Compliance standards taking effect this week
Jerrold Dorfman, a Providence investment adviser, is required to steer his clients toward the lowest-cost and most suitable mutual funds he can find. It’s part of his fiduciary duty under the Investment Advisers Act of 1940, which requires him to put his clients’ financial interests first.
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Brokers at companies such as Merrill Lynch often provide similar advice to their clients, but unlike Dorfman, they are not required to put their clients’ interests before their own.
Rather, they are held to a suitability standard that mandates they sell people appropriate investments, which, for example, may carry higher fees than other equally fitting options.
Registered investment advisers long have been irked by that disparity. But now, to their dismay, an amendment to the Advisers Act that goes into effect Jan. 31 has officially sanctioned brokers offering advisory services without adhering to the act – with some conditions.
The rules, which the Securities and Exchange Commission adopted last year, exempt brokers from the Advisers Act regardless of whether they receive fee-based or commission-based compensation, as long as:
*They provide advice in a nondiscretionary form, meaning they do not have the power to invest the client’s funds.
*Their advice is given in the normal course of brokerage services.
*They disclose to clients that they are in a brokerage account.
The SEC says the rules were created after the line between brokers and advisers had become blurry.
Under the 1940 law, investment advisers are required to place the interests of their clients before their own; in exchange, most are compensated with an hourly fee or payment based on amount of assets they manage for their clients.
Brokers, on the other hand, are compensated through commissions on trades, so their earnings depend on the number of transactions they execute. Under the Securities Exchange Act of 1934, brokers have no fiduciary duty toward clients, but are just required to sell them “suitable” investments.
“For example,” said Dorfman, “it may be suitable for you to buy a large-cap index fund and [brokers] can put you into an index fund – but they don’t have to look into whether their fund is more cost-effective.”
For years, brokerage firms have blurred the line between brokers and advisers by calling their representatives “advisers,” even though they operate as brokers, charging commissions, markups and markdowns on trades. The new rules say this is acceptable compensation, providing brokers disclose this to clients.
The SEC adopted the rules last April, having originally proposed the Advisers Act amendments, called “Certain Broker-Dealers Deemed Not To Be Investment Advisers,” in 1999. Opposition led the SEC to extend the compliance date from last Oct. 24 to Jan. 31.
Three industry groups – the American Council of Life Insurers, the Securities Industry Association and the Financial Services Institute – filed separate petitions to extend the deadline to April 2006. They argued that their members needed more time to institute the required organizational changes to comply with the rules.
In fact, the securities association and insurers’ group have said that to comply with the rules – specifically those dealing with what exempts broker-dealers from the Advisers Act – requires member organizations to train their staff and update company data.
Mark Herr, a spokesman for Merrill Lynch, which calls its brokers “financial advisers,” said the firm does not allow reporters to interview its advisers or in-house compliance officers (whose work is most impacted by the upcoming standards). Instead, the firm released the following statement about the new SEC rules:
“We are working diligently to comply with the requirements of the rule and to make sure that clients fully understand the nature of our brokerage services and our financial plans.”
Meanwhile, investment advisers continue to fight against the new rule.
In July 2004, the Financial Services Institute, which represents the interests of advisers, filed a lawsuit against the SEC in a U.S. court of appeals. The pending suit argues that brokers with fee-based accounts should be regulated under the Advisers Act.
Dorfman said he would like to see brokers, especially those holding themselves out as advisers, to be held to the same standards. “They should be playing by the same rules,” he said, “they should be held to the same fiduciary standard as registered investment advisers are.”
