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Ruling Further Separates Brokers, Registered Advisors

In rejecting the so-called “Merrill Lynch Rule,” a recent federal appeals court decision has re-established traditional regulatory guidelines that afford more protection to investors.

For years, some stockbrokers had attempted to blur the distinction between themselves and investment advisors, who have strict fiduciary duties to their clients. They succeeded for awhile, in part because of the Merrill Lynch Rule, adopted temporarily in 1999 and approved in 2005 by the Securities and Exchange Commission. It allowed brokers to bundle trade execution, investment advice and custodial services for one flat fee based on total assets. The idea was practical because it aligned the goals of the broker and the client, both of whom benefited from an increase in the client’s wealth. But it also let brokers provide basic investment advice within the fee-based accounts without being obliged to act as as fiduciaries. 

A fiduciary obligation means that one assumes a duty to act in good faith and with care, candor and loyalty on behalf of the investor. That rigorous standard was affirmed for investment advisors in 1963 by SEC vs. Capital Gains Research Bureau, Inc., in which the court held that the duty was imposed by the Investment Advisors Act of 1940. The act required anyone who offered investment advice and charged just an asset-based fee to register as an investment advisor. The court ruled that an investment advisor should occupy “an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice.”

Several releases since the 1963 case have supported the same position, requiring registered advisors to make reasonable and ongoing efforts to comply with their fiduciary obligations under the Advisors Act. Those duties include providing full and fair disclosure of all material facts and disclosing all conflicts of interest to clients. 

Stockbrokers, on the other hand, have historically been held to a less stringent set of rules, highlighted by the suitability standard applied by Rule 2310 of the National Association of Securities Dealers. The suitability standard is a “know your customer” rule, which requires the broker to consider the client’s financial situation, needs and investment objectives. Thus, the broker would not be allowed to recommend risky or speculative investments such as oil futures or penny stocks to an elderly retiree who needs current income to sustain his or her lifestyle. 

However, just because an investment is suitable does not mean that it is in the client’s best interest. Plenty of investments would meet the mere suitability standard in fitting the elderly retiree’s situation, but could be loaded with high fees and commissions, significantly detracting from the potential return.

There is an inherent conflict of interest in the client-broker relationship. A stockbroker owes a duty to his employer to maximize profits, and thus must balance the interests of the employer and the interests of the client. This tension can lead to overtrading in an account, generating higher profit for the dealer and lower return for the investor. Such “churning” is clearly not in the client’s best interest, but is not considered deceptive or illegal until it reaches extraordinarily high levels.   

For a broker’s fee-based accounts to persist under the allowances of the Merrill Lynch Rule, the accounts had to meet several criteria. The broker could not exercise discretion, the investment advice had to be incidental to the brokerage service, and all documents had to state that the account was indeed a brokerage account and not an advisory account. In the eyes of the law, conforming to these criteria was enough to distinguish the relationship as a brokerage relationship and not an advisory relationship, therefore dismissing any fiduciary obligation to the client. With the Merrill Lynch Rule in place, stockbrokers were allowed to provide services quite similar to those in an advisory relationship, without meeting the same standards of investor protection.

Stage Set For Consumers To Review Choices

Since the rule was overturned last March, many brokers have chosen to eliminate fee-based brokerage accounts rather than become registered investment advisors and face the more stringent obligations. As these accounts have been abandoned, many clients have had an opportunity to re-evaluate the source of their investment advice, as well as the options for professional services.

Many people are capable of managing their own investments; a few would likely do better than professionals. If you are comfortable developing your own investment strategy and you merely use the broker as a tool to implement that strategy, the brokerage approach may work best for you. Interactions with a broker are similar to those with a car salesman, a real estate agent or other commissioned salesperson. All help us complete transactions and can be valuable, as long as we recognize the seller’s divided interests. 

It is important to determine whether the professional is acting as a fiduciary and to understand the implications. Although registered investment advisors are required to act as fiduciaries 100 percent of the time, stockbrokers generally are not, even though they may call themselves financial advisors, wealth management specialists or something similar.

Brokers are seen as “order takers” by courts, which have been unwilling to apply a fiduciary standard to most broker-customer relationships. Such factors as broker discretion over the account or proven reliance on the broker’s skills by an unsophisticated investor can forge an advisory relationship, which would then subject the broker to fiduciary obligations. However, these characteristics are not often found in brokerage relationships, and disputes with brokers over breach of fiduciary duty are usually settled in arbitration, which some see as more lenient to brokers than a court of law.  

If you think a registered investment advisor better suits your needs, many of the questions you might have will be answered on forms your advisor files with the SEC or the state in which his or her principal place of business is located. Ask to see both parts of Form ADV. It details the services offered, investment strategies used, fees charged, alternative sources of compensation, the educational backgrounds of key employees and possible conflicts of interest. Pay particular attention to the sources of the advisor’s compensation. Any source other than you should raise a cautionary flag. Brokers do not file Form ADV and are not required to provide clients with the same level of disclosure.

Another point to ask about is “best execution” — advisors’ jargon for ensuring that total costs or proceeds are the most favorable possible under the circumstances. Advisors are required to monitor best execution for clients’ trades; brokers are not.

Be wary of provisions such as soft-dollar arrangements, in which an advisor receives research or other services in exchange for commissions from client accounts. Also be cautious of principal trading, in which securities are bought and sold for clients out of an advisor’s own account. Investment advisors may engage in principal transactions only in very limited situations, but it is not uncommon for brokerage firms to earn considerable profits by trading as a principal with their customers.

If you enjoyed this article, be sure to check out Palisades Hudson’s book, Looking Ahead: Life, Family, Wealth and Business After 55, now available in paperback and as an e-book.

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