FINRA’s
Illusionary “Best Interests” Standard
(unabridged and with footnotes)
NOTE TO READERS: This article previously appeared in RIABiz in a two part series:
I now offer the original version of the articles, with recitations to authorities.
“I am a stock and bond
broker. It is true that my family was somewhat disappointed in my choice of profession.” – Binx Bolling, The
Moviegoer (1960)
FINRA
recently advanced a “best interests” standard. Yet, the reality is that a great
deception is occurring by this brokerage-owned “self-regulatory organization,”
in which a true fiduciary standard is resisted as FINRA, along with brokerage
lobbying organization SIFMA. Instead, these organizations seek to re-define a
centuries-old, strict legal standard to a new suitability regime, together with
casual disclosure of conflicts of interest combined with securing the
customer’s uninformed consent. In so doing, FINRA endorses an exacerbation of
consumer confusion as it seeks to further obfuscate the merchandizing role of
broker-dealer firms.
In
touting a new “best interests” standard that, as will be shown, falls far short
of a true fiduciary standard of conduct, FINRA perpetuates a 75-year history of
opposing the substantial raising of standards of conduct for brokerage firms
and their registered representatives. In so doing, FINRA continues its
long-standing failure to live up to the hopes of Senator Maloney, who once stated
that his Maloney Act of 1938 (which led to the establishment of NASD, now known
as FINRA) had, as its purpose, “the promotion of truly professional standards
of character and competence.”
The compelling solution for these decades-long failures is to disband FINRA.
FINRA Chair Ketchum Suggests
“Best Interests” Standard for Brokers
In
his May 27, 2015 address to broker-dealer firm executives gathered at the 2015
FINRA Annual Conference, FINRA Chair and CEO Richard Ketchum inquired of
brokers whether “the time has come to require broker-dealers, when recommending
a security or strategy to retail investors, to ensure that the recommendation
is in the ‘best interest’ of the investor.” Mr. Ketchum went on to equate the
“best interest” standard with the “fiduciary standard,” noting that the
standard has existed under the law for centuries. Mr. Ketchum then outlined
what a “best interest” standard for brokers would look like, based upon the
principles involving “consent” by the customer to conflicts of interest,
procedures to “manage” conflicts of interest, “more effective disclosure” to
customers, and that firms undertake “fee leveling” for registered
representatives.
Yet,
despite Mr. Ketchum’s apparent support for a fiduciary standard, in the same
speech he opposed the U.S. Department of Labor’s proposed rule-making, calling
it “problematic” with the necessity of “contractual interpretations” by jurists
and further questioning “how a judicial arbiter would analyze whether a
recommendation was in the best interests of the customer ‘without regard to the
financial or other interests’ of the service provider.”
Yet
FINRA’s objections appear to this observer to be nonsensical, in light of
history. The fiduciary duty of loyalty, often referred to as requiring the
adviser to act in the “best interests” of a client, has – as Mr. Ketchum stated
– been applied in various legal contexts for hundreds of years. Moreover,
judges and arbitrators have, for centuries, interpreted contracts.
Moreover,
the additional DOL requirement that FINRA unfathomably objects to, that firms
and advisers act “without regard to the financial or other interests” of the
service provider, is derived from Section 913 of the Dodd Frank Act. It is the language
that must be applied by the SEC, if and when the SEC moves to adopt a fiduciary
standard for brokers.
Moreover, in the eyes of this observer, this additional language much more clearly
establishes a clear test for judicial finders of fact than the vague
suitability standards, and this language provides concrete guidance for both
brokers and their registered representatives.
In 2016, Does FINRA
Seeks to Address a Brokerage Firm’s “Culture” and “Ethics”?
In
FINRA’s 2016 Regulatory and Examination Priorities Letter, promulgated on Jan.
5, 2016, FINRA also sought to address three broad issues of “culture” and
“conflicts of interest” and “ethics.”
With
regard to “culture,” FINRA referred “to the set of explicit and implicit norms,
practices, and expected behaviors that influence how firm executives,
supervisors and employees make and implement decisions in the course of
conducting a firm’s business.” Yet, while FINRA noted that a brokerage firm’s “culture
has a profound influence on how a firm conducts its business and manages its
conflicts of interest,” FINRA also stated that it “does not seek to dictate firm
culture ….”
As
to conflicts of interest, FINRA appears to take an approach similar to the U.S.
Department of Labor’s proposed “Best Interests Contract Exemption” (BICE) to
its proposed “Conflicts of Interest” rule. FINRA states that its targeted
examinations of brokerage firms “encompasses firms’ conflict mitigation
processes regarding compensation plans for registered representatives, and
firms’ approaches to mitigating conflicts of interest that arise through the
sale of proprietary or affiliated products, or products for which a firm
receives third-party payments (e.g., revenue sharing).”
Likewise, DOL’s proposed BICE prohibits differential compensation to individual
registered representatives (while still permitting same to the brokerage firm
itself, subject to certain restrictions), and sets standards before proprietary
products can be recommended to customers.
As
to “ethics,” while FINRA stated that it was a broad area of focus, not
surprisingly there is little discussion in FINRA’s letter that directly
addresses a broker-dealer firm’s code of ethics.
Does FINRA Already
Possesses a “Best Interests” Standard?
In
Mr. Ketchum’s 2015 remarks he speaks of brokers moving toward a “best
interests” standard. Yet, in widely criticized earlier 2011 and 2012 releases,
FINRA already opined that a “best interests” standard exists for brokers.
In
2012 guidance to brokers regarding FINRA Rule 2111 (“Suitability”), FINRA
previously stated that, “In interpreting FINRA's suitability rule, numerous
cases explicitly state that ‘a broker's recommendations must be consistent with
his customers' best interests.’”
FINRA’s statement was largely seen as a movement toward a fiduciary standard,
as found under the Investment Advisers Act of 1940.
FINRA’s True Intentions
Revealed: Support for SIFMA’s New “Best Interests” Standard
In
its July 17, 2015 comment letter
to the U.S. Department of Labor, FINRA revealed the ugly truth that it’s
interpretation of “best interests” falls far below that required by a bona fide
fiduciary duty of loyalty. FINRA stated:
“FINRA has publicly advocated for a fiduciary
duty for years and agrees with the Department that all financial
intermediaries, including broker-dealers, should be subject to a fiduciary
“best interest” standard … At a minimum, any best interest standard for
intermediaries should meet the following criteria … The standard should require
financial institutions and their advisers to:
· act in their customers’
best interest;
· adopt procedures
reasonably designed to detect potential conflicts;
· eliminate those
conflicts of interest whenever possible;
· adopt written
supervisory procedures reasonably designed to ensure that any remaining
conflicts, such as differential compensation, do not encourage financial
advisers to provide any service or recommend any product that is not in the
customer’s best interest;
· obtain retail customer
consent to any conflict of interest related to recommendations or services
provided; and
· provide retail customers
with disclosure in plain English concerning recommendations and services
provided, the products offered and all related fees and expenses.”
These
criteria closely follow upon SIFMA’s more detailed proposal for a new “best
interests” standard that would modify FINRA’s suitability rule.
As will be discussed below, the requirements of FINRA’s suggested “best
interests” standard do not impose a bona
fide fiduciary duty of loyalty upon brokers.
Additionally,
FINRA suggests to the DOL that it offer “offer financial institutions a choice:
either adopt stringent procedures that address the conflicts of interest
arising from differential compensation, or pay only neutral compensation to
advisers.”
Yet, the adoption of “stringent procedures” is not the adoption of a fiduciary
standard of conduct. Nor does the payment of neutral compensation to advisers
prohibit the broker-dealer firm, itself, from the receipt of additional compensation
as they promote the sale of products that would pay them more. Also, the
receipt of additional compensation by the broker-dealer firm would not adhere to
the DOL proposed rule’s requirement that product recommendations be undertaken
without regard to the financial or other interests of the financial
institution.
FINRA
also suggests to the DOL that it, in essence, lower the fiduciary duty of due
care. FINRA states, incorrectly, that: “Fiduciaries generally are not required
to discern or recommend the ‘best’ product among all available for sale
nationwide or worldwide. Investment advisers, for example, are required to
recommend suitable investments, not the ‘best’ investment available to the
customer. A requirement to recommend the ‘best’ product would impose
unnecessary and untenable litigation risks on fiduciaries.”
Yet, fiduciaries, in adherence to their fiduciary duty of due care, and judged
against other prudent experts, clearly possess the obligation to undertake
extensive due diligence. This due diligence requires fiduciaries to select the
best investments resulting from the fiduciary’s due diligence processes,
augmented with the exercise of good judgment during the due diligence process.
Think about it. A fiduciary also
possesses a fiduciary duty of utmost good faith, which includes as part thereof
a duty to the client of honesty and complete candor. Would, in observance of
this duty, a fiduciary ever go to a client and state: “Our due diligence has
indicated that this is the third-best mutual fund on the marketplace today
within this asset class. But, even though other two other products would be
better for you, we don’t recommend them.” Of
course not. While fiduciary advisers certainly, in their exercise of good
judgment, might disagree about what product is “best,” once a fiduciary adviser
determines through a properly applied due diligence process the “best”
investment product to meet the client’s specific needs, then the fiduciary has
the obligation to recommend that product to the client.
I
am not suggesting that all fiduciaries would reach the same conclusion, as to
the choice of either investment strategy or investment products. But a due
diligence process, using sound criteria, and applying good judgment, will
result in a “best product” to be discerned by that adviser, and the fiduciary
adviser would clearly be unwise if such product were not recommended.
What
FINRA really wants the broker to be able to do, by its comment, is to continue
to recommend virtually any product, under the failed suitability standard, even
when that product is nowhere close to being the best product in the
marketplace.
FINRA’s Failed
Suitability Standard
Even
though FINRA in its June 17, 2015 comment letter criticizes the DOL for
introducing “new concepts that are fraught with ambiguity, the reality is that
FINRA is the promulgator of ambiguous and often contradictory rules and
statements with regard to the standards governing brokers.
In
fact, it is FINRA’s suitability standard that is both ambiguous and often
arbitrarily applied. In the early 20th Century, FINRA’s suitability
standard was originally designed to mitigate the duty of due care that all
service providers possess, in recognition that a broker should not be liable
for the default of a security merely for performing “trade execution” services.
Inexplicably,
however, the suitability standard was expanded in the 1970’s to brokers’
recommendations of investment managers (including mutual fund providers). In
turn this has led to a wide plethora of pooled investment vehicles, often
expensive, and often with “hidden” revenue-sharing. The result has been
widespread harm to investors, given the substantial academic research
demonstrating the close relationship between high mutual fund fees and costs
and lower returns, on average. Moreover, individual Americans are unable to
recover from brokers due to a breach of the duty of due care, since brokers do
not possess such a duty – even thought nearly every other service provider in
the United States possesses such a duty.
Instead,
investors are left, under suitability, with a subjective, unclear, amorphous
legal standard.
Even worse, the suitability standard is applied in FINRA arbitration, not as a
strict legal standard, but rather under an approach of “equitable fairness” –
leading to an inefficient and confused application of the law
by arbitrators with no duty to record their reasoning, and from which
arbitration there are very limited rights of appeal.
Suitability
does not generally require registered representatives to recommend a lower cost
product with similar risk and return characteristics, if one is available. Nor does the suitability doctrine require
monitoring of an investment portfolio (even where ongoing fees are received by
the brokerage firm). Nor does suitability require the design and management of
the investment portfolio for a client in a tax-efficient manner.
FINRA’s Confusing,
Contradictory Statements
FINRA’s
statements over the past few years have often been contradictory. FINRA stated
to brokers in its earlier release regarding Rule 2111 that brokers’
recommendations must be consistent with the “best interests” of their customers.
Yet, just last year, FINRA stated to the U.S. Department of Labor: “We
recognize that imposing a best interest standard requires rulemaking beyond what is presently in place for
broker-dealers.”
[Emphasis added.]
In
2005, FINRA opposed the application of the Advisers Act’s fiduciary duties upon
brokers who provided fee-based accounts, even though FINRA acknowledged that,
“[f]rom a retail client’s perspective, the differences between investment
advisory services and traditional brokerage services are almost imperceptible.”
Stating that “brokerage investors are fully protected”
FINRA even questioned the need for additional disclosures to investors.
In
a widely criticized statement, FINRA also expressed in 2005 that the SEC’s
proposed disclosure for fee-based accounts “implies that customer’s rights, the
firm’s duties and obligations, and the applicable fiduciary obligations are
greater with respect to an investment adviser account than they are with
respect to a brokerage account. As we have previously discussed, this is simply
not the case.”
FINRA’s statement is clearly erroneous, as everyone and their mother agree that
the fiduciary standard is a higher standard than the suitability standard.
FINRA’s statement is also contradictory to the FINRA Chair’s recent comments in
which he suggests that brokers move toward a higher “best interests” standard.
BD Execs Agree? “Best
Interests” = “Fiduciary Duty of Loyalty”
In
a December 2, 2015 hearing before the Subcommittee On Health, Employment,
Labor, And Pensions, of the U.S. House Education and Workforce Committee, Mr. Jules
O. Gaudreau, Jr., ChFC, CIC testified, on behalf of the National Association of
Insurance and Financial Advisors, under oath: “We already believe that we do
engage in the best interests of our clients; we take an ethics pledge on their
behalf.”
Subsequently,
U.S. Representative Suzanne Bonomaci addressed testimony in an earlier hearing,
noting that securities industry executives all responded affirmatively when she
inquired, “Just to be clear, does everyone agree that a ‘best interests’
standard means a ‘best interests’ fiduciary standard?”
Yet,
Mr. Gaudreau later testified, “These decisions that consumers make in the
financial realm are based upon rapport and trust and relationships. These are
not just simple transactions … we don’t disagree that we should work in the
best interests of our clients; my family’s been doing that for a hundred years.
In fact, it’s a little insulting to imply that we ever haven’t. The fact is
that we absolutely agree with that and endorse that public policy.”
"Should
retirement advisors be able to place their own profit-seeking before the best
interests of their clients?" asked U.S. Rep. Ellison at the Sept. 10, 2015
Congressional Joint Hearing before the Subcommittees on Oversight and
Investigations and Capital Markets and Government Sponsored Enterprises, of the
House Financial Services Committee, entitled “Preserving Retirement Security
and Investment Choices for All Americans." The President of NAIFA replied:
“No.” Immediately thereafter all of the panelists, most of whom represented the
securities industry, agreed that they were for the "best interests"
standard.
This
begs the question … if insurance companies and broker-dealers say that they support acting in the
“best interests” of their customers, do they truly understand the fiduciary
duty of loyalty? Or, are the executives’ understandings of the term “best
interests” flat out disconnected from the understanding of that legal term
under fiduciary law, and as commonly understood by the vast majority of
Americans?
Half-Truths and
Deceptions
“Goldman's arguments in
this respect are Orwellian. Words such as ‘honesty,’ ‘integrity,’ and ‘fair
dealing’ apparently [in Goldman’s eyes] do not mean what they say; [Goldman
says] they do not set standards; they are mere shibboleths. If Goldman's claim
of ‘honesty’ and ‘integrity’ are simply puffery, the world of finance may be in
more trouble than we recognize.” – Judge Paul Crotty, Richman v. Goldman Sachs Group, Inc., 868 F. Supp. 2d 261 (S.D.N.Y.
2012).
When
we are dealing with the fiduciary standard of conduct, and its requirement that
the fiduciary act in the “best interests” of the entrustor (client), we should
not accept half-truths and deception. If the fiduciary standard is to possess
meaning, we must hold firms and persons accountable to their words, and not
regard these important words as mere “puffery.”
As
stated by Professors James Angel and Douglas McCabe: “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.”
We Know that Disclosures
Are Ineffective
Academic
researchers have long known that emotional biases limit consumers’ ability to
close the substantial knowledge gap between advisors and their clients. Insights
from behavioral science further call into substantial doubt some cherished
pro-regulatory strategies, including the view that if regulators force delivery
of better disclosures and transparency to investors that this information can
be used effectively. This is in large part due to many behavioral biases that
limit the effectiveness of any form of disclosure.
Note
as well that, as Professor Robert Prentice has written, “instead of leading
investors away from their behavioral biases, financial professionals may prey
upon investors’ behavioral quirks … Having placed their trust in their brokers,
investors may give them substantial leeway, opening the door to opportunistic
behavior by brokers, who may steer investors toward poor or inappropriate
investments.”
Moreover,
as observed by Professors Stephen J. Choi and A.C. Pritchard, “not only can
marketers who are familiar with behavioral research manipulate consumers by
taking advantage of weaknesses in human cognition, but … competitive pressures
almost guarantee that they will do so.”
As
a result, much of the training of registered representatives involves how to
establish a relationship of trust and confidence with the client. Once a
relationship of trust is formed, customers will generally accede to the
recommendations made by the registered representative, even when that recommendation
is adverse to the customers’ best interests.
Other
investor biases overwhelm the effectiveness of disclosures. As stated by Professor Fisch: “The primary
difficulty with disclosure as a regulatory response is that there is limited
evidence that disclosure is effective in overcoming investor biases. … It is
unclear … that intermediaries offer meaningful investor protection. Rather,
there is continued evidence that broker-dealers, mutual fund operators, and the
like are ineffective gatekeepers. Understanding the agency costs and other
issues associated with investing through an intermediary may be more complex
than investing directly in equities ….”
The
inadequacy of disclosures was known even in 1930’s. Even back during the
consideration of the initial federal securities laws, the perception existed
that disclosures would prove to be inadequate as a means of investor
protection. As stated by Professor
Schwartz: “Analysis of the tension between investor understanding and
complexity remains scant. During the debate over the original enactment of the
federal securities laws, Congress did not focus on the ability of investors to
understand disclosure of complex transactions. Although scholars assumed that
ordinary investors would not have that ability, they anticipated that
sophisticated market intermediaries – such as brokers, bankers, investment
advisers, publishers of investment advisory literature, and even lawyers -
would help filter the information down to investors.”
We
must acknowledge that, if disclosures were effective, fiduciary law would not
exist. There would be no fiduciary duties imposed upon trustees, or attorneys,
or others in a relationship of trust and confidence with their entrustor in
which a substantial difference in either power or knowledge exists. Fiduciary
duties are imposed because disclosures are effective.
Wear Two Hats?
Impossible.
Time
and again our courts have enumerated the fiduciary maxim: “No man can serve two
masters.” Yet, FINRA promotes a new “best interests” standard that attempts to
straddle a line that, simply, cannot be bestrode.
As
the Virginia Supreme Court long ago stated: “It is well settled as a general
principle, that trustees, agents, auctioneers, and all persons acting in a
confidential character, are disqualified from purchasing. The characters of
buyer and seller are incompatible, and cannot safely be exercised by the same
person. Emptor emit quam minimo potest;
venditor vendit quam maximo potest. The disqualification rests, as was
strongly observed in the [English] case of the York Buildings Company v. M'Kenzie, 8 Bro. Parl. Cas. 63, on no
other than that principle which dictates that a person cannot be both judge and
party. No man can serve two masters. He that it interested with the interests
of others, cannot be allowed to make the business an object of interest to
himself; for, the frailty of our nature is such, that the power will too readily
beget the inclination to serve our own interests at the expense of those who
have trusted us.”
The
observation that a person cannot wear two hats and continue to adhere to his or
her fiduciary duties was echoed early on by the U.S. Supreme Court, “The two
characters of buyer and seller are inconsistent.”
The U.S. Supreme Court also observed: “If persons having a confidential
character were permitted to avail themselves of any knowledge acquired in that
capacity, they might be induced to conceal their information, and not to
exercise it for the benefit of the persons relying upon their integrity. The
characters are inconsistent.”
Why
should an advisor not attempt to wear two hats? Simply put, because persons are
weak. We are unable to not have our advice be affected by temptations (such as
for additional compensation) that might exist. As the U.S. Supreme Court opined
in its landmark 1963 decision, SEC vs.
Capital Gains Research Bureau, “the rule … includes within its purpose the
removal of any temptation to violate them …This Court, in discussing conflicts
of interest, has said: ‘The reason of the rule inhibiting a party who occupies
confidential and fiduciary relations toward another from assuming antagonistic
positions to his principal in matters involving the subject matter of the trust
is sometimes said to rest in a sound public policy, but it also is justified in
a recognition of the authoritative declaration that no man can serve two
masters; and considering that human nature must be dealt with, the rule does
not stop with actual violations of such trust relations, but includes within
its purpose the removal of any temptation to violate them … we [previously] said:
‘The objection … rests in their tendency, not in what was done in the
particular case … The court will not inquire what was done. If that should be
improper it probably would be hidden and would not appear.’”
Even Ardent Capitalists
Recognize the Need for High Standards
Even
Adam Smith, said to be the founder of modern capitalism, knew that constraints
upon greed were required. While Adam Smith saw virtue in competition, he also
recognized the dangers of the abuse of economic power in his warnings about
combinations of merchants and large mercantilist corporations.
Adam
Smith also recognized the necessity of professional standards of conduct, for
he suggested qualifications “by instituting some sort of probation, even in the
higher and more difficult sciences, to be undergone by every person before he
was permitted to exercise any liberal profession, or before he could be
received as a candidate for any honourable office or profit.” As
seen, “Smith embraces both the great society and the judicious hand of the
paternalistic state.”
In essence, long before many of the professions became separate, specialized
callings, Adam Smith advanced the concepts of high conduct standards for those
entrusted with other people’s money.
Hiding the Distinctions
Between Sales and Advice
The
fundamental problem is that broker-dealer firms, represented by FINRA, SIFMA,
and FSI, continue to advocate for the freedom to hold themselves out as trusted
advisers, and to provide investment advice on American’s important financial
decisions. Yet, these broker-dealer firms still desire to remain in a sales-customer
relationship, instead of a fiduciary-client relationship.
Perhaps FINRA, SIFMA and FSI first need to
understand the distinctions between the two general types of relationships
between product and service providers and their customers or clients under the
law – “arms-length relationships” and “fiduciary relationships.”
“Arms-length” relationships apply to the vast majority of service
provider–customer engagements.
In arms-length relationships, the doctrine of
“caveat emptor”
generally applies,
although there are many exceptions made to this doctrine that effectively
compel affirmative disclosure of adverse material facts in diverse contexts.
In other words, non-fiduciaries who contract with each other can engage in
“conduct permissible in a workaday world for those acting at arm's length.”
The standard of conduct expected of the actors in arms-length relationships has
also been described by the courts as the “morals of the marketplace.”
In
contrast, under a fiduciary relationship, the fiduciary steps into the shoes of
the client. The fiduciary adheres to the “fiduciary principle,” which Justice
Philip Talmadge of the State of Washington Supreme Court aptly summarized: “A
fiduciary relationship is a relationship of trust, which necessarily involves
vulnerability for the party reposing trust in another. One's guard is down. One
is trusting another to take actions on one's behalf. Under such circumstances,
to violate a trust is to violate grossly the expectations of the person
reposing the trust. Because of this, the
law creates a special status for fiduciaries, imposing duties of loyalty, care,
and full disclosure upon them. One can
call this the fiduciary principle.”
The
impact of serving in a fiduciary capacity is often underestimated, even by the
DOL itself. I estimate that intermediation fees and costs fall by roughly half,
on average, when a client transfers from a non-fiduciary adviser to a fiduciary
adviser.
Others
possess much higher estimates. For example, in a 2014 paper by Professor Mark
Egan, he opined: “Brokers utilize the space of available products to price
discriminate across consumers, selling high fee products to unsophisticated
investors and low fee products to sophisticated investors … I structurally
estimate the model to analyze the impact of the proposed broker regulations of
the Dodd Frank Act. I find that holding brokers to a fiduciary standard over
the period 2008-2012 would have increased investor returns by as much as 2.73%
per annum.”
The Term “Best
Interests” Has Legal Meaning
The
fiduciary duty of loyalty, in which the adviser is bound to act in the client’s
best interests,
is central to the fiduciary principle; it is the principle’s most
distinguishing characteristic. The term “best interests” has an established
legal meaning, which FINRA should not be able to alter.
The
phrase “act in the best interests of the client” is used to explain, in
language a non-lawyer would understand, the core aspect of the fiduciary duty
of loyalty. This use of the term “best interests” to describe the fiduciary
duty of loyalty is frequently found in judicial decisions.
For
example, in explaining the duty of loyalty owed by a board of directors to the
corporation, the instruction to a lay jury reads: “Each member of the … board
of directors is required to act in good
faith and in a manner the director reasonably believes to be in the best interests of the corporation when discharging his or her
duties.” Schultz v. Scandrett, #27158, Supreme Court of South
Dakota, 2015 SD 52; 866 N.W.2d 128; 2015 S.D. LEXIS 85 (June 24, 2015).
In
describing the fiduciary duty of the director of a corporation to the
corporation and its shareholders, a court opined: “The duty of loyalty
‘mandates that the best interest of
the corporation and its shareholderstakes
precedence over any interest possessed by a director, officer or controlling
shareholder and not shared by the stockholders generally.’ Cede
& Co. v. Technicolor, Inc., 634 A.2d 345, 362 (Del. 1993) (citing
Pogostin v. Rice, 480 A.2d 619, 624 (Del. 1984) and Aronson v.
Lewis, 473 A.2d 805, 816 (Del. 1984));see also Diedrick v. Helm, 217
Minn. 483, 14 N.W.2d 913, 919 (Minn. 1944). The classic example is when a
fiduciary either appears on both sides of a transaction or receives a
substantial personal benefit not shared by all shareholders. Id.”
DQ Wind-Up, Inc. v. Kohler, Court File No. 27-CV-10-27509, Minnesota District
Court, County Of Hennepin, Fourth Judicial District, 2013 Minn. Dist. LEXIS 118
(2013).
Similarly,
“[t]he duty of loyalty requires that the best interests of the corporation and its shareholderstake precedence over any self-interest of
a director, officer, or controlling shareholder that is not shared by the
stockholders generally.” Rales v. Blasband, 634 A.2d 927, 936 (Del.
1993).
Also,
"”n dealing with corporate assets [the corporate officer] was required
to act in the best interests of
the corporation and he was prohibited from using either his
position or the corporation's funds for his private gain.” Levin v.
Levin, 43 Md. App. 380, 390, 405 A.2d 770 (1979).
A
court, recently opining on ERISA’s fiduciary duty of loyalty, stated: “ERISA
imposes a duty of loyalty on fiduciaries. Donovan v. Bierwirth, 680
F.2d 263, 271 (2d Cir.), cert. denied, 459 U.S. 1069, 74 L. Ed. 2d 631, 103 S.
Ct. 488 (1982) (Friendly, J.). A trustee violates his duty of loyalty when he enters into substantial competition
with the interests of trust beneficiaries. Restatement (Second) of
Trusts, § 170, comment p … under the law of trusts, a fiduciary is generally prohibited,
not just from acting disloyally, but also from assuming a position in which a temptation to act contrary to the
best interests of the beneficiaries is likely to arise. Grynberg at
1319; 2 Scott on Trusts § 170, pp. 1297-98 (1967).” Salovaara v. Eckert,
94 Civ. 3430 (KMW), U.S. D.C. SDNY, 1996 U.S. Dist. LEXIS 323
(1996).
In
describing an attorney’s fiduciary duty of loyalty to a client, a court stated:
“public policy requires that he not be
subjected to any possible conflict of interest which may deter him from
determining the best interests of the client … a
client's right to the undivided loyalty of his or her attorneys must be
protected … The duty of
both the associate and the successor attorney is the same: to serve the best interests of the client." Beck
v. Wecht, No. S099665, Supreme Court Of California, 28 Cal. 4th 289; 48
P.3d 417; 121 Cal. Rptr. 2d 384; 2002 Cal. LEXIS 4197; 2002 Cal. Daily Op.
Service 5812; 2002 Daily Journal DAR 7326 (2002).
Numerous
law review articles and academic texts also reflect on the fiduciary’s
obligation to act in the client’s (entrustor’s) “best interests.”
“Tracing
this doctrine back into the womb of equity, whence it sprang, the foundation
becomes plain. Wherever one man or a group of men entrusted another man or
group with the management of property, the second group became fiduciaries. As
such they were obliged to act conscionably, which meant infidelity to the interests of the persons
whose wealth they had undertaken to handle. In this respect, the corporation
stands on precisely the same footing as the common-law trust.” Adolf A. Berle,
Jr. & Gardiner C. Means, The Modern Corporation and Private
Property 336 (1939).
“The underlying purpose of the duty of loyalty,
which the sole interest rule is meant to serve, is to advance the best interest of the beneficiaries … There
can be no quibble with the core policy that motivates the duty of loyalty. Any
conflict of interest in trust administration, that is, any opportunity for the
trustee to benefit personally from the trust, is potentially harmful to the
beneficiary. The danger, according to the treatise writer Bogert, is that a
trustee ‘placed under temptation’ will allow ‘selfishness’ to prevail over the
duty to benefit the beneficiaries. ‘Between two conflicting interests,’ said
the Illinois Supreme Court in an oft-quoted opinion dating from 1844, ‘it is
easy to foresee, and all experience has shown, whose interests will be
neglected and sacrificed’ …
“The
law is accustomed to requiring
that attorneys zealously pursue their clients' interests and that
they not indulge interests that may conflict with those of a particular client
without first disclosing the potential conflict to the client and receiving the
client's approval. There are some conflicts that cannot be overcome by the
client's permission where the conflicted attorney would have to avoid the
conflict entirely or quit the representation of the client. Law firms
vigorously monitor potential conflicts between attorneys and clients. The rules of professional responsibility go to
great lengths to define the appropriate standard of conduct for
attorneys and describe what constitutes a conflict and how an attorney, law
firm, and client should handle it. These
strictly enforced standards of conduct cover every facet of the attorney-client
relationship and leave very little to chance in a court's ex post
determination of whether an attorney has breached her fiduciary duties. While
fiduciary duties may apply to the relationship and zealous advocacy is clearly
required, the obligation an attorney owes a client is not left to vague,
unpredictable ex post judicial review. It is quite thoroughly described in
codes of conduct that have grown ever more complete and sophisticated over
time.” John H. Langbein, Questioning the Trust Law Duty of Loyalty: Sole
Interest or Best Interest?, 114 Yale L.J. 929 (March 2005).
We
also see the term “best interests” used to describe the legal obligations
arising for those who provide personalized investment advice to retail customers.
On January 22, 2011, the SEC's Staff, fulfilling the mandate under § 913 of the
Dodd-Frank Act, released its Study on the regulation of broker-dealers and
investment advisers. The overarching recommendation made in the Study is that
the SEC should adopt a uniform fiduciary standard for investment advisers and
broker-dealers that is no less stringent than the standard under the Advisers
Act. Specifically, the Staff recommended the following: “[T]he standard of
conduct for all brokers, dealers, and investment advisers, when providing
personalized investment advice about securities to retail customers (and such
other customers as the Commission may by rule provide), shall be to act in
the best interest of the customer
without regard to the financial or other interest of the broker, dealer, or
investment adviser providing the advice.” EC Staff, Study on Investment
Advisers and Broker-Dealers ii (2011) [hereinafter SEC Staff Study], available
at http://www.sec.gov/news/studies/2011/913studyfinal.pdf.
Understanding the Bona
Fide Fiduciary Duty of Loyalty
Under
the fiduciary duty of loyalty, as developed over centuries of case law, there
is a duty to not possess a conflict of interest, and to not profit off of the
client. In other words, fiduciaries owe the obligation to their client to not
be in a position where there is a substantial possibility of conflict between
self-interest and duty.
This is called the “no-conflict” rule, derived from English law. Fiduciaries
also possess the obligation not to derive unauthorized profits from the
fiduciary position. This is called the “no profit” rule, also derived from
English law.
If
a conflict of interest is not avoided
and does exist, mere disclosure to the client of the conflict, followed by mere
consent by a client to the breach of the fiduciary obligation, does not
suffice.
Under the law, we state that this is not sufficient to create either a “waiver”
of the client or to “estop” the client from pursuing a claim for breach of
fiduciary duty. If this were the case, fiduciary obligations – even core
obligations of the fiduciary – would be easily subject to waiver. Instead, to
create an estoppel situation, preventing the client from later challenging the
validity of the transaction that occurred, the fiduciary is required to
undertake a series of steps.
First,
disclosure of all material facts to the client must occur. [For some
commentators on the fiduciary obligations of investment advisers, this is all
that is required. Often this erroneous conclusion is derived from wishful misinterpretations
of the landmark decision of SEC v.
Capital Gains Research Bureau.]
Second,
the disclosure must be affirmatively made and timely undertaken. In a fiduciary
relationship, the client’s “duty of inquiry” and the client’s “duty to read”
are limited; the burden of ensuring disclosure is received is largely borne by
the fiduciary. Disclosure must also occur in advance of the contemplated
transaction. For example, when a conflict of interest is present, disclosure
via receipt of a prospectus following a transaction is insufficient, as this
does not constitute timely disclosure.
Third,
the disclosure must lead to the client’s understanding. The fiduciary must be
aware of the client’s capacity to understand, and match the extent and form of
the disclosure to the client’s knowledge base and cognitive abilities.
Fourth,
the intelligent, independent and informed consent of the client must be
affirmatively secured.
Silence is not consent. Also, consent cannot be obtained through coercion nor
sales pressure.
Fifth,
at all times, the transaction must be substantively fair to the client. If an
alternative exists which would result in a more favorable outcome to the client,
this would be a material fact which would be required to be disclosed, and a
client who truly understands the situation would likely never gratuitously make
a gift to the advisor where the client would be, in essence, harmed.
These
requirements of the common law are derived from judicial decisions over
hundreds of years.
While these requirements are strict,
they are intentionally so. The strict fiduciary duties aim to prevent or
protect against the disease of temptation.
The
provision of investment advice to a client involve decisions that, if made
improperly, clearly can jeopardize that client’s financial future. In the area
of investments, the client possesses far inferior knowledge compared to the
knowledge of the fiduciary. The inherent complexity of the modern securities
markets, combined with the need for investors to properly manage investment
portfolios over decades as a means of ensuring their retirement security, makes
reliance upon another for personalized investment advice essential. Nor can
financial literacy efforts overcome this need for reliance. As observed by the
Financial Planning Association of Australia Limited, “The average person will
no more become an instant financial planner simply because of direct access to
products and information than they will a doctor, lawyer or accountant.”
This
is closely analogous to the attorney-client relationship,
which also treats the maintenance of conflicts of interest severely. “Conflicts
of interest are broadly condemned throughout the legal profession because of
their potential to interfere with the undivided loyalty that a lawyer owes to
his or her client. The representation of adverse interests can likewise quickly
erode the bond of trust between the attorney and his or her client.”
FINRA’s “Best Interest”
Standard Fails to Meet the Fiduciary Duty of Loyalty
While
much of FINRA’s proposal is general, including its apparent requirement to
“avoid conflicts of interest,” upon close inspection, FINRA’s proposal to the
DOL that a new “best interest” standard be adopted is but an attempt to
undermine fiduciary law. This is evidenced most in FINRA’s requirements on how
a conflict of interest is to be managed, when it is not avoided.
For
example, under a bona fide fiduciary standard, all compensation of the
fiduciary must be disclosed to the client, and must be reasonable. Under
FINRA’s proposed standard there is annual disclosure of a product’s fees and
expenses, but not of the compensation of the broker-dealer firm.
Under
a true fiduciary standard of conduct, when a conflict of interest is
unavoidable, the fiduciary must ensure client understanding of the conflict of
interest. Yet, under FINRA’s proposal, it appears only that the broker-dealer
must “inform” the client of the conflict. Moreover, broker-dealers have long
advocated in opposing fiduciary standards mere “casual disclosures” of
conflicts of interest, such as “our interests might not be aligned with yours,”
rather than the full and frank disclosure required of a fiduciary.
Nor
is there is any requirement in FINRA’s proposal that the client’s consent be
“informed” – a key requirement of fiduciary law before client waiver of a
conflict of interest can take place. Nor is there a requirement that the client
provide informed consent prior to each and every transaction. Rather, FINRA
would only require brokers to “obtain client consent” to conflicts of interest.
Such consent, often given with little or no understanding by the customer of
the ramifications to the client of the broker’s conflict of interest, does not
meet the “informed consent” requirement of fiduciary law. It is fundamental
that no client would ever provide informed consent to be harmed.
Finally,
FINRA’s proposed “best interest” standard does not require, even in the presence
of informed consent, that the transaction remain substantively fair to the
client (as fiduciary law requires).
Rather, there is only a requirement that the transaction be in accord with the
client’s “best interest.”
FINRA’s
new “best interests” standard remains ill-defined and subject to much
interpretation. While, it appears that FINRA’s “best interest” proposal would
permit broker-dealers to still represent product manufacturers; the
broker-dealer firm would still function as a “seller’s representative” rather
than a “buyer’s representative” as a true fiduciary would. Under FINRA’s “best
interest” proposal it appears that broker-dealers would easily be able to place
their own interests above that of the client.
While
FINRA chides the U.S. Department of Labor, in FINRA’s July 17, 2017 comment
letter, for imposing “a best interest standard on broker-dealers that differs significantly
from the fiduciary standard applicable to investment advisers registered under
the federal and state securities laws,” the reality is that it is FINRA’s
proposal (and an earlier proposal advanced by SIFMA, of the same nature) that fails
to survive close scrutiny.
FINRA’s
“best interest” proposal, if it were to be adopted, would significantly weaken
long-standing fiduciary principles. It would mislead our fellow Americans to
believe that their best interests were paramount when, in fact, the principle
of caveat emptor would still apply.
Caveat Emptor Still Applies
with BDs
Mr.
Ketchum also stated in 2015 that recent “depictions of the present environment
as providing ‘caveat emptor’ freedom
to broker-dealers to place investors in any investment that benefits the firm
financially with no disclosure of their financial incentives or the risks of
the product, are simply not true.”
Yet, I have personally seen, over and over again, many a registered
representative of a broker-dealer firm sell variable annuities in very large
transaction amounts, and some have bragged to me of their avoidance of the breakpoint
discounts generally applicable to mutual funds but not to many variable
annuities at present. And, I have also examined many investment portfolios when
it is obvious that the broker’s recommendations of mutual funds, from different
fund families, were structured in a way to avoid certain breakpoint discounts.
The
fact of the matter is that, despite Mr. Ketchum’s assertion, customers of
brokers need to be on guard and protect themselves from brokers who provide
investment advice.
The doctrine of caveat emptor still
clearly applies to broker-customer relationships.
It
is clear that, consciously or unconsciously, the economic self-interests of
many brokerage firms and many registered representatives often profoundly
affect the recommendations made to customers. Despite Mr. Ketchum’s statement,
it is also clear that brokers are able to place investors in investments that
benefit the financial interests of the broker-dealer firm and/or its registered
representatives.
Disband FINRA
For
over seven decades FINRA (formerly called NASD) has refused to recognize in its
rules of conduct that brokers, when in a relationship of trust and confidence
with their customers, possess broad fiduciary duties to such customers. These
fiduciary duties act to restrict the conduct of the fiduciary.
Now,
on the eve of DOL rule-making, FINRA proposes not a fiduciary standard - but
rather an abomination of the "best interests" fiduciary duty of
loyalty. This new, perverse “best interests” standard that would reverse
centuries of understanding for that legal term. In making its proposal, FINRA seeks
to undermine established fiduciary law in a misleading effort to protect the
interests of its broker-dealer members, rather than the interests of the
American investing public.
Judge
Cardozo in Meinhard v. Salmon, 164 N.E. 545 (N.Y. 1928) famously
wrote: “Many forms of conduct permissible in a workaday world for those acting
at arm's length, are forbidden to those bound by fiduciary ties. A trustee is
held to something stricter than the morals of the market place. Not honesty
alone, but the punctilio of an honor the most sensitive, is then the standard
of behavior. As to this there has developed a tradition that is unbending and
inveterate. Uncompromising
rigidity has been the attitude of courts of equity when petitioned to undermine
the rule of undivided loyalty by the ‘disintegrating erosion' of particular
exceptions. Only thus has the level of conduct for fiduciaries been kept at a
level higher than that trodden by the crowd. It will not
consciously be lowered by any judgment of this court.”
Fiduciaries
– whether attorneys, doctors, trustees, corporate directors, or otherwise –
should resist any attempt to erode the fiduciary duty of loyalty. We need to
stand up to Wall Street and the insurance companies and say, "This has
gone on long enough. We are tired of you taking advantage at every opportunity
of the American people." Instead, we need the fiduciary standard of
conduct, to restrain the conduct of Wall Street, and to act as a restraint upon
its greed.
FINRA
continues its abysmal failure to properly advance the standards of its members,
and in so doing fails to safeguard consumer interests while favoring the
commercial interests of its own broker-dealer member firms. FINRA's utter
failure to protect consumers over many decades, augmented by its recent
colossal failure in proposing a deceptive new "best interests"
standard that would deceptively not be equivalent to a bona fide fiduciary duty
of loyalty, is good cause for removing from FINRA its ability to regulate any
market conduct. The U.S. Securities and Exchange Commission should act
forthwith to remove FINRA's authority to protect consumers from brokers by
removing its regulation of the market conduct of its broker-dealer firms and
their registered representatives.
Ron A. Rhoades, JD, CFP®
is an Assistant Professor of Finance and the Director of the Financial Planning
Program in the Gordon Ford College of Business at Western Kentucky University.
This article represents the personal views of the author, and does not
necessarily represent the views of any institution, organization or firm with
whom Ron A. Rhoades is associated.
Walter Percy, The
Moviegoer (New York: Ivy Books, 1960), pg. 6.
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).
“First, the best
interest standard should make clear that customer interests come first and that
any remaining conflicts must be knowingly consented to by the customer …
Second, any such proposal should include a requirement that financial firms
establish carefully designed and articulated structures to manage conflicts of
interest that arise in their businesses. This would include creating an ongoing
process to specifically identify any conflicts that might impact their
provision of fair and effective investment advice and develop written
supervisory procedures to address how those conflicts would be eliminated or
managed. Third, any best interest standard should also begin by applying
know-your-customer and suitability standards as ‘belt and suspenders’
backstops, similar to what is contained in FINRA’s rules. Fourth, there should
be more effective disclosure provided to investors. Broker-dealers should be
required to provide customers an ADV-like document annually that provides
clear, plain English descriptions of the conflicts they may have and an
explanation of all product and administrative fees. Moreover, the firms’
representatives should provide either point of sale disclosures regarding
relevant conflict, risk and fee issues relating to a recommendation, or, in the
alternative, follow up any discussion involving a recommendation with a written
or email communication that memorializes the conversation by describing the key
contractual terms and fees entailed in the product. Such communication,
including a balanced explanation of the benefits of the product or strategy
recommended as well as the potential adverse risk scenarios that the customer
should be aware of, would be critical to ensure that the investor had a clear
understanding of the benefits, risks and costs of the recommended investment.”
FINRA Rule 2111 (Suitability) Frequently Asked Questions
7.1., page 11, providing:
Q7.1. Regulatory Notice 11-02 and a
recent SEC staff study on investment adviser and broker-dealer sales-practice
obligations cite cases holding that brokers' recommendations must be consistent
with their customers' "best interests." What does it mean to act in a
customer's best interests? [Notice 12-25 (FAQ 1)]
A7.1. In interpreting FINRA's
suitability rule, numerous cases explicitly state that "a broker's
recommendations must be consistent with his customers' best interests."
The suitability requirement that a broker make only those recommendations that
are consistent with the customer's best interests prohibits a broker from
placing his or her interests ahead of the customer's interests. Examples of
instances where FINRA and the SEC have found brokers in violation of the
suitability rule by placing their interests ahead of customers' interests
include the following:
· A broker whose motivation for recommending one product over
another was to receive larger commissions.
· A broker whose mutual fund recommendations were
"designed 'to maximize his commissions rather than to establish an
appropriate portfolio' for his customers."
· A broker who recommended "that his customers purchase
promissory notes to give him money to use in his business."
· A broker who sought to increase his commissions by
recommending that customers use margin so that they could purchase larger
numbers of securities.
· A broker who recommended new issues being pushed by his firm
so that he could keep his job.
· A broker who recommended speculative securities that paid
high commissions because he felt pressured by his firm to sell the securities.
The requirement that a broker's
recommendation must be consistent with the customer's best interests does not
obligate a broker to recommend the "least expensive" security or
investment strategy (however "least expensive" may be quantified), as
long as the recommendation is suitable and the broker is not placing his or her
interests ahead of the customer's interests. Some of the cases in which FINRA and
the SEC have found that brokers placed their interests ahead of their
customers' interests involved cost-related issues. The cost associated with a
recommendation, however, ordinarily is only one of many important factors to
consider when determining whether the subject security or investment strategy
involving a security or securities is suitable.
The customer's investment profile,
for example, is critical to the assessment, as are a host of product- or
strategy-related factors in addition to cost, such as the product's or
strategy's investment objectives, characteristics (including any special or
unusual features), liquidity, risks and potential benefits, volatility and
likely performance in a variety of market and economic conditions. These are
all important considerations in analyzing the suitability of a particular
recommendation, which is why the suitability rule and the concept that a
broker's recommendation must be consistent with the customer's best interests
are inextricably intertwined.”
[Citations
omitted.]
SIFMA, Proposed Best Interest of the Customer Standard for
Broker-Dealers (June 2015), providing in pertinent part for a reformulation of
FINRA’s suitability rule:
SIFMA’S Proposed Best Interests of
the Customer Standard for Broker-Dealers. The
following SIFMA mark-up of existing FINRA Rules is intended to be fairly
streamlined and high-level in order to focus attention on, and promote
discussion about, the core elements of a proposed best interests of the
customer standard for broker-dealers. Missing from this treatment are, among
other things, key details about how the standard would operate under various
scenarios, and the content, timing and manner of disclosures and consents, if
any, all of which are of critical significance to SIFMA’s members.
2111. Suitability The
Best Interests of the Customer
a. A member or an associated person
must have a reasonable basis to believe that a recommended transaction or
investment strategy involving a security or securities is suitable
for in the best interests of the customer, based on the
information obtained through the reasonable diligence of the member or
associated person to ascertain the customer’s investment profile. A customer’s
investment profile includes, but is not limited to, the customer’s age, other
investments, financial situation and needs, tax status, investment objectives,
investment experience, investment time horizon, liquidity needs, risk
tolerance, and any other information the customer may disclose to the member or
associated person in connection with such recommendation.
i. The best interests
standard. A best interests
recommendation shall:
1. Reflect the care, skill,
prudence, and diligence under the circumstances then prevailing that a prudent
person would exercise based on the customer’s investment profile (defined
above). The sale of only proprietary or other limited range of products by the
member shall not be considered a violation of this standard.
2. Appropriately disclose and manage
investment-related fees. See Manage investment-related fees below.
3. Avoid, or otherwise appropriately
manage, disclose, and obtain consents to, material conflicts of interest, and
otherwise ensure that the recommendation is not materially compromised by such
material conflicts. See Manage material conflicts of interest below.
ii. Manage investment-related
fees. A member shall ensure that
investment-related fees incurred by the customer from the member are
reasonable, fair, and consistent with the customer’s best interests. Managing
investment-related fees does not require recommending the
least expensive alternative, nor should it interfere with making
recommendations from among an array of services, securities and other
investment products consistent with the customer’s investment profile.
iii. Manage material conflicts of
interests. A member or
associated person shall avoid, if practicable, and/or mitigate material
conflicts of interest with the customer. A member or associated person shall
disclose material conflicts of interest to the customer in a clear and concise
manner designed to ensure that the customer understands the implications of the
conflict. The customer shall be given the choice of whether or not to waive the
conflict, and must provide consent, as provided in Rule 2260 (Disclosure).
Notwithstanding the disclosure of, and customer consent to, any material
conflict, a recommended transaction or investment strategy must nevertheless be
in the best interests of the customer.
iv. Provide required
disclosures. A
member or associated person shall provide and/or otherwise make available to
the customer, among other things: 1) account opening disclosure, 2) annual
disclosure, and 3) webpage disclosure, as provided in Rule 2260 (Disclosure).
b. A member or associated person
fulfills the customer-specific suitability obligation for an institutional
account, as defined in Rule 4512(c), if (1) the member or associated person has
a reasonable basis to believe that the institutional customer is capable of
evaluating investment risks independently, both in general and with regard to
particular transactions and investment strategies involving a security or
securities and (2) the institutional customer affirmatively indicates that it
is exercising independent judgment in evaluating the member’s or associated
person’s recommendations. Where an institutional customer has delegated decisionmaking
authority to an agent, such as an investment adviser or a bank trust
department, these factors shall be applied to the agent.
2260. Disclosures
a. Account opening disclosure. A member or associated person shall disclose to the
customer, at or prior to the opening of the customer account, or prior to
recommending a transaction or investment strategy, if earlier, the following:
• the type of relationships
available from the broker-dealer and the standard of conduct that would apply
to those relationships;
• the services that would be
available as part of the relationships, and information about applicable direct
and indirect investment-related, fees;
• material conflicts of interest
that apply to these relationships, including material conflicts arising from
compensation arrangements, proprietary products, underwritten new issues, types
of principal transactions, and customer consents thereto; and
• disclosure about the background of
the firm and its associated persons generally, including referring the customer
to existing systems, such as FINRA’s BrokerCheck database.
b. Annual disclosure. A member shall disclose to the customer annually a good
faith summary of investment-related fees incurred by the customer from the
member or associated person with respect to all products and services provided
during the prior year (or such shorter period as applicable).
c. Webpage disclosure. A member’s webpage shall provide disclosure that is concise,
direct and in plain English, following a layered approach that provides
supplemental information to the customer. A member’s webpage shall include
access to all account opening disclosure. Paper disclosure shall be provided to
customers that lack effective Internet access or that otherwise so request.
d. Customer consent. Customer consent to material conflicts of interest or for
other purposes as appropriate may be provided at account opening.1 Existing
customers with accounts established prior to the effective date of the best
interests standard shall be deemed to have consented to the material conflicts
of interest, if any, disclosed to the customer, upon continuing to accept or
use account services.
e. Disclosure updates. Updates to disclosures, if necessary or appropriate, may be
made through an annual notification that provides a website address where
specific changes to a member’s disclosure are highlighted.
1 Customer consent to principal transactions, for example,
could be provided at account opening.”
Shearmur, Jeremy and
Klein, Daniel B. B., “Good Conduct in a Great Society: Adam Smith and the Role
of Reputation.” D.B Klein, Reputation: Studies In The Voluntary Elicitation Of
Good Conduct, pp. 29-45, University of Michigan Press, 1997.)
“An essential feature
and consequence of a fiduciary relationship is that the fiduciary becomes bound
to act in the interests of her beneficiary and not of herself.” In re Prudential Ins. Co. of America Sales
Prac., 975 F.Supp. 584, 616 (D.N.J., 1996). See also SEC’s “Staff Study on Investment Advisers and
Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act” (Jan. 21, 2011), p.22 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf),
citing Transamerica Mortgage Advisors,
Inc., 444 U.S. 11, 17 (1979). [“The duty of loyalty requires an adviser to
serve the best interests of its clients, which includes an obligation not to
subordinate the clients’ interests to its own.”]
In the Matter of
Dawson-Samberg Capital Management, Inc., now known as Dawson-Giammalva Capital
Management, Inc. and Judith A. Mack,
Advisers Act Release No. 1889 (August 3, 2000), citing SEC v. Capital Gains Research
Bureau, 375 U.S. at 191-92.
See Commission Guidance Regarding the Duties and Responsibilities
of Investment Company Boards of Directors with Respect to Investment Adviser
Portfolio Trading Practices, Release Nos. 34-58264; IC-28345 (July 30, 2008),
at 23: “Second, investment advisers, as fiduciaries, generally are prohibited
from receiving any benefit from the use of fund assets ….”
“Avoidance is perhaps the best solution to conflict
situations. Persons having a duty to exercise judgment in the interest of
another must avoid situations in which their interests pose an actual or
potential threat to the reliability of their judgment. Although avoidance of
conflict situations is an important duty of decision-makers, a flat
prescription to avoid all conflicts of interest is not only mistaken, but also
unworkable. On the one hand, not all conflicts of interest are avoidable. Some
conflict situations are embedded in the relation, while others occur
independently of decision-maker’s will.” Fiduciary Duties and Conflicts of
Interest: An Inter-Disciplinary Approach (2005), at p.20, available at http://eale.org/content/uploads/2015/08/fiduciary-duties-and-conflicts-of-interestaugust05.pdf.
“[D]isclosure is an effective response if it does not affect the
decision-maker’s judgment process and if the beneficiary is able to correct
adequately for that biasing influence. Psychological research shows that
neither of these conditions may be met. Sometimes both parties may be worse off
following disclosure.” Id., citing
Daylian M. Cain, George Loewenstein, and Don A. Moore, “The Dirt on Coming
Clean: Perverse Effects of Disclosing Conflicts of Interest” (2005) 34 Journal
of Legal Studies 1 at 3.
See, e.g., Sitkoff,
Robert H., The Fiduciary Obligations of Financial Advisors under the law of
Agency, available at http://www.thefiduciaryinstitute.org/wp-content/uploads/2013/07/Robert-H-Sitkoff.pdf [“The
common law of agency imposes fiduciary duties of loyalty, care, and a host of
subsidiary rules that reinforce and give meaning to the broad standards of
loyalty and care as applied to specific circumstances ….”] See also, e.g., See
Restatement (Third) of Agency §8.06 & cmts. b, c (2006).
Submission to the Financial System Inquiry by the Financial
Planning Association of Australia Limited,” December 1996.
See, e.g., Julia Smith, Out with “TCF” and in with “fiduciary”?,
Butterworths Journal of International Banking and Financial Law (June 2012),
P.344 [U.K.] [“On 23 February 2012, the FSCP
proposed an amendment to the Financial Services Bill because: “Customers of
banks should be owed the same fiduciary duty as those seeking the advice of a
lawyer or an MP, with providers prohibited from profiting from conflicts of
interest at the expense of their customers…The new Financial Conduct Authority
(FCA) should be given powers to make rules to ensure that the industry would
have to take their customers’ interests into account when designing products
and providing advice.”]
See “Without Fiduciary Protections, It’s ‘Buyer Beware’ for
Investors,” Press Release issued by the Investment Adviser Association, et al.,
June 15, 2010.
