Fiduciary or not a fiduciary: that is the question. Broker or investment advisor: that is the answer. (Part 1 of 2)
Co-authored by Jon Harris and Mark Enslin
Life used to be simpler. Years ago, in the Golden Age of transactional-oriented compensation, there were no compelling questions regarding the role that brokers played in servicing non-discretionary accounts. The distinction was readily apparent. They were salespersons, and got paid if they executed a trade. But with the advent and wide-spread acceptance of fee-in-lieu relationships, and the requirement that brokers qualify as investment advisor representatives if they are to share in the fees, the traditional role of the broker has been transformed.
Now, the distinction between investment advisors, who are compensated for providing advice about securities,[1] versus brokers, who just make recommendations and execute transactions, is murky at best and confused at worst. Let’s explore some of the distinctions.
Investment advisors are required to register with the SEC and are regulated under the Investment Advisors Act of 1940.[2] Pursuant to Section 206 of the Investment Advisors Act, advisors are fiduciaries, and owe customers a higher, fiduciary duty. In order to fulfill their fiduciary obligation, investment advisors must avoid conflicts of interest, make full disclosures of fees, and put their clients’ interests ahead of their own – i.e., investment advisors must recommend to their clients the very best investments. As a fiduciary, the advisor generally has a continuing duty to monitor and advise the customer regarding performance and material events affecting the underlying investments. For discretionary accounts, as circumstances may dictate, the advisor may be obliged to initiate appropriate, affirmative action to advance the customer’s interests.
Conversely, brokers (technically, registered representatives are persons licensed through and associated with a broker-dealer) are salespeople, whose primary responsibility is assisting clients in the execution of stock and other securities trades. Their principal duty is to make suitable recommendations to their customers, but they are not granted discretion. The customer determines whether or not the trade goes forward. Traditional brokers are not subject to the Investment Advisors Act and, accordingly, do not, per se, owe their clients a fiduciary duty. Instead, brokers are subject to the Securities and Exchange Act of 1934 and the rules of other self-regulatory organizations (most notably, the NASD).
Under NASD rules, brokers must profile their clients with regard to their assets, investment experience, and investment objectives, so that brokers can take comfort in knowing that the recommendations they make are in accordance with the investor’s investment temperament and needs, and ability to sustain loss. There is no continuing obligation to monitor the account or even the underlying positions established on the broker’s recommendation. The relationship, in theory, starts with recommendation and concludes with the execution of the particular trade. In sum, brokers must know their clients and recommend suitable investments but, unlike investment advisors, brokers are not legally required to put their clients’ interests ahead of their own, make the same level of disclosures about fees, or recommend the very best investments – just suitable ones.
The distinction between investment advisors and brokers is important and, accordingly, begs an obvious question: how does one tell the difference between an investment advisor and a broker?
As noted, today, the line between investment advisors and brokers is blurred. One contributing factor is broker-dealer marketing – for example, many broker-dealers now promote their brokers to the public as “financial advisors” or “financial consultants.” Other factors include the increased significance of asset management, the extensive licensing of brokers as investment advisor representatives, and an emphasis on promoting financial planning as a core investment tool. In fact, most brokerage firms are now dually registered as both broker-dealers and investment advisors, treating some accounts as true advisory accounts (to which a fiduciary obligation attaches) and others as pure brokerage accounts (to which the lesser, suitability standard applies). These distinctions have not come without a price, and customers, investment advisors, brokers, and industry officials alike often have difficulty discerning and defining the differences between investment advisors and brokers and, in turn, identifying the scope of legal duties owed respectfully by each.
In an effort to highlight the distinctions between investment advisors and brokers, early in 2006 the SEC adopted rule 202(a)(11)-1 (aka the “Merrill Lynch rule”) under the Investment Advisers Act of 1940. This rule specifically exempts from the definition of investment advisor certain services that brokers provide on a non-discretionary basis, and advice that is “solely incidental” to the brokerage role, regardless of the form of compensations that they receive for those services, does not transform the broker into a fiduciary under the rule. Likewise, and perhaps counter-intuitively, the designation “investment advisor representative” will not be dispositive on the issue. Actual functions, not labels, tend to be the litmus test.
Part 2 of 2 will be published next week....
[1] An investment advisor is a person who engages in the business of advising others, for compensation, either directly or through publications or writings, as to the value of securities or the advisability of investing in, purchasing or selling securities, or who promulgates analysis or reports concerning securities.
[2] There are exceptions to this registration requirement for persons serving a discrete number of accounts or managing smaller amounts of funds. Generally, persons who are managing less than $25 million must be registered with and are regulated by the state; those managing more than $25 million are subject to federal oversight. For purposes of this article, we are referring to persons or entities subject to ’40 Act registration requirements.
