Practical analysis for investment professionals
23 August 2012

Five Reasons for a Uniform Fiduciary Standard

In order to have fair and transparent markets, all investors must feel confident that the investment advice, products, and services offered by investment professionals are not only suitable for them but also in their best interest. Clients want to be assured that investment professionals are placing the clients’ interests ahead of their own personal interests or those of their employers. This simple concept is at the heart of the debate that is currently raging in the investment community about whether a uniform fiduciary standard of care should be imposed on all investment professionals that provide advice to clients.

Section 913 of the 2010 Dodd-Frank Act represents a first step in restoring, rebuilding, and strengthening the confidence and faith of all investors in the investment community. This section gives the Securities and Exchange Commission (SEC) the authority to impose a uniform fiduciary standard on all investment professionals that provide advice to clients. Since September of 2009, CFA Institute has been at the forefront of this battle by advocating for “a single, rigorous standard that requires prudence, care, and loyalty to clients.”

Under a fiduciary standard, investment professionals owe a duty of loyalty and a duty of care to their clients. This requires that they act in the best interest of clients, disclose all conflicts of interest, and have a reasonable basis for making investment recommendations. In other words, investment professionals must provide suitable and reasonable advice to their clients based on their investment objectives and financial circumstances.

Under a suitability standard, investment professionals are required to have a reasonable basis for recommending products and services after considering the client’s investment objectives and financial circumstances. However, they are not required to recommend products that are in the client’s best interest.

Two separate studies — one conducted by the SEC (“Study on Investment Advisors and Broker-Dealers”), and the other by two academics (“The Impact of the Broker-Dealer Fiduciary Standard on Financial Advice”) — support extending the fiduciary standard to all investment professionals who provide personalized advice to investors. The objective of the SEC study, which was required by Section 913, was to evaluate, among other things, the effectiveness of existing legal or regulatory standards of care and to determine whether there are any legal or regulatory gaps or shortcomings in the protection of retail customers. The objective of the academic study was to determine whether a stricter fiduciary standard of care would affect the cost and level of service that broker/dealers provide to retail investors. Based on the findings of these studies, a uniform fiduciary standard of care will:

  1. Enhance investor protection.
  2. Reduce/eliminate the bias against smaller investors.
  3. Preserve investor choice and maintain their access to existing products and services.
  4. Strengthen existing business models.
  5. Provide a net welfare gain to society.

Enhancing Investor Protection

The SEC study found that most investors do not understand the differences between investment professionals in terms of their roles and responsibilities, as well as the different standards of care which are applicable to them. Creating additional confusion are the myriad titles that investment professionals use (broker/dealers, financial planner, financial consultant, financial adviser, investment adviser, registered representative, registered investment adviser, etc.). Quite simply, all that investors want and expect to receive is investment advice and investment recommendations that are in their best interest. Therefore, a uniform fiduciary standard for investment professionals will address these needs and expectations by requiring that all investors receive advice that is in their best interest, regardless of the title of the financial professional serving them.

Eliminating the Bias against Small Investors

Under the current standards of care, there is an implicit bias against small investors who don’t have a large amount of investable assets, because they do not have access to investment professionals who are required to follow a fiduciary standard of care. Registered Investment Advisors (RIAs), whose actions are governed by the Investment Advisers Act and overseen by the SEC, must follow a fiduciary standard. They must act in the best interests of their client and strive to eliminate, or at the very least disclose, any potential conflicts of interest they face in providing investment advice or services. Most RIAs charge clients a flat fee based on the amount of client assets they manage and generally establish minimum client asset level of $500,000 to $1,000,000. As a result, investors who have asset levels below these thresholds (often referred to as retail investors) must get their investment advice from registered representatives who are employed by broker/dealers. Registered representatives (stock brokers, financial consultants, financial advisers) are required to follow a suitability standard, which is a much lower standard of care. Under this standard, they are only required to have a reasonable basis for believing that the products and services they are recommending are suitable for clients based on the client’s investment objectives and financial circumstances. Most registered representatives are compensated on a commission-only basis, which creates an inherent conflict of interest, because they have a financial incentive in the products and services they recommend to clients. In addition, they do not get paid unless the client takes some action.

In other words, why should investment professionals who work with lower-net-worth clients be held to a lower standard of care than those who work with higher-net-worth clients? Is it fair to allow investment professionals to place their own or their firm’s interest ahead of a client, just because the client does not have a large amount of investable assets? Why shouldn’t investment professionals who work with retail investors have to live up to the same standard of care as those who work with higher-new-worth individuals? The standard of care that an investment professional is required to follow should not be a function of their clients’ investable assets. Some people may even suggest that those with fewer investable assets are more in need of expert advice from professionals beholden to a higher duty of loyalty and care.

The academic study mentioned above found that investors who understood the difference between the two standards of care, preferred to have their investment professionals held to a higher standard because of the higher objectivity and competence that the standard encouraged.

Preserving Investor Choice and Maintaining Access to Existing Products

Terry Headley, president of the National Association of Insurance and Financial Advisors, has argued that application of a uniform standard “would negatively impact product access, product choice, and affordability of customer services for those consumers who are most in need of these services.”

The results in the academic study provide compelling evidence against this argument. The authors, Michael S. Finke and Thomas Patrick Langdon, evaluate and compare the behavior of registered representatives in states that impose a fiduciary duty and states that do not impose such a duty. They find no statistical difference between the two groups, in terms of the percentage of lower-income and higher-net-worth clients served. They also found no difference between the two groups in terms of their ability to offer tailored advice, provide a broad range of products, or in compliance costs.

Strengthening Existing Business Models

Another concern raised by the brokerage industry is that a fiduciary standard is incompatible with a commission-based business model, because it would limit a broker’s ability to recommend commission investments. Really? Are they saying that it would harder for brokers to earn a living if they had to place their clients’ interests ahead of their own?

Again the results of Finke and Langdon’s study provide compelling evidence against this argument. The authors found that the “saturation of registered representatives within states does not vary significantly among states with different fiduciary regulations. When advisers in states that have a stricter fiduciary standard were asked whether they are constrained in their ability to recommend products, or if they are unable to serve lower-wealth clients, [the authors found] no statistical difference between advisers from states that do and do not apply a common law fiduciary standard.”

Providing a Net Gain to Society

Underlying the registered representative–client relationship are two issues, information asymmetry and a principal-agent problem, both of which increase agency costs. Registered representatives (agents) are hired by broker/dealers (principals) to sell their product and services. As a result, and unbeknownst to most clients, the registered representative’s primary duty is to the broker/dealer (the principal), not the client.

The registered representative–client relationship is characterized by information asymmetry. The registered representative has more and/or better information about investments and financial markets than his clients do. Because of this information disadvantage, clients must rely on their registered representative to provide expert advice and assistance when selecting investment products. However, the interests of the registered representative may not always be aligned with the client, since the rep’s primary obligation is to the firm that hired him. As a result, agency costs increase.

A fiduciary standard would place client interests first, and eliminate the conflict that exists between the registered rep’s interest and those of his firm. This should not only reduce the ability of registered reps and their firms to extract economic rents from clients but also reduce agency costs by better aligning the interests of broker/dealers and their registered reps with those of the clients. This reduction in costs should ultimately provide a net gain to society.

Imposing a uniform fiduciary standard on all investment professionals who provide investment advice is a first step in instilling great trust in and respect for our profession. Although this is not a panacea for the ills of the investment industry, it will significantly contribute to eliminating or reducing many of them.

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, was director of ethics education at CFA Institute. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University.

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