text:
The Unsuitability of "Suitability": The Many Failings of SIFMA's Deceptive "Best Interests" Proposal
by Ron A. Rhoades, JD, CFP®[1] (DRAFT A - June 15, 2015)
Executive Summary
- FINRA's major protection for investors, the "suitability" obligation imposed upon broker-dealers (and their registered representatives), is a rule that actually reduces the duty of care that most sellers of products possess to their customers. The suitability rule, in essence, protects brokers, not customers.
- In contrast, a bona fide fiduciary standard possesses strong duties of due care, loyalty and utmost good faith. These core duties are largely incapable of waiver by the client and cannot be disclaimed.
- In particular, the fiduciary duty of loyalty requires avoidance of many conflicts of interest. Where a conflict of interest is not avoided, disclosure of a conflict of interest, alone, followed by mere consent of the client, are insufficient to satisfy the investment adviser's duties. This is because estoppel and waiver possess limited application when the strong fiduciary obligations imposed upon investment advisers are present. Instead, fiduciary law imposed upon the fiduciary investment adviser a series of obligations, extending far beyond casual disclosures and mere consent, and involving both procedural and substantive protections, in order to ensure that the client's interests remain paramount.
- The "best interests" standard recently proposed (June 3, 2015) by SIFMA only slightly expands upon the very weak suitability standard. It would deceptively deny individual investors who receive personalized investment advice from brokers the important protections of a bona fide fiduciary standard of conduct. This "best interest" standard is nothing more than an attempt to preserves the arms-length, product-sales nature of broker-customer relationships.
- Even worse, by wrapping arms-length product sales in a blanket of false assurance to consumers, SIFMA's "best interest" proposal creates an illusion of protection where none exists. As a result, if enacted, the proposal would lead to deceptive marketing by broker-dealer firms and even greater harm to consumers than that caused by the low suitability standard. In fact, one must question whether SIFMA's use of the term "best interests" in describing its proposed arises to the level of fraud and deceit that, if used by a broker-dealer firm to a customer, would constitute a violation of the securities laws' anti-fraud statutes.
- Hence, the proposed "best interests" standard serves to protect SIFMA's constituents. FINRA's embrace of SIFMA's proposal reveals, again, that FINRA is not a true regulatory organization, but rather more akin to a trade association for the protection of the failing business models of its members (broker-dealer firms).
- SIFMA'S proposed "best interests standard" fails to offer any meaningful protection for consumers who receive investment advice, and would instead actually lead to greater confusion among individual investors and, through false assurances of protections, lead to even greater harm to individual Americans.
- Congress, the SEC, and other policymakers should reject this bid to mislead and confuse investors while seeking to deny individual investors the protection of the forceful, powerful bona fide fiduciary standard of conduct. Instead, Congress, the SEC, the DoL and other policymakers should endorse the extension of a bona fide fiduciary standard upon all providers of personalized investment and financial advice.
A Concise Comparison: Bona Fide Fiduciary Standard vs. SIFMA's "Best Interests" Proposal
What requirements are imposed upon the person providing personalized investment advice?
Bona Fide
Fiduciary Standard
SIFMA's "Best Interest" Proposal
Who does the financial representative represent?
The firm and, through the firm, various product manufacturers. The financial representative functions as a "seller's representative," with no allegiance required to the purchaser (customer).
Does a duty exist upon the representative to clearly and fully disclose all compensation received by the person providing advice, and by his/her firm?
No. While annual disclosure occurs of "a good faith summary of the investment-related fees" associated with an investment, there is no requirement in SIFMA's proposal that the compensation of the broker-dealer or its registered representative be affirmatively quantified and then disclosed. As a result, customers will remain uninformed of the precise amount of the compensation of the broker and its registered representative.
Is there a duty upon the representative to ensure client understanding of material facts, including material conflicts of interest?
No. Under SIFMA's proposal disclosures must only be "designed to ensure client understanding." There is no requirement, as exists for a fiduciary, that client understanding of conflicts of interest, and their ramification, actually occur.
Is informed consent of the client required prior to the client undertaking each and every recommended transaction?
No. There is no requirement in SIFMA'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, SIFMA's would only require: "Customer consent to material conflicts of interest or for other purposes as appropriate may be provided at account opening." Of course, consent "at client opening" often involves a customer briefly initialing a line, as one of many initials or signatures provided in account opening forms which are often dozens of pages long. The result of SIFMA's proposal is that clients can and will consent to be harmed – an outcome which cannot exist under a bona fide fiduciary standard. And such "consent" will seldom be "informed."
Must the transaction remain, at all times, substantively fair to the client?
No. There is only a requirement that the transaction be in accord with the client's "best interest" – a new SIFMA-proposed standard that is ill defined and which remains subject to much interpretation. Such interpretations will primarily occur through FINRA's much-maligned system of mandatory arbitration. In contrast, the fiduciary standard possesses centuries of interpretation and application. Under a bona fide fiduciary standard, clients are unable to waive core fiduciary duties; the role of estoppel is quite limited. This is enforced by the courts by requiring both informed consent of the client and that the transaction remain substantively fair to the client.
Does there exist a duty to properly manage investment-related fees and costs that the client will incur at all times?
No. SIFMA expressly states: "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." These caveats leave the door wide open for the broker to recommend highly expensive products, including products which pay the broker more, in which the total fees and costs incurred by the customer will substantially lower the long-term returns of the investor.
Does there exist a duty to properly manage the design, implementation and management of the portfolio, in order to reduce the tax drag upon the customer's investment returns?
No. There is no express duty under SIFMA's proposal to properly manage the tax consequences of investment decisions. Far too often under the suitability standard, and under this proposed "best interests" standard, customers of broker-dealers have and will possess substantial tax drag upon their investment returns that otherwise could have been avoided through expert advice.
"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).
"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)[2]
Richard Ketchum, Chairman and CEO of FINRA, recently summarized the protections for customers of brokers, stating that these protections "show that 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."[3] However, Mr. Ketchum's characterization of broker-dealer firms' customers as not being subject to the ancient principle of 'caveat emptor'[4] is largely incorrect; by his statement he obfuscates the sales origins and present reality of today's broker-customer relationships.
FINRA's major conduct rule for brokers and their registered representatives, "suitability," is actually an abrogation of part of the duty of care most product sellers possess. FINRA's recent support of a new "best interests" standard advanced by SIFMA, the broker-dealer lobbying organization, grounded upon a weak suitability obligation accompanied by somewhat enhanced casual disclosures of additional information to investors, continues 75 years of failure to advance standards to the highest levels, as envisioned by Senator Maloney and others, and fails to protect individual investors.
SIFMA's proposed "best interests" standard is a far cry from the huge protections afforded by a bona fide fiduciary standard of conduct, as proposed by the U.S. Department of Labor in its "Conflict of Interest" rule proposal (April 2015) and as found in existing common law applicable to those in relationships of trust and confidence with their clients. SIFMA proposes that its "best interests" standard be adopted in lieu of the SEC moving forward with the adoption of fiduciary standards for brokers providing personalized investment advice, as authorized under Section 914 of the Dodd Frank Act of 2010. Hence, SIFMA's proposed "best interests" standard would – if enacted- deny consumers, in today's complex financial world, important protections by keeping individual investors in the situation where "caveat emptor" remains the rule for investors, even for those in relationships of trust and confidence with those who provide personalized investment advice.
SIFMA's new "best interests" standard is also inherently misleading and deceptive, as the term "best interests" is understood by consumers to mean that the advisor is acting on behalf of the consumer/investor, keeping the consumer's interests paramount at all times.
FINRA's shocking support for SIFMA's proposal, and its opposition to the DOL's extension of fiduciary standards upon nearly all providers of investment advice to retirement accounts, further reveals FINRA's as the protector of Wall Street's broker-dealer firms, rather than Main Street. FINRA's ill-advised support for Wall Street lobbyists' deceptive "best interests" proposed standard also confirms FINRA's inability to substantially raise the standards of conduct of brokers to the highest levels, as contemplated by Senator Maloney and others at the time of FINRA's inception (when it was called the NASD). FINRA's recent actions provide further evidence supporting the conclusion that FINRA is largely a trade association that seeks to protect its member firms' business models, while utterly failing to protect consumer interests. Accordingly, the SEC and/or Congress should act to disband FINRA.
In this paper I examine the distinctions between sales and fiduciary relationships. I then explore the "suitability" obligation of brokers. I observe that consumer protections grounded upon mere disclosures are, and will always be, largely ineffective, especially in situations (such as the delivery of investment advice) where there is a great disparity of knowledge between the advisor and the client.
I then examine the significant requirements imposed upon investment advisers pursuant to the fiduciary duty of loyalty when conflicts of interest arise, and explain why conflicts of interest must be avoided in some instances, and at a minimum properly managed in other instances. I detail the procedures that must be followed, and the substantive obligations that must be met by the fiduciary, for the all-important "informed consent" to the "proper management" of a conflict of interest.
I call upon policy makers to reject the ill-named and ill-advised "best interests" proposal advanced by Wall Street's lobbyists and endorsed by FINRA, as it would result in substantial harm to our fellow Americans as they seek to save and invest properly for their own future needs. I conclude by observing that SIFMA's proposal is but a last-minute attempt to dodge the important fiduciary protections which all of our fellow Americans deserve when they are in receipt of personalized investment advice.
Below I first set forth SIFMA's mark-up of FINRA's suitability rule, verbatim. Thereafter I proceed with my analysis.
SIFMA'S Proposed Best Interests of the Customer Standard for Broker-Dealers[5]
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.
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."
The Distinctions Between Sales and Fiduciary Relationships
As a foundational matter, and as a means to understand the distinctions between SIFMA's proposal and the much greater requirements imposed upon an investment advisor acting under a bona fide fiduciary standard of conduct, there exist two distinct types of relationships in commercial transactions: (1) sales (salesperson-customer); and (2) fiduciary (advisor-entrustor/client).
In the sales relationship between a product or service salesperson and her or his customer, the customer generally possesses no right to rely upon any advice provided by the product salesperson, except that actual fraud (misrepresentation) is not permitted. In certain instances governments have imposed additional requirements, such as mandating certain disclosures (such as of costs, or compensation) or requiring suitability determinations. Even with the aid of these additional rules, the customer generally possesses no right to rely upon any advice provided by the product salesperson, except that actual fraud (misrepresentation) as to the information regarding the product or service is not permitted. Caveat emptor ("let the buyer beware") largely applies.
In contrast is the fiduciary relationship between a trusted advisor and her or his client. Reliance by the client not only exists but it is necessary, as in such instances the client usually lacks the high degree of knowledge and skill of the expert advisor. The fiduciary advisor is an expert, and uses her or his expertise by "stepping into the shoes" of the individual investor to act on behalf of, and in either the sole interests or best interests of the investor. Fiduciary obligations impose far greater due diligence requirements upon the advisor, who must act as an expert under the largely non-waivable core fiduciary duty of due care. The advisor is prevented from using her or his expertise to benefit herself or himself under the largely non-waivable core fiduciary duties of loyalty (wherein either the "sole interests" or "best interests" of the client must be observed) and utmost good faith (i.e., the requirement of complete candor and honesty).
When are Brokers Fiduciaries?
It has long been acknowledged that registered investment advisors (RIAs) and their investment advisor representatives (IAR) are fiduciaries possessing of broad fiduciary duties. It is usually understood that broker-dealer firms (BDs) and their registered representatives (RRs) are not generally fiduciaries. However, this is an oversimplification. All brokers are quasi-fiduciaries, and at times BDs and their RRs undertake actions leading to a relationship of trust and confidence with a client under which the broad fiduciary obligations are imposed.
All brokers possess quasi-fiduciary obligations, such as the duty to safeguard clients' securities (when custody exists) and the duty to effect best execution of a client's trade. In essence, these obligations flow from the activities of the broker as an agent of the customer.[6]
While brokers under current statutory law do not always possess broad fiduciary obligations with respect to their product sales recommendations, in certain instances such broad fiduciary duties of due care, loyalty and utmost good faith can be imposed as a result of state common law. As Professor Louis Loss stated log ago, a broker "will almost inevitably render some advice as an incident to his selling activities, and who may go further to the point where he instills in the customer such a degree of confidence in himself and reliance upon his advice that the customer clearly feels—and the salesman knows the customer feels—that the salesman is acting in the customer's interest. When you have gotten to that point, you have nothing resembling an arm's-length principal transaction regardless of the form of the confirmation. You have what is in effect and in law a fiduciary relationship."[7] (Emphasis added.)
Congress excluded brokers from the registration requirements of the Investment Advisors Act of 1940 if the broker-dealer (and its registered representatives) met two requirements: first, that the broker's advice must be "solely incidental" to the brokerage services provided; and second, that the broker must not receive any "special compensation" for advising the client. Much has been written in recent years which is critical of the SEC's interpretation of these provisions in recent years, as the execution services of brokers (once an activity that required great individual skill) have become largely ancillary to the investment advice provided by brokers, and as brokers have induced reliance upon their advice though the use of titles (such as "financial consultant" and "financial advisor" and "wealth manager"). This article is not focused upon these issues – i.e., the primarily "advisory" nature of most brokers' practices today[8] and issues such as receipt of asset-based compensation (e.g., 12b-1 fees). Yet, these ongoing legitimate concerns are acknowledged in much of the recent literature.[9]
It is important to note, however, that merely being exempt from the registration requirements of the Advisers Act does not lead to the conclusion that a broker does not possess broad fiduciary obligations; these obligations can arise, as stated above, under state common law when the broker's marketing and promotional efforts, and actual delivery of advice to a client, creates a relationship of trust and confidence.[10]
Moreover, broad fiduciary obligations can arise under ERISA, which imposes a default "sole interests" fiduciary standard. The U.S. Dept. of Labor (DoL) has recently promulgated proposed rules which would greatly expand the applicability of fiduciary duties to those who provide investment recommendations to retirement plan sponsors, retirement plan participants, and IRA account owners.
Additionally, the SEC is said to be exploring the imposition of the Advisers Act fiduciary obligations upon brokers pursuant to the authority granted to the SEC under Section 913 of The Dodd Frank Act of 2010.
Understanding the Inherent Weakness of FINRA's "Suitability" Standard
Generally, "suitability" refers to the obligation of a full service broker to recommend to a customer only those securities that match the customer's financial needs and goals. There are essentially two major dimensions of the suitability obligation: (1) "reasonable basis" or "know your security" suitability that focuses on the characteristics of the recommended security and requires a degree of product due diligence prior to the sale of the security to any client; and (2) "customer-specific" or "know your customer" suitability, which focuses on the financial objectives, needs, and other circumstances of the particular customer. A third dimension of suitability guards against churning.
In simplistic terms, the "reasonable basis" aspect of suitability prohibits one from selling investments which are high explosives, as brokers cannot sell investments are "unsuitable" for any investor, regardless of the investor's wealth, willingness to bear risk, age, or other individual characteristics. This might, for example, present a barrier to the sale of unregistered securities with no operations, assets or earnings. However, under "reasonable basis suitability" the sale of high-risk Roman candles and other firecrackers might be permitted as a portion of some investors' portfolios.
The "customer-specific" aspect of suitability prevents the sale of Roman candles and firecrackers to those particular investors who might be unable to bear the risks of certain investments. It prevents brokers from selling by high-risk, illiquid, and/or complex securities to elderly, inexperienced or unsophisticated customers who do not understand the risks of such investments. In order to meet this aspect of suitability FINRA "know-your-customer" obligations exist; these require the broker to possess adequate information about the financial circumstances of each customer before recommending a security to that customer.
While the suitability obligation was for a time imposed directly[11] by the U.S. Securities and Exchange Commission (SEC) upon brokers who were not a member of a self-regulatory organization (SRO), the SEC's regulation was rescinded in 1983 when all broker-dealers were required to be a member of an SRO. Hence, the source for the suitability obligation is now found exclusively in the rules of the National Association of Securities Dealers (NASD), renamed as the Financial Services Regulatory Authority (FINRA), and in FINRA Rule 2111.[12]
The Exchange Act directs that FINRA's rules be "designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade."[13] FINRA also imposes on its members the duty to "observe high standards of commercial honor and just and equitable principles of trade."[14] This duty has been interpreted by FINRA to he prohibit registered firms from making false, misleading, or exaggerated statements or claims or omitting material information in all advertisements and sales literature directed to the public.
At its core, when it applies to the provision of advice, the suitability doctrine actually lessens the duty of due care. In the context of advisory recommendations, suitability serves to confine the duties of broker-dealers and their registered representatives to their customers to below that of the broad common law duty of due care.
By way of explanation, with the early 20th Century rise of the concept of the duty of due care, and the commencement of actions for breach of one's duty of due care (via the negligence doctrine that saw accelerated development during such time), broker-dealers sought a way to ensure they would not be held liable under the standard of negligence. After all, "[t]o the extent that investment transactions are about shifting risk to the investor, whether from the intermediary, an issuer, or a third party, the mere risk that a customer may lose all or part of its investment cannot, in and of itself, be sufficient justification for imposing liability on a financial intermediary."[15] This appears to be a valid view as to the duty of care that should be imposed upon a broker-dealer, and appears appropriate if the broker-dealer is only providing only trade execution services to the customer.
In essence, the suitability standard was originally designed solely to protect brokers who provided trade execution services from breaches of the duty of due care applicable to all product sellers, given the inherent risks of investing in individual securities. Yet, as broker's services have expanded, the suitability standard has inappropriately been applied to broker's other services, including those services that are clearly of an advisory nature.
In contrast to the individual stocks and bonds for which brokers mostly executed transactions in the 1930's, currently brokers often recommend mutual funds and other pooled investment vehicles (including but not limited to unit investment trusts, ETFs, variable annuity subaccounts and equity indexed annuities). Indeed, mutual fund sales exploded a thousand-fold shortly following the SEC's abolition of all fixed commission rates effective May 1, 1975. But, along the way, no longer were broker-dealers just performing trade execution services, but they were, in fact, providing advice through their recommendation of investment managers. Yet, inexplicably, the SEC and FINRA permitted the suitability doctrine to be extended to incorporate broker-dealers' recommendations of the managers of pooled investment vehicles. As a result, brokers operate with a free hand today when providing advice on mutual fund selection. Brokers, as a result of the incorrect expansion of the application of the suitability doctrine, are unburdened by the duty of nearly every other person in the United States with respect to their advisory activities, which, at a minimum, for other providers of advice require adherence to the duty of due care of a reasonable person.
Suitability's abrogation of the duty of care means that suitability lacks teeth when investment advice is provided.
· Suitability does not generally impose upon broker-dealers any obligation to recommend a "good" product over a "bad" one.
· Suitability does not impose upon brokers and their RRs a duty to recommend a less expensive product over an expensive product, even where the product's composition and risk characteristics are almost identical, and even though substantial academic research concludes that higher-cost products return less to investors than similar lower-cost products over longer periods of time.
· Suitability does not require brokers and their RRs to recommend products that meets most client's objectives for tax-efficient and prudent investment portfolios.
· Suitability does not require brokers and their RRs to avoid conflicts of interest, nor to properly management conflicts of interest that remain to keep the clients' best interests paramount at all times.
In summary, the suitability standard permits the conflict-ridden sale of highly expensive, tax-inefficient and risky investment products, leaving the customer with little or no redress.
Suitability remains a "nebulous and amorphous with respect to its content and parameters."[16] It essentially imposes upon broker-dealers only the responsibility to not permit their customers to "self-destruct."
In summary, the "suitability" standard was not originally designed to, nor should it be permitted to, apply to the provision of investment advice. Suitability abrogates the all-important duty of care required of nearly every other provider of services.
In essence, suitability is a shield that protects brokers, not investors. It is such a low standard of conduct that, even when surrounded by a multitude of other rules and an enforcement regime, it is but a loud dog that lacks any teeth.
The Inherent Weakness of Disclosures
Securities laws and regulations have, over time, imposed additional disclosure obligations upon brokers. However, such disclosures are inherently ineffective, for a variety of reasons. Indeed, the necessity for the imposition of fiduciary standards of conduct is grounded in the realization, over the centuries, that disclosures possess limited impact as a means of consumer protection. It is no wonder then, that SIFMA proposes to expand upon disclosures somewhat under its "best interests" standard, given the academic and real-world realization that such disclosures would not substantially protect investors from the limitations of the inherently weak suitability standard.
Even in the 1930's, the perception existed that disclosures would prove to be inadequate as a means of investor protection. As stated by Professor Schwarcz:
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.[17]
Academic research exploring the nature of individual investors' behavioral biases, as a limitation on the efficacy of disclosure and consent, also strongly suggests that client waivers of fiduciary duties are not effectively made. In a paper exploring the limitations of disclosure on clients of stockbrokers, Professor Robert Prentice explained several behavioral biases which combine to render disclosures ineffective: (1) Bounded Rationality and Rational Ignorance; (2) Overoptimism and Overconfidence; (3) The False Consensus Effect; (4) Insensitivity to the Source of Information; (5) Oral Versus Written Communications; (6) Anchoring; and (7) Other Heuristics and Biases. Moreover, as Professor Prentice observed: "Securities professionals are well aware of this tendency of investors, even sophisticated investors, and take advantage of it."[18] Much other academic research into the behavioral biases faced by individual investors has been undertaken, in demonstrating the substantial challenges faced by individual investors in dealing with those providing financial advice in a conflict of interest situation.
Behavioral biases also negate the abilities of "do-it-yourself" investors. As shown in DALBAR, Inc.'s 2009 "Quantitative Analysis of Investor Behavior", most individual investors underperform benchmark indices by a wide margin, far exceeding the average total fees and costs of pooled investment vehicles. A growing body of academic research into the behavioral biases of investors reveals substantial obstacles individual investors must overcome in order to make informed decisions,[19] and reveal the inability of individual investors to contract for their own protections.[20]
Financial advisors also utilize clients' behavioral biases to their own advantage, if not restricted by appropriate rules of conduct. As stated by Professor Prentice, "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."[21] Practice management consultants train financial and investment advisors to take advantage of the behavioral biases of consumers. The instruction involves actions to build a relationship of trust and confidence with the client first, far before any discussion of the service to be provided or the fees for such services. It is well known among marketing consultants that once a relationship of trust and confidence is established, clients and customers will agree to most anything in reliance upon the bond of trust which has been formed.
The SEC's emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities Acts on enhanced disclosures, results from the myth that investors carefully peruse the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image a vast majority of investors who are unable, due to behavioral biases and lack of knowledge of our complicated financial markets, to undertake sound investment decision-making. As stated by Professor (and former SEC Commissioner) Troy A. Paredes:
The federal securities laws generally assume that investors and other capital market participants are perfectly rational, from which it follows that more disclosure is always better than less. However, investors are not perfectly rational. Herbert Simon was among the first to point out that people are boundedly rational, and numerous studies have since supported Simon's claim. Simon recognized that people have limited cognitive abilities to process information. As a result, people tend to economize on cognitive effort when making decisions by adopting heuristics that simplify complicated tasks. In Simon's terms, when faced with complicated tasks, people tend to "satisfice" rather than "optimize," and might fail to search and process certain information.[22]
In reality, disclosures, while important, possess limited ability to protect investors, particularly in today's complex financial world. As Professor Daylian Cain has remarked, "The saying 'sunlight is the best disinfectant' is just not true."
The insufficiency of disclosure as a means of investor protection was highlighted at the Fiduciary Forum, held in September 2010 in D.C. and co-sponsored by the Committee for the Fiduciary Standard, CFP Board, NAPFA, FSI, and FPA. Two of the professors presenting at that conference also have written extensively regarding the inherent limits of disclosure as a means of consumer protection.
In a paper by Professors Daylian Cain, George Loewenstein, and Don Moore, "The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest," they challenged the belief of some that disclosure can be a reliable and effective remedy for the problems cause by conflicts of interest, and concluded:
In sum, we have shown that disclosure cannot be assumed to protect advice recipients from the dangers posed by conflicts of interest. Disclosure can fail because it (1) gives advisors strategic reason and moral license to further exaggerate their advice, and (2) the disclosure may not lead to sufficient discounting to counteract this effect. The evidence presented here casts doubt on the effectiveness of disclosure as a solution to the problems created by conflicts of interest. When possible, the more lasting solution to these problems is to eliminate the conflicts of interest. As Surowiecki (2000) commented in an article in the New Yorker dealing specifically with conflicts of interest in finance, 'transparency is well and good, but accuracy and objectivity are even better. Wall Street doesn't have to keep confessing its sins. It just has to stop committing them.'[23]
In another paper co-authored by Professor Cain, he opined:
Conflicts of interest can lead experts to give biased and corrupt advice. Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects. First, people generally do not discount advice from biased advisors as much as they should, even when advisors' conflicts of interest are honestly disclosed. Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. This means that while disclosure may [insufficiently] warn an audience to discount an expert-opinion, disclosure might also lead the expert to alter the opinion offered and alter it in such a way as to overcompensate for any discounting that might occur. As a result, disclosure may fail to solve the problems created by conflicts of interest and it may sometimes even make matters worse.[24]
The dimensions of the biases of advisors, when attempting to deal with non-avoided conflicts of interest, was revealed in a paper citing earlier research by Professor Cain and others, Professor Antonia Argandoña wrote:
As a rule, we tend to assume that competent, independent, well trained and prudent professionals will be capable of making the right decision, even in conflict of interest situations, and therefore that the real problem is how to prevent conscious and voluntary decisions to allow one's own interests (or those of third parties) to prevail over the legitimate interests of the principal – usually by counterbalancing the incentives to act wrongly, as we assume that the agents are rational and make their decisions by comparing the costs and benefits of the various alternatives.
Beyond that problem, however, there are clear, unconscious and unintended biases in the way agents gather, process and analyze information and reach decisions that make it particularly difficult for them to remain objective in these cases, because the biases are particularly difficult to avoid. It has been found that,
· The agents tend to see themselves as competent, moral individuals who deserve recognition.
· They see themselves as being more honest, trustworthy, just and objective than others.
· Unconsciously, they shut out any information that could undermine the image they have of themselves – and they are unaware of doing so.
· Also unconsciously, they are influenced by the roles they assume, so that their preference for a particular outcome ratifies their sense of justice in the way they interpret situations.
· Often, their notion of justice is biased in their own favor. For example, in experiments in which two opposed parties' concept of fairness is questioned, both tend to consider precisely what favors them personally, even if disproportionately, to be the most fair.
· The agents are selective when it comes to assessing evidence; they are more likely to accept evidence that supports their desired conclusion, and tend to value it uncritically. If evidence contradicts their desired conclusion, they tend to ignore it or examine it much more critically.
· When they know that they are going to be judged by their decisions, they tend to try to adapt their behavior to what they think the audience expects or wants from them.
· The agents tend to attribute to others the biases that they refuse to see in themselves; for example, a researcher will tend to question the motives and integrity of another researcher who reaches conclusions that differ from her own.
· Generally speaking, the agents tend to give far more importance to other people's predispositions and circumstances than to their own.
For all these reasons, agents, groups and organizations believe that they are capable of identifying and resisting the temptations arising from their own interests (or from their wish to promote the interests of others), when the evidence indicates that those capabilities are limited and tend to be unconsciously biased.[25]
In essence, disclosure – while important - has limited efficacy in the delivery of financial services to clients. As stated by Professor Ripken:
[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one's own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is 'doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases' … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.[26]
The inability of disclosures to overcome the substantial economic self-interest that brokers possess when selling products can also be understood through judicial prose. If disclosures were sufficient, there would be no need for the fiduciary obligation. But disclosure, being insufficient as a means of consumer protection, requires that individual investors seeking investment advice be served under a bona fide fiduciary standard. In Bayer v. Beran, 49 N.Y.S.2d 2, Mr. Justice Shientag observed:
The fiduciary has two paramount obligations: responsibility and loyalty. * * * They lie at the very foundation of our whole system of free private enterprise and are as fresh and significant today as when they were formulated decades ago. * * * While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties. It actually accomplishes a practical, beneficent purpose. It tends to prevent a clouded conception of fidelity that blurs the vision. It preserves the free exercise of judgment uncontaminated by the dross of divided allegiance or self-interest. It prevents the operation of an influence that may be indirect but that is all the more potent for that reason.
A Listing of the Core Fiduciary Duties
While suitability is a very low standard of conduct, the fiduciary standard of conduct is known as the "highest standard under the law." In the U.S., the "triad" of fiduciary duties is most commonly referred to as the duties of due care, good faith and loyalty.
A further elicitation of fiduciary duties can be discerned from English law, from which the U.S. system of jurisprudence was initially derived. Under English law, it is reasonably well established that fiduciary status gives rise to five principal duties:
(1) the "no conflict" principle preventing a fiduciary placing himself in a position where his own interests conflict or may conflict with those of his client or beneficiary;
(2) the "no profit" principle which requires a fiduciary not to profit from his position at the expense of his client or beneficiary;
(3) the "undivided loyalty" principle which requires undivided loyalty from a fiduciary to his client or beneficiary;
(4) the "duty of confidentiality" which prohibits the fiduciary from using information obtained in confidence from his client or beneficiary other than for the benefit of that client or beneficiary; and
(5) the "duty of due care," to act with reasonable diligence and with requisite knowledge, experience and attention.
Reflecting English law's "no benefit" and "no conflict" principles, the Restatement (Third) of Agency dictates that the duty of loyalty is a duty to not obtain a benefit through actions taken for the principal (client) or to otherwise benefit through use of the fiduciary's position.[27]
Observing the Duty of Loyalty When A Conflict of Interest is Present: Disclosure Is Not Enough
The duty of loyalty is what makes the fiduciary standard so distinctive from the duties found in any arms-length relationships. And how the fiduciary duty of loyalty addresses the situation where the advisor is faced with a conflict of interest is, perhaps, the most important application of the fiduciary standard of conduct.
The term "conflict of interest" is often used to describe one of the following situations:
1) Where a person is in a position where their duty as a trustee may conflict with any personal interest they may possess;
2) Where a person may not be able to act properly in a particular capacity because of a person or matter with which they are connected; or
3) Where a person may profit personally from decisions made in their capacity as fiduciary or from knowledge gained through holding such position.
The duty to avoid a conflict of interest derives from the fiduciary obligation of undivided loyalty. In Bristol and West Building Society v Mothew [1998] Ch 1, 18, Lord Justice Millett provided this masterful summary of fiduciary:
A fiduciary is someone who has undertaken to act for or on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence.
Lord Millet went on to note that the distinguishing obligation of a fiduciary is the obligation of loyalty. The principal is entitled to the single-minded loyalty of his fiduciary. The core responsibility has several facets. A fiduciary:
must act in good faith; he must not make a profit out of his trust; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of fiduciary obligations.[28]
In situations in which a fiduciary possesses a conflict of interest with a client, avoidance of many conflicts of interest is required. However, other conflicts of interest, not easily avoided, may be permitted, provided that they are properly managed and the interests of the client are kept paramount at all times, is required. These two specific means of addressing conflicts of interest – avoidance, and proper management when not avoided - reflect centuries of common law applying the fiduciary standard, including the application of the time-honored phrase, "no man can serve two masters."[29]
Avoidance of conflicts of interest is preferred. However, sometimes in spite of fiduciaries' best efforts, conflicts of interest cannot be avoided. At other times, law or regulation permit a conflict of interest to exist that otherwise would normally be prohibited.
The courts have mandated that the conflicts of interest that are not avoided must still be properly managed. However, this does not mean proceeding as if the conflicts of interest did not exist. Rather, it means ensuring that the conflict does not prevent the decision being made in the best interests of the client and that the fiduciary can demonstrate this if the fiduciary's actions are ever called into question.
The process of managing a conflict of interest involves several steps:
First, disclosure of such conflict of interest to the client is required. However, this only one of the many requirements involved in managing the conflict of interest. It must be emphasized that disclosure of a conflict of interest and mere consent of the client thereto does not discharge the fiduciary's obligations.[30] Also, the disclosure must be affirmatively and timely delivered.
Second, client understanding of the conflict of interest, and its ramifications, must be achieved. The responsibility for ensuring client understanding rests with the fiduciary, not the client.
Third, the client must provide informed consent. This is not "mere" consent, but rather consent which is provided after full understanding of the conflict of interest, and its ramifications for the client, is achieved. It must be recognized that it is a fundamental truth that clients will not consent to be harmed; clients are not so gratuitous to their investment advisers as to provide the advisers with additional fees and costs at the expense of the investor's own investment returns.
Fourth, and even if all of the foregoing are present, the transaction must remain substantively fair to the client.
Disclosure Of Conflicts is Not Enough: SEC v. Capital Gains Is Often Misconstrued
Wall Street's lobbyists often suggest that court precedent exists for the proposition that disclosure alone is all that is required to meet the fiduciary standard when a conflict of interest is present. These paid lobbyists state that once disclosure of a conflict of interest takes place and the client "consents" thereto (often by signing off on various disclosures in account opening statements or other forms which are dozens of pages long), the fiduciary obligation of loyalty is satisfied.
The wishful thinking of Wall Street's lobbyists desire that disclosure is all that is required usually rests in language found within the U.S. Supreme Court's seminal case applying the Advisers Act, SEC vs. Capital Gains Research Bureau.[31] However, a correct construction of this case reveals that investment advisers are required to do much more than merely disclose conflicts. The U.S. Supreme Court in the Capital Gains decision held that the fiduciary investment adviser had an affirmative obligation to "to make full and frank disclosure of his practice of trading on the effect of his recommendations."[32] Why did the U.S. Supreme Court not go further, and hold that the Advisers Act prohibited the very existence of certain conflicts of interest, and require much more of the investment adviser when a conflict of interest is present? The answer can be found in the language of the U.S. Supreme Court's decision:
It is arguable – indeed it was argued by 'some investment counsel representatives' who testified before the Commission -- that any 'trading by investment counselors for their own account in securities in which their clients were interested ….' creates a potential conflict of interest which must be eliminated. We need not go that far in this case, since here the Commission seeks only disclosure of a conflict of interests with significantly greater potential for abuse than in the situation described above.[33] [Emphasis added.]
In other words, it was not necessary to the U.S. Supreme Court decision, as it was before the Court, for the Court to find that the Advisers Act outlawed significant conflicts of interest between investment advisers and their clients. The SEC in the underlying action only sought an injunction pertaining to disclosure; given that this was the only relief requested, the Court did not need to address the other parameters of the fiduciary duty of loyalty.
The Fiduciary Duty of Loyalty: The Proper Handling of Conflicts of Interest
Given the importance of the fiduciary duty of loyalty, this section addresses the specific requirements that must be observed by the fiduciary advisor when a conflict of interest is present. First I address the difficulties of seeking "client waivers" or "estoppel via disclaimer" of these important fiduciary duties, for understanding the limited application of the doctrines of waiver and estoppel is essential to understanding the necessity for avoidance and/or proper management of conflicts of interest. I then explore in more detail the steps required to properly manage an unavoided conflict of interest.
Estoppel and waiver apply possess limitations when operating as a defense to "constructive fraud" (breach of fiduciary duty). For estoppel to make unactionable a breach of a fiduciary obligation due to the presence of a conflict of interest, it is required that the fiduciary undertake a series of measures, far beyond undertaking mere disclosure of the conflict of interest.
This contrasts with the relative ease in which estoppel and waiver apply to arms-length relationships, in which mere disclosure and consent creates estoppel and a defense against "actual fraud" – for customers generally possess responsibility for their own actions. Prosser and Keeton wrote that it is a "fundamental principle of the common law that volenti non fit injuria – to one who is willing, no wrong is done."[34]
Yet, the doctrine of estoppel springs from equitable principles, and it is designed to aid in the administration of justice where, without its aid, injustice might result. [35] For example, one cannot claim actual fraud if the facts indicate that knowledge of the facts underlying the fraud was delivered to the other party. The other party is estopped from denying knowledge of the facts when notice of the facts has been provided, and hence estopped from bringing a claim for actual fraud. Providing notice of the facts breaks any chain of causation in such circumstances; misrepresentation cannot be said to have occurred where the customer was notified of the truth of the matter.
However, a breach of the fiduciary standard is "constructive fraud," not "actual fraud." To prove a breach of fiduciary duty, a plaintiff must only show that he or she and the defendant had a fiduciary relationship, that the defendant breached its fiduciary duty to the plaintiff, and that this resulted in an injury to the plaintiff or a benefit to the defendant. It is not necessary for the plaintiff to prove causation to prevail on claims of certain breaches of fiduciary duty.
It is the agent's disloyalty itself, not any resulting harm, which violates the fiduciary relationship. The RESTATEMENT (SECOND) OF TORTS recognizes that a plaintiff may be entitled to "restitutionary recovery," to capture "profits that result to the fiduciary from his breach of duty and to be the beneficiary of a constructive trust in the profits."[36] In some circumstances, the plaintiff may also recover "what the fiduciary should have made in the prosecution of his duties."[37]
Hence, the role of estoppel in fiduciary law is different in fiduciary relationships than in its application to arms-length relationships in in which caveat emptor (even when aided by disclosure obligations under the '33 Act and '34 Act) plays a role. Mere consent by a client in writing to a breach of the fiduciary obligation is not, in itself, sufficient to create estoppel. If this were the case, fiduciary obligations – even core obligations of the fiduciary – would be easily subject to waiver. In essence, fiduciary relationships could easily be transformed back into arms-length relationships. But the law is not so permissive, given the importance of the fiduciary principle and its application in advisor-client relationships where, due to disparity in knowledge between the two as well as significant behavioral biases, clients are largely unable to protect themselves.
In similar situations to that of investment adviser and client, where a great disparity in knowledge and expertise exists, at times the law requires third-party protections for the benefit of the entrustor (client). For example, in many states judicial approval is required when a trustee seeks to enter into a transaction with the trust. At other times absolute prohibitions are imposed. For example, in nearly all states an attorney may not prepare a will of which the attorney is a beneficiary. At other times independent third-party advice must be secured; for example, an attorney cannot normally enter into a transaction with a client unless the client has either secured independent legal advice or, at a minimum, has been advised to do so.
Yet, the fiduciary law applicable to investment advisers has not required advance judicial approval, and only rarely has approval from an independent third party been required by the investment adviser prior to proceeding.[38] Instead, reflective of the desire to reduce the costs of transacting business, fiduciary law applies a set of procedural steps and substantive obligations upon the fiduciary, where a conflict of interest is present, which must be satisfied before the fiduciary can proceed.
Hence, to create an estoppel situation in a fiduciary-client relationship, the fiduciary is required to undertake a series of steps, beyond providing mere notice of the material facts to the client:
(1) Disclosure of all material facts to the client must occur, in an affirmative and timely manner;
(2) The disclosure must lead to the client's understanding;
(3) The informed consent of the client must be affirmatively secured; and
(4) At all times, the proposed action or transaction must be and remain substantively fair to the client.
Each of these required actions is explored in the sections that follow.
Preliminarily, it must be remembered that there exists no fiduciary duty of disclosure (although disclosure may be imposed by other law or regulation, or by contractual obligations created between the parties). 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. Fiduciaries also possess the obligation not to derive unauthorized profits from the fiduciary position.
While there is no fiduciary duty of disclosure, questions of disclosure are often central in the jurisprudence discussing fiduciary law, as many cases involve claims for breach of the fiduciary duty due to the presence of a conflict of interest. Additionally, Sect. 206(3) of the Advisers Act imposes an statutory obligation of disclosure for principal trades, in recognition of the conflict of interest present in principal trades by fiduciaries with their clients. In essence, a breach of fiduciary obligation – either the obligation not to be in a position of conflict of interest and the duty to not make unauthorized profits – may be averted or cured by the informed consent of the client (provided all material information is disclosed to the client, the adviser reasonably expects client understanding to result given all of the facts and circumstances, the informed consent of the client is affirmatively secured, and the transaction remains in all circumstances substantially fair to the client).
In essence, asking a client to provide informed consent to a conflict of interest by the fiduciary is requesting that the client waive the no conflict rule and/or the no profit rule generally applicable to fiduciaries (including investment advisers) under the broad fiduciary duty of loyalty. If truly informed consent occurs following full disclosure of all material facts in a manner designed to ensure understanding given that particular client's knowledge base and present circumstances, and if the transaction remains substantively fair to the client (i.e., the client is not disadvantaged by the transaction, as no client would likely ever consent to harm), only then would a client be estopped from asserting a breach of fiduciary duty claim due to the presence of the conflict of interest. Hence, the distinction between mere consent, in which waiver occurs easily and estoppel is often found, and informed consent, which is subject to much stricter tests to ensure its validity and that the fiduciary nature of the relationship is not substantially compromised.
The first step necessary in order to secure the defense to the claim of breach of fiduciary duty, disclosure of all material facts to the client must occur. See SEC vs. Capital Gains Research Bureau, 375 U.S. 180, 84 S.Ct. 275, 11 L.Ed.2d 237 (1963) ("Courts have imposed on a fiduciary an affirmative duty of 'utmost good faith, and full and fair disclosure of all material facts,' as well as an affirmative obligation 'to employ reasonable care to avoid misleading' his clients." Id. at 194.)
Disclosure must be full and frank. Even in arms-length relationships, a ratification or waiver defense may fail if the customer proves that he did not have all the material facts relating to the trade at issue. E.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1213 (8th Cir. 1990); Huppman v. Tighe, 100 Md. App. 655, 642 A.2d 309, 314-315 (1994). In contrast, in fiduciary relationships the failure to disclose material facts while seeking a release has been held to be actionable, as fraudulent concealment. See, e.g., Pacelli Bros. Transp. v. Pacelli, 456 A.2d 325, 328 (Conn. 1982) ('the intentional withholding of information for the purpose of inducing action has been regarded ... as equivalent to a fraudulent misrepresentation.'); Rosebud Sioux Tribe v. Strain, 432 N.W. 2d 259, 263 (S.D. 1988) ('The mere silence by one under such a [fiduciary] duty to disclose is fraudulent concealment.')" (Id.)
SEC Staff recently noted that under the "antifraud provisions of the Advisers Act, an investment adviser must disclose material facts to its clients and prospective clients whenever the failure to do so would defraud or operate as a fraud or deceit upon any such person. The adviser's fiduciary duty of disclosure is a broad one, and delivery of the adviser's brochure alone may not fully satisfy the adviser's disclosure obligations."[39]
Disclosure must be full and frank: "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."[40]
While disclosures and informed consent are possible in some circumstances, the application of this device requires much more than casual disclosure. This is especially so in the context of principal trading, since dumping is so difficult to detect. Generally, and as stated by Professor Band in a 2006 white paper:
In principle, any fiduciary duty can be modified by disclosure and consent. However, and the however is significant, achieving this end is not as easy as the principle may suggest. In order to be effective, contractual exclusions or limitations have to be agreed on the basis of full information, the consent has to be informed consent. Whilst this could be seen as an ordinary principle of contract law, this is not a helpful way to look at the issue in this context. Since the relationship between the parties is one which, ex hypothesi, would otherwise attract fiduciary duties, the fiduciary is not in a position where he can simply demand blind agreement to limitations on those duties. He has to provide information to enable the client to determine whether the limitation on the protection from which he would otherwise benefit is ultimately in his interests or whether [the client] should look elsewhere for another adviser who might look after [the client's] interest on a broader basis. In the financial services context, and indeed in many other professional advisory relationships, the problem will be whether the adviser is able to provide sufficient information, constrained as he will be by duties of confidentiality (whether fiduciary or otherwise) owed to other clients. What is required in terms of full disclosure depends on what duties are required of the fiduciary. There have to be some real doubts about whether the very general exclusion clauses work in circumstances where the institution has a real – as opposed to theoretical – conflict on its hands. Very often, of course, the client whose rights have been affected by reason of the fact that fiduciary duties have been curtailed is not in a position to challenge the validity of the consent which he gave since he does not know what information the institution had but felt unable to give him.[41]
"When a stock broker or financial advisor is providing financial or investment advice, he or she … is required to disclose facts that are material to the client's decision-making." Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006).
A material fact is "anything which might affect the (client's) decision whether or how to act." Allen Realty Corp. v. Holbert, 318 S.E.2d 592, 227 Va. 441 (Va., 1984). A fact is considered material if there is a substantial likelihood that a reasonable investor would consider the information to be important in making an investment decision. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Basic, Inc. v. Levinson, 485 U.S. 224, 233 (1988).
The existence of a conflict of interest is a material fact that an investment adviser must disclose to its clients because it "might incline an investment adviser -- consciously or unconsciously -- to render advice that was not disinterested." SEC v. Capital Gains Research Bureau, Inc., 375 U.S. at 191-192.
The standard of materiality is whether a reasonable client or prospective client would have considered the information important in deciding whether to invest with the adviser. See SEC v. Steadman, 967 F.2d 636, 643 (D.C. Cir. 1992).
All facts which might bear upon the desirability of the transaction must be disclosed. "[W]hen a firm has a fiduciary relationship with a customer, it may not execute principal trades with that customer absent full disclosure of its principal capacity, as well as all other information that bears on the desirability of the transaction from the customer's perspective … Other authorities are in agreement. For example, the general rule is that an agent charged by his principal with buying or selling an asset may not effect the transaction on his own account without full disclosure which 'must include not only the fact that the agent is acting on his own account, but also all other facts which he should realize have or are likely to have a bearing upon the desirability of the transaction, from the viewpoint of the principal.'" Geman v. S.E.C., 334 F.3d 1183, 1189 (10th Cir., 2003), quoting Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 979 (10th Cir.1996) (applying Kansas law) (quoting RESTATEMENT (SECOND) OF AGENCY § 390 cmt. a (1958)).
The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related professional advisory contexts, such as the duties imposed upon an attorney with respect to his or her client: "The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure." In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007). "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].") Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) [emphasis added], quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); "[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients." In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007) [emphasis added].
In other words, in order for disclosure to be effective, not only must all material facts be disclosed, but also the ramifications of those material facts (including the ramifications of any conflict of interest) must be explained to the client. Even then, other requirements exist, as set forth below.
The Requirement that Disclosure Occur Affirmatively and Timely
The disclosure must be affirmatively made (the "duty of inquiry" and the "duty to read" are limited in fiduciary relationships) and must be timely made – i.e., in advance of the contemplated transaction. ["Where a fiduciary relationship exists, facts which ordinarily require investigation may not incite suspicion (see, e.g., Bennett v. Hibernia Bank, 164 Cal.App.3d 202, 47 Cal.2d 540, 560, 305 P.2d 20 (1956), and do not give rise to a duty of inquiry (id., at p. 563, 305 P.2d 20). Where there is a fiduciary relationship, the usual duty of diligence to discover facts does not exist. United States Liab. Ins. Co. v. Haidinger-Hayes, Inc., 1 Cal.3d 586, 598, 83 Cal.Rptr. 418, 463 P.2d 770 (1970), Hobbs v. Bateman Eichler, Hill Richards, Inc., 210 Cal.Rptr. 387, 164 Cal.App.3d 174 (Cal. App. 2 Dist., 1974).)
As stated in an early decision by the U.S. Securities and Exchange Commission: "[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised and understands before the completion of each transaction that registrant proposes to sell her own securities." [Emphasis added.] In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).
The burden of affirmative disclosure rests with the professional advisor; constructive notice is insufficient. See also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient."). A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver. Manoir-Electroalloys, 711 F.Supp. at 195.
The duty to disclose is an affirmative one and rests with the advisor alone. Clients do not generally possess a duty of inquiry. "The [SEC} Staff believes that it is the firm's responsibility—not the customers'—to reasonably ensure that any material conflicts of interest are fully, fairly and clearly disclosed so that investors may fully understand them."[42]
As stated in an early case applying the Advisers Act: "It is not enough that one who acts as an admitted fiduciary proclaim that he or she stands ever ready to divulge material facts to the ones whose interests she is being paid to protect. Some knowledge is prerequisite to intelligent questioning. This is particularly true in the securities field. Readiness and willingness to disclose are not equivalent to disclosure. The statutes and rules discussed above make it unlawful to omit to state material facts irrespective of alleged (or proven) willingness or readiness to supply that which has been omitted." Hughes v. SEC, 174 F.2d 969 (D.C. Cir., 1949).
The burden of affirmative disclosure rests with the professional advisor; constructive notice is insufficient. See also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient."). A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver. Manoir-Electroalloys, 711 F.Supp. at 195.
"[D]isclosure, if it is to be meaningful and effective, must be timely. It must be provided before the completion of the transaction so that the client will know all the facts at the time that he is asked to give his consent." In the Matter of Arleeen W. Hughes, SEC Release No. 4048 (February 17, 1948), affirmed 174 F.2d 969 (D.C. Cir. 1949).
"The adviser's fiduciary duty of disclosure is a broad one, and delivery of the adviser's brochure alone may not fully satisfy the adviser's disclosure obligations." SEC Staff Study (Jan. 2011), p.23, citing see Instruction 3 of General Instructions for Part 2 of Form ADV; Advisers Act Rule 204-3(f); also citing see also Release IA-3060.
Disclosures of fees, costs, risks and other material facts, far in advance of specific investment recommendations, such as those found upon the initial delivery of Form ADV, Part 2A, would not meet the requirement of undertaking affirmative disclosure in a manner designed to ensure client understanding. Point-of-recommendation disclosures, for recommendations of pooled investment vehicles of any form, may be required, as called for under the DoL's proposed BIC exemption to its proposed "conflicts of interest" rule, in order to provide all fiduciary advisors with the benefit of a provisional safe harbor for disclosures. However, to be meaningful and operable as a full disclosure of all material facts, such a disclosure form, if adopted, should incorporate an estimate of all of the fees and costs attendant to pooled investment vehicles, such as brokerage commissions (that are not included in the fund's annual expense ratio).
The Requirement of Client Understanding
The disclosure must lead to the client's understanding – and 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.
Where there is a conflict of interest that is not avoided and is present with respect to a particular proposed transaction, there is an obligation upon the fiduciary to disclose adequate facts to ensure client understanding. The amount of facts that are deemed material, and required to be disclosed, will by necessity vary with the knowledge base already possessed the client. Those clients with a lesser knowledge base and/or cognitive abilities will require greater disclosure. There will arise circumstances, due to the complexity of the contemplated transaction and/or the cognitive abilities and knowledge base of the client, in which client understanding is unable to be secured; in these circumstances the conflict of interest must be avoided, as informed consent cannot be obtained.
The inability of clients to understand should not be underestimated. In a recent study, Professors "Madrian, Choi and Laibson recruited two groups of students in the summer of 2005 -- MBA students about to begin their first semester at Wharton, and undergraduates (freshmen through seniors) at Harvard. All participants were asked to make hypothetical investments of $10,000, choosing from among four S&P 500 index funds. They could put all their money into one fund or divide it among two or more. 'We chose the index funds because they are all tracking the same index, and there is no variation in the objective of the funds,' Madrian says … 'Participants received the prospectuses that fund companies provide real investors … the students 'overwhelmingly fail to minimize index fund fees,' the researchers write. 'When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80% still do not invest everything in the lowest-fee fund' … [Said Professor Madrian,] 'What our study suggests is that people do not know how to use information well.... My guess is it has to do with the general level of financial literacy, but also because the prospectus is so long." Knowledge@Wharton, "Today's Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?" citing Choi, James J., Laibson, David I. and Madrian, Brigitte C., "Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds" (March 6, 2008). Yale ICF Working Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023.
Consent is only informed if the client has the ability to fully understand and evaluate the information. Many complex products (such as CMOs, structured products, options, security futures, margin trading strategies, alternative investments and the like) are appropriate only for sophisticated and experienced investors. It is not sufficient for a firm or an investment professional to make full disclosure of potential conflicts of interest with respect to such products. The firm and the investment professional must make a reasonable judgment that the client is fully able to understand and evaluate the product and the potential conflicts of interest that the transaction presents. Fiduciary law reposes this burden – to ensure client understanding - on the advisor / fiduciary. It is not the client's responsibility. The "duty to read" generally possessed by consumers is somewhat circumscribed in a fiduciary relationship.
The Requirement of Informed Consent
The informed consent (which is not coerced by the fiduciary in any manner) of the client must be affirmatively secured (and silence is not consent). [There must be no coercion for the informed consent to be effective. The "voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so." Tamar Frankel, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.]
The consent of the client must be "intelligent, independent and informed." Generally, "fiduciary law protects the [client] by obligating the fiduciary to disclose all material facts, requiring an intelligent, independent consent from the [client], a substantively fair arrangement, or both." Frankel, Tamar, Fiduciary Law, 71 Calif. L. Rev. 795 (1983). [Emphasis added.]
The Requirement of Substantive Fairness
The previous requirements address a procedure that must be followed in order for estoppel to take place. This last requirement looks not at the procedures undertaken, but rather casts view upon the transaction itself. It requires that, even if the previous steps are followed, at all times the proposed transaction must be and remain 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. In the absence of integrity and fairness in a transaction between a fiduciary and the client or beneficiary, it will be set aside or held invalid. Matter of Gordon v. Bialystoker Center and Bikur Cholim, 45 N.Y. 2d 692, 698 (1978) (2006 WL 3016952 at *29). As stated by Professor Frankel, "if the bargain is highly unfair and unreasonable, the consent of the disadvantaged party is highly suspect. Experience demonstrates that people rarely agree to terms that are unfair and unreasonable with respect to their interests." Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.]
Disclosure, in and of itself, does not negate a fiduciary's duties to his or her client. As stated in an SEC No-Action Letter: "We do not agree that an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest. While section 206(3) of the [Advisers Act] requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent." Rocky Mountain Financial Planning, Inc. (pub. avail. March 28, 1983). [Emphasis added.]
"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." SEC Staff Study, January 2011, at p.22, citing see, e.g., Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003 ("Release 2106"); also citing Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010) ("Release 3060").
The Commission recently characterized this as an adviser's obligation "not to subrogate clients' interests to its own." ADV Release, at 3. See also "Without Fiduciary Protections, It's 'Buyer Beware' for Investors," Press Release issued by the Investment Adviser Association, et al., June 15, 2010, available at: http://www.financialplanningcoalition.com/docs/assets/3C7AB96C-1D09-67A1-7A3E526346D7A128/JointFOFPressRelease-ConferenceCommitteeFINAL6-15-10.pdf.
There must be no coercion for the informed consent to be effective. The "voluntariness of an apparent consent to an unfair transaction could be a lingering suspicion that generally, when entrustors consent to waive fiduciary duties (especially if they do not receive value in return) the transformation to a contract mode from a fiduciary mode was not fully achieved. Entrustors, like all people, are not always quick to recognize role changes, and they may continue to rely on their fiduciaries, even if warned not to do so." Frankel, Tamar, Fiduciary Duties as Default Rules, 74 Or. L. Rev. 1209.
It should also be noted that attempts to waive core fiduciary duties of an advisor may violate Section 215(a) of the Advisers Act. As stated by SEC Staff in its Jan. 2011 Study: "Advisers Act Section 215(a) voids any provision of a contract that purports to waive compliance with any provision of the Advisers Act. The Commission staff has taken the position that an adviser that includes any such provision (such as a provision disclaiming liability for ordinary negligence or a "hedge clause") in a contract that makes the client believe that he or she has given up legal rights and is foreclosed from a remedy that he or she might otherwise either have at common law or under Commission statutes is void under Advisers Act Section 215(a) and violates Advisers Act Sections 206(1) and (2). The Commission staff has stated that the issue of whether an adviser that uses a hedge clause would violate the Advisers Act turns on 'the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client.' The Commission has brought enforcement actions against advisers alleging that the advisers included hedge clauses that violated Advisers Act Sections 206(1) and (2) in client contracts." SEC Staff Study (Jan. 2011), p.43. [Citations omitted.]
FINRA's "Best Interests" Standard Proposal – Misleading and Inherently Weak.
A common tactic used by securities litigators to defend against claims of fraud, where such claims are based on broad statements that may not be entirely truthful, is to argue that such statements are "mere puffery" incapable of causing any harm. To prove a securities fraud claim, it must be shown that statements are material. In other words, it must be shown that such a statement would matter to the investor, when the investor makes his or her decision.
Are the words "best interests" – utilized in conduct standards if they are adopted by FINRA as SIFMA proposes – meaningful, or "mere puffery" incapable of causing harm?
For the answer to this question, we turn to definitions of "fiduciary" and "best interests" and their interpretations over the centuries:
"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). (Emphasis added.)
The (S.E.C. Staff) Study on Investment Advisers and Broker-Dealers (Jan. 2011) stated "Fundamental to the federal fiduciary standard [applicable to registered investment advisers] are the duties of loyalty and care. 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." Id. at p.22. (Emphasis added.)
"The requirement of loyalty entails that in exercising judgment in relation to these powers, the fiduciary must act in what she perceives to be the best interests of the beneficiary." Andrew S. Gold, Paul B. Miller, Philosophical Foundations of Fiduciary Law, p.154 (Oxford University Press, 2005).
"The federal fiduciary standard requires that an investment adviser act in the 'best interest' of its advisory client." Belmont vs. MB Investment Partners, Inc., 708 F.3d 470; 2013 U.S. App. LEXIS 3732; Fed. Sec. L. Rep. (CCH) P97,297 (2013) (citing other previous federal court decisions). (Emphasis added).
Even the consumer public understands the term "best interests" as equating with undivided loyalty. This has been emphasized in various articles appearing in the consumer press:
"My personal observations and experiences indicate that over the course of a year, brokers charge from five to 10 times (or more) what an investment adviser will charge per account. So long as it is for "suitable" investments, it is all perfectly legal. So the ordinary individual investor has three problems with the suitability standard: 1. It favors the brokerage firm and its employees over the investor. 2. It costs much more than services provided under other standards. 3. And it creates an inherent conflict of interest between the adviser and the investor. in my observations, the suitability standard serves more of a public-relations role for brokers than a protection function for investors. I have jokingly said that the next lower standard of care below suitability is "grifting." I wish that was more of an exaggeration … fiduciary rules protect investors from adviser malfeasance, while suitability rules protect brokers from investor lawsuits. When seeking out advice, do yourself this favor: Find an adviser who is legally obligated to put your interests first." Barry Ritholtz, "Find a financial adviser who will put your interests first, "The Washington Post (online column), Oct. 25, 2014. (Emphasis added.)
As seen, the term "best interests" has long equated in meaning to the fiduciary duty of loyalty. Hence, SIFMA's proposed rule, which cherry-picks just a few of the duties of a true fiduciary (and does not arise even close to the entirety of a fiduciary's total obligation), raises several questions by the use of the term "best interests":
1) Is SIFMA's proposal an attempt to co-opt the term "best interests" and redefine it as something other than equivalent to the fiduciary duty of loyalty, as has been understood for centuries?
2) Is this an attempt by SIFMA and FINRA to hold out to the public that its members act under a fiduciary duty of loyalty (understood as "acting in one's best interests), when most will still turn around and deny the existence of fiduciary duties?
3) Worse yet, is this misrepresentation on SIFMA'S and FINRA's behalf – rising to such a level of deceit that the very name of the proposed rule, if enacted, would violate the anti-fraud provisions of federal securities laws?
SIFMA's attempts to change the meaning of a legal term should be resisted. Moreover, one could easily challenge SIFMA's attempt an more than mere obfuscation, but perhaps arising to fraud and deceit as those terms are observed under federal and state securities laws. As one jurist recently observed, when considering a complaint for fraud and deceit: "Goldman contends that statements concerning its integrity alleged in the Second Amended Complaint are not actionable because they amount to vague statements … Goldman also challenges the inclusion of its business principles which contain value statements such as: 'integrity and honesty are at the heart of our business' … it defies logic to suggest that, for example, an investor would not reasonably rely on a statement, contained in what … was a list of Goldman's business principles, that recognized Goldman's dedication to complying with the letter and spirit of the laws .…" Lapin v. Goldman Sachs Group, Inc., 506 F. Supp. 2d 221 (S.D.N.Y. 2007).
SIFMA's proposal is but a wolf in sheep's clothing. Only in this case the wolf's wool suit has written on each side: "best interests." SIFMA is a tricky wolf, indeed!
In Conclusion
SIFMA's failure to embrace a fiduciary standard for brokers when providing personalized investment advice can be understood as an attempt to preserve a conflict-ridden, profitable business model. But it is a business model that consumers, who desire trusted advice, no longer desire.
SIFMA's proposal, if enacted, would fail to provide important consumer protections. As stated by the Consumer Federation of America, in its Statement on SIFMA's Proposed Best Interests of Customer Standard for Broker-Dealers: "Offering a securities law proposal that does not even adequately protect retail securities investors from conflicted investment advice renders SIFMA's framework severely deficient standing alone."
What is more alarming is FINRA's embrace of SIFMA's proposal. At a minimum, FINRA continues to disrespect its mandate to raise the standards of the profession to the highest level, and instead it acts to preserve the conflict-ridden, highly profitable business model of its member firms. And, perhaps even worse, FINRA appears to embrace a wholly inappropriate use of the term "best interests" to describe a "suitability plus casual disclosures" standard, when our jurisprudence and common consumer understanding of the term is altogether different. One can only question if FINRA endorses moving far beyond the boundaries of sales puffery and embraces the incorrect use of legal terms in such a fashion as to violate both federal and state securities laws which prohibit fraud and deceit.
[1] Ron A. Rhoades, JD, CFP® serves as Director of the Financial Planning Program at Western Kentucky University, where he is an Asst. Professor – Finance providing instruction to students in the areas of investments, retirement planning, and estate planning. Prof. Rhoades also is a member of the Steering Group for The Committee for the Fiduciary Standard (CFS), a group of industry leaders and volunteers who support the application of broad fiduciary obligations and advocate for the embrace CFS' Fiduciary Oath for all providers of personalized financial and investment advice. This article represents the views of the author, only, and not of any organization or firm with whom he may be associated. Prof. Rhoades can be reached via e-mail at: firstname.lastname@example.com.
[2] Walter Percy, The Moviegoer (New York: Ivy Books, 1960), pg. 6.
[3] Richard G. Ketchum, Remarks From the 2015 FINRA Annual Conference, Washington, DC (May 27, 2015)
[4] BLACK'S LAW DICTIONARY 252 (9th ed. 2009) (defining "caveat emptor" as a Latin phrase meaning "let the buyer beware"); see also Matthew P. Allen, A Lesson from History, Roosevelt to Obama – The Evolution of Broker-Dealer Regulation: From Self-Regulation, Arbitration, and Suitability to Federal Regulation, Litigation, and Fiduciary Duty, 5 ENTREPRENEURIAL BUS. L.J. 1, 20 n.77 (2010) ("Caveat emptor is an old property law doctrine under which a buyer could not recover from the seller for defects in the property that rendered it unfit for ordinary purposes. The only exception was if the seller actively concealed latent defects.").
[5] SIFMA provided this "mark-up of existing FINRA Rules that outlines the broad contours of how a best interests standard for broker-dealers might be developed as part of the path forward on this most important investor protection issue." Retrieved from SIFMA web site, June 10, 2015.
[6] Note that "[u]nder agency law, the extent of one's fiduciary duty is limited by the scope of one's agency." Arthur Laby, Fiduciary Obligations of Broker-Dealers, 55 Vill.L.Rev. 701, 714 (2010).
[7] Louis Loss, The SEC and the Broker-Dealer, 1 VAND. L. REV. 516, 529 (1948). Both the Restatement (First) and Restatement (Second) of Torts state, "[a] fiduciary relation exists between two persons when one of them is under a duty to act for or to give advice for the benefit of another upon matters within the scope of the relation." Restatement (Second) Of Torts § 874 cmt. a (1979) (citation omitted); Restatement (First) Of Torts § 874 cmt. a (1939) (citation omitted). As Deborah DeMott has observed: "As a legal principle, the [fiduciary] obligation originated in Equity. Equity granted relief-and common law courts did not-in numerous situations involving one person's abuse of confidence reposed in him by another. As Equity evolved, concrete rules in many instances supplanted the chancellors' exercise of discretion based on broad principles; established usages for terms like 'trust' and 'confidence' replaced an earlier and imprecise vocabulary.5 The term 'fiduciary' itself was adopted to apply to situations falling short of 'trusts,' but in which one person was nonetheless obliged to act like a trustee." Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, Duke L.J. 879, 880 (1988).
[8] See, e.g. Arthur Laby, Fiduciary Obligations of Broker-Dealers, 55 Vill.L.Rev. 701, 733-4 ("Although brokers historically provided advice to their customers, advice rendered in the past was relatively less significant in the context of the overall relationship than it is today … A history of the Merrill Lynch firm explains that, in the early part of the twentieth century, many brokerage firms did not do much more than execution—their sales forces were primarily intermediaries arranging trades on secondary markets—and the information available to investors seeking advice was rather meager. Open a modern description of the activities of broker-dealers and advice often is paramount.") (Citations omitted.)
[9] "[I]t cannot be disputed that broker-dealers want to be perceived as providers of investment advice. In the 1990s, 'brokerage firms began to use titles such as 'adviser' or 'financial adviser' for their broker-dealer registered representatives and even encouraged customers to think of the registered representative more as an adviser than a stockbroker.' This rebranding is particularly significant because "[m]arketing methods used by financial services providers bear on the level of protection afforded by the federal securities laws' … Where advice is intended to lure customers to the firm, it seems contradictory to say that a broker-dealer's investment advice is 'solely incidental' to its brokerage activities." Note, Defining a New Punctilio of an Honor: The Best Interest Standard For Broker-Dealers, 92 Boston U.L.Rev. 291, 308-9 (2012) (citations omitted).
[10] For a detailed discussion of the state law imposition of fiduciary duties upon brokers who are in a relationship of trust and confidence with their clients, see Rhoades, What Are The Specific Fiduciary Duties Of Those Who Provide Investment Advice To Retail Consumers? (attached as an exhibit to a comment letter to the U.S. Dept. of Labor, April 12, 2011), at pp.35-42, available at http://www.dol.gov/ebsa/regs/cmt-1210-AB32.html.
[11] 1934 Act Rule 15b10-3.
[12] FINRA generally explains its current version of the suitability rule, FINRA Rule 2111, as follows: "FINRA Rule 2111 requires, in part, that a broker-dealer or associated person 'have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile.' In general, a customer's investment profile would include the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. https://www.finra.org/industry/faq-finra-rule-2111-suitability-faq#sthash.LWz8PjDs.dpuf (retrieved June 10, 2015).
[13] 15 U.S.C. § 78o-3(b)(6).
[14] FINRA Conduct Rule 2110: Standards of Commercial Honor and Principles of Trade.
[15] 60 Am. U.L. Rev. 1265, 1275.
[16] Lowenfels and Bromberg, Suitability in Securities Transactions, The Business Lawyer (Aug. 1999) 1557.
[17] Steven L. Schwarcz, Rethinking The Disclosure Paradigm In A World Of Complexity, Univ.Ill.L.R. Vol. 2004, p.1, 7 (2004), citing "Disclosure To Investors: A Reappraisal Of Federal Administrative Policies Under The '33 and '34 Acts (The Wheat Report)," 52 (1969); accord William O. Douglas, "Protecting the Investor," 23 YALE REV. 521, 524 (1934).
[18] Robert Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals For Its Future, 51 Duke L.J. 1397 (available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397#H2N5).
[19] As stated by Professor Ripken: "[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one's own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is 'doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases' … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices." Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.
[20] See Robert Prentice, Whither Securities Regulation Some Behavioral Observations Regarding Proposals for its Future, 51 Duke Law J. 1397 (March 2002). Professor Prentices summarizes: "Respected commentators have floated several proposals for startling reforms of America's seventy-year-old securities regulation scheme. Many involve substantial deregulation with a view toward allowing issuers and investors to contract privately for desired levels of disclosure and fraud protection. The behavioral literature explored in this Article cautions that in a deregulated securities world it is exceedingly optimistic to expect issuers voluntarily to disclose optimal levels of information, securities intermediaries such as stock exchanges and stockbrokers to appropriately consider the interests of investors, or investors to be able to bargain efficiently for fraud protection."
Available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397.
[21] Id. See also Stephen J. Choi and A.C. Pritchard, "Behavioral Economics and the SEC" (2003), at p.18.
[22] Troy A. Parades, Blinded by the Light: Information Overload and its Consequences for Securities Regulation, 83 Wash.Univ.L.Q. 907, 931-2 (2003).
[23] See http://papers.ssrn.com/sol3/papers.cfm?abstract_id=480121.
[24] Cain, Daylian M., Loewenstein, George F. and Moore, Don A., The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest (December 1, 2003). Available at SSRN: http://ssrn.com/abstract=480121
[25] Anonia Argandoña, Conflicts of Interest: The Ethical Viewpoint (2004).
[26] Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.
[27] See Restatement (Third) of Agency § 8.02 cmt. a (2006) (explaining that under duty of loyalty, "an agent has a duty not to acquire material benefits in disconnection with transactions or other actions undertaken on the principal's behalf or through the agent's use of position").
[28] Bristol and West Building Society v Mothew [1998] Ch 1, 18).
[29] See, e.g., Thorp v. McCullum, 1 Gilman (6 Ill.) 614, 626 (1844) ("The temptation of self interest is too powerful and insinuating to be trusted. Man cannot serve two masters; he will foresake the one and cleave to the other. Between two conflicting interests, it is easy to foresee, and all experience has shown, whose interests will be neglected and sacrificed. The temptation to neglect the interest of those thus confided must be removed by taking away the right to hold, however fair the purchase, or full the consideration paid; for it would be impossible, in many cases, to ferret out the secret knowledge of facts and advantages of the purchaser, known to the trustee or others acting in the like character. The best and only safe antidote is in the extraction of the sting; by denying the right to hold, the temptation and power to do wrong is destroyed.")
Wall Street's abusive practices, seen in the late 1920's (leading to the Great Depression) and more recently in the early part of this century (leading to the 2008-9 near-financial-collapse and the resulting Great Recession), have long been seen as fixable. "I venture to assert that when the history of the financial era which has just drawn to a close comes to be written, most of its mistakes and its major faults will be ascribed to the failure to observe the fiduciary principle, the precept as old as holy writ, that 'a man cannot serve two masters.'" Harlan Stone (future Chief Justice of the U.S. Supreme Court), The Public Influence of the Bar (1934) 48 Harv.L.Rev. 1, 8-9.
[30] See, e.g., SEC No-Action Letter: "We do not agree that an investment adviser may have interests in a transaction and that his fiduciary obligation toward his client is discharged so long as the adviser makes complete disclosure of the nature and extent of his interest. While section 206(3) of the [Advisers Act] requires disclosure of such interest and the client's consent to enter into the transaction with knowledge of such interest, the adviser's fiduciary duties are not discharged merely by such disclosure and consent." Rocky Mountain Financial Planning, Inc. (pub. avail. March 28, 1983). [Emphasis added.]
[31] SEC v. Capital Gains Research Bureau, ___________
[32] Id. at p.___.
[33] Id. at p.___.
[34] W. Page Keeton et al., PROSSER AND KEETON ON THE LAW OF TORTS 112 (5th ed. 1992); see RESTATEMENT (SECOND) OF TORTS § 892A cmt. a (1977) (asserting that one does not suffer a legal wrong as the result of an act to which, unaffected by fraud, mistake or duress, he freely or apparently consents).
[35] Levin v. Levin, 645 N.E.2d 601, 604 (Ind. 1994).
[36] RESTATEMENT (SECOND) OF TORTS § 874 cmt. b (1979).
[37] RESTATEMENT (SECOND) OF TORTS § 874 cmt. b (1979); see also 2 DAN B. DOBBS, THE LAW OF REMEDIES 670 (2d ed. 1993) (noting that a fiduciary who wrongfully takes an opportunity, if "treated as a fiduciary for the profits as well as for the initial opportunity," would "owe a duty to maximize their productiveness within the limits of prudent management and might be liable for failing to do so").
[38] The procedures for resolving conflicts of interest vary depending upon the nature of the fiduciary relationship. For example, in the context of business partnerships, contracting out of certain fiduciary obligations might be permitted, as both parties are usually believed to be sophisticated (or, at least, wise enough to secure legal counsel to assist in the negotiation of partnership agreements). An employee is an agent (fiduciary) to his or her employer, yet it is the employer – not the fiduciary – in such instance who likely possesses the greater knowledge and sophistication; hence, notice to the employer of conflicts of interest the employee may possess may be all that is required. In contrast, the fiduciary duty is applied much more strictly when the knowledge and expertise of the parties is usually vastly different, such as in the case of a trustee and the beneficiary of the trust. Contrasted with trustees, the fiduciary duty of loyalty is required somewhat less strictly when the fiduciary is an attorney or investment adviser; but the application of fiduciary duties is much more stringent than in the case of business partners or employees acting in fiduciary capacities. "Although one can identify common core principles of fiduciary obligation, these principles apply with greater or lesser force in different contexts involving different types of parties and relationships." Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, Duke L.J. 879 (1988).
[39] 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.23 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)
[40] 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).
[41] Christa Band, Conflicts of Interest in Financial Services and Markets (2006) (Australia).
[42] See, e.g., 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.117 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.)