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RIAs: Held to a Higher Standard

May 31, 2018

BY BILL LEE, DIRECTOR OF MARKETING OPERATIONS

The investing public is bombarded with conflicting messages from a variety of financial services firms, making it difficult to sort things out among the noise.  Especially targeted by these firms are wealthy individuals, or “HNWs” (industry jargon for people of High Net Worth, typically defined as those with investible assets exceeding $1-5 million).  They are prized targets of stockbrokers, registered investment advisers (RIAs), and wealth management firms alike.

But for the investors themselves, how can they sort through the various messages – and motivations behind them – to better understand where they should be seeking investment advice?  We think we can provide some assistance by helping to compare and contrast the various financial services players in an effort to highlight important differences, not the least of which are the different standards-of-care to which they are held.

FIRST:  BACKGROUND, BROKER-DEALERS

I feel qualified to write on this topic, having spent years of my Financial Services career on both sides of the Broker-Dealer/RIA divide.  I was an institutional stockbroker for the first 20 years, the brokerage world being known as the “Sell Side”.  There I executed transactions for my institutional customers (such as investment advisers and pension funds) for which I earned commissions.  My customers’ goal was to get their trades executed while paying as little in transactional costs as they could, while MY goal as their broker was to give the best possible service in exchange for as much in commissions as I could get away with charging:  Free market capitalism in its purest form.  Each party, broker and customer, had their own interests to consider first and foremost – we were in some respects in competition with each other, with a “zero-sum” mentality.   It doesn’t require much imagination to see the various conflicts of interest for the broker inherent in such a situation.  It was only when our common interests sufficiently overlapped that any business was transacted.  A useful analogy might be the car salesman and the customer negotiating the purchase of vehicle – each haggles to achieve the best deal from their perspective and in light of their own objectives.

The Securities & Exchange Commission (SEC) defines a broker as someone who acts as an agent for someone else, and a dealer as someone who acts as a principal for their own account. An example of an activity a dealer may carry out is selling a bond out of his or her firm’s inventory of fixed income securities. The primary income for a broker-dealer are commissions earned from making transactions for the underlying customer.  Broker-dealers are held to a standard of “suitability”, and are required only to have a reasonable basis to believe a transaction is suitable for a customer at the time it is recommended.  Takeaway:  Broker-dealers are most involved in trading securities for commissions.

NEXT:  REGISTERED INVESTMENT ADVISERS (RIAs)

My more recent experience in the Financial Services arena has been on the “Buy Side”, working over the past six years on the staff of two Registered Investment Advisers (RIAs)[1].  Rather than being transactional in nature, RIAs work with clients based on a pre-agreed fee schedule and their clients’ interests come above their own – by law.  Investment advisers are bound to a fiduciary standard that emanates from the Investment Advisers Act of 1940.  It consists of a duty of loyalty and care, and simply means that the advisor must act in the best interest of his or her client – much as other professions such as attorneys and CPAs. They can be regulated by the SEC or state securities regulators, both of which hold advisors to a fiduciary standard that requires them to put their client’s interests above their own. The fiduciary standard is more demanding and exceeds the suitability standard of broker-dealers.

The work RIAs like MONTAG perform for their clients predominantly focuses upon portfolio management for the long-term.  Based upon careful consultation with each client we prepare written Investment Objectives incorporating individual client circumstances.  Transactions occur as a part of the portfolio management process, but they are not the focus because they are typically not tied to the adviser’s compensation as is primarily the case with stockbrokers.

A fiduciary must also disclose any conflicts of interest.  Per regulations by the SEC and most states, RIAs like MONTAG must maintain an up-to-date disclosure document, provide it to a client prior to or at the time of engagement and notify the client of  any material changes to the disclosures at least annually.  The document is known as a “Form ADV Brochure.”  MONTAG Chief Compliance Officer Stacey Godwin did a great job last week explaining all about ADV’s.  (Revisit the ADV post here)Takeaway:  RIAs are most involved in managing portfolios of securities for a fee.

In the chart below, we have endeavored to compare and contrast the roles of Broker-Dealers and RIAs:

        Broker-Dealers         (“Stockbrokers”)

Registered Investment Advisers (“RIAs”—Like MONTAG)

Standard-of-Care:

“Suitability”

At the time of the recommendation, broker has a reasonable basis to believe a security is suitable for the customer

“Fiduciary”

The client’s best interests must come first and foremost, not the firm’s interests; firm owes a duty of loyalty to the client

Typical Minimum Relationship Size ($ Assets):

None, or low

Varies, often $1 million or more

Regulatory Oversight:

FINRA, States, SEC, Exchanges

SEC (States for smallest firms)

Method of Compensation:

Typically COMMISSIONS on Transactions (Trades)

Typically FEES on Assets Under Management (AUM)

Discretionary Authority[2]

Typically not

Typically yes

Credentials:

Typically FINRA licenses to sell securities

Often CFA or CFP® and/or may need to earn a license issued by the States

Disclosure:

Investors can search a public database for disciplinary history

Investors can search a public database for disciplinary history; in addition, RIAs provide clients a comprehensive Brochure, including fee schedule, disciplinary history, conflicts of interest, professional profiles, etc.

Nature of Relationship:

Salesperson/Customer

Adviser/Client

Loyalty Owed to Whom?

Salespersons are Agents who have a duty to their firm as Principal

Adviser’s duty to their client, first and foremost

Custodian:

Typically the brokerage firm or a related entity houses account(s)

RIAs may use an independent or affiliated custodian, and often offer choices of custodians to clients


FINALLY:  RULES IN LIMBO, STAY TUNED!

All of the above applies to past and current regulatory standards.  At the risk of confusing the issue, we should point out that things have been in a state of flux in recent years, starting with an Obama-era move by the Department of Labor (DOL) requiring retirement plan advisors to offer only advice that’s in the best interest of plan participants regardless of fees or commissions—and holding plan sponsors liable for seeing that they do.  These proposed rules have become caught up in court, with rulings against the DOL.  It now appears that the Trump-era DOL is effectively abandoning the implementation effort by ceasing its appeals.

Meanwhile the SEC has picked up the cause for its own part, and they published proposed rules in the Federal Register just last month.  Like the DOL before them, the aim is to make Broker-Dealers held to the higher standard of putting their clients’ interests ahead of their own. (Although this sounds like a fiduciary standard, the proposed rules combine elements of the current suitability standard with a few fiduciary-like elements including conflicts disclosures.)  The resistance is certain to be strong, as vested interests on Wall Street fight to keep from being held to higher standards – so the outcome is far from certain.

Those interested in knowing the details of the proposed rule can visit the Federal Register Text Here (an excellent sleep-aid for others!).  We’re in the 90-day comment period at present, slated to end in early August.  So we won’t know for a while whether — or when, if ever — broker-dealers will finally be held to the same higher Fiduciary standard that RIAs meet.  Either way we don’t expect any change in MONTAG’s case, as we’ve met the higher fiduciary standard as an RIA for over 35 years and counting.

[1] I joined MONTAG in 2017, upon the sale of the prior RIA firm where I worked to an Atlanta-area buyer in connection with the founder’s retirement.
[2] The authority to implement trades without individual customer/client approval

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