Elder Financial Abuse-the Fiduciary Rule and Broker/Dealer compliance.

There are two general rules in the financial markets that you should never forget: 1) the higher the yield or growth potential for any investment the higher the risk of loss, and 2) investments that have a higher risk frequently pay a higher commission to the stockbrokers who sell them.

Seniors and retirees often want to draw as much as possible from their retirement accounts every month. Stock brokers are constantly tempted to give the customers what they want (higher yields) because it puts more money in their own pockets at the same time. The end result is that a lot of seniors are steered into making investments that are riskier than they wanted or could afford.

To address this temptation head on, the Securities and Exchange Commission (SEC) has proposed a new standard of conduct for all stockbrokers. The SEC’s proposed rule 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.”

Although Registered Investment Advisers have lived and prospered under this “fiduciary” standard for decades, the financial services industry has organized an effort to assure that this standard will not apply to most stock brokers. This rule squarely hits the industry’s bottom line.

The rule is very much the result of many years of seniors being steered into riskier investments to increase the industry’s profits. In May 2015 the staff of the SEC and FINRA published a joint report of their examination of brokerage firms selling investments to seniors. The staff asked firms to provide a list of the top revenue-generating securities purchased by their senior investors by dollar amount. http://www.sec.gov/ocie/reportspubs/sec-finra-national-senior-investor-initiative-report.pdf

Variable annuities were among the top revenue generating financial products sold to seniors at 68% of the firms examined. Non-traded REITs, alternative investments such as options, leveraged inverse ETFs and structured products made the list at between 10% and 20 % of the firms.

A variable annuity usually comes with a significantly higher than average commission to the salesperson. While variable annuities do offer tax deferrals and other benefits that might be attractive to some investors, no one disputes that variable annuities are high cost, high risk and high commission products. It is no secret that the high load and withdrawal charges that can go on for years make variable annuities less suitable for investors as they get older.

All stock brokerage firms are required to have procedures in place where managers officially supervise all employees. As part of their supervisory efforts, most firms employ a compliance department, usually populated by professionals tasked with the supervision of every account on the firms’ books and every order that the firm handles.

Most compliance departments compile daily exception reports of the previous days’ trades that were uncharacteristic or fit within pre-determined parameters as potential problems. It is much easier to fix problems with trades before the settlement date.

There should be a similar system that would identify the sale of a variable annuity to a 70 year old retiree as outside the norm of expected behavior. If the surrender charges extend out for 10 years, the customer’s access to his own money is restricted until the customer is 80 years old. Throughout, the investment portfolio will be exposed to market risk. Often the customer could substitute a mutual fund or funds for the same investment purpose at much less cost.

Where surrender charges extend out for ten years it often means that the sales commission on this transaction might be a high as 10%. That is why the SEC’s proposed rule focuses upon the “financial or other interest of the broker”.

The industry firms sell more and more variable annuities each year and make a lot of money doing so. I am certain that their shareholders expect nothing less. If you have been thinking about the “Fiduciary Rule” debate on a philosophical level, this is where the regulation meets the cash register.

The risk tolerance of each customer, for each transaction, is considered by the stock broker, the supervisor, and the compliance department. An investor’s risk tolerance can be easily ascertained with the question: how much of the money that you are investing are you prepared or willing to lose?

Many non-traded REITS began their lives as private placements issued under Regulation D. Once you buy them, selling them can be very difficult if not impossible. If the market turns against you, you have to ride the investment all the way down. In 2008-2009 many non-traded real estate investments lost significant value or went bankrupt. An investor in a non-traded REIT can often suffer a total loss.

Again, the SEC is keenly aware that these private placements often pay very high sales commissions. The SEC also knows that there are a multitude of comparable REITs that are liquid because they trade in the public markets and can be bought or sold for normal brokerage commissions and on any day the markets are open for trading.

Is it fair, then, to ask why a professional compliance department would not think it odd that a great many seniors seem willing to invest large amounts in clearly speculative investments when similar investments are readily available with much less risk and much less cost? Can the industry make a plausible argument that higher commissions do not drive these sales?

The industry is fighting for the right to set commissions at levels it deems fit without due consideration of whether the extra cost makes any sense from the investors’ point of view. Adopting this rule should lower commissions and customers costs overall and promote market efficiency. Diverting seniors to safer, less expensive products at the same time cannot be anything but positive.

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.