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How to Treat Other People's Money

If you hold a Series 7 and you offer clients mutual funds for their retirement accounts, are you brokering a transaction or are you offering ongoing financial advice? The answer could be in the gray: You may think you are acting as a registered rep, but you may actually be offering something more akin to continuous and comprehensive financial advice. It's an important question, because there is a

If you hold a Series 7 and you offer clients mutual funds for their retirement accounts, are you brokering a transaction or are you offering ongoing financial advice? The answer could be in the gray: You may think you are acting as a registered rep, but you may actually be offering something more akin to continuous and comprehensive financial advice.

It's an important question, because there is a big difference in your legal responsibilities. If you are brokering a deal, you have suitability requirements and the like, but you don't have the fiduciary and conflict-of-interest standards that come with being a registered investment advisor (the Series 65 license). For example, a broker can fulfill his disclosure responsibility in putting his client's retirement money in a given mutual fund by handing over a prospectus. But an RIA must actually spell out the fees and any conflicts of interest he may have in choosing that fund.

So, if you are positioning yourself as a financial advisor and you think you are only acting as a registered rep, you may be considered a fiduciary whether you like it or not. (More registered reps are getting dually licensed, in which case the rep is already regarded by the SEC as a fiduciary. And many reps are in fact adhering to fiduciary standards already.)

The bottom line? Brokers providing investment advice without a proper investment process could end up with legal bulls-eyes strapped to their backs. Indeed, over the last eighteen months, the largest category of investor complaints lodged with the NASD was for breach of fiduciary duties.

Making matters worse, while the concept of a fiduciary is easily construed as putting your clients' interests ahead of you own, the SEC has never stipulated exactly what investment process is the preferred or “prudent” method for achieving that status.

And this haziness has important ramifications, especially if the Pension Security Act (H.R. 1000) passes the Senate as written. The proposed bill adds registered reps to ERISA's list of prudent experts (which now include insurance companies, banks and registered investment advisors).

401(k) in Play

This will allow brokers to pursue defined contribution business. Secondly, the bill would make companies more comfortable in allowing outside financial experts to come in and give personal investment advice to its employees in its 401(k) programs. (Currently, defined contribution plan sponsors typically let fund companies provide “educational” services but not personalized investment advice for fear of lawsuits should an employee lose money.) If the bill passes, this would open up the $1.5 trillion 401(k) world to brokerage firms and RIAs in a big way. (See related story on page 40.)

Adopting fiduciary standards is critical for many reasons, says Don Trone, president of the Foundation for Fiduciary Studies and also the investment counseling industry's representative on the U.S. Department of Labor's ERISA Advisory Council. If you want to attract 401(k) assets, the fine print in ERISA (Employee Retirement Income Securities Act) requires advisors to meet a fiduciary standard of care. Besides, following fiduciary standards is better for the client and helps send a positive message to investors, who grew embittered during the Wall Street conflicts-of-interest meltdown, Trone says.

That said, not every broker needs to transform himself into a fiduciary. If you are operating as a traditional commissioned broker, who recommends stock and bonds to clients, you might not need to change. But if you're providing financial advice on what Trone calls a “comprehensive and continuous basis,” you are acting as a fiduciary whether you want to or not. “The advantage of this industry-specific definition,” Trone says, “is that it is applicable whether a wealth manger is a registered representative or a registered investment advisor, whether he is commission or fee-based and whether he is operating with or without client discretion.”

Broker Benefits

There's also a financial incentive to adopt fiduciary standards. “The brokers who are acting as fiduciaries are getting clients in a big way and the firms know it,” says Steve Winks, founder of the Society of Senior Consultants and publisher of Senior Consultant, a newsletter (

This is not to suggest that adopting all these practices will be a cinch. To help, the Foundation for Fiduciary Studies, which is based in Sewickley, Penn., recently published a handbook, entitled Prudent Investment Practices, that outlines the practices which it believes fiduciaries should be following. (It is available for $30, plus shipping by visiting the Foundation's Web site at Some of the advice is simple and is already a part of any broker's practices. For example, the handbook urges readers to select asset classes that are consistent with a client's identified risk, return and time horizon. And another recommended practice urges advisors to ensure that investments be appropriate for a portfolio's size. For instance, an advisor should determine at what point he shifts from mutual funds to a separate account strategy.

Overall, the Foundation offers 27 bits of advice that fit into one of the seven broad categories noted in the chart on page 53. [The legal work necessary to produce the handbook was undertaken by Reish Luftman McDaniel & Reicher in Los Angeles, which is one of the country's premier ERISA law firms. The firm addressed the legal expectations of investment fiduciaries by examining the legal requirements contained in ERISA, the Uniform Prudent Investor Act and the Uniform Management of Public Employee Retirement Systems Act, which modernized and clarified the rules for investing assets in state, county and municipal retirement plans. What the firm ultimately produced was a companion handbook, Legal Memorandums for Prudent Investment Practices, which can also be obtained through the Foundation.]

Sticking Points

Several of the practices could be especially thorny for registered reps, says Trone. One is practice No. 4.4, which requires due diligence in selecting service providers, including the custodian. So what happens if your broker/dealer isn't the most appropriate custodian for your clients? Practice No. 5.3 could also give some reps fits. It requires that a fiduciary control and account for investment expenses. Specifically, the Foundation recommends an investment advisor should seek the best execution in trading a portfolio's securities. That may mean shopping the trade around, something clearly impossible for wirehouse brokers. What's more, soft dollars should only be expended for brokerage and research for the benefit of the client and should be “reasonable” to the value provided — again, something not under the control of an individual wirehouse broker.

Numerous brokerage firms have already taken notice of the Foundation's efforts and have arranged for educational programs, primarily for top producers. Hilliard Lyons, the Louisville-based broker/dealer, is one of the firms that has taken advantage of Trone's training. John Deglow, the firm's director of wealth strategies, says he appreciates how Trone has codified the fiduciary standards. “He's laid out the different steps so that it's easy to follow and easy to understand,” Deglow says. “If you follow the process, you end up providing a better level of service to the client.” Some of the Foundation's recommended practices, however, have made audience members squirm during presentations. Deglow jokes that his firm's compliance officer, who has kinky hair, walked out of the presentation with straight hair. What she heard about fiduciary obligations within a brokerage firm setting, Deglow says, “scared her to death.”

Even when firms are motivated and engaged, adhering to fiduciary standards will pose some challenges. Some of the technology that would make it easier to adopt the practices is only now being developed. In fact, identifying technologies that can make a fiduciary's life easier is one of the aims of a new high-net-worth initiative led by Winks. Spurred on by the Foundation's efforts, Winks formed a working group of 10 high-profile investment professionals. Where the Foundation provided the breadth of what's necessary to be a model fiduciary, the working group aims to flesh out the specifics of what should constitute the industry's best practices. The members include Jim Pupillo of Smith Barney, who is president of the Association of Professional Investment Consultants; Bob Rowe of Morgan Stanley, an authority on investment policy and investment methodology; Guy Cumbie, the past chairman of the Financial Planning Association; and Harold Evensky, past chairman of the board of governors of the Certified Financial Planner Board of Standards. The group hopes to finish its task sometime this fall.

“It's pretty clear,” Winks predicts, “that if advisors do not have access to the processes and technology to allow them to fulfill fiduciary obligations, they will be up the creek.”

Uniform Fiduciary Standards of Care

Seven steps to designing a “prudent” investment process.

  1. Know standards, laws and trust provisions.

  2. Diversify assets to specific risk/return profile of client.

  3. Prepare investment policy statement.

  4. Use prudent experts (money managers) and document due diligence.

  5. Control and account for investment expenses.

  6. Monitor the activities of the prudent experts.

  7. Avoid conflicts of interest and prohibited transactions.

Source: Foundation for Fiduciary Studies

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