People who give financial and investment advice are governed under two very different standards: the suitability standard and the fiduciary standard.
What’s the difference?
The fiduciary standard requires an advisor like us to put your interests ahead of all others when giving advice and recommendations; that is, to determine what is best for you under all circumstances. The Advisors of Eugenias Advisory Group operate as a fiduciary.
The suitability standard merely means that the broker, agent or person (often calling him/herself a financial or investment advisor) must determine that a recommendation would be suitable to your needs.
What’s the difference in real life? Suppose you need advice on developing a sound investment portfolio. Under the fiduciary standard, an advisor is required to look for what he or she believes to be the best possible mix of investment categories—which may be mutual funds that invest in foreign and domestic stocks and bonds, and in stocks of different sizes and flavors. Then the fiduciary standard would go further, and require the advisor to research the track records, manager tenure and annual costs of different mutual funds, to identify those he or she believes will provide the best return with the least risk and expense.
If you talk with a broker, agent or someone who has a sales license, then this person would be governed by the suitability standard, which means that he or she would (once again) determine that you need mutual funds. However, the similarity stops there. Someone who provides recommendations under a suitability standard would be legally free to recommend the mutual funds that pay him or her the highest commissions, and that money has to come from somewhere, right? It comes out of your pocket in the form of high fees that the fund takes out of your investment over the course of the year. There is no suitability requirement that the funds be well managed, or that the portfolio be diversified among different asset classes—or (and this is the important point) in your best interests. Chances are the recommendation will be in the broker or agent’s best interests.
How did we get two different standards for people giving advice? Most people don’t realize that there are actually two different laws in the legal code, one governing brokers, the other governing advisors.
The Investment Company Act of 1934 was passed after the sales horrors leading up to the 1929 stock market crash, as a way to protect investing consumers. It required, for the first time, all brokers and dealers (someone managing a broker) to pass certain licenses before they would be allowed to sell investment products. Some of those licenses are Series 6, 63, 7, 24 and 65—the licenses that young stockbrokers pass before they hit the phones and start dialing for dollars.
The focus of this Act is to require a stockbroker to have a reasonable basis for their recommendations – that the recommendations be “suitable." That means the broker has to know something about your situation and something about whatever he or she is recommending, so that the security relates in some way to the customer’s need.
Is this not a low standard? It is, but at the time, it represented a huge improvement over the stock touts who plied Wall Street in the days leading up to 1929. They would recommend this or that stock almost at random in order to secure a generous commission, sometimes recommending that the same stock be bought and sold multiple times over the course of a year in order to generate the maximum amount of trading commissions. Consider the 1934 Act as an effort to require brokers to be somewhat professional when they sell investment products.
The problem? Nobody envisioned the situation we have today, when many sales agents and brokers pose as if they are advisors, as persons who have expertise to guide you forward financially, when they are actually trying to sell you a product that you may or may not need, and which will certainly not be the best option available.
What about the other standard?
Congress passed the 1940 Investment Advisers Act in order to differentiate (this is in the minutes of the Congressional debate on the bill) “honest advisers” from “stock touts.” The idea was to create rules for real professionals to follow when they gave advice.
The Act also led to the creation of the Security and Exchange Commission (SEC). The SEC mandates that if you hold yourself out as giving advice, then you must register as an Investment Advisor.
The Investment Adviser’s Act of 1940 requires that the companies that register as a Registered Investment Advisor and the Investment Advisor Representatives that work for those firms, to embrace a fundamental duty to care to the client. A later Supreme Court ruling affirmed that this is a fiduciary duty owed to clients of a Registered Investment Advisor.
By virtue of this law, we came under the fiduciary standard when we registered with the SEC as an Advisor.
In putting our client’s interest first. We embrace our fiduciary standard of care and we, of course, look at suitability, too. However, as a fiduciary we must operate in a fashion the same as a lawyer, doctor, or accountant. As a fiduciary we are required to eliminate—and where we cannot eliminate, we must disclose—all conflicts of interest that might incline us — consciously or unconsciously — to render advice that is not in your best interests.
To read about the fiduciary requirements under the Investment Adviser’s Act of 1940 go to http://www.sec.gov/divisions/investment/advoverview.htm.
You can find information about this and other information including how to find out if your Broker or Advisor has any regulatory issues or sanctions by visiting www.sec.gov