Brooke’s note – From our occasional RIABiz columnist, Ron Rhoades, comes a purely hypothetical discussion between a dual registrant at a major wirehouse firm and his client, “Aunt Bea,” at a distant time in the future, and assuming that SIFMA’s version of a “uniform fiduciary standard” is adopted by the U.S. Securities and Exchange Commission. This hypothetical discussion does not necessarily represent the experience of any current client of a dually registered firm, nor the views of RIABiz.

Scene: The well-appointed office of a Financial Consultant, a dual registrant who works at a major wirehouse. He sits at his desk. Across from him is his client, “Aunt Bea.”

Financial Consultant: Well, Mrs. Beatrice, I’m glad we’ve completed the presentation of your financial plan. In the past several conferences, we’ve covered a strategic asset allocation for you, how much you can withdraw from your investment portfolio during your retirement and the required minimum distributions you will need to take from your retirement accounts. We’ve also discussed your estate plan, recommendations for various insurance coverage, and much more.

Mrs. Beatrice: (Or “Aunt Bea” as everyone calls her, who is indeed impressed by the plethora of reports and graphs that the Financial Consultant has displayed to her across the desk.) Thank you, young man.

FC: (Leaning forward) Now is the time for us to implement this financial plan. But first I have to review the nature of our firm’s relationship with you.

AB: (Somewhat taken aback) Oh?

FC: In implementing your investment portfolio, we want you to choose to have an investment advisory account, as well as a brokerage account. We will continue to act in a fiduciary manner on your investment advisory account, but in your brokerage account we will not be a fiduciary to you.

AB: (Puzzled) What’s a fiduciary?

FC: A fiduciary acts in your best interests.

AB: Of course, that’s why I hired you. You are a financial consultant, are you not?

FC: (Squirming a bit in his seat) Yes, Aunt Bea, I am. My job is to consult with you about many things. And some of these things are investment products we can offer you.

AB: OK, let’s discuss them.

FC: In your brokerage account …

AB (Quickly cutting him off) Are not all of my accounts with you — my revocable trust account, my IRA account, and my Roth IRA account, all brokerage accounts?

FC: Well yes, they are, in the sense that we take custody of your investment assets here, and we agree to safeguard them for you.

AB: Of course you do. You are a big firm. That’s one reason I chose you.

FC: But let me try to be clear. In a brokerage account we are not a fiduciary to you, and our interests may not be aligned at all times with yours.

AB: What does that mean?

FC: (Stammering a bit; perplexed at how to continue this conversation and not lose the client) It means just what I said. We have a duty to find suitable investments for you ….”

AB: Suitable? Does that mean they are very good investments for me?

FC: It only means that they are suitable to you, given your financial circumstances. “Suitability” refers mostly to whether the investment is too “risky” for you, not whether it is a good, very good, or the best investment for you. And, in a brokerage account, at times our interests in recommending a product to you may conflict with your interests.

AB: (Growing agitated) What does THAT mean? Does that mean that sometimes I can’t trust you?

FC: Our business is built on trust. We pride ourselves on providing you with great advice. But, on occasion, we may recommend products to you in a brokerage account, which is not an investment advisory account, which present a conflict of interest for us.

AB: What kind of conflicts?

FC: Well, these are disclosed on our website.

AB: (Growing ever-more agitated) Well, excuse me for saying this, but I don’t want to visit your website – I doubt I ever will, or that many of the clients you tell that to will ever visit your website and read those disclosures – even if they can find them. Instead, tell me about these conflicts of interest now!

FC: In your brokerage account, which is not a fiduciary account, we might recommend products to you, such as mutual funds, where we receive a higher commission than other products we could recommend to you. Of course, we would fully disclose to you that we receive higher commissions and any other forms of compensation we might receive.

AB: (Inquisitively) Would you tell me if a lower-commission product is available?

FC: Not necessarily.

AB: (Who, unlike some senior citizens, is an alert and astute lady who possesses a strong personality, thereby permitting her to ask the tough questions.) You also said “other forms of compensation.” What might those be?

FC: Well, sometimes our firm gets paid by mutual fund companies to promote their funds, and we might receive soft dollar compensation, and we might get compensated out of 12b-1 fees.

AB: Will you tell me how much you and your firm are receiving from all of these commissions and fees, for each and every investment product you recommend to me?

FC: Quite frankly, Aunt Bea, I don’t even know what the firm receives from all of these payments, or how they might affect you. I’ve asked, but the firm won’t provide me with specific numbers, as they affect each of our clients.

AB: (Mind racing) Well, thanks for being honest with me, at least in that regard. So what if I want ONLY the other kind of account … what did you call it?

FC: An investment advisory account.

AB: Yes, that’s it. Can I TRUST you with an investment advisory account?

FC: Well, yes, you can. Of course, we may still have conflicts of interest, which we would disclose to you. For example, we might seek to sell you mutual funds which have been developed by an affiliate firm in which our firm owns an interest.

AB: (Growing fatigued) Why?

FC: Because we think it will be the best fund for you. Our firm has over fifty funds to choose from.

AB: (Who has been doing a bit of reading about mutual funds in between her sessions with the consultant) You mean to tell me that, out of thousands and thousands of mutual funds out there, YOUR firm’s few funds are likely to be recommended to me?

FC: (Knowing the conversation is going poorly and trying to regroup) Mrs. Beatrice, in an investment advisory account you can trust me.

AB: That’s all I am TRYING to do, young man. But I must say, you are making it increasingly difficult. (Pause) What other types of investments might you recommend to me in the advisory account?

FC: We might recommend municipal bonds to you. And some of the bonds we recommend to you might come from our inventory.

AB: (Slyly) Now, young man, out of tens of thousands of municipal bonds out there, why would you not just shop for the best bond for me, rather than have me buy them from you?

FC: My bond desk tells me that the bonds we hold are really good bonds.

AB: Well, if they are so good, why is your firm selling them? Seems to me that your firm would have an incentive to get rid of the bad bonds, on unsuspecting investors like me — or other retirees.

FC: (Brushing aside the uncomfortable thought that when interest rates were really low his firm’s bond desk unloaded a great deal of long-term bonds by prompting dual registrants such as himself to push them into client accounts.) We would NEVER do that. We are a fiduciary to you, with the investment advisory account. We would ensure that you receive very favorable pricing for the bonds we sell to you.

AB: (Long a purchaser of municipal bonds) How would you do that? Sometimes these municipal bond issues might not trade for weeks, months, or even years. How can you possibly set a price that’s the best possible price for me?

FC: (Somewhat out of his depth at this juncture as to the rather vague methods of discerning fair prices for highly illiquid muni bonds.) We have all kinds of methods.

AB: Seems to me you are just trying to make more money off of me. I’ve read where buying and selling out of your own inventory, for firms like yours, is a lot more lucrative than when you shop bonds from other firms.

FC: But Mrs. Beatrice, with your investment advisory account, we are a fiduciary to you.

AB: There’s that word “fiduciary” again. Seems to me the word means different things to different people, and for every time you say the word “trust” you also say the word “but!” Seems to me that you ask me to trust you, but then you tell me I have to protect my own interests, because you might not be fully protecting my interests! (Thinking for a second) What other kinds of investments would you recommend to me in an investment advisory account?

FC: (Relieved that Aunt Bea changed the subject, as he can now turn to something he is truly proud of) Well, Aunt Bea, each year our firm underwrites offerings of many individual stocks, and we work with other firms like ours as well that do the same. As a result, we are able to offer to you investments in Initial Public Offerings.

AB: Hmm. When you “underwrite” stock offerings, who do you represent, and who pays you?

FC: The issuer of the stock – the corporation – of course.

AB: Then of course you have a monetary incentive to make certain that all the stock is issued, at as high a price as possible. In that case, how could you possibly be representing ME too?

FC: (In a dither) We are … we just wear two hats at that time.

AB (Emphatically) Two hats? Sounds like you can’t represent either one effectively. You either represent the seller, or the buyer … it’s impossible to represent both at the same time! (Pause) Do you have any academic evidence that demonstrates that IPOs do better than stocks bought on the open market?

FC: (On firmer ground) Actually, Mrs. Beatrice, I recall an academic paper I read that said that on average IPOs underperform the market, at least in the short term … But I can assure you, we are not recommending just “average” IPO stocks to you.

AB: Then it must be all of those other large firms … the ones you work with to promote these IPOs … that fall into the “under average” category … Of course, YOUR firm never engaged in underwriting and promoting all of those mortgage-backed securities loaded with subprime mortgages!

FC: (Worn down by Aunt Bea’s persistent questioning, and recalling that, in fact, his firm did advise clients back in the middle part of the past decade to purchase MBS, CDOs, and similar securities offerings.) I suppose.

AB: (Taking stock) Let me ask you this, young man … as you’ve explained the differences between a brokerage account which IS NOT a fiduciary account, and an investment advisory account which IS a fiduciary account, why would someone like me EVER choose to put my hard-earned money in a non-fiduciary brokerage account, if given the choice.

FC: (Exasperated) I really can’t give you one good reason, Aunt Bea. It’s just that my firm wants me to push our brokerage accounts over our investment advisory accounts. We were given the freedom by the SEC to permit our clients to make such a choice. Quite frankly, our firm makes more money when our clients choose brokerage accounts.

AB: I see. Well, I may be an old biddy, but it sounds to me like I can’t trust you AT ALL in a brokerage account, while with an investment advisory account I MIGHT be able to trust you some — but even then only if I keep my wits about me and read all those disclosures. If I can understand all of those disclosure documents, and all the complexities of the investment products you recommend, maybe then I can then protect my own interests.

FC: (Seeing an opening) That’s true. So we’ll make all of your accounts investment advisory accounts!

AB: Well, I’m glad we have that settled. Now, in that financial plan you provided to me, the plan said to invest tax-efficiently. How are we going to do that?

FC: Mrs. Beatrice, here is the agreement for your investment advisory account, and I just want to point out to you that it clearly says there that I cannot provide tax advice.

AB: (More than a little perturbed) You mean to tell me that I need to invest tax-efficiently, but you have NO RESPONSIBILITY as my advisor for insuring that I do so?

FC: (Cornered by the policies of his own firm) I’m afraid so.

AB: (In high dudgeon) Well I know this, young man … every dollar I give to Uncle Sam if I don’t invest tax efficiently is one less dollar in my pocket. I just don’t understand how, if you hold yourself out as an expert financial advisor, you say you have no duty to advise me on how to invest in a way to keep taxes at a minimum, over the long term. Sounds to me like you’re not the expert you have claimed to be.

FC: (Defeated) I don’t know what to say.

AB: (Trying in vain to get the Financial Consultant to look her in the eye) I DO KNOW WHAT TO ASK! Can you promise to me, in writing, that you will act as a fiduciary to me at all times, in my best interests at all times, and provide to me the expert advice I require, including advising me how to manage the investment portfolio tax-efficiently? Can you promise to me, in writing, that you will disclose to me, in specific dollar or percentage amounts, each and every form of compensation both you and your firm might receive as a result of the recommendations made to me? Can you promise me that, even with such disclosure, you will only recommend to me those very few investment strategies and investment products which are best for me — not just “suitable” — after you perform adequate due diligence upon them, including a comparison to other investments which are available?

FC: (Resigned to his fate) Aunt Bea, you know my firm won’t permit me to make those promises, and certainly not in writing.

AB: (Standing and starting to gather her things) But that’s what me – your client – expects! You know, I came in here looking for someone who would look after me. Someone I can TRUST to look after my interests, and my investments. I don’t mind you getting reasonable compensation. But it seems to me that, even with an investment advisory account, you have all of these conflicts of interests given your firm’s higher fees earned from proprietary funds, the muni bonds your firm owns and wants to unload on me, and your firm’s commitment to be successful in investment underwriting.

FC: (Making one last ditch effort to retain his client) But, Mrs. Beatrice, we disclose all of those conflicts of interest to you!

AB: I know a bit about conflicts of interest, young man. I’ve seen their insidious nature in many different types of situations. They often result in bad advice, even when the conflicts are disclosed. You simply can’t trust someone who has a lot of conflicts of interest; even if they try to be good, over time he or she “self-justifies” his or her actions, and the advice just keeps getting worse and worse. Seems to me it’s just a whole lot better to avoid the conflict, in order to retain my trust and keep my best interests paramount at all times. Simply put, I don’t see how you can wear two hats at the same time. You either represent me and my interests – or you don’t. It’s that simple.

FC: That may be true.

AB: Young man, you held yourself out as an “advisor” and as a “financial consultant” and a provider of “financial services.” Seems to me you are just a wolf in sheep’s clothing … trying to use the guise of a trusted advisor to make more money for you and your firm.

(And with that, Aunt Bea sweeps out of the office. The Financial Consultant remains seated, in a bit of a daze.)

Epilogue
Aunt Bea was so disgusted with the entire experience that she doubted she would ever seek out advice to invest in the stock or bond markets again. It seemed to her that there was a lot she knew, but a lot more she didn’t know, about investments and investment strategies. She thought of how tired she was. She thought … investing in CDs just seems a whole lot safer. She doubted that she would ever look for a “trusted financial advisor” again.

Ron A. Rhoades, JD, CFP® is a Professor at a college in upstate New York, where he teaches classes in both financial planning and law. He is also the principal of a registered investment advisory firm. This article represents his views only, and not those of any institution, firm or organization to which he may belong.