Why your stockbroker is not a fiduciary

In the Dodd-Frank Act, Congress mandated that the SEC consider raising the bar for all stockbrokers and registered investment advisers (“RIAs”). The Commission responded with a recommendation that all stockbrokers and RIAs be held to a fiduciary’s standard of care.

The uniform standard proposed by the SEC, states:

The standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.

RIAs have been held to this standard for a long time. In California and several other states stockbrokers are held to a fiduciary’s standard of care which imposes a duty on the broker to act in the highest good faith. The law in California is rooted in a case decided in 1968 and somehow the markets have continued to function.

Notwithstanding, many in the financial services industry strongly oppose any type of uniform standard that would hold a stockbroker to a fiduciary’s standard of care or require a stockbroker to exercise good faith as regards their public customers. Why?

If you are older like I am and practiced law in New York back in the day, you might remember when lawyers who were acting as trustees of their client’s money were likewise held to a fiduciary’s standard of care. At the time there was a “legal list” of investments that were appropriate for a fiduciary’s consideration. This list was very restrictive and strategies like using margin were prohibited.

The standard was modernized to the “prudent man rule” and later the “prudent investor rule” which were more ambiguous than the legal list and gave trustees and other fiduciaries a little wiggle-room. Prudence would still not find a fiduciary investor in the commodities markets or purchasing purely speculative investments.

A fiduciary would have a difficult time justifying the recommendation of speculative  investments in any event. Fiduciaries are expected to protect and to preserve the assets that are being entrusted to them.

Speculative investments frequently offer stockbrokers much higher commissions than investments that are less risky. Under a fiduciary standard, stockbrokers would certainly have difficulty arguing that they were putting their clients’ interests first when they were recommending a speculative investment that paid them an 8% or higher commission.

Perhaps that is the point that the SEC was trying to make when it said: “without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”  A stockbroker who recommends speculative investments to an average customer just to earn a little more commission would fit squarely within this rule.

A stockbroker necessarily implies to the customer that every investment they recommend is in the customers’ best interest. By refusing to adopt the standard, the industry is saying that it reserves the right to recommend investments that are not in the customers’ best interest just because the industry can make a little more money.

Whether the final rule will continue to allow stockbrokers to put their own interests before their customers’ interests remains to be seen. Perhaps the Commission will opt for full disclosure and require stockbrokers to disclose that one of the factors supporting any recommendation of a speculative investment is the fact that the investment pays higher commission.

Probably not.

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