The current suitability procedures in effect at many brokerage firms are insufficient to satisfy more robust fiduciary standards.
The SEC and the Department of Labor have announced that they are going to re-propose that Registered Representatives be held to the standards of a fiduciary. These new requirements, if adopted, could cause major changes to the way financial services are provided in our country.
Of course, how profound these changes will be will depend on the final rules and how "fiduciary" ends up being defined within the context of the traditions and customs of the financial-services industry. We have written on this subject in the past, but we believe that it is important to revisit it in light of what will be happening in the near future.
The concept of "fiduciary" and "fiduciary duty" is well-established in Anglo/American jurisprudence. In its simplest application, a "fiduciary" is one who owes another person a duty of trust and the obligation to place the other person's best interests above the interest of the fiduciary. Traditionally, a fiduciary has been held to the standard of absolute loyalty to the beneficiary of the trust relationship. The most important element in a fiduciary relationship is that the fiduciary avoid self-dealing that is not to the benefit of the beneficiary. The majority of disputes involving fiduciary relationships have been with respect to the question of self-dealing by the fiduciary.
Stock brokers have long been held to have a fiduciary relationship with their customers. However, this relationship has not been held to the same level as other types of fiduciary relationships--for example, the loyalty owed by a trustee to the beneficiary of a trust, or that owed by a lawyer to his client. Thus, the existing fiduciary relationship between a stock broker and her customer has not been as extensive as other, more traditional fiduciary relationships have been. The proposals from the SEC and the DOL will have to expand on the fiduciary duties owed by a stock broker to his customer or they will be meaningless.
The current fiduciary relationship requirements have been primarily derived from court cases and arbitration proceedings. The application of fiduciary standards to stock brokers seems to be derived from the longstanding suitability standard and the concept of fair dealing with customers, which are requirements imposed by FINRA and its predecessor. It has never been clear how these fiduciary standards impact commissions paid to stock brokers--particularly when the recommendations made by stock brokers involve different types of commissions with different commission levels attached to the securities that are the subject of the recommendations. If fiduciary standards are taken to their extreme conclusion, it could be impossible for a true fiduciary to recommend any investment resulting in a commission to the fiduciary. A fiduciary should always recommend only those investments that are in the best interests of the customer--never in those that result in the most commission to the fiduciary. A possible result of new fiduciary standards applied to stock brokers is the end of payment of commissions on purchases of securities.
A stated reason for the application of fiduciary standards to stock brokers as enunciated by the SEC is to "level the playing field" between stock brokers and investment advisors. Investment advisors have always been subjected to high standards of fiduciary duty and have generally looked to fee-based compensation rather than to commissions. Obviously, a requirement that permits only fee-based compensation will dramatically affect the securities business as we have all known it. It will also make it much more difficult for "startup" brokers and investment entities to become established. After all, it is always easier to put customers in well-established forms of investment than to take the risk of trying new things. Moreover, fee-based compensation may be inadequate for a newcomer without a large established customer base. It may well be that the new standards will cause a trend toward higher compensation depending on the results obtained by a broker or investment advisor. So long as the investment process is "compensation blind," other forms of giving incentives to investment professionals will have to come to the fore.
An unforeseeable consequence of the new fiduciary standards is that which will come from the plaintiff's lawyers. Fiduciary standards should provide a fruitful ground for the plaintiff's bar to bring actions whenever the result of the investment process is less than perfect.
Depending on the form the new fiduciary standards take, it is difficult to see how many of the current FINRA rules applicable to securities transactions and to broker-dealer operations will need to be continued. Even a cursory reading of the FINRA rules leads to the conclusion that the bulk of them are directed toward the commission-driven securities business that has been in place for decades. If everyone is, in effect, an investment advisor, then all the trading rules, operational rules, and much of the rest of the FINRA procedures would seem to be obsolete. If the applicable standard of conduct is fiduciary duty and there is no longer a commission element in the investment process, much of the FINRA infrastructure could well be eliminated with no damages to consumers.
Regardless of how the fiduciary rules are finally written, it may well be that many problems can be avoided by more effective disclosure to customers. At the very least, there will be a requirement for better disclosure about the costs to consumers when they make investments and what incentives the broker may have in making the recommendations. The current suitability procedures in effect at many brokerage firms are insufficient to satisfy more robust fiduciary standards. Once any new fiduciary standards are available to public view, we will be better able to determine just how much retooling will be necessary for our customer forms and training and procedures for our financial-services professionals.
Judith A. Hasenauer is an attorney with the law firm of Blazzard & Hasenauer, P.C. She devotes her practice exclusively to the financial services industry, providing consulting on the development and regulatory clearance of products, compliance issues, distribution issues and related matters, such as advisory activities and industry initiatives.