reasonable care to avoid misleading clients."

Given its legal status, an RIA must follow the fiduciary standard of the 1940 Act which requires it to place the interests of its clients ahead of its own and to fulfill critical fiduciary duties such as attempting to avoid outright (and if not possible, minimize) all material conflicts of interest (and to disclose any such conflicts that cannot be avoided or minimized) which might tempt the RIA to render disinterested investment advice. Under this standard, an RIA must provide its "best advice" to clients.

It is said that the conduct of fiduciaries is governed by principles (as illustrated by the language in the preceding Supreme Court opinion) and that the 1940 Act is a principles-based statute. Although such principles may seem merely aspirational in nature, the failure to actually implement them in a reasoned manner does carry the risk of significant legal and regulatory penalties. The process (or lack thereof, as the case may be) by which these fiduciary principles are implemented is subject to the inherent uncertainties of the requisite facts-and-circumstances test in litigation.

The World of (Non-Fiduciary) Broker-Dealers
Broker-dealers, as noted, are regulated under the 1934 Act and, as such, they are not fiduciaries. A broker-dealer and its registered representatives (to keep things straight here, the same (non-legal) relationship exists between an RIA and its investment advisor representatives) follow the "suitability" standard (rather than the fiduciary standard). This standard doesn't require a broker-dealer to place the interests of its clients ahead of its own.

Under the non-fiduciary suitability standard, a broker-dealer need provide only "suitable advice" to its clients - even when it knows that the advice is not the best advice as required under the fiduciary standard. (A broker-dealer, of course, is allowed legally to avoid being subject to the suitability standard altogether by ensuring that any advice it does provide is only "incidental" to any transaction executed on behalf of its client.) Suppose, for example, that a registered representative recommends a mutual fund with a 5% load and high annual expenses that would be suitable for its client but it also knows of an equivalent no-load fund with low annual expenses. The registered representative ordinarily wouldn't be at fault for recommending the more expensive investment to its client. It is more likely that an RIA would be liable for engaging in such conduct because of its fiduciary status.

It is said that the conduct of non-fiduciaries such as broker-dealers is governed by rules and that the 1934 Act is a rules-based statute. Adherence to cut-and-dried rules such as those concerning suitability and disclosure provides broker-dealers with a safe harbor, thereby protecting them from liability. Yet certain sales practices--based on such rules--that some broker-dealers engage in might not always be in the best interests of their clients, despite the fact that they follow these rules to the letter. Even the many broker-dealers that have their clients' best interests at heart may have to do wrong by them at times in order to comply with some rule.

In days long past, the SEC began to regulate both RIAs and broker-dealers. (broker-dealers are subject to the Financial Industry Regulatory Authority, a self-regulating authority founded in 2007 and the successor to the National Association of Securities Dealers, formed as an SRO in 1939 in response to certain amendments to the 1934 Act.) Back then, however, broker-dealers gave no investment advice to their clients--they only executed orders to trade stocks and bonds. Broker-dealer s conducted a transaction-based business in which some commission-compensated financial product was employed to satisfy a particular need of a client at a particular point in time. Broker-dealers provided no ongoing advice or monitoring.

This picture has changed in recent years. Today, many broker-dealers give investment advice to their clients. Because they do, many (including the Obama administration) believe that broker-dealers providing investment advice to their clients should have to meet the higher standard required of an RIA fiduciary rather than the lower suitability standard required of a broker-dealer.

As I've mentioned in this column a number of times over the years, broker-dealers do not want to have anything to do with being fiduciaries. That just is, and has been, a fact for a long time. Perhaps figuring that a fiduciary moniker will attach to them one way or another, broker-dealers are attempting to shape the outcome of this wrestling match to their own advantage. They have suggested, for example, that a new federal fiduciary standard should be developed that will apply to all broker-dealers and RIAs providing investment advice to their clients.

In addition to broker-dealers and RIAs, employee benefits brokerage firms can provide investment services to qualified retirement plans such as 401(k) plans. Benefits brokers, typically licensed under state insurance laws, can also be (but are not required to be) licensed as registered representatives of broker-dealers under the 1934 Act. It should be noted that state insurance laws make no mention of any kind of fiduciary standard. Benefits brokers (as well as RIAs and broker-dealers) may become fiduciaries under ERISA once they provide a qualified retirement plan with individualized advice based on the particular needs of the plan or its participants. Treasury's proposal doesn't discuss employee benefits brokerage firms at all. This is an interesting twist and may allow them to remain flying under the radar when it comes to this wrestling match.

Which Fiduciary Standard?
Given the significant interest in whether or not broker-dealers will be turned into fiduciaries and, if so what kind of fiduciary standard they will actually have to meet, it's no surprise that there's been some discussion of late about different "kinds" of fiduciary standards. For example, it has been suggested that the fiduciary standard of the 1940 Act (and accompanying SEC regulations)--requiring a fiduciary to act merely in a client's "best interests"--is less robust than that of ERISA--requiring a fiduciary to act "solely in the interest" of plan participants (and their beneficiaries).

Apart from the issue of whether or not that's actually true, there's no good reason why any RIA, broker-dealer, benefits broker, or any other entity providing investment advice to individual clients (and obviously to qualified retirement plans and participants in them) should not be charged with living up to the fiduciary standard found in ERISA section 404(a).

ERISA section 404(a) reads, in part: "A fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and (A) for the exclusive purpose of providing benefits to participants and their beneficiaries, (B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims . "

The fiduciary standard set forth in ERISA section 404(a)--including the great "sole interest" and "exclusive purpose" rules--is based on trust law. The prefatory note to the 1994 Uniform Prudent Investor Act explains: "[ERISA] . absorbs trust-investment law through the prudence standard of ERISA [section] 404(a)(1)(B) . The Supreme Court has said: 'ERISA's legislative history confirms that the Act's fiduciary responsibility provisions 'codif[y] and mak[e] applicable to [ERISA] fiduciaries certain principles developed in the evolution of the law of trusts.' Firestone Tire & Rubber Co. v. Bruch, 489 U.S. 101, 110-11 (1989) (footnote omitted)." John H. Langbein, the Reporter for the Uniform Prudent Investor Act and the Chancellor Kent professor of law and legal history at Yale University law school, notes: "The core fiduciary law is ERISA [section] 404(a)(1) which propounds the foundational norms--the duties of loyalty and prudence--which underlie all trust fiduciary law."

Professor Langbein describes the nexus among ERISA, the common law of trusts and the Uniform Prudent Investor Act: "ERISA has always been interpreted with a strong eye on the common law, and it is therefore quite clear that the Uniform Prudent Investor Act will powerfully affect the federal courts in their interpretation of ERISA." This is all explored in detail--some would say agonizing detail--in my book, The Prudent Investor Act: A Guide to Understanding.

Section 5 of the Uniform Prudent Investor Act, which defines the duty of loyalty, clearly spells out to all who wish to provide investment advice to their clients the high standard required of them: "A trustee shall invest and manage the trust assets solely in the interest of the beneficiaries." Commentary to section 5 explains: "The duty of loyalty is perhaps the most characteristic rule of trust law, requiring the trustee to act exclusively for the beneficiaries [which would be participants and their beneficiaries in the qualified plan milieu], as opposed to acting for the trustee's own interest or that of third parties. The concept that the duty of prudence in trust administration, especially in investing and managing trust assets, entails adherence to the duty of loyalty is familiar. ERISA 404(a)(1)(B) . extracted in the Comment to Section 1 of [the Uniform Prudent Investor] Act, effectively merges the requirements of prudence and loyalty. A fiduciary cannot be prudent in the conduct of investment functions if the fiduciary is sacrificing the interests of the beneficiaries."

Adoption of the ERISA fiduciary standard and making it mandatory for all providers of investment advice also obviates the need for the broker-dealer industry to come up with a new federal fiduciary standard. Why? Because we already have a federal fiduciary standard, and have had it for 35 years: ERISA section 404(a). Professor Langbein couldn't put it more succinctly: "ERISA is derived from the common law of trusts; ERISA federalized the common law of trusts."

Broker-Dealers and Other Non-Fiduciaries Can Prosper Whether or Not They Become Fiduciaries
To me, then, the fiduciary standard found in ERISA merits application to all investment advisors and should be the overarching outcome of this great wrestling match. The beauty for broker-dealers, though, is that even with this seemingly worst-case outcome there's still a way for them to not only avoid being a fiduciary but also to thrive in the qualified retirement plan market like they never have before. This newly found prosperity is found not at the plan level per se but among the many plan participants that can provide a multiple of revenue for broker-dealers. Next month's column will describe how broker-dealers (or RIAs for that matter) can gain access to this approach.

Note: In last month's column, I may not have explained one issue with enough clarity: the duties of a plan sponsor in a multiple employer plan. In considering the MEP scenario, a plan sponsor need make only one decision: whether to join the MEP or not to join it. If the sponsor decides to join the MEP, it then morphs, so to speak, into what I would term a "participating employer" in the MEP.

Once the plan sponsor undergoes this metamorphosis, it then has no discretion or power to appoint anyone, or delegate any duties. If the former-plan-sponsor-but-now-participating employer has no discretion or power to appoint, or delegate, then it has no duty to monitor. A fiduciary can only monitor what it has discretion or power over, or can appoint or delegate.

So the answer to the question--what duties does a plan sponsor that decides to join a MEP have--must be none at all. Once the plan sponsor joins the MEP, it has absolutely no duties, including the on-going duty to monitor any vendors or investments. All duties would devolve to the realm of the plan sponsor that set up the MEP and that received delegation of such duties from the former-plan-sponsor-but-now-participating employer.

The plan sponsor that set up the MEP would then be able to exercise its power to appoint, and delegate to, a full-scope ERISA section 3(21) named fiduciary. That 3(21) fiduciary could, in turn, appoint, and delegate to, an ERISA section 3(38) fiduciary that would assume fiduciary responsibility for the selection, monitoring and (if necessary) replacement of the plan's investment options.

The former-plan-sponsor-but-now-participating employer does have the inherent power to quit the MEP if it so desires. If it does, it morphs back into the plan sponsor and reassumes all fiduciary duties that attach to it under ERISA.

Get practice-building tips and information from our team of experts delivered to your e-mail inbox every Thursday. Sign up for our free Practice Builder e-newsletter.

©2017 Morningstar Advisor. All right reserved.