Brokers, astonishingly, have no fiduciary duty to their clients. Maybe they should.

How to protect your pockets.
Jan. 24 2011 7:33 PM

Does Your Broker Love You?

Brokers, astonishingly, have no fiduciary duty to their clients. Maybe they should.

Stock broker. Click image to expand.
Your investment broker is looking out for you, right? Right?

When you talk to your broker about how you should invest your money, it's reasonable to suppose that any advice he offers will be based on a disinterested consideration of your financial needs. After all, if he gave you deliberately bad advice, his reputation would suffer, and he'd lose clients. And surely he bears … what's that legal term? Fiduciary duty. Your broker has a fiduciary duty to give you his best possible advice. Violate that and he'll be in serious legal trouble, right?

Actually, no. As far back as the New Deal, the Securities and Exchange Commission ( created in 1934) has regulated "broker-dealers" less strictly than "investment advisers." For many years that distinction made sense. A broker was a salesman. You rang him up to buy or sell stocks and bonds, not to tell him your life story. An investment adviser, on the other hand, was, well, an adviser. You met with him, discussed your near-term and long-term financial goals, and he helped you work out a strategy. Your investment adviser's loyalty was to you. Your broker's loyalty was to the sale.

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Like a lot of boundaries in the financial world, the one between brokers and investment advisers has evaporated in recent years. Brokers now advise clients about what securities they should buy from them, and investment advisers now buy for their clients securities that they recommend. Ordinary investors (i.e., suckers like you and me) aren't very clear on whether the people who handle their investments are brokers or advisers. That wouldn't especially matter if the two groups bore the same legal responsibility to clients But they don't. Now the Securities and Exchange Commission is arguing that they should.

The 2010 Dodd-Frank financial reform bill  empowered the SEC to impose a uniform fiduciary standard requiring both broker-dealers and investment advisors to "act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser." That standard is already imposed on investment advisers, but brokers operate under a looser standard. Brokers have no fiduciary duty to act in their clients' best interests. Instead, they must adhere to a weaker "suitability standard," which in practical terms means largely that they shouldn't commit outright fraud. It's a good example of what Jacob Hacker and Paul Pierson, in their recent book Winner-Take-All Politics, call "drift": a stupid advantage acquired when the marketplace evolves and the regulatory apparatus doesn't keep up because it's been immobilized by business interests. "The suitability standard for brokers can basically be met by recommending the least suitable of the suitable products," says Barbara Roper, director of investor protection at the Consumer Federation of America.

Why wouldn't your broker want to put you into the best available investments? Because, Roper explained to me, there might be an investment that's almost as good that will earn that broker a higher commission from the investor or a higher administrative fee from the seller. (Investment advisers, by contrast, get paid, by the investor, either a flat fee or an hourly fee or a fixed percentage of the assets they manage.) Or the broker might, for reasons that aren't necessarily clear, favor what attorney Stuart Meissner terms a "one size fits all" investment strategy. Meissner's clients, Claire and Alex Moskvin of West New York, N.J., sold their house in 2006 for $975,000. They told their broker at Wachovia (since purchased by Wells Fargo) that they wanted to invest the money for a year or two and then retrieve it to buy a new house. The Moskvins suggested treasury or municipal bonds, where the principal would be insured. Instead the Wachovia broker steered them into mutual funds. When the market crashed and the Moskvins lost $227,000, they sued. "The defense," Meissner told me, "was basically that [Wachovia] didn't have a fiduciary duty." The case went to arbitration, and the Moskvins won about $90,000, but Meissner believes they would have won much more had Wachovia been statutorily bound to the stricter standard to which the Moskvins assumed, in their ignorance, it already adhered.

Concrete examples like this are, alas, absent from the SEC's new report recommending a uniform fiduciary standard. That allowed two Republican-appointed SEC commissioners to complain in a dissentthat the report needs a "stronger analytical and empirical foundation" for its recommendation. But such cavils won't matter because there's a Democrat in the White House and the necessary legislation has already become law. And anyway, the brokers' trade association is cautiously supportive of the uniform standard. Maybe that's because it would be too embarrassing for the brokers to say out loud that they don't feel like putting clients' financial interests ahead of their own. Till now, though, that's precisely what they've been allowed to do.

Timothy Noah is a former Slate staffer. His  book about income inequality is The Great Divergence.

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