Trust but Verify: The Legal Duties of Broker-Dealers in the Financial System

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Posted in: Business Law

Introduction

The proverb “trust but verify” was used by President Ronald Reagan when he met with Russia’s President Gorbachev. This statement did not please the Russian president, perhaps because this saying is a Russian expression. The usual reaction to this proverb is a chuckle because it is self-contradictory. If you trust you need not verify. Trust is based on the assumption that the statements or promises or actions are true and reliable. If you seek to verify, it strongly suggests that you do not trust; you do not believe, or are not sure that the statements or actions or promises are true. After all, one of the reasons for trusting is to avoid the need to verify and the attendant costs.

And yet, intentionally or unintentionally, actions and words by one party may induce baseless or  unreasonable trust. That is especially so if the actions or words are not true but seem to be true. Failure of the other party to verify may result from its inability to verify or perhaps because verification may be embarrassing or too costly.

This article examines the legal status of securities brokers’ “advice” or “sales talk,” which is offered to investors and potential investors. The meaning of “sales talk” is evaluated in light of the proverb “trust but verify.” Should most, if not all, brokers’ “sales talk” be trusted without verification? If not, are investors able to verify? And if not, should brokers be imposed with a duty to be trusted? In other words, should brokers be bound by fiduciary duties? And what is the extent of these duties?

In addition, words can be used in different contexts for different purposes, sending different messages, and bringing different results upon which people might act to their benefit or detriment. Different contexts may include the law, business, and advertising. The messages can be trustworthy or misleading. They may have been made by mistake or may be purposely designed to persuade or defraud. Therefore, one specific rule does not fit all.

Part One of this article outlines the definition of fiduciaries, their duties and the rationale for these duties.

Part Two will deal with words related to fiduciary duties of broker-dealers and with the ambiguities regarding these duties. For example: What difference does it make if “securities” are described as “products,” and brokers, managers, advisers and mutual funds in the financial system are called an “industry”? What legal difference does it make if “sales talk” is called “advice”? What if this “advice” is motivated by interests that conflict with those of the advisee? In sum, what is the impact of the use of these words?

Part Three of this article will list the words used to describe broker-dealers’ duties towards their clients. What if the broker-dealers’ services involve “advice” as compared to or contrasted with “sales talk”? This part will summarizes the legal consequences of the various classification of broker-dealers’ talk to clients and potential clients.

Part Four of the article will conclude with a speculation about the future of the broker-dealers fiduciary duties. The broker-dealers war against their fiduciary duties did not go unnoticed and may result in the best protection by the investors themselves.

Part One. Who Is a Fiduciary?

1. The definition of Fiduciaries. Introduction

Generally speaking, fiduciaries have relationships with those who rely on them (entrustors). Consequently, depending on the nature and extent of the reliance, fiduciaries are imposed with duties that require them to (i) act with care, and (ii) act for the benefit of the entrustors and avoid conflicts with their own interests. To be sure, fiduciaries may refuse to deal with potential clients if their relationships with the clients involve such burdens. But once they do accept investors generally, the question is: Under what conditions do broker-dealers owe fiduciary duties? What precisely are their duties? What are the justifications for imposing these duties on broker-dealers?

The definition of a fiduciary is flexible but its roots are quite deep and fixed. If Party A deals with Party B, and Party B can take care of his or her interests, then Party A need not bear fiduciary duties. Instead both parties are subject to contract law and may not engage in behavior prohibited by that law, aimed at protecting people who are either too young or too old or are being forced to sign the contract.  That is because contract deals with parties that can take care of its own interests in usual circumstances, and if these parties are negligent in doing so they should bear the consequents of their negligence. The burden of taking care of every contract party would be too great and reduce people’s socially desirable interactions.

However, fiduciary law deals with situations in which verification undermines other socially desirable objectives. The question is the extent to which a party could verify the other party’s activities that might affect its interests adversely, and protect its own. The difference between ability and inability to protect one’s interests is not clear-cut. In all cases, however, one can point to the law’s purpose of smoothing and encouraging such relationships.

2. What is the purpose of fiduciary law?

The general purpose of fiduciary law is to encourage people to deal with each other to the benefit of both parties, as well as the economic and financial health of society. The law encourages people to specialize and provide necessary services to others who lack the knowledge and experience of a specialist. In addition, law encourages others to make use of the special services, in which they are not experts. The specialists can gain from offering their services to many non-specialists, and the persons who receive the specialists’ services gain the benefits from these services, although at a price. In sum, the system aims at enriching both the participants and society.

By definition, these encouraged relationships involve parties with unequal knowledge and abilities. Experts offer high levels of expertise to all. However, unequal levels of expertise create an unequal power relationship. Specialists know more, and may be able to hide abuses of those who rely on them. Not surprisingly, those in power might be tempted to use their knowledge and abilities for their own benefits, Thus, the law interferes to protect the people who are vulnerable to the experts. We call these vulnerable people “entrustors.”

3. Abuse of trust can vary

How is abuse of trust identified and evaluated? The evaluation and measure of abuse of trust is clear in significant abuses of entrusted powers. If a broker, who is a fiduciary as an agent, misappropriates the investor’s money, the broker commits the crime of theft. However, if a broker receives very high commissions from a securities seller and strongly recommends these securities as an investment to a buying client, despite that these securities might not be the right investment or the least expensive investment for the client, this behavior is usually not criminal. Yet, the client is unable to evaluate the benefits and risks posed by these securities.

In such a case, if the broker is deemed to be the client’s fiduciary, the broker may be liable to the client for breach of his duties. In that case the broker may not recommend the securities unless the recommendation is accompanied by a statement that the broker has received or will receive payment for the sale of the securities from another party. In other words, the broker should disclose that he or she has interests that conflict with those of the buyer-client.

In contrast, under contract law, the broker is not liable to the client except: if the broker commits fraud or duress, the client is clearly unable to understand what the transaction is about, or the client is under undue influence. These are the contract law conditions, when the client has greater ability to fend for himself or herself.

The difficulty arises when the interests of the fiduciaries the entrustors are unclear and the measure of abuse of fiduciary power is vague. So what triggers fiduciary duties of brokers to their investors? Are inducing or tempting words sufficient to create a fiduciary relationship by the speaker? Is reliance by entrustors necessary to impose limits on the self-interested actions of the fiduciary?

In this article the discussion about fiduciary issues and the law focuses on the status of broker-dealers and the nature of their relationships with their clients. These issues have become increasingly important with the retirement of the “baby boomers.” Many retirees have received their pension funds and are unable to deal with the complexity of their financial investments, taxation, and preparation of transferring the rest of their estates after their death. They lack the necessary expertise and must depend on others to answer and manage the problems. Most importantly, for many, the pension their only source of livelihood.

Therefore, many of these investors need advice and guidance. Brokers have greater expertise in risk evaluation than most of their client investors. To be sure, investors may hope for high profits, and may not be as focused on risk. Broker-dealers may recommend and emphasize the bright side—the profits, which might sell more securities, rather than the emphasis on the risk of potential losses, which might deter the sales, even though risk is a crucial aspect of investment for some investors. As fiduciaries, brokers should warn their advisee-clients about risk, but that warning may conflict with the brokers’ interests by reducing the number of trades and consequently their commissions. Hence being a fiduciary may cost brokers who offer advice their trading commissions. If they recommend securities that might bring profits but also losses, they might violate their duties. Further, if they recommend continuous trading, their clients may not be able to calculate the cost of the trading, and follow the recommendation, to the clients’ disadvantage. As fiduciaries, brokers may be required to avoid or reduce such a disadvantage, but at a cost to the brokers’ own interests.

For brokers, retirees are attractive clients. Retirees often have significant amounts of money, and many, if not most, need advice, especially if they did not manage their savings before retirement. Many of these retirees do not understand or know how to manage their retirement money and investments. The correct management of their pension funds, however, is not a mere private matter. It is of crucial importance to the nation. On the national level, if the retirees lose their savings, they will not be able to replenish them by work or any other means. The country may witness a large number of older beggars asking for shelter, food, and protection. Therefore, to avoid the possible impoverishment of millions of retirees, the law ought to protect the pensions of these retirees.

In sum: Should broker-dealers be trustworthy to their investors? Yes. That is, unless the investors can “fend” for themselves. “Fending for themselves” may mean that investors have sufficient knowledge, practice, and independence to make an informed or perhaps even a professional decision regarding their investments. Even so, if, for any reason, investors distrust their broker-dealers, investors are likely to protect their investment decisions from advice driven by conflicting interests. In such a case the system will suffer: the broker-dealers will suffer and the investor will suffer as well, but perhaps suffer the least.

4. Two fundamental policy issues arise in connection with the status of broker-dealers as fiduciaries.

(a) Should the law require brokers to be trustworthy to investors? After all, they are salespersons who earn a living by selling and trading in securities on behalf of their clients. So what if the brokers say “trust me” to a potential buyer! In fact, these are the words salespersons use when trying to convince a potential buyer. However, securities are not products the buyers can easily evaluate themselves. Many, if not most, investors must trust the brokers, to evaluate for them the securities they offer.

(b) Should broker-dealers present themselves as the experts, which they usually are, as compared with their usual clients, and ask to be trusted? And if they do, should they be trustworthy, and committed to the investors’ interests, as they say they are?

5. The answers to these questions may depend in part on the situation and ability of each the investors.

(a) Is the investor unsophisticated in financial matters, like a person who must decide on whether to sign a document in the language he does not know?

(b) Is the investor sufficiently sophisticated to make the investment decision himself or to evaluate the suggestion and offer of the broker-dealer? Is a sophisticated investor entitled to the protection to which the unsophisticated investor is or should be entitled?

In sum: Can the investor fend for himself and make the investment decision? The investor’s ability or inability to determine the value of the broker’s proposals is not clear-cut and may depend on many circumstances. This test would exclude not only investors who are not knowledgeable in financial matters, but also investors who are tempted to follow the broker-dealer’s advice based on added benefits that the broker-dealer may offer the investor, such as free lunch.

A broker who says “trust me” or “rely on me” or signifies that his interests are aligned with those of the client should be deemed a fiduciary. After all, the broker-dealer chose to obligate himself. No one forced him to do that. These words should bind the speaker.  By saying “trust me” or similar words the broker presents himself as trustworthy. By asking about the investor’s situation, his or her family, age, and other conditions that may determine the ability of the investor to fend for themselves and discern sales pitch from advice, the status of the broker should be determined.

6. Consenting to a Fiduciary’s Conflicts of Interests

Assuming a fiduciary’s interests conflict with the client’s interests, how would the fiduciary receive the beneficiary’s consent?

  • Is it enough for the fiduciary to tell the beneficiary: “By the way, I have conflicts of interest; do you agree to my services?”
  • What precisely should the conflicted fiduciary or potential fiduciary say to a potential entrustor?
  • Does it matter if the investor is sufficiently sophisticated to make the investment decision himself or to evaluate the suggestion and offer of the broker-dealer?
  • How should the fiduciary make the disclosure in terms that are understandable to an unsophisticated entrustor and obtain truly informed consent?

A general guide to all the answers relates to the purpose of the disclosure.

The purpose of the disclosure is:

(i) To make the recipient of the disclosure understand that the proposed fiduciary is conflicted, and therefore cannot be fully and totally relied upon to serve the interest of the client-entrustor and (ii) To help the entrustor to determine to what extent, if at all, could he or she rely on the proposed fiduciary? Therefore, the disclosed information must provide the entrustor with sufficient information to make a decision whether, and to what extent, he or she should trust the proposed or current fiduciary.

Having understood the issue, the enrustor’s consent or refusal to consent to the conflicting interest and following the broker’s advice should be clearly given. No formula can be established for the fiduciary on how to disclose conflicts of interest. Both the parties and the conflict are too varied. Perhaps the only guides about the degree and substance of disclosure are two combined tests:

  1. “If I (the fiduciary) were the entrustor, what type of information and in what form should the information given to me (as the entrustor) in order to ensure that I understand the issue? If the information is insufficient or if the entrustor is unable to understand the issues, then the third question is: who should be brought into the discussion to represent the entrustor’s understanding?
  2. “Relating to the substance of the entrustor’s decision: “If I (the fiduciary) were an entrustor, what would I want to know about the fiduciary, and what verification would I demand to ensure that the conflict does not undermine my trust in the fiduciary?” If the fiduciary does not answer these questions or does not answer the questions freely and honestly, and tells me (the entrustor) a story that is muddled or imprecise, then such a disclosure would not be binding, and should expose the fiduciary to liability.

Another question that should be asked and answered in this context, is:

  • What triggers the fiduciary’s liability? The absence of disclosure about the fiduciary’s conflicts of interest, or the possible future violation of his fiduciary duty?

I assume that the liability is triggered by the absence of full disclosure. However, the weight of the liability would depend on whether the fiduciary proceeded to violate his or her fiduciary duties as a result of the conflict of interests, and whether these violations harmed the entrustors’ interests. After all, the real problem is the broker dealers’ conflicts of interests. Disclosure is a way to relieve the fiduciary from liability. Disclosure is not a separate independent duty. It is more a measure of relief from a duty, provided the beneficiary’s consent addresses the conflicts and agrees to them. Thus, if the entrustor did not receive full disclosure of the conflict or did not fully understand the conflict and its implications, he cannot give meaningful consent and no relief should be granted to the fiduciary. Disclosure involves two related items: The amount that the client pays and the risk that the client bears. A one-time transaction and payment is one thing, a continuous trading is another. Risk level cannot be specifically evaluated but the broker knows more about it, and must explain to the client.

Finally, here is a suggestion: In light of the long and tortuous fight of brokers against brokers’ exposure to fiduciary duties (notwithstanding their “trust me” suggestions and language) it might be desirable to impose on the employers of these brokers a duty to ensure their brokers’ fiduciary behavior. After all, these employers may have more influence and power to teach the brokers how fiduciaries should behave and avoid the kind of employers’ pressures that might induce brokers to violate their fiduciary duties.

6. A Securities and Exchange Commission official stated that brokers SHOULD be fiduciaries because they, like surgeons, know more than the client, including the sophisticated client. After all, securities investment is their business.

A comparison of a broker to a surgeon may be informative. A surgeon who gives advice to another surgeon may not be responsible for bad advice unless he or she plans to benefit from the advice and the advice is not honestly given on the merits. However, a surgeon who is drunk while operating on another surgeon will probably lose his license for life, whether or not the patient-surgeon happened to survive. And yet after all, the client-surgeon was not hurt! Besides, the client was an expert about surgery.

The answer is: no surgeon should ever drink when operating, even if the patient is a surgeon. In the case of a broker-dealer the customer may be exposed to loss of investment money. If the broker holds the money, and if the investors did not give the broker express, specific directives, even a sophisticated investor may be hurt. The broker should be held liable.

Similarly, the test is whether the client can fend for himself AND whether the broker presents himself as a trusted person. If he does, he should be what he is purporting to be. That is because the investors, whether experts or not, are relaxed by these words. They supervise and check less, and trust more. Besides, like the surgeon, the broker holds the client’s money. So he or she is a fiduciary as an agent.

One example which relates to the Securities and Exchange Commission is the practice of the Chairpersons of the agency to put their securities in a “blind trust.” The trustee of the trust must hold the securities of the Chairperson and may not receive direction from the Chairperson with respect to their securities holdings. The Chairperson of the SEC is a fiduciary of the country. The Chairperson holds the power and information not for his or her benefit but for the benefit of the country. Thus, the Chairperson hold the information as a fiduciary and may not misappropriate it for their use.

For the same reason, every person who works in the agency must provide information about his securities holdings, and any securities transaction of such a person must be approved by a higher authority. Thus, when I worked at the agency and had an obligation before I joined it to testify in connection with a securities matter that involved interpretation of securities acts, I sought and received the Commission’s exemption. That was a preventive measure to ensure that the knowledge that I acquired by working in the agency was not involved in my testimony, as it was not.

The Advisers Act of 1940 excludes from the definition of an adviser brokers who were not paid for their advice.

It was recognized that brokers usually use an advisory language to induce clients to trade, and that unless the brokers are paid for the advice the client may not expect and should not expect the broker to give advice as a fiduciary. Thus, arguably a salesperson who says “trust me” does not intend to put himself or herself in the position of an investment adviser under the 1940 Act. That may have been the right solution years ago, in the 1940s. Today, the language “trust me” may be inappropriate. The sales language of “trust me” may apply to the sale of shoes. It does not, and should not, freely apply to securities, which are sold to people whose life depends on the securities and who do not know nor understand the complexities of securities. They cannot try on the investments the way they try on shoes and determine whether they are comfortable.

Today, the interpretation of the word “trust me” might be different than in the past. Perhaps today, when a broker says: “trust me,” it means: “I am trustworthy.” It means “I have (i) both expertise to offer and (ii) no conflicting interests to yours, and (iii) if I do, I will disclose these conflicts and ask for your consent to continue and serve you.” A broker should not be permitted to pose as a fiduciary and then deny the duties of a trusted fiduciary. A broker should decide whether to state: “I am a broker and will not give you advice.” This broker is not a fiduciary with respect to advice, but he is a fiduciary as an agent subject to the regulation of brokers. Or he would say: “I am a broker who gives you free advice.” This broker is a fiduciary, just as a doctor who treats a person who fainted without his consent is a fiduciary.