As Of: May 2, 2007

INVESTMENT CONSUMER PROTECTION

Who can you trust?

    Advocates for the public interest would like consumers to know absolutely everything about every transaction they are involved in. The Securities and Exchange Commission is one agency in particular that has strongly advocated for full disclosure. Although a lofty goal, lets face it, most people will never read the fine print. Truth be told, fine print is written by lawyers, and wouldn't be understood by most people even if it was read! So how can the consumer be protected if the consumer doesn't even know the "rules of the game"?

    In the real world, most people manage to get along just fine without onerous regulation to ensure exhaustive disclosure. The fact is, a lot of required disclosure is about absurdly remote possibilities that can largely be ignored, or about minutia that is of little interest to most people. As long as there is a correlation between the expectation of how a transaction or relationship should work, with how they truly do work, there generally isn't a problem. Problems arise when common perception is vastly different from the facts. Such has been the case with the relationship between securities brokers and customers. (Some customers think they are clients. Brokers know they are just customers - caveat emptor.)

    There was a time when stock brokers were almost the only game in town. Except for the very wealthy, the concept of an investment advisor or an investment manager did not exist for the retail public. Brokers existed to facilitate a trade for a customer. Knowledge of the markets and the dispensing of advice was always part of the stock brokers service, but advice was incidental to the primary task of executing the trade that the customer requested. Only in the last twenty-five years have investment advisers become increasingly available to the retail investor. With an investment adviser, the customer became a "client", and the adviser owed a "fiduciary duty" to the client. The adviser could not have a conflict of interest with the client. Owing a fiduciary duty meant that the adviser must place the interests of the client first. Investment Advisers must be separately registered with the Securities and Exchange Commission (whereas broker/dealers are regulated by the NASD).

    Stock brokers have always been exempt from registration as investment advisers, but as they started gathering assets in the 1980's and 1990's for fee management programs, the role of a broker versus an adviser became increasingly blurred. In 1999, the SEC finally recognized the confusion in the marketplace and proposed a rule to clarify the role of the broker as opposed to the adviser. However, the rule was not finalized for another six years, after several modifications. Surprisingly, the rule was not in the public interest. It allowed stock brokers to continue to act as advisers as long as it was disclosed in the fine print that they are acting as brokers, not advisers - the difference being that any advice they dispense was supposed to be "incidental". Did the public understand that brokers could appear to be doing exactly the same thing as an adviser, but did not owe a fiduciary duty and could have a conflict of interest? No. If it looks like a duck and quacks like a duck, isn't it a duck? This was clearly a case of the fine print revealing (or obscuring) a reality that was far different from the common public understanding.

    The SEC was sued by the Financial Planning Association and lost in the U.S. Court of Appeals for the District of Columbia Circuit. The broker/dealer exemption was wrong, but it is not clear what will happen next. The courts have recognized that there is a higher standard of care that a client deserves when provided with investment advice. Investment advisers cannot perform their basic function of providing unbiased and continuous advice unless all conflicts of interest are removed. Regarding the regulations that govern investment advisers, the Supreme Court has said, "A fundamental purpose, common to these statutes, was to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry." The old broker exception did not promote the standards intended by Congress and upheld by the courts. However, there is a large vested interest in the brokerage industry to hold on to their advisory accounts. Will congress be lobbied for another exception? Will there be another court challenge? Will the SEC propose another murky rule? Or will the court decision stand and brokers will have to register if they want to act as advisers? Regardless of the outcome, the publicity (minor as it is to industry outsiders) may at least cause some investors to ask the question, "Who does my adviser work for? Does he work for me? Or does he work for a Wall Street broker that may have an agenda in conflict with mine?" Asking the question is an important first step to getting the relevant disclosures.