CBA Record Jan-Feb 2021
Advisors Advisors—also known as “registered investment advisors” or “RIAs”—provide investment advice, as the name implies. Their work is more comprehensive than simply attempting to sell stock to inves- tors. Advisors are compensated through a periodic “fee,” as explained below. For example, an advisor may direct customers to divide their invested assets among big companies, small companies, bonds, and a money market account. The advisor should continue to monitor the portfolio and recommend changes in the allocation as the investor approaches retirement. At the federal level, an advisor’s conduct is governed primarily by the Advisers Act of 1940, 15 U.S.C § 80b-1 et seq. At the state level, advisors are governed primarily by the Illinois Securities Law of 1953, 815 ILCS 5/1, et seq. and the common law. Federal law requires investment advisers to abide by a fiduciary duty, described by the U.S. Supreme Court as “an affirmative duty of utmost good faith, and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading . . . clients.” SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180, 194 (1963). Advisors must register with the SEC if they manage $100 million or more in client assets. If they manage assets below this threshold, they must register with a state authority, absent an exemption. In Illinois, the Securities Department, within the Office of the Secretary of State, handles the registration of advisors. Some Overlap in Duties Although not held to a fiduciary standard, brokers do have some obligations. They have long been subject to a “suitability” standard of care, which requires them to “have a reasonable basis to believe that the recommended transaction or investment strategy . . . is suitable for the customer.” FINRA Rule 2111(a). Many investor advo- cates argue that this suitability standard is weak. Merely because an investment is “suitable” does not mean it is the “best” or even close to the best—a standard more akin to the fiduciary standard for advisors.
An individual broker must be “spon- sored” by a registered brokerage firm. The brokerage firm registers them with a “self- regulatory organization” or “SRO,” the most common of which is the Financial Industry Regulatory Authority (FINRA). FINRA is quasi-governmental; the SEC has deputized it to regulate brokers. At the federal level, a broker’s conduct is governed primarily by the Securities Exchange Act of 1934, 15 U.S.C. § 78a, et seq., and FINRA rules. At the state level, a broker’s conduct is governed primarily by the Illinois Securities Law of 1953, 815 ILCS 5/1, et seq. , and the common law. As noted, brokers historically have been treated as arms-length salespeople, not trusted advisors. Brokers proposed trades in stocks but bought or sold at the direction of their customer. The customer could take or leave the terms offered. The broker’s duty of good faith was limited to executing the particular transaction that their customer accepted (or requested) at the best price and as quickly and securely as possible. Other than good faith in trade execution, the broker owed no fiduciary duties, unless they were holding themselves out as something more than a mere broker. Exceptions arose, and brokers exposed themselves to a fiduciary standard if they created an agency relationship that “involve[d] a special trust and confidence” in the broker. For example, brokers who convinced their clients to turn over deci- sion-making to the broker via a “discretion- ary” account may involve a fiduciary duty. See, e.g., Martin v. Heinold Commodities, Inc. , 117 Ill. 2d 67, 79 (1987). It was generally assumed that brokers would not take over accounts or provide customers with broader, trusted invest- ment advice, such as recommendations for a lifelong investment plan. Indeed, federal law effectively prohibits brokers from doing so. Under the federal law, any investment advice by the broker must be without “special compensation” (i.e., free) and “solely incidental” to the service of buying and selling securities for the cus- tomer. Otherwise, the broker must register as an advisor and be subject to the fiduciary standard. See XY Planning Network, LLC v. SEC , 963 F.3d 244, 248 (2d Cir. 2020).
In any event, both brokers and advisors have long been required to consider the investor’s “investment profile,” including age, net worth, financial circumstances, risk tolerance, and investment time hori- zon. But brokers could argue that a wider swath of investments were “suitable” or “reasonable” for the profile, even if they knew of a better option, whereas advisors were typically expected to select something that they thought was “best” (or close to it), particularly if they knew about the better option. Additional Designations Additional designations exist that are unrelated to regulatory registration. They include “Certified Financial Planner,” “Chartered Financial Analysts,” “Char- tered Financial Consultant” and “Personal Financial Specialists.” These designations indicate training and vetting by private industry boards. Designations such as these, however, do not replace registration as a broker or advisor and, without more, do not alter the standard of care. Compensation: Brokers vs. Advisors Brokers generally charge “commissions” on trades. Advisors generally charge periodic “fees” on total assets under management. Consider an investor with just over $100,000 who buys 1,000 shares of stock at $100 per share. A broker might charge $0.05 per share, or $50 ($.05 x 1,000 shares = $50) for the whole trade. A “discount” broker might charge a flat commission—say, $5—for the entire trade. A “full service” broker who provides research along with the trade might charge half a percent of the dollar amount of the trade, or $500 (.005 x $100,000 = $500). After the commission on the trade, the broker receives no more compensation. If the investor holds onto the shares for five years, the broker receives no further compensation. If the investor at some point sells the shares, the broker will charge another commission on the sale. By contrast, an advisor typically will not charge a commission on trades. Instead, the advisor charges a “fee” on an annual or quarterly basis. Sometimes it is called a “wrap fee” because the fee “wraps” all CBA RECORD 27
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