Fiduciary Duties for Brokers

Mark Kleiman:

Does the current system of legalized bribery through campaign contributions matter?

Consider the case of a provision in the financial products regulation bill that would impose on stockbrokers the same sort of fiduciary duty lawyers have: to act in the interests of their clients when that conflicts with their own interests. It’s not a hard question, it seems to me, though I’d be willing to settle for a system where each brokerage house had to choose whether to be subject to such a standard or not, and disclose its choice to its clients.

The provision was in the original Obama Administration proposal and in Sen. Dodd’s version of the bill, but Tim Johnson of South Dakota wants to replace it with a “study,” and may get his way.

Campaign contributions aside, a fight over the fiduciary standard is a huge political winner for the Democrats. This is exactly the kind of issue we want to take into November. Go ahead, Goopers: explain why it’s “big government” and “the nanny state” and “socialism” to ask brokers not to cheat their clients. Good luck with that.

I don't think anyone disputes that brokers should have fiduciary duties to their clients. indeed, brokers already owe such duties.

As Justice Felix Frankfurter explained, however:

[T]o say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?

It's not at all clear to me that it makes sense for the same set of fiduciary obligations to be imposed on (1) brokers with discretionary trading authority over their client's account, (2) investment advisers who get paid for providing investment advice, (3) brokers who provide tailored investment advice without separate charge incidentally to their main function of executing trades ordered by the client, (4) brokers that provide generic investment research to all clients without separate charge, and (5) brokers that simply execute trades without providing investment research or advice. The higher one goes on the last list the more likely it is that the investor will place his trust and confidence in the advice being given and the more severe the broker's conflict of interest becomes. Why shouldn't the scope of their duties therefore vary, as well? After all, free advice is worth what you pay for it.

It may be the case that Tim Johnson wants to simply kill the idea. But that doesn't justify rushing a one size fits all rule through Congress.

Comments

[gs]

"Mark Kleiman: Campaign contributions aside, a fight over the fiduciary standard is a huge political winner for the Democrats. This is exactly the kind of issue we want to take into November. Go ahead, Goopers: explain why it’s “big government” and “the nanny state” and “socialism” to ask brokers not to cheat their clients. Good luck with that."

Does Mr. Kleiman realize that the study is being proposed[1] by Sen. Tim Johnson (D-SD), and not by Rep. Tim Johnson (R-IL)?
*********************
[1] http://www.topix.com/us-senate/tim-johnson/2010/02/lobbying-may-push-fiduciary-rules-for-brokers-off-reform-agenda

[JorgXMcKie]

Don't worry about the small stuff. Kleiman was just looking for an excuse to use Goopers. It wouldn't have worked as well if he went after his own Dims.

It's also quite possible to think of systems not under "nanny state" control that would make it difficult for brokers to cheat their clients.

Does Kleiman have any ideas on how to keep candidates like Obama from cheating his voters? I mean, how many promises has he broken already?

[Mark Kleiman]

Yes, I do. Some Democrats are as much in the pockets of the financial-services industries as are most Republicans. But a vote on this question would be mostly a party-line vote, and a good one for my party to force.

[Octus]

I have been a financial planner/stock broker with a major wirehouse for 30 years. I have the designation of Certified Financial planner (TM) which demands that I accept fiduciary status for my clients. Many "brokers" feel, as I do, that it is way past time for regulation of financial planners. Not just for the sake of ethics but for education. The great majority of damage to clients I have seen is through ignorance not ethics. The damage is just as devastating regardless of the source. It is the large financial firms (who give overwhelmingly to the Democratic party) that does NOT want their employees to have fiduciary responsibility due to the liability. The unholy alliance of Big Banks, Big Business and Big Government have this goal in common.

[Concerned Citizen]

The brokers should be able to do whatever they want to -- but they should disclose their conflicts each and every time to their clients. e.g.

- We recommend you buy this stock. Disclosure: We already bought a ton of this stock six months ago and need a sucker to unload it on.

- Here's a derivative swap you should do. Disclosure: We'll be playing the other side of this trade and have enough muscle in the market to make sure our side of the trade comes out a winner.

And while we're talking about disclosures....why not hold the politician's feet to the fire, while we're at it. When they vote for or against a bill, they need to disclose all donations they received that might benefit from their vote. Every bill in Congress will have a disclosure schedule the size of a large metro area's phone book.

[dave]

Seconding GS' point, this move is made the Dem head of committee. Arguably in the pocket of Citigroup, perhaps that makes him an honorary GOOPER?
I think the Senator clearly is killing the bill to benefit his constituent; but your point regarding degrees of obligation is critical to this debate.

[LifeTrek]

I don't get it -- this standard already exists.

It is well established in law that a broker owes a fiduciary duty to a securities investor. See Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042, 1049 (11th Cir. 1987); Ward v. Atlantic Security, 777 So.2d 1144 (Fla. 3d DCA 2001); State ex. rel. Painewebber v. Voorhees, 891 S.W.2d 126 (Mo. 1995); Glisson v. Freeman, 532 S.E.2d 442 (Ga. App. 2000); Beckstrom v. Parnell, 730 So.2d 942 (La. App. 1st Cir. 1998)[claris law].

In addition the underlying NYSE Rule 405 of "know thy client" along with the NASD's requirement to brokers for suitable investments demands that brokers hold out their customers first in any transaction. This is true even where the investor suggests- or even demands- a product that would be unsuitable for their purposes. (The only time a broker could sell an "unsuitable" product might exist when an investor makes an initial suggestion for an investment and where the broker subsequently informed the investor both verbally and IN WRITING PRIOR to the sale that the investment did NOT fit the suitability standards for the particular investor. (After which the broker may still refuse to conduct the transaction.))

Investors "trust" brokers based upon a real or perceived level of honesty, good faith, judgment and responsibility in looking after the money entrusted to him/her. The broker, in accepting this money, assumes and accepts a responsibility to serve the best interests of the investor. The broker MUST determine if an investment fits within the customers risk profile, income, age, objectives (assuming correct), etc. and is also within the guidelines for proper diversification.

The Rules of Fair Practice set down by the NASD state that a broker has definitely breached his/her duty if a broker

1. recommends speculative securities without finding the customer's financial situation and being assured that the customer can bear the risk

2. does excessive trading (churning) in a customer's account (whether the account is discretionary or not)

3. does short term trading (and switching) of mutual funds

4. set up fictitious accounts to transact business that would otherwise be prohibited

5. makes unauthorized transactions or use of funds

6. recommends purchases that are inconsistent with the customer's ability to pay.

7. makes unauthorized transactions or use of funds

8. commits fraudulent acts (such as forgery and the omission or misstatement of material facts including any conflict of interest).

This obligation for fair dealing is not removed through the simple completion of a one page new account form required by brokerage firms. (Minimum information includes full name, address, phone number, employer, social security number, citizenship, acknowledgment that customer is of legal age, spouse's name and employer (if any) and investment objective.

Other information varies as to firm but might include bank and personal references, previous brokerage accounts, and if the account was solicited, referred, walk in, etc.)

Nor is the liability removed by sending the completed form to the client since clients do not and cannot be expected to know how a particular investment fits within individual and specific investment guidelines. It does however relieve the broker of mistakes entered on the form by either party that would be apparent to- and should have been corrected by- the client. [efmoody]

There is no such waiver for a broker that just conducts transactions as you suggest -- or any of your other 4 points. One cannot claim, for example, to be an investment adviser or simply make trades but not give advise without being subject to the regulations, even if they don't conduct transactions or only conduct transactions.

They are all covered. Even Etrade and the like review all orders (most likely automatically with a manual secondary review if issues arise) to see if the order meets certain requirements including but not limited to your stated assets/income/risk selection (the form you filled out when you started the account).

Brokers are also required to report and receive approval for any outside activities whether paid or volunteer including but not limited to serving on the board of charities, corporations, moonlighting employment, outside income, family trusts/businesses, substantial gifts received, etc. (minimum standard exists some firms are more stringent in their requirements to ensure they meet the standards for a fiduciary) and are required to provide documentation including tax returns as verification if asked.

So not only are they required to inform their client their Principal is required to verify transactions are within regulations and free of conflicts of interest. Brokers are also restricted from insider trading and IPO's and are required to inform any company they have a personal account with that they are a registered broker.

Contrary to popular belief the securities industries are highly regulated (Madoof was a Federal enforcement issue and changing the law isn't going to change that).

It sometimes seems current regulations boarder on being onerous for average brokers, forcing many honest ones from starting or into leaving the business early in their careers, leaving behind either the best and slickest "cheats" or those large and committed enough to survive (did you know that every letter you receive from your broker is pre-approved by the legal/marketing department, including the birthday card you received and any notations outside the approved texts is subject to regulatory actions -- at least annually files are audited for adherence to all regulations by most firms). Yet these facts are unknown to the general public and, it appears, to our lawmakers.

Full disclosure - I am a broker and I have seen the explosion of regulations paperwork over the past 30 years. Most for the better, some just CYA.

[James Dexcente]

Mark,

You framed the issue incorrectly since a broker would not have the same fiduciary obligations as a lawyer, she would have the same fiduciary obligations as an investment adviser. Investment advisers manage money for clients and in return are paid a percentage of assets under management. Brokers execute trades on behalf of clients and offer advisory services in the form of recommendations to clients with a current obligation to "know your client" such that all investment recommendations must be suitable for that individual client. It's not at all clear why a person who offers recommendations gratis ought to be held to the same standard as a person who is charging a client for making decisions on that client's behalf. As Prof. Bainbridge points out, there are gradations of brokerage activity that resemble pure advisory services in that the recommendations cease to be incidental and it would make sense to regulate that activity in the way that pure advisory activity is regulated. Note also that non-adviser brokers are routinely sued when investments fail under the current KYC suitability regime.

But it is telling that the substance is not particularly important, rather it's whether the decision will help the team that one roots for. This is a nation of overgrown children.

[Jason]

People who are arguing for a fiduciary standard to apply to brokers and insurance advisors don't understand how investment or insurance products are distributed. Taking insurance companies as an example: Insurance companies "manufacture" a product. They have a captive sales force go sell it. Since a captive agent has a limited menu of products manufactured by the company, those are the solutions he or she must present.

Suppose a captive agent presents and sells a perfectly suitable insurance product to a consumer. Suppose also that there is an identical insurance product available from another company, with similar ratings and features, available for 12 dollars per year less in premium.

If the agent were held to a fiduciary standard, he or she would have to present a solution they can't sell. The product is never placed. Meanwhile, the first company is the one on the hook who has invested thousands of dollars in training the agent, in housing him or her, in providing expense allowances and marketing support. Who wins? Nobody.

Now, someone who is charging a fee, and hangs out a fee-only shingle as an independent financial advisor? Sure, a fiduciary standard is workable.

What is happening behind the scenes here? This is a ploy by the fee-only crowd - a big chunk of the FPA and NAPFA, to rent-seek and take market share from the commissioned channels. The insurance and investment industries are constantly vying for advantage as well, in similar ways, by attempting to "shape" the regulatory environment to make it more difficult for competing channels to sell popular products.

The suitability standard is the one to apply to the commissioned-based brokers. The requirement is that any solution placed with a client be 'suitable,' given that client's objectives, situation and tolerance for risk. Trying to apply a fiduciary standard for this channel is going to open a pandora's box of litigation, hamper new product development and innovation, and put a huge dent in the career agency systems... systems which, by the way, do a lot of hiring.

Trying to apply the fiduciary standard to people who don't charge fees is trying to put a square peg in a round hole.

Full disclosure: I'm a recovered journalist, and in my days as a personal finance reporter covered the financial planning world, but now make my living as a commissioned life and health insurance agent.

[R. O.]

A series 7 licensed stock broker most certainly do NOT owe a fiduciary to their clients. That is a common misconception. In fact, brokers owe fiduciary duty to their brokerage house.

If you want an investment advisor w a fiduciary obligation you must find a Registered Investment Advisor (RIA).

Why anyone would do business with a stockbroker who not only has every incentive, but an obligation, to act on the best interest of themself and their firm is beyond me.

[Fat Man]

I have always believed that no commission salesman can be trusted father that he can be thrown. I have never seen a case where whatever trust and confidence you have in a commission salesman has not been abused.

Merely labeling a commission salesman a fiduciary won't help anybody. And, without labels you can crochet a fireproof blanket for your own hind end.

For my accounts, I hire an investment manager. He works on a percentage of managed assets fee. He does not have possession of the funds, those are in the hands of a broker-dealer who sends me the confirms and statements. I make it a habit to not speak to the brokers. If one of them calls me up to peddle his wares, I tell him to talk to the IM, he knows that is a waste of time.

My mother, whose accounts I handle according to these principles, was one of the few people who lived in Palm Beach and belonged to Bernie Madoff's country club, and who did not lose a cent to him.

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"a good one for my party to force."

Guess he is a partisan hack.

[Luke]

So someone asks me if Google is a good buy at a cocktail party... what duty have I assumed in answering that question (assuming I'm Series 7 registered and stupid enough to answer it directly without a multitude of qualifiers and adverbs)?

I am in complete agreement with your summarizing thoughts and the five divisions of obligations referenced therein. I have no problem with adding more clarity to NASD Rule 2310 and NYSE Rule 405, but anyone who has sat in the chair knows the role of financial advisory takes many forms. One-size-fits-all is a recipe for disaster and only serves the lawyers that earn their living in the bowels of arbitration.

[T. Shaw]

Assuming financial institution reform legislation may be meant to prevent a future financial catastrophe ala September 2008 . . . some must believe brokers cheating wealthy clients caused . . . No! It was tax cuts for the rich! Raise taxes!

Could this be traditional demokrat demogaguery? It's been in use since A. Jackson vetoed the Second National Bank charter and cited the fact it enriched a few hundred evil rich citizens and ferners. The result was thousands of wildcat banks, boom and bust, and nearly a hundred years of financial anarchy (panic every ten or so years).

Once the wholly useless politicians narrowly define fiduciary duties of brokers to not cheat their clients - clients who can 'fire' their brokers at discretion - they might narrowly and specifically define the fiduciary duties of congress critters to not screw up (health care - deconstruction, cap and trade - depressionary energy price hikes, etc.) the people's country.

You can put your gotcha game where the sun don't shine.

The tea party tsunami may just get the rest of the professional politicos-for-life.

[Rick Caird]

So, Kleiman has zero interest in good government. He is solely interested in political power. Hence, he advocates forcing a vote on bad legislation because he believes it will help his party maintain control.

We have a faculty member of the University of Maryland School of Public Policy advocating demonstrably poor policy. At what point do such actions disqualify Kleiman from spreading such dishonesty to his students. Do not universities have some responsibility to it students to protect them from dishonest professors? Let us have a vote on that.

[save_the_rustbelt]

Based on what I've seen the past 35 years (both as a professional and a researcher) if brokers cannot churn accounts and cheat old ladies about half of the brokers will have to leave the business.

That would be a good thing.

[ohwilleke]

FWIW, when Colorado created an option that would leave Realtors without a fiduciary duty to their clients (a transaction broker statute) whcih included strict disclosure requirements, it soon became the norm.

[Say what?]

Professor B., you wrote,
"I don't think anyone disputes that brokers should have fiduciary duties to their clients. indeed, brokers already owe such duties."
You are flat wrong, sir. That's flat wrong, except in such a vitiated sense of the concept as to be misleading.

Brokers, aka Registered Reps., or salespeople, are not under a fiduciary standard, but, as other commenters have said, a suitability standard. Suitability, as in a suitable investment, of course, has nothing much to do with being a "good investment". A meaningful fiduciary standard would include much which would be antithetical to a good brokerage business model, for example, minimal trading, tax-efficient approaches, avoidance of active investment management (reliance on index funds), and using lowest practical investment expenses for the client -- all things good for the clients' financial outcomes, but just hell on brokerage profitability. I think you might fairly say that the whole idea of the brokerage industry is embodies in being able to imply, but not promise that you or your firm possess skill at stock-picking sufficient to beat the market. Given that it is undeniable that 75% or more of active managers are at any time failing to keep up with tight-fit index performance, the making of such implied claims is very close to scam or hoax territory. Brokers are fiduciaries? Please!