Out dated legal arguments re fiduciary obligations!

Canadian industry submissions on the CSA Best Interests Standards are relying on out dated legal arguments, which were themselves based on no longer relevant service relationships, for determining whether fiduciary duties apply to advisory relationships. 

I have argued that the complexity of the process underpinning the relationship imbues the relationship with fiduciary type duties because of the considerable discretion the advisor has over the processes that comprise portfolio construction, planning and management (advice) irrespective of whether the client has the final decision. 

A recent 2010 article by Arthur Laby, Professor of Law at Rutgers Schools of Law (US), argues, inter alia, that in the US brokers were only allowed to evade a fiduciary type responsibility in the 1940 Act because their advice was incidental to the transaction.  This is no longer the case.   As is the case with Canada, advice has become the predominant service activity and the transaction incidental.  

“The decision to exclude brokers that provide advice from the Advisers Act may have been appropriate in 1940 when advice was a minor ingredient in the services provided. Today, however, brokers’ functions have changed and advice is more central……

….When a customer turns to a broker for advice, the customer reposes discretion in the broker to provide appropriate guidance and direction. Moreover, the broker has the ability to affect the customer’s legal position, either directly, in the case of a discretionary account, or indirectly, in the case of a non-discretionary account, assuming the customer accepts the advice. The furnishing of advice therefore calls for the imposition of fiduciary duties…..

….These titles imply that the individual is not acting at arm’s length. They are meant to induce a customer to repose trust in the professional as a neutral source of research and recommendations. Because advice is such an important part of a broker’s activity, and because dispensing advice calls for the imposition of fiduciary duties, brokers that give advice should be subject to fiduciary obligations…..

…..Though at one point it may have been appropriate to allow brokers to provide advice incidental to brokerage without the obligations imposed on advisers, the exclusion is no longer applicable because providing investment advice looms as the more significant aspect of a broker’s activity”

I have taken some considerable excerpts from the article itself (some noted above) and reproduced them below, but I would recommend reading the entire document.

The following text is taken from – FIDUCIARY OBLIGATIONS OF BROKER-DEALERS, AND INVESTMENT ADVISERS,   ARTHUR B. LABY*

Nature of the Relationship:

Although the differences may be exaggerated, the fiduciary obligation imposed by the Advisers Act appears broader than the duties imposed on brokers through application of the Exchange Act’s antifraud rules and FINRA requirements.

The primary reason for this stems from the way courts and regulators view the scope of activity undertaken by each when administering non-discretionary accounts. As discussed, the duty imposed on an agent depends on the scope of his or her activity.

Although the scope of activity can be altered by contract, in the case of non-discretionary accounts, a broker’s activity generally is limited to conduct surrounding a particular transaction, whereas the scope of an adviser’s activity extends beyond a particular trade. The different scope of activity yields different duties.

Consider the scope of activity undertaken by advisers. In some cases, an adviser might limit its advice to providing a financial plan, or it might restrict its advice to a particularly type of security, such as municipal bonds, or a particular sector, like technology.163 In those cases, the adviser’s fiduciary duty would be commensurate with the scope of the relationship.

Most advisers, according to the Rand Report, however, agree to provide portfolio management services. The phrase “management services” connotes an ongoing relationship, which extends beyond the time a particular trade is made. Moreover, the scope of activity for federally registered advisers is usually to provide ongoing, continuous services, even for a non-discretionary account.

If an adviser has agreed to provide continuous supervisory services, the scope of the adviser’s fiduciary duty entails a continuous, ongoing duty to supervise the client’s account, regardless of whether any trading occurs. This feature of the adviser’s duty, even in a non-discretionary account, contrasts sharply with the duty of a broker administering a non-discretionary account, where no duty to monitor is required. The two accounts in this example are similar in nature—both the broker and the adviser hold themselves out as providing non-discretionary investment advice—yet the adviser’s duty entails ongoing diligence while the broker’s duty is episodic.

……..For non-discretionary accounts, however, brokers’ duties tend to be intermittent, while advisers’ duties tend to be ongoing—extending to dormant periods of inactivity in the customer’s account.  During these periods, a typical stockbroker owes no duty to the customer while an adviser acts more like a protective guardian and has a positive duty to act should market conditions or the client’s circumstances call for a change.

…….whether fiduciary duties should be imposed on brokers that provide advice. In 2005, the SEC recognized the importance of this issue, calling for a study regarding whether brokers that provide advice should be subject to fiduciary obligations normally imposed on
advisers. This is precisely the question taken up in the Obama Administration’s 2009 White Paper and in the Dodd-Frank Wall Street Reform Act. Although brokers have always provided advice, that component of their services did not predominate at the time the Advisers Act was passed. 

In recent years, however, advice has displaced transaction execution as a chief activity carried out by brokers. It comes as no surprise that today brokers market themselves as financial advisers rather than stockbrokers. This change in emphasis from execution to advice as a primary feature of a broker’s business represents a change in circumstances for the brokerage industry and justifies the imposition of fiduciary duties.

Although brokers historically provided advice to their customers, advice rendered in the past was relatively less significant in the context of the overall relationship than it is today. The Security Market study referenced above explained that in the 1930s, a brokerage  firm’s relationship with a customer had four aspects. First, it acted as a broker in the purchase and sale of securities and in borrowing and lending stocks. Second, it acted as a pledgee, lending its own capital to the customer or advancing capital borrowed from banks. Third, it was the custodian of the customer’s cash and securities. Fourth, it exercised, “to some extent,” the function of investment counsel.

The advice component is last on the list and qualified in scope. A history of the Merrill Lynch firm explains that, in the early part of the twentieth century, many brokerage firms did not do much more than execution—their sales forces were primarily intermediaries arranging trades on secondary markets—and the information available to investors seeking advice was rather meager. Open a modern description of the activities of broker-dealers and advice often is paramount.

….primary reason for this shift is technology.209 In the early part of the twentieth century, transaction execution was difficult to accomplish. Today, advances in technology have reduced the time and cost to process trades.210 As a result, the advice component of brokerage business has eclipsed transaction execution in importance. When asked which professional services matter most, survey responders chose retirement planning, investment advising, financial planning, and estate planning over executing stock or mutual fund transactions and other possible responses

Although brokers provided some advice when the Advisers Act was passed, as long as advice was not the primary service offered to investors— that is, as long as the advice was “solely incidental” to brokerage services performed—the broker was excluded from the definition of adviser and the Advisers Act’s fiduciary standard was not imposed.213

The decision to exclude brokers that provide advice from the Advisers Act may have been appropriate in 1940 when advice was a minor ingredient in the services provided. Today, however, brokers’ functions have changed and advice is more central

When a customer turns to a broker for advice, the customer reposes discretion in the broker to provide appropriate guidance and direction. Moreover, the broker has the ability to affect the customer’s legal position, either directly, in the case of a discretionary account, or indirectly, in the case of a non-discretionary account, assuming the customer accepts the advice. The furnishing of advice therefore calls for the imposition of fiduciary duties.

….Because advice has eclipsed execution as the primary service performed by broker-dealers, advice can no longer be considered “solely incidental” to brokerage. Indeed, it is brokerage that appears to be solely incidental to advice. In the 1980s, to better compete with investment advisers, many brokerage firms began to offer financial planning services and shun the title of stockbroker.224 Instead, broker-dealer registered representatives began to label themselves as financial advisors, financial consultants, financial representatives, and investment specialists.

These titles imply that the individual is not acting at arm’s length. They are meant to induce a customer to repose trust in the professional as a neutral source of research and recommendations. Because advice is such an important part of a broker’s activity, and because dispensing advice calls for the imposition of fiduciary duties, brokers that give advice should be subject to fiduciary obligations.

The provision of advice is the type of activity where agency costs are high and, therefore, fiduciary protections are needed most. It can be difficult ex post to determine the wisdom of an investment recommendation at the time it was made. A decision to recommend one investment over another is based on many factors; one can seldom know if self-interest was a motivating force. The imposition of the fiduciary duty of loyalty and the regulation of conflicts are ways to control the risk that an investment recommendation will not be objective.

………….. A fiduciary duty should be imposed on a broker providing advice regardless of the method of compensation employed. Customers who pay commissions need fiduciary protections to guard against opportunism that may arise in any commission-based business.

In the world of securities brokerage, a common risk in a commission-based account is the risk of churning, where a broker makes excessive recommendations.240 Customers who pay an asset-based fee are equally in need of protection.

An asset based fee, although reducing the likelihood of churning, increases the chance that a broker-dealer will ignore a customer’s account—aptly called “reverse churning”—because the firm will be paid regardless of whether a transaction occurs.241 In a fee-based account, regulators are concerned about “opportunism by neglect”—inattention and indifference to the account. Payment of a fixed asset-based fee provides disincentives to monitor, which results in neglected customers who receive little or no advice and seldom trade even when transactions are called for.

Though at one point it may have been appropriate to allow brokers to provide advice incidental to brokerage without the obligations imposed on  advisers, the exclusion is no longer applicable because providing investment advice looms as the more significant aspect of a broker’s activity. Moreover, both types of remuneration brokers receive—commissions and asset-based fees—call for the introduction of fiduciary duties

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