Wednesday, September 24, 2014

A Simple Solution to Fiduciary Rulemaking at the SEC

Fiduciary opponents bemoan possible rulemaking at the SEC in which brokers who provide "personalized investment advice" would be subject to broad fiduciary duties (including due care, loyalty, and utmost good faith) currently applicable to investment advisers (pursuant to the Investment Advisers Act of 1940).

Fiduciary advocates worry that the SEC will choose not to apply fiduciary standards - or even worse, adopt a "new federal fiduciary standard" based upon disclosure of conflicts of interest. Fiduciary advocates correctly point out that disclosure of a conflict of interest is not enough - informed consent must occur, and no client would likely ever provide informed consent to be harmed. In other words, even with informed consent, conflicts of interest must be managed properly in order that the best interests of the client remain paramount - a matter of "substantive fairness."

What will the SEC do?

There is a simple, elegant solution. It is found in state common law, which serves to inform federal common law. The SEC can merely adopt the following rule: "Any registered representative of a broker-dealer, and its firm, become a fiduciary to its customer when a relationship of trust and confidence is formed."

After promulgating this simple statement, the SEC could let the courts determine when a relationship of trust and confidence arises. There is already a body of common law around this issue.

Of course, further guidance will likely be needed from the SEC, over time, to ensure that fiduciary obligations are not attempted to be circumscribed by the actions of broker-dealers. Such as:
  • The contract with the client does not determine whether a relationship of trust and confidence exist. Substance trumps form.
  • No client may waive the application of fiduciary status when a relationship of trust and confidence exist.
  • Core fiduciary obligations cannot be disclaimed, nor waived by the client. Estoppel and waiver possess limited application to most fiduciary relationships. (Even the "contractualist view" of fiduciary standards, as expressed by Easterbrook, acknowledges that the core fiduciary duty of loyalty cannot be waived by client consent. The contractualist view of fiduciary obligations is better suited to situations where the parties do not possess vast information asymmetry, such as might be found in the formation of a partnership.)
  • Certain narrow limits on the scope of an engagement are permitted (such as the duration of the engagement).
  • Once a relationship of trust and confidence is formed, it extends to all aspects of the relationship. (No wearing of two hats at the same time can occur.)
  • Once a relationship of trust and confidence is formed, the "fiduciary hat" cannot be removed if any advice (including product recommendations) is to be provided to the client.
  • While a registered representative may also possess a fiduciary duty to her or his broker-dealer firm, this obligation is secondary to the fiduciary duty which the registered representative and the firm owe to the client, when a relationship of trust and confidence exists.
Also, a great deal of education will be required of broker-dealer firms and their registered representatives. It can take quite an effort to instill a fiduciary culture within a firm, especially when there is a sales culture already embedded in such firm. Extensive training, from the top to the bottom, is necessary.

Ron A. Rhoades, J.D., CFP, is an Assistant Professor of Business at Alfred State College, Alfred, NY. He also serves as Chair of the Steering Group of The Committee for the Fiduciary Standard, a volunteer group of industry leaders who commit parts of their time and treasure to advocate for the application of the fiduciary standard to all providers of investment and financial advice. Ron can be reached by e-mail at  Web site: 

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