Fiduciary Duties of Brokers, Investment Advisers, and Financial Planners

1. Fiduciary Duties of Brokers, Investment Advisers, and Financial Planners Recent Observations, Current Issues Ron A. Rhoades, JD, CFP® Program Director, Financial Planning Program Alfred State College, Alfred, NY

2. Were Brokers Fiduciaries in 1940? “Essentially, a broker or agent is a fiduciary and he thus standards in a position of trust and confidence with respect to his customer or principal. He must at all times, therefore, think and act as a fiduciary. He owest his customer or principal complete obedience, complete loyalty, and the exercise of his unbiased interest. The law will not permit a broker or agent to put himself in a position where he can be influenced by any considerations other than those to the best interests of his customer or principal … A broker may not in any way, nor in any amount, make a secret profit … his commission, if any, for services rendered … under the Rules of the Association must be a fair commission under all the relevant circumstances.” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940). Available at http://c0403731.cdn.cloudfiles.rackspacecloud.com/collection/papers/1940/1940_0622_NASDNews.pdf

3. Were Brokers Fiduciaries in 1940? The SEC summarized a court decision finding that the furnishing of investment advice by a broker was a “fiduciary function.” The SEC stated: “In the Stelmack case the evidence showed that the firm obtained lists of holdings from certain customers and then sent to these customers analyses of their securities with recommendations listing securities to be retained, to be disposed of, and to be acquired … The [U.S. Securities and Exchange] Commission held that the conduct of the customers in soliciting the advice of the firm, their obvious expectation that it would act in their best interests, their reliance on its recommendations, and the conduct of the firm in making its advice and services available to them and in soliciting their confidence, pointed strongly to an agency relationship and that the very function of furnishing investment counsel constitutes a fiduciary function.” – from the 1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J. StelmackCorporation, Securities Exchange Act Releases 2992 and 3254.

4. Are Brokers Fiduciaries Now? • Of course, Registered Investment Advisers (RIAs) and their investment adviser representatives (IARs) are fiduciaries, applying the Investment Advisers Act of 1940. • Brokers and their registered representatives (RRs) are also always fiduciaries, within the scope of their services: • This is simply an application of the common law of agency. • BDs and RRs always possess fiduciary duties relating to best execution of trades, and safeguarding customer assets entrusted to their custody • In 1940, if a broker provided “investment advice,” then fiduciary duties extended to the advice provided, under state common law. • The same applies today, if a court or arbitration panel finds that a “relationship of trust and confidence” exists.

5. Why Don’t FINRA’s Rules of Conduct Mention Fiduciary Obligations? • When revised and adopted in the early 1940’s, the NASD (n/k/a FINRA) omitted any discussion of the fiduciary duties of BDs and RRs in their Rules of Conduct. • The much lower “suitability standard” was given effect, however. In essence, over time FINRA has sought to keep the duties of BDs and their RRs at the very low level of “suitability” and has fought the application of fiduciary duties to the advisory activities of BDs and their RRs.

6. The Maloney Act Failure • FINRA (formerly NASD) was created to raise the conduct standards for broker-dealers and their registered representatives. In 1938, the Assistant General Counsel of the SEC stated that the “Commission has concluded that the next stage in the job – the job of raising the standards of those on the edge to the level of the standards of the best – can best be handled ... by placing the primarily responsibility on the organized associations of securities dealers throughout the country.” Chester T. Lane, Address Before The Seattle Bond Club (Mar. 14, 1938), available at http://www.sec.gov/news/speech/1938/031438lane.pdf. • Senator Maloney himself noted that the Act had, as its purpose, “the promotion of truly professional standards of character and competence.” Senator Francis T. Maloney, Regulation of the Over-the-Counter Security Markets, Address at the California Security Dealers Association, Investment Bankers Association, National Association of Securities Dealers 2 (Aug. 22, 1939) (transcript available in the SEC Library at 11 SEC Speeches, 1934-61).

7. Is Dodd-Frank Act Superfluous? • BDs and RRs are already fiduciaries under state common law. • Dodd-Frank empowers the SEC to write rules applying the Advisers Act’s fiduciary standards upon BDs and their RRs when providing “personalized investment advice.” • A return to 1940?

8. Current Issues: “Two Hats” and “Hat Switching” • Sept. 2007 proposed SEC rule (never finalized) appears to permit dual registrants (those registered both as RRs of BD firm and as IARs of RIA firm) to act as: • Non-fiduciary with respect to brokerage accounts • Fiduciary with respect to investment advisory accounts FOR THE SAME CUSTOMER / CLIENT • Yet, under common law, fiduciary status extends to the entirety of the relationship. • The “fiduciary hat” – once assumed – cannot be taken off lightly. • What does a dual registrant tell a client when switching from fiduciary to non-fiduciary status? Why would any client – who understands what is happening – permit that?

9. Current Issue: Fiduciary Status Determined by Actions, Not by Contract • In discussing the decisions of two court cases, NASD (n/k/a FINRA) stated: “In relation to the question of the capacity in which a broker-dealer acts, the opinion quotes from the Restatement of the law of Agency: ‘The understanding that one is to act primarily for the benefit of another is often the determinative feature in distinguishing the agency relationship from others … The name which the parties give the relationship is not determinative.’” - from N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).

10. Current Issue: Use of Titles Which Denote Fiduciary Status In its 1941 Annual Report, the U.S. Securities and Exchange Commission noted: “If the transaction is in reality an arm's-length transaction between the securities house and its customer, then the securities house is not subject' to 'fiduciary duty. However, the necessity for a transaction to be really at arm's-length in order to escape fiduciary obligations, has been well stated by the United States Court of Appeals for the District of Columbia in a recently decided case: ‘[T]he old line should be held fast which marks off the obligation of confidence and conscience from the temptation induced by self-interest. He who would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not disguised as confidant and protector. He cannot commingle his trusteeship with merchandizing on his own account…’” Seventh Annual Report of the Securities and Exchange Commission, Fiscal Year Ended June 30, 1941, at p. 158, citing Earll v. Picken (1940) 113 F. 2d 150.

11. Current Issue: Use of Titles • BD advertising “may create an atmosphere of trust and confidence, encouraging full reliance on broker-dealers and their registered representatives as professional advisers in situations where such reliance is not merited, and obscuring the merchandising aspects of the retail securities business … Where the relationship between the customer and broker is such that the former relies in whole or in part on the advice and recommendations of the latter, the salesman is, in effect, an investment adviser, and some of the aspects of a fiduciary relationship arise between the parties.” 1963 SEC Study, citing various SEC Releases.

12. Current Issue: Use of Titles Why is this important? • “[T]o give biased advice with the aura of advice in the customer’s best interest – is fraud.” Professors James J. Angel and Douglas M. McCabe, Georgetown University, Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010). Terms such as “financial advisor” or “financial consultant” or “wealth manager” or “financial planner” denote a relationship of trust and confidence, and should be reserved for use by fiduciaries, only.

13. Who is Responsible for Due Diligence on Investments? • July 30, 2012 FINRA arbitration decision: Case # 11-00263 • C & H Properties, Inc., Calvert-Spradling Engineers, Inc. and Robert L. Calvert Consulting, Inc. vs. Morgan Keegan & Company, Inc. • Broker recommended that an investor (Robert L. Calvert) place $2m in proprietary funds containing high-yield “structured finance” instruments, which subsequently lost nearly all value • Broker met with investor several times over the years, and had telephone calls, and was family acquaintance • Held: Investor bore responsibility for due diligence, not the firm. No fiduciary relationship. • LESSON: Don’t rely on broker for due diligence. Suitability standard is inherently flawed and protects BD firms, not investors.

14. Current Issue: Can Fiduciary Duties be Disclaimed? • Can a fiduciary provide investment recommendations with no duty to minimize tax impact of the actions recommended? • Can “disclaimers” arise to such a level that fiduciary duties are, in essence, negated? LEGAL PRINCIPLE: Scope of relationship may be limited. But core fiduciary duties are not subject to disclaimer.