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Sunday, August 3, 2014

Rights of the Clients of Financial Advisors to Good Faith During Relationship Formation

Filled with apprehension, apposite to her uncertain personal financial future, abetted by anxiety pertaining to the global economy, my neighbor yearns for my guidance in today's complex financial world. She yearns to place faith and confidence in me, in my expertise, and in my judgment. My neighbor seeks my counsel, bound faithfully to her through the power of trust.

My neighbor's expectation of my faithful service exists not just within her, but within all of our fellow Americans, as they struggle to navigate a maze of investment products, mitigate risks, and secure their own financial futures. My neighbor is not alone, for her longing for the peace of mind which flows from the placement of trust is nearly universal among our fellow brethren.

But we must ask, and financial advisors and investment counselors - when our neighbors give to us, financial advisors, their confidence, what rights do they in return secure from us? I explore just one aspect of these rights - those which exist during the formation of the relationship between the investment or financial advisor and the client.


We begin with good faith in the formation of a contract in which trust and confidence are to be reposed by a client to a fiduciary. While the doctrine of culpa in contrahendo has long been viewed as a source of the obligation of good faith in civil law jurisdictions, in the context of negotiations to form a contract, only recently have our common law courts chosen to embrace good faith in contract formation. In 1808, Justice Sedgwick of the Massachusetts Supreme Judicial Court observed, in disregarding a pretense by a party in securing a contract which resulted in fraudulent concealment, that "not only good morals, but the common law, requires good faith, and that every man in his contracts should act with common honesty." Bliss v. Thompson, 4 Mass. 488, 492 (1808).

Each of our neighbors possesses a choice - to engage with a person in an arms-length transaction, or to go further and secure the services of a fiduciary. Yet, during this process, our neighbor is not to be fooled by misleading titles, false statements, or other designs amounting to fraudulent concealment. Indeed, given the expectations of our fellow citizens (as evidenced by so many surveys of consumers over the past decade) that they will place trust in those who provide financial and investment advice, full and complete frankness of the nature of the relationship must be undertaken.

Hence, we require full and frank disclosure of the nature of the relationship to be assumed. "If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its start significance.” See “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference, citing Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949).


There must be no attempts as obfuscation of the nature of the relationship, when an arms-length relationship exist and trust and confidence is neither placed nor accepted. As stated by the U.S. Securities and Exchange Commission (SEC) early on in its history: "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. [Emphasis added.]

Yet, the very use of titles, such as "financial advisor" or "financial consultant" or "wealth manager," or designations such as "Chartered Financial Consultant" or "Certified Financial Planner(tm)," are indicative of an advisory relationship. Someone forgot to tell Wall Street that trust-based marketing, without acceptance of fiduciary status, can rise to the level of intentional misrepresentation.

The view that one holding out as an advisor should be governed by the fiduciary standard of conduct finds recent support in academic literature: “The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.” James J. Angel and Douglas M. McCabe, Georgetown University, Ethical Standards for Stockbrokers: Fiduciary or Suitability? Sept. 30, 2010. [Emphasis added.]

See also Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 Bus. Law. 395, 400, 413-17 (2010) (arguing that the broker-dealer exclusion from the definition of "investment adviser" in 15 U.S.C. § 80b-2(a)(11)(C) should be lost if a broker-dealer markets itself or otherwise holds itself out as an "adviser" in light of the connotation of the word).

The SEC, over five decades ago, warned against the use of any attempt to obscure the nature of the relationship by brokers. In its 1963 comprehensive report on the securities industry, the SEC stated that it had “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 …. ” 1963 SEC Special Study on the Securities Markets. [Emphasis added.]


The form of payment must also be consistent with one's status as a fiduciary. If an asset-based fee is to be charged, then there exists a reasonable expectation of the client of an ongoing advisory relationships.

In reality, in many contexts, 12b-1 fees are "investment advisory fees in drag.”  They are utilized to compensate registered representatives and their broker-dealer firms for services of an investment advisory nature.

The anti-fraud provision of the Advisers Act, 15 U.S.C. § 80b–6, Prohibited transactions by investment advisers, forms the basis on which fiduciary duties have been applied to investment advisers, states: “It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly— ….”  (Emphasis added.)  Broker-dealers who receive “special compensation” -  generally, anything other than a commission at the time of a product sale or upon the deposit of funds into the product, appear to fall outside of the broker-dealer exclusion from the Advisers Act.  See Philadelphia Suburban Water Co. v. Pennsylvania Public Utility Commission, 2002 PA 3603 (PACW, 2002) (“’Indirectly’ signifies the doing by an obscure circuitous method something which is prohibited from being done directly, and includes all methods of doing the things prohibited except the direct one. Farmers' State Bank v. Mincher (Tex. Civ. App.) 267 S.W. 996. State v. Pielsticker, 225 N.W. 51, 52 (Neb. 1929). Moreover, in Amicable Life Insurance Co. v. O'Reilly, 97 S.W. 2d 246, 249 (Tex. Civ. App. 1936), the Texas Supreme Court noted that ‘indirectly’ cannot be treated as surplusage; this word must be given its meaning in the adjudicated case.”)

Noting hat the ill-advised fee-based accounts rule was overturned in Financial Planning Ass'n v. S.E.C., 482 F.3d 481 (D.C. Cir., 2007), I can only wonder why no judicial challenge to 12b-1 fees as impermissible special compensation has not yet arisen. One cannot do indirectly what one cannot do directly.


While other blog posts have addressed other aspects of the fiduciary obligation, including the inability to "switch hats" at will and the impossibility of wearing "two hats" for the same client, in this post I have directed my attention at the harm caused, in the business practices today, during the contract formation stage.

The SEC and FINRA have, for far too long, permitted this harm to occur. Yet, through the Dodd-Frank Act, the SEC has the ability to right these wrongs.

For the sake of all of our neighbors, let us hope that the SEC will proceed down the path of correctly applying, and then enforcing, fiduciary obligations. Let us hope that the SEC will choose to respect the rights of our fellow Americans to honesty and good faith, as they enter into contracts for the receipt of personalized investment advice.

Ron A. Rhoades, JD, CFP(r) serves as Chair of the Steering Group of The Committee for the Fiduciary Standard. He is an Asst. Professor at Alfred State College, where he serves as Program Director of its B.B.A. Financial Planning program.

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