Fiduciary Standards of Financial Advisors Part of Proposed Regulatory Reforms

This week, the U.S. Treasury unveiled their vision and recommendations for regulatory reform in the securities industry in a detailed whitepaper entitled, “Financial Regulatory Reform, a New Foundation: Rebuilding Financial Supervision and Regulation”. (Background: "Fiduciary Standard Part of Sweeping Regulatory Reforms", FA Magazine, June 18, 2009) The most pertinent changes for brokers and financial advisors is the sweeping reforms that make all investment advisors fiduciaries, including registered reps at broker-dealers and all CFP®s. The stated goal is to bring all classes of investment advisors under a common fiduciary standard (the strictest) to avoid confusion among consumers and to ensure the highest degree of integrity when dealing with clients for all professionals throughout the industry. While many brokers and advisors are still taking a wait and see attitude, and take an arms-length view of the whole regulatory alphabet soup, I think these changes will have profound impact on the industry and the way nearly all advisors run their practice, how they market themselves, and the services they offer. Understanding the big picture and preparing for what appears to be inevitable regulatory reform at this juncture is critical.

First, a bit of background: Today, the various certifications and designations of investment advisors are held to different sets of regulatory requirements and guidelines, particularly in the determination of whether the advisor is or is not held to a fiduciary standard. Registered Investment Advisors are held to a fiduciary standard, meaning that they are liable to provide appropriate investment advice for the needs and risks of the clients, but registered reps, insurance agents, and broker-dealer agents are not. CFP®s and financial planners are fiduciaries only if they are RIAs. Most descriptions of fiduciary responsibility focus on the requirement to further divulge how the advisor is compensated and any potential conflicts of interest that arise from the advisors compensation and the client’s needs. In general, a fiduciary needs to put a client’s needs first and foremost, and are held to strong ethical standards, much like a doctor or lawyer. OK, well, doctors anyway, “do no harm”, and all.

Divulging conflicts of interest and compensation schemes is all well and good, but where the fiduciary standard really matters is when the advisor gets sued. And, unfortunately, after down markets and investor losses, clients sue a lot. If the client has suffered losses that will affect their lifestyle or children’s college plans, there is a much greater liability on the part of fiduciary to prove that he considered all downside risks, and to show that the investment plan was clearly in line with the client’s risk tolerance and comprehensive investment needs. The onus falls on the fiduciary when material harm is done.

By comparison, nearly all broker-dealers require clients to agree to binding arbitration in the event of a dispute. They also make no warranties about keeping the client’s needs first and foremost, merely that a particular investment is “suitable”. The onus is on the client to show lack of suitability to the arbitrator, a much more challenging prospect for the uninitiated.

The National Association of Professional Financial Advisors (NAPFA) compares the approach of a fiduciary (which their members are), with that of broker-dealers who provide the following disclaimer in their client agreements:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. [My emphasis. – GK] Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.”

Andy Gluck, CEO of Advisor Products, Inc. wrote an impressive blog about the regulatory changes and the impact of all registered reps becoming fiduciaries. He concludes that, “making all advisors say they will act as a fiduciary will water down the meaning of the term… I suspect that advisors who today are fiduciaries are going to have a tough time differentiating the way they give retail advice from the way brokers who are fiduciaries do it.”

Taking another perspective, I’m hopeful that the fiduciary standard will continue to maintain its inherent liability implications, as this is clearly the intent of the regulatory reform: to close loopholes that keep consumers from getting the best, most appropriate advice and standardizing ethical guidelines that alleviate confusion and clarify issues to the public. What I take all this to mean is less that RIAs will now face a marketing challenge, but that brokers won’t be pushing high flying Internet IPOs, and emerging market ETFs on quite so many unsuspecting investors. While they may never give up their binding arbitration clauses, broker-dealers are going to find themselves in court having to defend their investment advice with a whole new level of fervor where there will be much more of a presumption of guilt than innocence. Since there are many more registered reps at broker-dealers than RIAs, I think this reform will have much broader impact than many expect, particularly those that think that the fiduciary and ethical standards are going to be watered down to the least common denominator.

What is a broker-dealer, financial planner, registered rep, or variable annuity agent supposed to do? Well, I’m no lawyer, and I don’t even play one on T.V., but your goal should be that if you ever end up in court that you’ve got all the facts on your side. Have you taken a holistic view of your client’s financial situation in order to ensure that their risk tolerance was in line with your proposed investments? Have you taken into account all their lifestyle needs, goals and factored in an appropriate measure of downside risk commensurate with “doing no harm” according to historical precedents? Have you built an investment strategy that minimizes risk for the anticipated returns according to asset class correlations determined by historical data going back long enough to cover all reasonable market conditions? My guess is that if you are not doing financial planning, or at least are collecting enough data about your client to be in a position to do it, that the answer to most of these questions is “no”. Further, unless you are using asset allocation and portfolio management software to design efficient portfolios, the answer is probably “no”.

We know that the vast majority of RIAs, who have long been held to fiduciary standards, do make comprehensive financial planning an integral part of their practice. The reason is that they need to be in a position to answer “yes” to all the above questions when pressed. We also know that the vast majority of financial advisors at the large broker-dealers don’t do financial planning, or do it only as a marketing gimmick to show a need to sell products and services. Clearly, as these regulatory reforms move forward from the good intention/whitepaper stage to new legislation, this is going to change. Would you want to end up in court needing to prove that you have operated at the highest fiduciary standard possible without the documentation and planning details that justifies your decisions and the design of your portfolios according to the best historical asset correlation and risk management data available? Again, I think the answer is, “no”.

The last question is: will financial planning technology vendors be regulated through technical certifications of their products (sort of an FDA or UL approval for planning apps), with appropriate liabilities for their role in the delivery of advice? Well, AdviceAmerica welcomes being held to an equally high standard, but I wouldn’t expect any real legislation in this area until after they sort out the next great crash around 2050.

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