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The Logical Inconsistency of a Broker Fiduciary Standard

Serving two masters in the realm of financial services is impossible, argues W. Scott Simon of Prudent Investor Advisors.

W. Scott Simon, 03/01/2012

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award. 

I'm generally sympathetic to the weak, the old, and the infirm, whether they be humans or animals (even including cats--well, most cats). More particularly, I feel a special compassion for those personally close to me who are somehow wronged by forces more powerful than they or who need someone to stand up for them because they cannot do so themselves. In such cases, I usually work up a feeling of indignation that can be expressed as "It's just not right!" Most people would probably have similar feelings.

However, sometimes I get really incensed. That happened back when I practiced law and was called on to argue a case in court. We represented an old woman who had so clearly been wronged by an individual that I was ready to personally hang him up by his thumbs. My indignation was so great that I was visibly contemptuous of the defendant in open court. My victory was so complete that even the defendant--an attorney--congratulated me afterward and offered me a job to boot.

But whatever personal feelings I may have had about that defendant's conduct really didn't mean diddlysquat. In fact, I had to show that his conduct was subject to some legal standard of care--in his case the fiduciary standard--and then prove that he violated it.

The personal feelings of, say, a stockbroker who is subject to the suitability standard are similarly irrelevant when she says that she cares for her clients so much she feels like a fiduciary to them. She can say that, and even believe it, but her feelings are of no legal import because ordinarily she isn't subject to the fiduciary standard.

Reported attempts by federal regulatory authorities to devise a broker fiduciary standard, if enacted as the result of a successful political beat-down by the brokerage and insurance industries, would change that. But it wouldn't change the logical inconsistency of attempting to fit the square peg of brokers into the round hole of a fiduciary standard. Here's why.

(The discussion in this month's column isn't limited to stockbrokers; it can also apply to benefits brokers, insurance agents, or any other entity following a sales model in the financial-services arena. In addition, distinct from commissioned stockbrokers emphasized in the column are brokers who provide great value to their customers by serving as order-takers but are not permitted to provide any advice at all. Such brokers don't muddle up transactions with advice.)

No One Can Serve Two Masters
The Biblical admonition that a person cannot serve two masters is, at base, really all you need to know about the logical inconsistency of a broker fiduciary standard and the resultant impossibility of devising such a standard. Serving two masters in the realm of financial services is impossible because there will always be the perception--if not the reality--that a broker will at times be disloyal to its customers and favor its broker/dealer. This is an inherently fatal flaw in brokerage sales models because the duty of loyalty is the fundamental duty that underlies all other fiduciary duties. To be disloyal is the very antithesis of being a fiduciary. Disloyalty negates the very meaning of what it means to be a fiduciary.

Two Broker Sales Models
There are essentially two sales models followed by brokers. In one model, the broker sells to its customers only the proprietary products manufactured by its broker/dealer and receives a commission in exchange, usually an amount higher than for non-proprietary products. The broker (i.e., "registered representative") is the agent of its broker/dealer principal. A broker does in fact owe a fiduciary duty in this model--but it is to its broker/dealer principal not to its customer, to whom it owes only a duty of suitability. (The duty of suitability requires only that a product be suitable and not necessarily in the best interest of a customer.)

In the other sales model, the broker can go beyond selling only the proprietary products manufactured by its own broker/dealer; it can also sell products manufactured by others for which it receives a commission in exchange. Many brokers claim that this is a superior model to the "captive" broker model where a broker is able to sell only the proprietary products of its own broker/dealer. This alleged superiority arises from the ability of a broker to sell a multitude of products manufactured by those other than its broker/dealer.

On its face, this model sounds superior, but on reflection it is often worse: The perception--if not the reality at times--is that the broker will simply pick the product for its customers with the highest paymaster. Although some brokers may give their customers the impression that they have their best interests at heart because they're not limited only to proprietary products, under the guise of objectivity these brokers may nonetheless end up choosing a non-proprietary product that pays a commission similar in amount to a proprietary product.

Now, many brokers would never do this. But any knowledgeable and honest outsider looking at these two models (and even a third model in which a broker sells proprietary and non-proprietary products in exchange for commissions, and also provides advice for which it receives a fee) would have to conclude that even the possibility of disloyalty to customers renders such models incompatible with a true fiduciary standard. These models produce outcomes that are inconsistent with any notion of acting for the exclusive purpose, and solely in the interests, of a customer.

The Problems Common to These Sales Models
There are two problems common to these broker sales models: the advice conveyed and the compensation earned. The first problem is that, under the FINRA regulation, any advice offered by a broker to its customer is incidental in nature to the sale of a product to that customer. As a result, this regulation itself denigrates the value of a broker's "advice" and that alone violates a key tenet of a fiduciary relationship in which the provision of advice is central. Under broker sales models, brokers essentially provide advice as an afterthought ("incidental in nature"). But how valuable can such advice be when it's merely incidental? The answer is that it has little value because it's not legally accountable advice--it's simply sales patter.

Even if incidental advice had any value, the FINRA regulation really doesn't hold the broker legally accountable for such advice. The duty of suitability, as noted, requires only that a product be suitable and not necessarily be in the best interest of a customer. In any event, many brokers conduct no comprehensive analysis in order to advise their customers of how all the products they sell them correlate with each other. In this kind of model, it's no wonder why, say, the tenets of modern portfolio theory never even enter the discussion.

The second problem common to these broker sales models is the nature of the compensation earned. Many brokers measure their value by the amount of commissions they receive. When the value of any broker "advice" provided to its customers is measured by commissions, though, it's impossible to reconcile with a fiduciary standard. Commissions generated by product sales do not yield any sort of legally accountable advice. Indeed, a broker sells products for a living, and any advice offered is supposed to be incidental in nature by regulation and therefore shouldn't be relied on because it's conflicted. No customer should be given advice that's paid for by a product.

The dilemma with any of these models is that the advice/sales patter conveyed by a broker to its customers is tied to the compensation received by the broker for the products it sells to those customers. How, then, is it possible to provide disinterested investment advice about a product when advice rendered is linked to the compensation generated by that product? The only logical (and honest) answer is that it is impossible. In this day and age, when the entire financial-services industry is heading--more or less--toward full transparency, how can anyone have any confidence in the integrity of the "advice" being offered in broker sales models when the compensation for that advice is tied to the product being sold?

The crucial point to keep in mind is that the advice provided by a broker to its customers must be severed from the compensation the broker earned from selling the product before any sort of fiduciary relationship is possible. Indeed, if the only way you can make money is to cause something to happen, sooner or later you are going to cause something to happen. A fiduciary advisor is not required to cause something to happen because it receives fees in an ongoing fiduciary relationship. In fact, it may even advise its clients to do nothing because that's the best advice it can give them. That's conduct that isn't widely engaged in by brokers because if it were, they would starve.

By the way, an advisor once accused me of being just like a broker because our firm sometimes places the products of just one mutual fund company on a retirement plan's investment menu. That charge would be true if we were compensated by the fund company, but we never are. Instead, we are compensated directly by a plan sponsor, so we have no financial motivation to favor one product over another. Even the perception of disloyalty is removed in this equation. Under the model followed by our firm, the crucial difference is that there is no link between the advice we provide to a client about a product and any compensation we earn from that product--simply because we do not receive any compensation from that product.

In fact, the advice we provide as fiduciaries to our plan sponsor clients is central to our fiduciary relationship with them. In addition, we have unfettered access to any products that we feel will be the best solution for our clients. Note, though, the crucial difference in our model from broker sales models: Any products are merely incidental to the advice we provide. So in the fiduciary model we follow, advice is central and products are incidental and only tools to be used to implement the discretionary and legally accountable advice we provide to our plan sponsor clients. In broker sales models, advice is merely incidental (i.e., sales patter) but products are central.

The Best Interest Fiduciary Standard
Conflicts of interest--actual disloyalties in reality--are rampant in the broker sales model and under the suitability standard administered by the Financial Industry Regulatory Authority (FINRA) that allows them.

This is not to say that serious conflicts of interest don't exist under the "best interest" fiduciary standard followed by registered investment advisors (RIA) under the Investment Advisors Act of 1940. Indeed they do. For example, suppose an RIA advisor (or a broker under FINRA, for that matter) uses a brokerage firm, bank, or custodial affiliate to execute trades. Doing so allows the RIA to engage in a "double dipping" of compensation by not only earning a fee on the advice it provides to its client but also earning commissions from the brokerage firm, bank, or custodial affiliate on the trades it directs. Yet the Securities and Exchange Commission (SEC) (which regulates larger RIAs) freely allows these kinds of conflicts of interest in which trade executions become a profit center to be maximized rather than a cost center to be minimized. In such situations, there's no requirement by the SEC that a customer consent to an RIA's use of, say, an affiliated broker; the RIA need only disclose such practices in its Form ADV. (Nor is there a requirement that customers consent to conflicts of interest under the fiduciary standard promulgated by the Certified Financial Planner Board of Standards, the entity that awards the CERTIFIED FINANCIAL PLANNERâ„¢ designation.)

The Sole Interest Fiduciary Standard
The preceding example of double dipping that the SEC allows RIAs to engage in is but one reason why I maintain that any advisor dealing with qualified retirement plans (and individual investors, for that matter) should be governed by the "sole interest" fiduciary standard found in section 404(a) of the Employee Retirement Income Security Act (ERISA) instead of merely by the "best interest" fiduciary standard of the Investment Advisors Act.

Other than disruption of established business models (which, from any customer's view, is not an issue of concern), there is no reason why the sole interest fiduciary standard, which is derived from trust law (the highest known in law), should not be the fiduciary standard to be followed by all advisors. Any proposal to "harmonize" the sole interest fiduciary standard to accommodate the sales models of commissioned brokers who are governed by the suitability standard of FINRA (and perhaps even the fee models of RIAs who are governed by the "best interest" fiduciary standard of the SEC) can only result in debasement of centuries-old fiduciary tenets. Regulators shouldn't be in the business of dumbing down the high fiduciary standard set by ERISA (or even the SEC's best interest fiduciary standard) to accommodate the sales models of politically well-connected commissioned brokers.

The Difficulty of Transforming Commissions to Fees
To be sure, it's very difficult to transform a commission-based business model in which brokers sell products on a transactional basis to a fee-based business model in which advisors provide advice on an ongoing basis. (Such advice, of course, is not always provided on that basis, but at least advisors are subject to a fiduciary standard--which is continuing and doesn't end at the conclusion of a sales transaction--and can be penalized for violation of that standard.) For example, it's possible for a broker with $2 million under management to make $250,000 a year in commissions. To equalize that income as a 1% fee-earning advisor, the broker-turned-advisor would need to gather $25 million under management. That's a tough nut to crack, whether or not the broker has a high overhead.

But no one is forcing brokers to compete in the qualified retirement plan marketplace. The sole interest fiduciary standard should be the one required in that market, and if brokers cannot compete according to the dictates of this standard, then so be it--that's a business decision they will have to make. Brokers unwilling or unable to compete under such a standard shouldn't be let near participants in a qualified retirement plan.

Note: I would recommend that anyone (including, and perhaps especially, regulators) who wishes to gain an understanding of the logical inconsistency of a broker fiduciary standard and therefore the impossibility of fashioning such a standard should read the work of Bob Clark, Ron Rhoades, and Janice Sackley. These three individuals are, in my opinion, light years ahead of others in providing clear and cogent insights in this important area.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding, is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visit Prudent Investor Advisors or you can e-mail him at wssimon@prudentllc.com. The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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