Is Your Financial Advisor a Fiduciary or an Order Taker?

As a general rule, financial advisors fall into two categories: (1) brokers, who are registered under the Securities Act of 1934, and (2) investment advisors, who are registered under the Investment Advisors Act of 1940 (“IAA”). Investment advisors are subject to higher standards of regulation and licensing than brokers, and accordingly, investment advisors owe higher duties of care to their clients.

Brokers must pass the Series 7 exam, while investment advisors must pass the more extensive Series 65 exam. Likewise, while brokers are subject to the Financial Industry Regulatory Authority (FINRA) “suitability” rule, investment advisors are subject to that rule and a full fiduciary standard of care.

In general, the IAA defines an “Investment Advisor” as any person who is compensated for advising others as to the value of securities or to investing in, purchase or sell securities. The IAA carves out an exemption for “brokers.”

The IAA’s exemption for brokers is based on the notion that brokers perform a lower level of service for clients and are compensated differently. A “broker” does little more than bring a buyer and seller together for a given transaction and is compensated by receiving a commission on the transaction. Any investment advice is incidental to the transaction .

The Transition from Commissions to Fee-Based Accounts

By 2005, the securities industry had changed vastly since the adoption of the IAA. Large brokerage firms had blurred the lines between brokers and investment advisors by actively marketing their employees to the public as “advisors.” At many firms, brokers had begun to carry the title “Financial Advisor.”

Most importantly, by 2005, brokerage firms had begun offering fee-based accounts (which proved more profitable than commission-based accounts). This negated the original premise behind the broker exemption. Brokers were no longer receiving compensation for transactions; they were receiving compensation for giving financial advice. Yet, they were not subject to the heightened fiduciary standards of the IAA.

This prompted protest from consumer advocate groups and the Financial Planning Association, comprised of Investment Advisers and Financial Planners. The financial planners pointed out that large brokerage firms were trying to “have their cake and eat it too” by marketing themselves to the public as advisors, but not holding themselves to fiduciary standards. They argued this created an uneven playing field for financial planners trying to compete against the large brokerage firms.

The SEC’s Rule Extending the IAA’s Broker Exemption to Fee-Based Accounts is Stricken

In response, the SEC moved quickly to defend the large brokerage firms. In 2005, the SEC enacted a rule colloquially called the “Merrill Lynch Rule.” This Rule, found at 17 C.F.R. §275.202 (a)(11-1), extended the IAA’s broker exemption further than Congress had written. It provided that a broker who received special compensation through a fee-based account would not be deemed an Investment Advisor under certain circumstances. The effect of the Merrill Lynch Rule was to ensure that large brokerage firms could offer fee-based accounts without being subject to the IAA’s fiduciary standard of care.

Consumer advocate groups and the Financial Planning Association expressed outrage over the new rule and promptly challenged it in court. In 2007, the United States Court of Appeals for the District of Columbia struck down the Rule, finding that the SEC had exceeded its rule making power in enacting it. See Financial Planning Ass’n v. S.E.C., 482 F.3d 481 (D.C. Cir. 2007). The Court held that the SEC could not make a special exemption from the IAA for brokerage firms and their fee-based accounts.

Fee-Based Advisors Are Fiduciaries

As a result of this decision, brokerage firms cannot credibly claim their fee-based financial advisors are mere “order takers.” Instead, these financial advisors owe their clients a heightened standard of care of a fiduciary nature under the IAA. These fiduciary duties include the following:

• To render advice and to act solely in the best interests of the client at all times.
• To refrain from self-dealing and to provide full disclosure of all material facts affecting the client’s accounts.
• To comply in full with the suitability rule, borrowed from broker-dealer standard.
• To analyze the client’s investment objectives and risk tolerance and to devise an appropriate investment plan for the client.
• To provide ongoing advise and monitoring of the client’s investment plan.

These duties are the beginning, not the end, of a financial advisor’s duties as a fiduciary.