Fiduciary responsibility and investment professionals

RSM McGladrey
When selecting a professional to assist with investment decisions, most investors would probably agree that it makes sense to compare the products and services offered by different providers.
When evaluating offerings of investment advisors with those of broker-dealers, investors should also consider the variations between the two types of providers, as well as the differences between the duties imposed on those professionals under the regulatory framework that governs the investment industry.
Both investment advisors and broker-dealers owe clients certain responsibilities, including the duty to refrain from engaging in securities fraud. However, investment advisors have additional fiduciary responsibilities that do not apply to broker-dealers in most situations. According to a report released Jan. 3, 2008 by the RAND Corporation[1], many investors do not fully understand the differences between investment advisors and broker-dealers, including distinctions concerning the level and types of responsibility these providers owe to clients. In fact, clients who have employed financial professionals for years may not understand these distinctions.
The following information provides a brief overview of some of the key differences between the services offered by, and responsibilities of, registered investment advisors and broker-dealers.
What is a fiduciary?
Simply put, a fiduciary is someone acting in a position of trust on behalf of, or for the benefit of, a third party. Where investments are concerned, fiduciary responsibility can be defined as the responsibility to act solely with clients’ investment goals and interests in mind, free from direct or indirect conflicts of interest. While registered investment advisors are categorically considered fiduciaries for their clients, broker-dealers, in most cases, are not held to the same standard.
Investment advisors vs. broker-dealers
Investment advisors and broker-dealers operate under separate and distinct rules. Investment advisor representatives are registered with the Securities and Exchange Commission or individual states. Broker-dealer representatives must register with the state(s) in which they conduct business and with the Financial Industry Regulatory Authority, which is the self-regulatory organization for broker-dealers and issues its own rules for its registrants. In order to obtain either of these registrations, individuals must meet certain qualification requirements, although those qualification requirements differ and depend on the type of registration being sought.
From a compensation standpoint, investment advisors are typically compensated under a fee-based model – with project-based fees payable for services such as financial planning – and asset-based fees payable for investment advice and management. Investment advisors usually operate under an advisory services agreement with clients which outlines responsibilities and fees. Basically, this type of compensation arrangement means the advisor isn’t compensated at different levels based on the selected asset classes or investments, and therefore has no built-in incentive to recommend one investment over another. In comparison, broker-dealer compensation has traditionally been transaction-based, with commissions based on the dollar amount of a particular transaction payable to the broker-dealer and possibly to the registered representative(s) involved in the transaction.
As mentioned, registered investment advisors owe fiduciary obligations to their clients. As fiduciaries, they’re required to inform clients of any conflicts of interest and the procedures used to address those conflicts. Investment advisors are also required to inform clients of all types of compensation, including indirect compensation and any additional compensation they may receive from someone other than a client in connection with providing investment advice. These disclosures are included in Part II of the investment advisor’s registration statement, known as Form ADV — a copy of which must be offered to clients annually.
While broker-dealers are expected to disclose conflicts of interest, there’s no mechanism for a disclosure document specific to the broker-dealer analogous to Part II of Form ADV. Broker-dealers also have a responsibility to ensure that investments are suitable for their clients. However neither broker-dealers nor individual registered representatives have an explicit fiduciary responsibility to act solely with clients’ investment goals and interests in mind, unless the client relationship is discretionary. In a discretionary relationship, the client has authorized the broker to execute transactions on the client’s behalf without consent for each transaction.
When choosing an investment professional, investors should understand whether the provider is an investment advisor or a broker-dealer. Both providers can offer important services to clients and many financial professionals are registered as investment advisor representatives and registered broker-dealer representatives. Investors should always understand in what capacity the investment professional is working, how the professional will be compensated for the service provided and whether the provider has any real or perceived conflicts of interest that could affect the service being offered. If the investment professional is acting as an investment advisor representative, answers to these questions will be found in Part II of the Form ADV.
[1] Hung, Angela, et. al, Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, RAND Corporation Technical Report TR-556-SEC, 2008 Pre-Publication, 132.
Cindy DeRuyter ChFC, CLU, is a compliance associate with RSM McGladrey. For more information, contact her at cindy.deruyter@rsmi.com.