Dancing on the Head of a Pin

Dancing on the Head of a Pin

Regulators and courts may focus on the different rules for “investment advisers” and “brokers.” But, in the real world, this distinction confuses investors and undermines consumer protections.

The battle over the appropriate standard of conduct for investment advisors and brokers is being waged on a number of fronts – the courts, the Department of Labor, the Securities and Exchange Commission, Congress and various state legislatures. And the arguments and counterarguments used in this battle can be pretty confusing.

Adviser or Broker? Guess Which

One of the most important distinctions in this battle is the difference between the responsibilities of an investment adviser and a broker. Under current rules, this difference has tremendous implications. Investment advisers are held to a high standard of conduct, including an obligation to act in the best interests of their clients. On the other hand, brokers are held to a lower standard of conduct – that investments recommended be “suitable” (in effect, that a recommended investment not be an awful fit for the client). More importantly, brokers are not required to act in the best interest of clients — as long as recommended securities meet the suitability standard.

The legal basis for these different standards is the difference between the definition of an “investment adviser” and a “broker” under federal law.

•      Under the Investment Advisers Act of 1940 an investment advisor is a “person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the …advisability of investing in, purchasing, or selling securities.” 15 United States Code (U.S.C.) Section 80b-2.

•      On the other hand, under the Securities Exchange Act of 1934 a broker “means any person engaged in the business of effecting transactions in securities for the account of others.” 15 U.S.C. Section 78c.

So far, so good. An advisor gives advice while a broker simply gives effect to (or executes) transactions. The difference between these roles, as defined by law, is important – it was a key argument used by the Fifth Circuit Court of Appeals in invalidating the DOL’s fiduciary rule and was at the center of the SEC’s new standards for broker-dealers.

Well–here’s where it gets messy–what happens if a broker also gives advice? According to the Investment Advisers Act, a broker can give advice and still be held to the (lower) standard of conduct if the broker’s advice “is solely incidental to the conduct of his business as a broker” and the broker “receives no special compensation” for the advice. So, a broker who is paid on a commission basis and recommends investment products to clients – investment products that pay a commission to the broker only if he or she closes the sale – is still held only to the suitability standard. In effect, a broker can give advice – but not too much advice – and be paid only if the consumer acts upon that advice. This is a recipe for confusion and brokers, with commission revenue at stake, have a strong incentive to capitalize on this confusion.

Comment Letter to SEC

A comment letter to the SEC, prepared by the Public Investors Arbitration Bar Association, an international bar association of attorneys who represent investors in securities arbitrations (“PIABA”) highlights this issue and is worth reading for anyone interested in the contrast between elegant legal theories and the real world. The PIABA letter, submitted last year, was written in response to the SEC Chairman’s request for comments regarding the different standards of conduct for investment advisers and brokers. The letter focuses on two key issues:

•      Consumers do not understand the difference between the responsibilities of an investment adviser and a broker. The letter lists numerous studies over the past decade (including studies prepared by the SEC) documenting this reality.

•      The confusion over investment advisers and brokers is exacerbated by industry advertising, with references to “financial advisers,” “wealth managers” and “financial consultants” further blurring the difference between investment advisers and brokers.

Admittedly, an organization that represents investors involved in disputes will have a particular perspective. But, even after taking PIABA’s likely biases into account, the comment letter provides clear support for the conclusion that the legal difference between investment advisers and brokers may look meaningful in theory but, in the real world, serves to undermine consumer protections.

The bottom line is that this very important difference in standards of conduct is based on a legal difference that has been blurred to the point where it is impossible for consumers to understand whether a financial professional is really just a very slick salesman or whether that professional has any responsibility to look out for the consumer.

Don’t Forget Dual Registration

If all of this isn’t confusing enough, think about consumer uncertainty when dealing with a professional who is dually-registered – both as an investment adviser and a broker. The SEC has noted “[t]his business model presents multiple conflicts” and has determined that dual-registrants should be subject to special scrutiny, especially around determining whether to recommend that consumers use brokerage or advisory accounts. SEC, Office of Compliance Inspections and Examinations, Examination Priorities for 2013.

However, additional SEC scrutiny does not address the core issue: investment advisers and brokers play by different rules and consumers are not likely to understand the difference.

Angels on the Head of a Pin

The term “how many angels can dance on the head of a pin” is a metaphor for debating topics that do not have practical value, while more urgent issues are left unaddressed.

There is significant evidence that consumers are placing their trust – and their money – with financial professionals who have financial incentives that conflict with consumers’ best interests. And, according to various sources cited in the PIABA letter, conflicted advice costs investors between 17 billion and 21 billion dollars per year. These sound like urgent issues. Unfortunately, too much of the current debate is focused the formal designation of investment adviser vs broker, rather than consumer confusion over this distinction. In effect, the focus seems to be on those elusive angels on the head of that pin.