ROGER MUNS

Laws, rules and regulations shape the relationship of clients with their Registered Investment Advisors and Stockbrokers. Let’s explore this further.

Registered Investment Advisors (RIAs)
They are regulated by the Investment Advisors Act of 1940, which mandates that RIAs owe their clients a fiduciary duty. This duty is one of loyalty and utmost good faith — obligating the RIA to act in the best interest of the client and to place the client’s interest ahead of its own. RIAs must avoid all conflicts of interest. However, if a conflict of interest is clearly disclosed to and approved by the client, then the RIA may proceed. Investment Advisors must fully inform clients in writing of their education, business experience, any disciplinary history, fee schedules and other pertinent information. Laws, rules and regulations for RIAs are very client-friendly.

The most common arrangements between the RIA and his/her client are as follows: RIAs, with considerable investment knowledge and experience, typically manage clients’ financial assets on a discretionary basis. This means the RIA is solely responsible for identifying and successfully implementing an investment strategy that fits the client’s goals and objectives. (Management can be done on a nondiscretionary basis, where the client makes all trading decisions.) The fee is commonly based solely on the value of the assets under management. If the client’s financial assets go up in value, then fees go up. If the value goes down, fees go down. The RIA receives no additional compensation — none! To help the value of the client’s financial assets grow, the RIA seeks to minimize or avoid (a) commissions and other trading costs, (b) mutual funds with sales charges, distribution fees and high expenses, and (c) all other investment products that are too costly and/or unwise. The financial interests of clients and RIAs are truly aligned.

Broker-Dealers (Stockbrokers)
They are regulated by the Securities Exchange Act of 1934, Securities Act of 1933, and rules and regulations of NASD and various exchanges. Stockbrokers do not owe customers a fiduciary duty and cannot manage their accounts on a discretionary basis. Congress intended the broker-customer relationship to be on a transaction by transaction basis. Stockbrokers are generally guided by the requirement to “know their customer” so recommendations are suitable for customers. They only give advice that is “incidental” to the brokerage services and cannot receive special compensation for the delivery of investment advice unless they are a Registered Investment Advisor.

In 1995, the SEC created a group called the Tully Commission headed by Dan Tully, CEO of Merrill Lynch. It proposed the “Merrill Lynch” rule to allow stockbrokers to bundle together trade execution, investment advice and custodial services and charge a fee based on the value of the financial assets. This was only permitted when (a) the stockbroker did not exercise discretion, (b) investment advice was “incidental” to the brokerage service and (c) all documents clearly stated “Your account is a brokerage account, and not an advisory account. Please ask us questions … including the extent of our obligations to disclose conflicts of interest, and to act in your best interest. We are paid by you and by people who compensate us based upon what you buy.” The SEC felt the fee-based brokerage program eliminated the incentive for stockbrokers to churn accounts and make multiple, risky trades.

Regardless, the Merrill Lynch rule was overturned in March 2007 by the DC Court of Appeals. Now, stockbrokers must decide by October 2007 to manage fee-based accounts under the stringent rules of the Investment Advisors Act of 1940 or convert them back to traditional broker accounts.

Conclusion
The legal obligations of stockbrokers are minimal compared to those of RIAs. Yet, stockbrokers have substantially more instances of litigation and subsequent liability than RIAs. Therefore, stockbrokers may be reluctant to accept greater legal exposures borne by RIAs. The stockbrokers who converted clients to fee-based brokerage accounts for all the right reasons must make a decision: become a full-fledged registered investment advisor or switch their clients back to the standard brokerage account with its conflicts of interest.

Managing accounts as a Registered Investment Advisor with no conflicts of interest is ideal for clients. RIAs’ investment decisions are not influenced by conflicts of interest and their financial interest are aligned. Under law, a client’s RIA has a fiduciary duty and must be loyal by putting clients’ interest ahead of their own, deal fairly and take reasonable care.

Next month: Country Bias.


November 2007