SEC needs to protect investors, not brokers
UNION-TRIBUNE
April 17, 2005
During a time when the Nazis were bombing Paris and Allied forces were frantically fleeing across the English Channel, securities regulators in the United States were preoccupied with more prosaic financial concerns.
Thanks to their efforts, Congress passed the landmark Investment Advisers Act of 1940, which has been protecting investors like you and me ever since. The document is simple in its most basic premise. The legislation requires that investment advisers always act in their client's best interests.
While it might seem sad to think that legislation was necessary to mandate this, we're revisiting this historical act today because of who was not originally covered by its language. The act notably exempted traditional stockbrokers, who simply traded securities for commissions. At the time, the exemption made sense because brokers have historically been sales reps, not financial advisers.
But as anybody who has watched the recent commercials for brokerage houses knows, brokers aren't just pushing stock tips anymore. In fact, many of them would probably rather staple their mouths shut than admit they are stockbrokers. Instead, they are calling themselves financial consultants, financial advisers and wealth managers.
It's probably better for investors that many brokers have evolved beyond simply handling sales transactions in return for commissions, but that evolution has triggered a debate that's centered on this question: If a stockbroker is behaving like an investment adviser, shouldn't he or she be subject to the same higher standards that any financial planner must observe?
While the answer is certainly obvious to me and probably everybody reading this column, regulators have been agonizing over the issue for many years. In 1999, the SEC floated a proposed rule that would have extended the exemption to brokers, who had started charging fees instead of relying strictly on commissions. Brokers began switching to fee-based pricing when the increasing popularity of do-it-yourself discount brokerage firms caused commissions to plummet.
But as stockbrokers started repositioning their business to offer customers advice, they encountered a potential problem. The 1940 act states that any advice brokers provide to their clients has to be be "solely incidental" to their jobs as sales reps. Since 1940, the SEC had never defined what "solely incidental" meant or enforced the provision. Wall Street, however, pretty much defined the term to mean anything goes. In television commercials, magazine spreads, and marketing materials, stockbrokers promise to help investors meet their retirement goals, plan wisely for college and find ingenious ways to afford a second home. Does that sound like "solely incidental" advice to you?
The SEC must have been swamped with other really important things because five years later, the controversial decision to expand the exemption to include brokers charging fees – presumably for advice – still hadn't made it on the commission's agenda for approval.
I can understand how these things happen. Sometimes the laundry piles up at our house for an awfully long time. But plenty of staunch critics of the expanded broker exemption, including the Consumer Federation of America, which represents roughly 300 nonprofit organizations, the AARP and financial planning groups, weren't so understanding. And for good reason. Paradoxically, the SEC's inaction, procrastination, or whatever you want to call it, meant that Wall Street, for all these years, could act as if the proposed rule was in effect.
Clearly peeved, the Financial Planning Association, which represents certified financial planners and other professionals, filed a lawsuit last year to force the SEC to vote on the revised exemption. That got the government's attention. The commission solicited a new round of comments from interested parties on the proposed exemption. Only one major brokerage firm, T.D. Waterhouse, sided with consumer groups, who wanted the expanded exemption hacked to itty bitty pieces.
Which brings me to what happened a few days ago in Washington, D.C. The SEC commissioners unanimously voted to allow brokers to keep their prized exemption, but there were some changes. The SEC now says that a broker must register as an investment adviser if he or she maintains discretionary control over an account or engages in financial planning. That's a good thing, but at the same time the SEC only encouraged the anything-goes interpretation of that pesky "solely incidental" standard. The SEC now says financial advice will be considered solely incidental if it is in "in connection with and reasonably related to brokerages services." That could mean just about anything.
While planting a fat kiss on the brokerage industry's cheek, the SEC did acknowledge that investors are terribly confused about the differences between an investment adviser and a broker. No kidding. Consequently, the SEC announced that it would pay for an outside study to determine whether brokers and investment advisers should abide by the same regulations now that we're in the 21st century. So the SEC hasn't ruled out future changes. Thank goodness.
If you're on the verge of dispelling this controversy as a big stink about inconsequential wording, it's not. The regulatory language is important for many reasons. For instance, if you have a brokerage account with a stockbroker, you need to understand that the interests of the brokerage firm come before yours. This means that a broker, for example, could recommend a mutual fund, not because it's excellent, but because his brokerage firm is getting extra cash from the fund company to promote it. A broker could also urge that his client invest in a variable annuity because he could win a free vacation if he meets a sales quota.
Certainly not all brokers are going to conduct themselves in this way, but the point is, it's perfectly legal. In fact, even if a broker wanted to act as a fiduciary for his or her brokerage clients (and plenty would like to), the firm would forbid it. By the way, you won't necessarily ever find out about the behind-the-curtain investment motivations because the disclosures for brokers' conflicts of interest are weak. In contrast, investment advisers are prevented from behaving this way and their disclosure requirements are much stricter. Investment advisers are fiduciaries, who by law, are required to act strictly in their client's best interests.
When you're shopping for a new refrigerator at Sears and the salesperson is praising the latest Kenmore side-by-side model, you may naturally wonder if this refrigerator is really better than the Whirlpool or General Electric model displayed on the same aisle. Or is the salesperson just being partial to his employer's brand? Maybe he is, maybe he isn't. It's up to you to decide. If you have a brokerage account, you need to maintain that same sort of skepticism when a broker advises you. Too bad it has to be like that.
Lynn O'Shaughnessy is the author of "The Retirement Bible" and "The Investing Bible." She can be reached at LynnOShaughnessy@cox.net
