Trust But Verify: The Legal Duties of Broker-Dealers in the Financial System, Part Two

Posted in: Business Law

The first column, dealing with the duties of broker dealers, set the stage for defining fiduciaries and the rationale for their duties. This second part of the column deals with the legal duties of broker-dealers, and their ambiguous status.

First, we visit the use of words. Financial securities are often called “products” and securities servicers are named “industry.” Arguably, these words are dangerously misleading and confusing.

Second, we consider the main services which brokers offer to clients: trading in securities, usually holding for the clients the acquired securities, and the price money for sold securities. Therefore, brokers act as (1) agents in trading securities, and in most cases as (2) custodians of the investors’ securities and/or money.

Third, we deal with the legal status of broker dealers “sales talk” used to attract customers, which is often laced with “advice.” We discuss the duties of experts whom non-experts must trust and on whom they must rely. We distinguish here the legal category of contract from the category of fiduciary and suggest that brokers are fiduciaries when they give advice. In light of these distinctions we list the regulations of broker dealers under the self-regulatory organization FINRA; the Department of Labor, which regulates sale of pensions; and the Securities and Exchange Commission, which regulates the securities markets.

Just as medicines and their sellers are regulated to validate the trust of the buyers in the applicability of the medicines to the buyers, so are the advisers and sellers of securities regulated to ensure the investors’ trust in their advice regarding the investments in the securities Choice, pricing, risk, and trading. As past securities market crashes have taught us, these markets’ existence depend on investors’ trust. Trust on experts substitutes for investors’ lack of expertise. To reduce the cost of investors’ trust, the law regulates the securities market intermediaries and advisers.

Fourth we deal with the service of brokers. Brokers earn with trading, not mere advice. “Sales talk–advice” offers potential buyers something which they cannot evaluate. The call to require brokers to be trustworthy is arising with the millions of retirees who lack expertise to manage their pension securities. Managers and advisers of pension are regulated by law, enforced by the Department of Labor. Brokers have been fighting a rule imposing additional duties towards investors-retirees for years (currently successfully). Our issue here is: Why, and to what extent, should brokers’ “sales talk” be classified and regulated as fiduciaries’ “advice”?

In conclusion: How should this dilemma be resolved?

Part One. The importance of words and names

Words and names are important; they can reflect true substance or mislead. Some broker-dealers, advisers, and others may use the word “products” to represent securities and those who offer financial services are described as an “industry.” Arguably securities are not products, although some disagree.

Unlike products, securities are promises or obligations, even though securities can be transferred. In contrast, “products” are things that have an independent existence, whether or not created from other different things. In essence products have a separate existence from their creator or creators—the producers as well as from their components.

Securities are promises to pay, which are created and produced by a promising parties. In contrast, a product is separate from its producer, regardless of whether the product is sold or kept by the producer. Further, a product may be owned by its producer yet has an existence of its own– severed and separated from its producer, regardless of whether it is sold, kept, or given as a gift. In contrast, securities cannot exist without a promisor.

In sum, even though brokers, managers, investment advisers, and boards of directors are often called and referred to as an “industry,” they are not an industry. They produce nothing. They offer services involving the management of other people’s entitlements and money. “Service” is the correct word. Service disappears with its performance. The servicers’ obligations usually reflect the power that is entrusted to them in order to enable them to perform their services, as well as the degree of verification or trust that they invoke. Service is not products and neither are the securities.

1. Money managers and corporate directors offer services. Mutual fund directors offer services. They have duties to protect the interests of the corporate shareholders from violations by the advisers who manage the funds. Judicial supervision of these directors depends on the degree and nature of the directors’ legal power and the power they actually exercise over other people’s money.

2. Mutual funds do not have an operational staff. Rather, they contract with an adviser who provides the funds with all that they need to function. The nature of these services is not very different from those of internal corporate managers. The difference is mostly in the ability of the directors (of the funds) to supervise the advisers. In fact, the law has expanded the fund directors’ ability to supervise, to some extent. Nonetheless, the adviser has great influence over the board of the investment company. Thus, the adviser rules the mutual funds and may even chair the fund’s board. Fund directors may serve on the boards of many funds managed by the adviser.

3. It is the adviser and its acquired power that is regulated. Most advisers view their service as a business, and have public shareholders who press for highest returns from managing the funds. The fact that the funds have a board of directors does not limit the adviser’s power over the funds’ investors’ money. So let us use the appropriate words. Advisers offer services. Boards of funds offer services. They owe duties to the funds and indirectly to their investors to serve and protect the investors’ interests. The relationships are services not products.

Part Two: The brokers’ legal duties to investors and potential investors: “sales talk” or “advice”?

1. Why regulate broker dealers?

Brokers offer investors investments and trading in securities. Because many investors know little about securities trading, brokers’ “sales talk” includes “advice,” sometimes laced with the words: “trust me.” Two general legal categories are involved in this case: contract and fiduciary. Contracts are enforced when each party can fend for itself. “Fiduciary duties” are enforced when one party is far more knowledgeable than the other and represents itself as expert on whom the other party may rely.

2. Brokers are agents.

Agents’ powers can range from highly controlled and easily supervised activities, to highly discretionary and impossible to supervise services. For example, a house cleaning person may be under the supervision of the owner with little discretion in performing the service. But brokerage, investment management, legal, and medical services cannot be tightly controlled because control requires expertise and time commitment, which is precisely what most investors/clients/patients in these situations don’t have.

3. The balance between trusting and verifying depends on the client/entrustor’s need to trust and their ability to verify.

We must trust a surgeon to perform an operation more than we need to trust a physician who merely provides prospective advice about the surgery, in large part because the latter physician’s advice is still subject to our final decision. But if we discover that the physician was negligent we will avoid returning to seek his or her help.

There are situations in which the investors are driven by self-conflicting interests. For example, employees seek high return investments of their pension fund but not investments in a competitor of their own employer company. Pension high returns will conflict with the employees’ need for stable employment.

Trusting and trustworthiness are not dictated by law alone. Their balance is affected by the society’s culture–a social habit: a “knee-jerk” reaction.

Trustworthiness can be deteriorated by weak law enforcement, and by justifications for dishonest behavior: “The trusting-people are greedy. They might cheat if they only had the chance; therefore, cheating them first is a defensive action. Besides: “Everyone does it. Therefore, we must do it too. Otherwise we will be the losers.”

4. The following are three definitions of broker-dealers’ duties.

The differences between these definitions may explain the reasons for the past years’ heated and enormously costly conflict about broker-dealers’ advisory duties to their clients.

  1. The SEC’s Regulation Best Interest: In April 2018 the Securities and Exchange Commission (SEC) proposed Regulation Best Interest requiring broker-dealers to act in the “best interest” of retail customers when recommending trades in securities. This rule does not expressly focus on the brokers’ conflicting of interest with those of the clients, although conflicts are the core issue.
  2. FINRA’s Suitability Test: FINRA, the self-regulator of broker-dealers, imposes on brokers a duty to offer clients “suitable” investments. “Suitability” can mean “suitable” to the client investors’ personal circumstances and financial needs, the client’s current investments, or a combination of the client’s personal and financial situations. Even though the client’s personal and financial situations are related, suitability seems to focus on the client’s portfolio. Even though both may have changed, the focus seems to be on the changes in the portfolio, which may require more regulation and supervision of the expert salespersons and their advice.
  3. Department of Labor—Best interest: The Department of Labor’s rule, which has been vacated by what might be a final court decision, is understood to impose on brokers a duty of serving the “best interest” of the clients. These words seem to focus on similar tests as the suitability of the portfolio. However, the rule raises the weight of the clients’ needs and interests and avoidance of brokers’ conflicts of interests. Yet, why does the rule seem to be a revolutionary change in the current law? Why did it bring about years of fighting in the courts and the Labor Department? Where is the difference that was worth this fight?

It seems that “best interest” raises the issue of the brokers’ conflicting interests with those of the clients. Conflicts of interest are a crucial aspect of fiduciary law. The broker must be expert in trading and give expert performance.. If they offer the clients advice, the advice must be in the best interest of the client. Yet, suitable advice to the client may not necessarily be in the best interest of the client. Furthermore, the term “best interest” signals low or perhaps lack of conflicting interests with those of the clients.

Where is the difference that was worth this costly fight? It leads to a fiduciary duty to act in the clients’ best interest. Thus, if the broker can acquire two securities, both of which are suitable to the client and one is better or less expensive for the client than the other, yet brings fewer rewards to the broker, the broker must recommend or advise the latter, even though it would pay less to him or her.

It is important to note also that the road to dishonesty can be slippery. One small dishonest act can lead to another, For example, Ponzi schemes have been around for a very long time. Even former US President Ulysses Grant was a victim to such a scheme in 1884. The plans appear around the world. Con artists can be talented and able psychopaths, and their methods differ in details but not in design. And their victims’ weaknesses seem to follow a pattern as well.

Part Four. What does the Future Hold?

Recently, attention to broker-dealers’ duties has risen dramatically. For almost five years the Department of Labor negotiated with the representatives of broker-dealers a rule regulating their duties with respect to retirees’ pension funds. The criticisms of the rule were carried out in various courts, and the last decision, in which the Department of Labor rule was held to be unauthorized, was hailed as a great victory by the broker-dealers and their representatives. The Supreme Court has not yet had its say. And various states may still attempt to impose stricter rules on “sales talk” by broker-dealers.

On April 18, 2018, the Securities and Exchange proposal was criticized by Commissioner Kara M. Stein. Nothing could better explain the weakness of the proposal. It highlights the failure of the rule to meet the needs of change. I may also answer the following question: Why are the broker-dealers fighting so hard to avoid fiduciary duties?

Brokerage will be more lucrative free of the rule’s limitations. There are institutions that offer brokerage services as part of their broader services and fight for sales talk as advice. Perhaps the large number of older people whose savings are in securities may trigger this approach as well.

However, some advisers and brokers are reconsidering the position. They may have concluded that being fiduciaries in offering advice in “the best interests of the client” is good business and sales strategy. In addition, the long conflict over the DOL’s rule has been advertised sufficiently to draw investors’ attention and create a business benefit in advertising a commitment to “best interests.”

Moreover, even though investors may not understand investment and trades in securities, they may begin to understand trusted advisers’ duties. Scandals involving financial services, (e.g., Wells Fargo Bank brokerage), may have attracted attention to this issue. Perhaps, regardless of the fact that the DOL rule did not survive in the courts, and that broker-dealers’ “trust me” will continue to entice vulnerable investors, the trend may be shifting and investors may begin to ask questions reflecting greater knowledge and understanding:

  1. How much do you, the broker, make if I accept your advice?
  2. Who else pays you for this transaction?
  3. Is another comparable investment cost me less?
  4. How about investing in a more stable investment that does not require continuous trading?

Retirement planners should be careful. Negative publicity can undermine their attractiveness and destroy their enterprise. Negative and positive publicity can effectively modify retirees’ behavior. And once trust turns into mistrust or doubt, it might be hard to turn it around. Interestingly, content marketing can help advisers to attract clients. Content marketing should be used in conjunction with other methods of gaining prospective clients, writes Fred Barstein. He argues that content marketing helps with the three sale elements – content, credibility, and trust.

Trust does not mean gullibility. Investors should have a role to play in their relationships with their broker. Investors might tell themselves:

  • I am not here just to become rich. I am here to make sure that I would not lose what I have. I must plan long-term, because the investment will be my only source of income, on which I will rely for food and shelter.
  • How much would these trades cost me? I focus not on one trade, but on continuous trades, for example, for five years. Loss in day one (including cost) will lose all possible income in the years to come).
  • I should become, and have been, risk-averse. Money will come little by little but I have to be sure of it. Sorry Mr. Broker-Dealer: I cannot and will not gamble for more; I will not take the risk for less, and will not pay you for the excitement and continuous trading.

Perhaps what the Department of Labor, the courts, the lawyers, and even the Securities and Exchange Commission will not achieve, or at least not fully, the news and retirees themselves would achieve: suitable, low-risk investments at low cost for services.

Brokers might learn as well. They should begin to be concerned with moral behavior. A society cannot develop and prosper unless its members can rely on each other. We must trust the people we work with, experts, the managements of the corporations, the securities they issue, and in which we invest. And generally, experts on whom we rely.

However, reliance is only part of the healthy social relationships. After all, reliance involves risks. We might entrust too much power to the people on whom we rely. Therefore, a healthy society creates a balance.

The balance between trusting and verifying depends on the need to trust and ability to verify. We may have to trust a money manager more than the adviser who leaves to us the final decision and execution of our transactions.

Trusting and trustworthiness are not dictated by law alone. Their balance is affected by the society’s culture. Culture can be viewed as a social habit. It prescribes actions or abstentions that are automatic “knee-jerk” reactions, rather than the results of evaluation and debate. There are things we simply do not do in a certain culture that may be done even if prohibited in another culture. It may well be that investors and the general public have been taught about the issues involving trusting but verifying brokers’ “sales talk.”

These lessons could have been taught by the long-term and expensive “war,” which broker-dealers have been waging to avoid being classified as advisers and being imposed with fiduciary duties to their clients. This fight may not have offered investors information about the fine legal issues that are involved. However, the publicity of the brokers’ fight for freedom from the duty to be legally trustworthy and the inability of the investors to verify may drive to publicity about the issues of “trust but verify” and raise the awareness of the investors. They might begin to ask the brokers: “Are you giving me advice as fiduciary? Please sign your answer.” The questions and answers may become binding in law.

This conclusion is not based on iron-clad evidence. But there are signs that may mature into a fundamental change in the investors’ inquiry and demand to verify trust in their brokers. This demand may, without much attention to court cases and rules, lead to some brokers’ voluntary adoption of fiduciary duties. Their sales-talk accompanied by “trust me” will hopefully be trustworthy.

Posted in: Business Law

Tags: Legal, Securities

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