Selling Advice and Creating Expectations: Why Brokers Should Be Fiduciaries

• Publication year: 2021

SELLING ADVICE AND CREATING EXPECTATIONS: WHY BROKERS SHOULD BE FIDUCIARIES

Arthur B. Laby(fn*)

Abstract: Investors face a dizzying array of choices regarding where to invest their funds and increasingly rely on experts for advice. Most advice about securities is provided by investment advisers or broker-dealers, legal categories with little meaning to most people but fraught with consequences. Although advisers and brokers often perform the same function, advisers are subject to a strict fiduciary standard to act in their clients' best interest while brokers are subject to a less rigorous standard of suitability to ensure that their recommendations are suitable for customers. In 2010, the Dodd-Frank Act authorized the U.S. Securities and Exchange Commission (SEC) to harmonize the regulation of advisers and brokers and impose a fiduciary duty on brokers that give advice. This Article is about whether the SEC should exercise its authority. After explaining the historical context of the debate over a fiduciary standard, the Article critiques common arguments for a fiduciary duty, concluding that they are incomplete and do not alone justify a change in the law. The Article then puts forth a better justification, based on the reasonable expectations of investors. Reasonable expectations arise from brokers marketing their services as advisory and using titles, such as financial advisor and financial consultant. Reasonable expectations provide a stronger justification for a fiduciary standard than the conventional arguments.

I. DISPARATE REGULATION OF INVESTMENT ADVISERS AND BROKER-DEALERS THAT PROVIDE ADVICE IS ROOTED IN HISTORY ................................................................ 716

A. Early State Regulation of Brokers and Advisers Was Minimal .............................................................................. 716

B. Federal Securities Regulation Was First Enacted During the Great Depression .......................................................... 718

1. Broker-Dealer Regulation Was Enacted in 1934 .......... 718

2. Investment Adviser Regulation Was Enacted in 1940 . 720

3. Certain Broker-Dealers Were Excluded from the Advisers Act ................................................................. 723

C. The Regulation of Brokers and Advisers Differs ............... 724

D. Changes in the Securities Industry Disrupted the Coherency of Broker and Adviser Regulation ................... 726

1. The Elimination of Fixed Commissions Resulted in Two-Tier Pricing .......................................................... 727

2. Certain Broker-Dealers Began to Charge Asset-Based Fees .................................................................... 728

3. The Focus of Brokerage Services Moved from Execution to Advice ..................................................... 729

E. The SEC Addressed Changes in Compensation Through an Administrative Rule ....................................................... 731

F. The Obama Administration and Congress Sought a Political Solution to Changes in the Securities Industry .... 733

II. CONVENTIONAL ARGUMENTS THAT SUPPORT A FIDUCIARY DUTY FOR BROKERS ARE INADEQUATE ...... 736

A. Investor Confusion Is an Insufficient Basis to Support a Fiduciary Standard ............................................................. 737

1. Advocates of a Fiduciary Standard Claim Investor Confusion Justifies Regulatory Harmonization ............ 737

2. Investor Confusion Is Not a Compelling Argument for Regulatory Harmonization ...................................... 739

B. Inconsistent Standards Are an Insufficient Basis to Support Regulatory Harmonization .................................... 741

1. Advocates of a Fiduciary Duty Claim Inconsistent Standards Justify Regulatory Harmonization ............... 741

2. Existence of Inconsistent Standards Is Not a Compelling Argument for Regulatory Harmonization .............................................................. 742

C. Ineffective Standards Are an Insufficient Basis to Support a Fiduciary Obligation .......................................... 743

1. Advocates of a Fiduciary Duty Claim that Ineffective Standards Justify Regulatory Harmonization .............................................................. 743

2. Existence of Ineffective Standards Is Not a Compelling Argument for Regulatory Harmonization .............................................................. 744

D. Purported Economic Benefits Are an Insufficient Basis to Support a Fiduciary Standard ......................................... 746

1. Advocates of a Fiduciary Standard Claim Economic Benefits Justify Regulatory Harmonization .................. 746

2. Economic Benefits of a Fiduciary Standard Do Not Necessarily Outweigh Costs ......................................... 748

E. Empirical Expectations Are an Insufficient Basis to Support a Fiduciary Standard ............................................. 750

1. Advocates of a Fiduciary Standard Claim that Investor Expectations Justify Regulatory Harmonization .............................................................. 750

2. Empirical Expectations Do Not Themselves Justify a Fiduciary Duty for Brokers ........................................... 751

III. REASONABLE EXPECTATIONS JUSTIFY A FIDUCIARY OBLIGATION FOR BROKER-DEALERS .................................. 753

A. Broker-Dealers Employ Advertisements and Titles Promoting the Advisory Function ...................................... 754

B. Broker Advertising Creates Reasonable Expectations to Receive Advice ................................................................... 758

1. Reasonable Expectations Can Ground a Right ............. 758

2. Several Criteria Can Determine Reasonable Expectations ................................................................. 759

a. The Contract Is One Basis for Determining Reasonable Expectations ........................................ 760

b. Empirical Expectations Form Another Basis for Determining Reasonable Expectations .................. 760

c. Normative Expectations Are a Further Basis for Determining Reasonable Expectations .................. 762

3. Advertisements Induce Customers to Engage Broker-Dealer Firms ..................................................... 764

a. Advertisements Are Important to Customers ......... 764

b. Advertisements Are Intended to Be Believed ........ 765

C. Brokers' Claim to Provide Advice Results in a Fiduciary Promise ............................................................................... 766

1. Advising Another Implies Advising Impartially .......... 767

2. A Claim of Impartiality Results in a Fiduciary Duty ... 768

D. Regulatory and Common Law Consequences Follow from Investors' Reasonable Expectations of a Fiduciary Obligation ........................................................................... 771

1. Reasonable Expectations Support a New Fiduciary Duty Under the Dodd-Frank Act .................................. 772

2. Reasonable Expectations Support a Common Law Fiduciary Duty for Broker-Dealers That Provide Advice ........................................................................... 773

CONCLUSION .................................................................................... 775

INTRODUCTION

Consider an individual who, with a modest amount of money to invest, visits a financial services professional to decide where to place the funds. The investor will face a dizzying array of choices and must decide among stocks, bonds, mutual funds, annuities, commodities, insurance policies, and other investment products. Because most people are unable to make investment decisions on their own, the individual will likely turn to the professional sitting across the desk for help. The professional's legal status under the federal securities laws will be of little importance to the investor. "Just tell me what to do," is his likely sentiment.

The professional across the desk is typically a representative of either a broker-dealer or an investment adviser-legal forms that are meaningless to most people but fraught with consequences. A broker-dealer engages in numerous activities, such as executing trades, selling securities, lending money to investors to invest on margin, maintaining custody of funds and securities, and advising about investment decisions.(fn1) When recommending securities, a broker-dealer owes a duty of suitability, which is a duty to ensure that an investment recommendation or strategy is suitable for a particular individual at a particular time.(fn2) An investment adviser, by contrast, engages primarily in advisory activities, including portfolio selection, asset allocation, portfolio management, selecting and monitoring other advisers, and financial planning.(fn3) An adviser owes a fiduciary duty to act in an investor's best interest, which includes a duty to avoid, or at least to disclose, material conflicts of interest.(fn4)

There is a significant difference between a suitability standard and a fiduciary standard of conduct.(fn5) Assume the investor in the example above would like to buy shares of a mutual fund that focuses on global technology companies. Assume further that the professional advising the investor is aware...