Brokers as fiduciaries

Cite this Article
Larry Ribstein, Brokers as fiduciaries, Truth on the Market (August 19, 2010),

One of Dodd-Frank’s major gifts to lawyers is Section 913(g), titled “authority to establish a fiduciary duty for brokers and dealers.” The section authorizes the SEC to create a standard of conduct for broker-dealers and investment advisers

when providing personalized investment advice about securities to retail customers . . . to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice. In accordance with such rules, any material conflicts of interest shall be disclosed and may be consented to by the customer.

The President’s signature on Dodd-Frank was hardly dry when the SEC requested comment on such rules. It seems the SEC is fixing to impose a fiduciary duty on people who sell securities to customers at arms’ length.

The proposal is controversial. As yesterday’s WSJ reports:

Some in the industry paint a picture of brokers paralyzed by red tape, unable to say anything about a stock or mutual fund without risking punishment for failing to uphold fiduciary duty—particularly if the stock tanks later. * * *

Brokers say they hope regulators will provide clear rules for what is permitted rather than outlining broad principles, which the brokers fear could be too vague.

Consumer advocates on the other hand are pushing the SEC to be aggressive:

[Brokers] are trying to turn the fiduciary duty into a renamed suitability requirement,” said Barbara Roper, director of investor protection at the Consumer Federation of America. “If the SEC went with that approach, it would trash the opportunity we have here.

Does an open-ended fiduciary duty make sense? Other sales people give you “personalized advice” to buy stuff, but we don’t think of them as fiduciaries. Normally we think of fiduciaries as those to whom we’ve delegated control of our property, and who we expect to act selflessly in managing it. Indeed, I’ve written that this is the appropriate definition of a fiduciary.

A big impetus behind this move is that investment advisers are currently subject to a fiduciary duty. So, the reasoning goes, why not also broker-dealers who give investment advice? It would put all these competitors for investment business on the same playing field, and eliminate potential investor confusion about who has duties and who doesn’t.

The problem is that it’s far from clear what a fiduciary duty “to act in the best interest of the customer” would mean for either broker-dealers or investment advisers (whose duty has been only sparsely defined in the cases).

I addressed these problems in Senate testimony last spring on an effort to impose fiduciary duties on investment bankers with criminal penalties. I noted among other things the following questions that imposing a fiduciary duty might pose:

(1) What types of conflicts of interest are permissible (particularly including whether investment bankers can participate in market-making, which inherently involves positions on both sides of the market)?

(2) What types of compensation investment bankers are entitled to earn?

(3) When are contracts waiving fiduciary duties, including those entered into by investment bankers’ sophisticated clients, enforceable?

(4) Is disclosure of conflicts alone sufficient to avoid a fiduciary duty?

(5) What types of information must the fiduciary disclose?

(6) How material must omitted information be to trigger liability?

(7) To whom is the fiduciary duty owed (that is, to the issuers that are the investment bankers’ clients, the issuers’ shareholders, or the market as a whole)?

(8) What are the remedies for breach?

The duty would pose similar questions for broker-dealers and advisers.

In a recent article I discuss the forty years of chaos triggered by the more limited statutory fiduciary duty of mutual fund advisers regarding their compensation, still unresolved by the Supreme Court’s decision in Jones v. Harris. The confusion resulting from an open-ended fiduciary duty could be even worse.

A big problem here is that fiduciary duties are generally the product of state law, where they have been defined in generations of cases with some consistency, at least within states. A brand new federal fiduciary duty would have to be defined in sporadic cases by federal judges (many of whom are former prosecutors with little experience in these matters), and with no clear precedents. This would be a wonderful field day for lawyers, because just about any disappointed customer could have a claim.

Although disappointed customers might get to sue, investors as a whole would not necessarily be helped. Customers may have little idea how much protection they’re actually getting. Also, real fiduciary duties are costly. If customers have to pay a fiduciary tax on every transaction with a broker-dealer or adviser who is rendering advice, they may choose to just rely on their own misguided assumptions about the market and trade through discount brokers.

The best outcome is for the SEC to simply leave the law where it is. But given the SEC’s need to dispel the clouds of failure that surround it, as well as Congress’s explicit request for action in Dodd-Frank, inaction is unlikely.

If it has to do something, the SEC might eschew the general fiduciary approach and decide whether new specific rules are necessary.

Alternatively, the SEC can preserve a distinction between fiduciaries and non-fiduciaries, but define it better. Duties should depend on the role a party plays in a particular relationship, not on the general distinctions between broker-dealers and advisers under the securities laws. Whether the relationship is fiduciary-type depends, as discussed above, on the general delegation of power. Giving “personalized advice” shouldn’t be enough.

So here’s a radical suggestion: why not rely on contract? A fiduciary-type duty should arise in either the broker-dealer or investment adviser situation if and only if the parties agree. The customer would get clear, boldface, disclosures as to whether the adviser or broker dealer is acting as a fiduciary.

In other words, rather than a one size, ill-defined federal duty for all retail securities transactions that many consumers do not want, let the market decide how much advice and help consumers get. Firms have incentives not to regularly cheat and disappoint their customers. If customers are confused about what they’re getting now, it’s because of the current regulation. They will not be made better off by adding a vague fiduciary duty on top of that confusion. Give contracts a chance.