Fiduciary or not a fiduciary: that is the question. Broker or investment advisor: that is the answer. (Part 2 of 2)
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.
However, early returns suggest that the SEC’s attempt to inject clarity has instead had the opposite effect, and raised more questions than provided answers. Advisors, brokers, and industry commentators have opined that the new rule fails to clearly distinguish when a broker is acting in a fiduciary capacity. As a result, securities attorneys anticipate that the new rule will spark a slew of contested cases in which the battle over the role and relationship of the broker/IAR to the customer will be addressed in some confused and inconsistent manner.
There are at least two major flaws with the new rule. First, the rule still does not provide the industry with a clear delineation between an investment advisor and broker. For example, the rule and explanatory commentary put great importance in the distinction between a “financial plan” (to which a fiduciary duty attaches) and a “financial tool” (to which a fiduciary duty does not attach). The SEC attempted to clarify this distinction by explaining that a “financial plan” generally seeks to address a wide spectrum of a client’s long-term financial needs, and can include recommendations about insurance, savings, tax and estate planning and investments. According to the SEC, this is distinct from a “financial tool” that is used to provide guidance to a customer with respect to a particular security transaction or an allocation of customer funds and securities based upon the long-term needs of a client, but that is not applied in the context of a more comprehensive plan. The SEC further opined that where the “financial tool” is used with a brokerage customer, the fact that the broker-dealer discloses to the customer that the “financial tool” is a brokerage service and not a financial plan can be “helpful” in determining whether the broker-dealer is providing brokerage services, but the customer’s perception of the services would also have to be a consideration.
The flaws of the SEC’s rule are evident and obvious. Even if one can discern the distinctions between a “financial plan” and a “financial tool” at the peripheries of the spectrum, in practice there are likely to be a host (probably the majority) of situations where the particular consultation falls somewhere in the middle (i.e., the dreaded grey area). If that proves to be the case, how does one decide when operating in the grey area whether a particular situation amounts to advice about a “financial plan” or “financial tool?” Based on the SEC’s scant clarification to date, even applying Justice Potter Stewart’s famous quotation regarding pornography, “I know it when I see it,” may not provide concrete answers. While the SEC’s definition might work fine for the regulatory officers at the SEC, such a definition provides no comfort to dually registered advisors/brokers attempting to discern during their day-to-day practices which legal obligations they are subject to or assuming.
A second major flaw with the rule is that, assuming, arguendo, that advisors, brokers, and other industry officials might eventually come to a reasonable understanding of the new rule’s terms, what does it mean for the customer and, perhaps more importantly, the advisor/brokers’ relationship with the customer? The SEC has recognized that under the new rule, dually registered advisors/brokers may wear “multiple hats,” acting as advisors/fiduciaries in some transactions, but brokers/non-fiduciaries in others transactions – with the same clients. The SEC suggests that when moving from one role to another, advisors should make it very clear – not just verbally – that they are “stepping out of the trust and confidence role” of the advisor into the registered representative/broker role. Already, advisors have recognized the impracticality of a disclosure in which the advisor-turned-registered rep must essentially give an “I am slime speech,” yet still effectively maintaining the relationship with the client. And, of course, all this presumes that the customers can comprehend the advisor/brokers shifting rules and legal obligations.
Bottom line, it is not effective rule-making to create an “it depends” legal or compliance standard. Brokers/advisors and the investing public are entitled to some degree of clarity in defining their relationships. Unfortunately, we may have to wait for legal precedence or more finely-honed regulatory commentary to address this elusive issue. Until then, uncertainty breeds discord, discord creates controversy, and both the plaintiff and defense bars are salivating over the current confusion.
