Friday, March 15, 2013

Wall Street's Deceptions, Brokers as Fiduciaries, and Investors' Trust Betrayed

As my last blog [] mentioned, broker-dealer and investment adviser firms often consume 30% or more of the gross returns investors could expect from the capital markets. The financial services industry, as a proportion of the overall U.S. economy, has grown to unforeseen levels. Wall Street, once providing the grease that ran the economy, now provides a sludge, effectively deterring effective capital formation as well as failing to efficiently provide the returns of the capital markets to both institutional and individual investors.
In recent years massive marketing campaigns by Wall Street firms have touted their “objective advice” from “financial consultants” who attended their client’s soccer games and made so many believe that the “advice” received would result in the ability to afford that second home on the beach. Wall Street firms tout "wealth management" services, yet often provide, in actuality, the limited services of arms-length product brokers.
The trend has not gone unnoticed. In recent years many courageous journalists have exposed the many conflicts of interests which exist between product salespersons (however disguised they might be by the use of titles) and their clients. They have noted that “financial consultants” and “wealth managers” employed by Wall Street firms are seldom in an acknowledged “fiduciary relationship” with their customers.
Yet, despite the best efforts of many wise and candid financial journalists, the deceptions largely persist. Even though most customers believe they can “trust” their advisor, they are often sold high-cost, tax-inefficient products. These products in turn effect a high cost of intermediation, and drive down the long-term returns of investors - jeopardizing the retirement security of hundreds of millions of Americans.
With increasing frequently the customers of Wall Street’s broker-dealer firms and the insurance companies have realized the harm to which they have been subjected. Not always quickly, and not all the time, of course. Even after these customers read articles questioning the objectivity and/or competence of their "financial consultant." Why the slow reaction? “[I]ndividuals continue to trust beyond the point where evidence points to the contrary. Eventually, however, the accumulated weight of evidence turns them towards distrust, which is equally reinforcing.” [Anand, Kartik, Gai, Prasanna and Marsili, Matteo, Financial Crises and the Evaporation of Trust (November 16, 2009). Available at SSRN:]
Yet many consumers, already confused as to what obligations are owed to them by their “financial consultants,” are realizing that their trust has often been misplaced.  Increasingly, “Member, FINRA” – a required disclosure in broker-dealer firm advertising - has come to be seen as a consumer warning sign, much like the disclosure “Cigarettes are harmful to your health” found on the side of cigarette packs.
As knowledgeable consumers became more aware that true fiduciary advisors, with few conflicts of interest, were available, Wall Street re-doubled its efforts to obfuscate and confuse consumers, in a valiant but ill-advised attempt to preserve its archaic business model.
The past few decades have seen a small but now significant rise in the number of fee-only financial advisors, such as those who are members of the National Association of Personal Financial Advisors,, and/or those advisors who are members of the Garrett Planning Network, personal financial advisors eschew all commissions and material third-party compensation paid by product manufacturers (including 12b-1 fees). Instead, they choose to accept reasonable fees paid directly by the clients. In this manner, they avoid many of the conflicts of interest found in Wall Street's large broker-dealer firms. These independent, fee-only and fiduciary financial advisors act solely as the “client’s representative,” researching and then choosing far-lower-cost investments and investment products (and insurance products) for their clients.
Fee-only advisers continue to thrive within their own small universe of clients.  Yet attracting tens of thousands more advisors to the “fee-only” trusted advisor space has been difficult. Why? The reasonable compensation these fee-only advisers receive is insufficient to fund promotional efforts sufficient in quantity to counter the huge marketing budgets of the broker-dealer firms. Wall Street’s marketing machine, fueled by the high diversion of returns from individual investors, is extremely powerful.
For example, in recent years Wall Street’s promotional machine has further confused consumers (and even advisors) by adopting the term “fee-based” to refer to advisors who receive both fees (paid by clients) and commissions (through product sales).  Originally the term “fee-based” referred to fee-based brokerage accounts, which by virtue of a 2007 U.S. Court of Appeals decision were shut down. Following that decision, Wall Street firms embraced using the term "fee-based" to refer to many (if not most) of its dual registrants.
Regulators have failed to step in to warn that the use of “fee-based” to describe an advisor (as opposed to an account), where the advisor was also receiving commission-based compensation, is inherently misleading.  Worse yet, since the term “fee-based advisor” is intended to obfuscate, confuse, and lead to greater business, the necessary intent requisite for actual fraud exists through the use of the term, at least in most instances.  Yet still regulators have refused to clamp down.
In essence, the use of common or similar titles, and the high fees received by those operating under a conflict-ridden standard of conduct (which in turn funds Wall Street's marketing efforts) results in the inability by consumers to distinguish higher-quality advisors from lower-quality advisors. This effect is one Wall Street loves, and of which it takes advantage.
Could regulators stop all of this nonsensical misrepresentation? Yes. However, in recent years we have seen a simple ignorance by the SEC and FINRA of the fundamental truth that “to provide biased advice, with the aura of advice in the customer’s best interest, is fraud.” [Angel, James J. and McCabe, Douglas M., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (September 30, 2010), at p.23.  Available at SSRN:] 
Yet, such disconnect between regulators and the truth has not always existed.
Decades ago brokers providing investment advice to clients, as opposed to mere trade execution services, were perceived by both the SEC and the NASD (now known as FINRA) to owe broad fiduciary obligations to their clients. In other words, they were required to act in the best interests of their clients, and with a high degree of due care and utmost good faith.
Additionally, many court cases, throughout the 20th Century and extending into this new era, find brokers to be fiduciaries when providing investment advice to clients.  For example, in 1934 the Supreme Court of Massachusetts stated: “The relations between the plaintiff (consumer) and the defendants (brokers) as found by the master were not those which ordinarily exist between a broker and his customer: the findings conclusively show that the relationship was one of trust and confidence … and that relying upon the good faith of the defendants the plaintiff placed in their hands for investment about $82,000, all the money she possessed. In these circumstances it was the duty of the defendants in investing the plaintiff's money to make full disclosure to her of their interest in the transactions instead of making secret profits for themselves in the purchase of securities with her funds.” Birch v. Arnold, 288 Mass. 125; 192 N.E. 591 (Mass. 1934).
In a more recent case, a dual registrant crossed the line in "holding out" as a financial advisor, and in stating that ongoing advice would be provided, and other representations, and in so doing the dual registrant, who sold a variable annuity, was found to have formed a relationship of trust and confidence with the customers and was held to a fiduciary duty. The decision also states in part: "Obviously, when a person such as Hutton is acting as a financial advisor, that role extends well beyond a simple arms'-length business transaction. An unsophisticated investor is necessarily entrusting his funds to one who is representing that he will place the funds in a suitable investment and manage the funds appropriately for the benefit of his investor/entrustor. The relationship goes well beyond a traditional arms'-length business transaction that provides 'mutual benefit' for both parties." Western Reserve Life Assurance Company of Ohio vs. Graben, No. 2-05-328-CV (Tex. App. 6/28/2007) (Tex. App., 2007).
Even the National Association of Securities Dealers (NASD) (now known as FINRA), in an early pronouncement shortly after its creation, confirmed that brokers were fiduciaries: “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 ….” – from The Bulletin, published by the National Association of Securities Dealers, Volume I, Number 2 (June 22, 1940).
Additionally, the U.S. Securities and Exchange Commission (SEC), early on in its history, commented in its official report to Congress that the manner in which brokers hold themselves out is often determinative of their fiduciary status. In its 1940 Annual Report, the SEC 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 a 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.
A short time thereafter in its annual report to Congress 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.” [1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J. Stelmack Corporation, Securities Exchange Act Releases 2992 and 3254.]
The early principles that a broker providing investment advice was a fiduciary, and that holding out as a trusted advisor should only be undertaken by fiduciaries, were further confirmed and elaborated upon by the SEC in 1963.  In discussing the issue, the SEC noted that it “has held that where a relationship of trust and confidence has been developed between a broker-dealer and his customer so that the customer relies on his advice, a fiduciary relationship exists, imposing a particular duty to act in the customer’s best interests and to disclose any interest the broker-dealer may have in transactions he effects for his customer … [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.
In those situations in which brokers provide investment counsel (i.e., personalized investment advice), as indicated above the SEC, NASD (now known as FINRA) and the courts early on concluded that fiduciary status attached to the broker.
Yet, in recent years the debate over fiduciary standards has often been characterized by various statements from broker-dealer lobbyists pronouncing brokers to be non-fiduciaries and only bound by suitability standards, while at the same time declaring that investment advisers are fiduciaries.  Yet these statements misconstrue the effect of the Investment Advisers Act of 1940 (“Advisers Act”), at least as to brokers.
It has always clear that investment advisers were fiduciaries under the Advisers Act.  This was widely known at the time of the Advisers Act adoption (as reflected in early SEC decisions and early SEC speeches).  The fact that the Advisers Act imposed fiduciary status upon registered investment advisers and their representatives was only confirmed by the U.S. Supreme Court in its seminal 1963 Capital Gains decision.
Yet nowhere in the Advisers Act did it state that brokers were not fiduciaries. Indeed, as reflected in the early regulator commentary and court decisions discussed above, brokers who provide investment advice and not mere execution of trades are considered fiduciaries – by the courts applying state common law, by the SEC, and also by NASD (n/k/a FINRA).
It has long been held by the courts that a factor in determining whether fiduciary status attaches is the use of a title which connotes trust and influence, such as “financial advisor” or “financial planner.”  However, and while the use of such a title (or designation similar to same) can be a major factor in finding fiduciary status to attach to a broker, it is not necessary for a broker to represent himself or herself as a “financial consultant” or use some other term that represents the broker out as a trusted advisor.  The actual conduct by the broker is what matters most.  Nor are broker’s attempts to disclaim fiduciary status, such as by client execution of a brokerage agreement to that effect, determinative. One cannot disclaim fiduciary status simply by signing an agreement with the customer to such effect, and then provide personalized investment advice (and hence fiduciary advisory services).
For example, in discussing the decisions of two early cases, the NASD said it was “worth quoting” statements from various court opinions:  “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.’ And again: ‘An agency may, of course, arise out of correspondence and a course of conduct between the parties, despite a subsequent allegation that the parties acted as principals.’” - from N.A.S.D. News, published by the National Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).
Study after study demonstrates of consumers in recent years clearly demonstrate that consumers desire to place their trust in the financial advisors, and have largely done so.  Yet so often, due in part to the misuse of titles and other misrepresentations by brokers, the result has been that this trust has been misplaced and betrayed. The life savings Americans entrust to their financial advisors has failed, in most instances, to earn returns even close to the market indices. Unable to discern all of the fees and costs of the investment products existing, or the risks to which they were exposed by these financial advisors, many investors paid dearly.
Even worse were the “sh**ty” investment products which over the past decade were developed by Wall Street’s investment banks, then sold to consumers (as they often met the low “suitability” test for such a sale to occur). Subsequently many of these investment products “blew up” – destroying the life savings of many individual consumers.
As a result, many Americans have now rightfully regarded the past actions of their “advisers” as fraudulent. In essence, customers of broker-dealer firms feel betrayed. Unfortunately, many consumers also succumb to the incorrect belief that they cannot trust any financial advisor.
As the media continues to report on these travesties, some investors have abandoned the use of financial advisors altogether. Yet individual investors, lacking the skills to navigate the intricacies of the capital markets themselves, and subject to behavioral biases which were not countered with the aid of a knowledgeable and trusted adviser, tend to flee the capital markets following the inevitable periodic price declines in the equities markets. Then, perilously, these same investors return only well after stock market prices had recovered nearly fully – thereby losing out on much of the long-term returns of the capital markets.  Individual investors are seldom trained to undertake due diligence on investments, and are often unaware of the key characteristics of investment products (especially since so many fees and costs are "buried" and not shown in the annual expense ratio of mutual funds and ETFs, and other pooled investment vehicles). Nor do individual investors usually know how the better products may be best utilized to construct a tax-efficient, cost-efficient investment portfolio.
No one said investing – and securing the majority of the gains the capital markets provides – was easy. The vast majority of our fellow Americans need a trusted, guiding hand.
As scandal upon scandal involving Wall Street firms, their brokers and others have been exposed by the media in recent years, many individual investors have fled the capital markets altogether. Subjected to all of the confusing titles and advertising which obscures the truth of many financial advisor-customer relationships, and not knowing who to trust, some individual investors now choose to not participate at all in the process of capital formation. Instead they choose to place their hard-earned accumulated wealth in depository accounts - to their own peril (since such will seldom outpace inflation) and the peril of the U.S. economy.
This should not come as a shock. Participation in the capital markets, especially the equities market, requires a requisite amount of trust. “[S]pecific trust in advice given by financial institutions represents a prominent factor for stock investing, compared to other tangible features of the banking environment.”  [Georgarakos, Dimistris, and Pasini, Giacomo, Trust, Sociability and Stock Market Participation (2009), available at     
[See also César Calderón, Alberto Chong, and Arturo Galindo, Structure and Development of Financial Institutions and Links with Trust: Cross-Country Evidence (2001) (“We use a new World Bank data set that provides the most comprehensive coverage of financial development and structure to this date. We find that trust is correlated with financial depth and efficiency as well as with stock market development.”)
Available at]
The result – some individual investors fleeing from stock market investing - should have not been unexpected.  Nor should it be a surprise that lack of trust in Wall Street will translate to lower economic growth in future years. “It is well documented that public trust is positively correlated with economic growth … and with participation in the stock market … we develop a two-period theoretical model in which investors entrust their wealth to a continuum of heterogeneous agents and rely on the agents to honor their fiduciary duty … Trust that arises from the law evolves because investors can rely on the government to make sure that agents honor their fiduciary duty to clients … we consider the effect that professional fees have on the trust that forms in markets … We show that when the value to social capital is relatively low and/or the growth potential in the economy is low, it is never optimal to institute a Coasian plan (absence of government regulation). We also show that ceteris paribus there should be more government intervention in a low-trust equilibrium than in a high-trust equilibrium.” [Carlin et. al., supra.]
On the day this blog post has been written, President Obama has nominated highly respected attorney and former federal prosecutor Mary Jo White to be the next Chair of the U.S. Securities and Exchange Commission.  Will the SEC, with a full contingent of five commissioners, use its newfound authority, provided under Dodd-Frank Act Section 913, to clear up the confusion individual investors possess and to mandate fiduciary status for brokers at all times when providing personalized investment and financial advice?
Will the Department of Labor, and specifically the Employee Benefits Security Administration, undertake action first – by re-promulgating a proposed rule which would expand the definition of “fiduciary” to include many providers of investment advice to plan sponsors, plan participants, and to IRA account owners?
Will the Consumer Financial Protection Agency step in?
Will federal-registered investment advisers remain under the oversight of the S.E.C., or will Congress enact legislation enabling a professional or self-regulatory organization for investment advisers? Will FINRA’s attempt to secure that role be successful?
Who are the courageous actors, in the halls of the buildings found in our nation’s capital?
More to come.
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Ron Rhoades, JD, CFP(r) is the Program Director for Alfred State College's Financial Planning Program. He also serves as 2013 Chair of the Steering Committee for The Committee for the Fiduciary Standard. 
To discuss these matters in person with Ron, visit with him at the TD Ameritrade National Conference in San Diego, Friday, Feb. 1, 2013, after a panel discussion on this subject that day.

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