The relationships between financial advisers and their clients are based on trust. When investors hire financial professionals based on their perceived expertise in providing investment advice, investors often believe that these financial advisers are acting in the customers’ best interest. Because financial advisers and their firms receive compensation as commissions or as a percentage of a client’s assets under management, the broker’s self-interest may affect the investment recommendations that are made to the customer. Below is a list of examples that can serve as sources of conflicts of interest for financial professionals:

  • Commissions: A commission is a payment made to the broker as compensation for the sale of an investment. The commission amount may vary among investments. Some investments pay higher commissions than others. Differing commission rates may influence a broker to recommend a product that isn’t necessarily suitable for the customer.
  • Mark-Ups: A mark-up occurs when a brokerage firm maintains an inventory of a particular product. By adding a profit margin or spread on top of the amount they paid for the product, the firm creates additional revenue for itself, which in turn may lead to a higher commission paid to the broker.
  • Mutual-Fund Shelf Space: Historically, mutual fund companies have paid brokerage firms to promote their products over mutual funds offered by other competing mutual fund companies. The payment usually is derived from the 12b-1 fee charged to the investor by the mutual fund companies (A 12b-1 fee is a mutual fund marketing or distribution fee. These fees are usually 0.25–1.0 percent of a fund’s net assets). As a result, brokers are frequently pressured into selling the mutual funds that have “paid to play” with the brokerage fi rm.
  • Wrap Accounts: A wrap account is a type of account in which the brokerage firm delegates the investment decision-making responsibility to a third-party asset manager. Rather than paying the brokerage firm commissions on each transaction, the customer pays a “wrap fee” or a fixed rate, usually a percentage of the value of the assets in the account. Wrap fees charged by the brokerage firm typically range from 1 percent to 2 percent annually. A wrap account is an alternative to commission-based accounts because it may allow the customer to make as many trades as he or she would like without incurring a per-trade cost. For active traders, the wrap account may ultimately save on transaction costs. However, a buy-and-hold investor may end up paying considerably more under a wrap fee arrangement than he or she would under a transaction-based commission payment structure.
  • Margin: A margin account provides a customer with the ability to borrow funds from the broker-dealer that are secured by the assets in the account. This allows the customer to purchase more securities than he or she otherwise would be able to purchase. The broker-dealer charges the customer interest on the borrowed funds. Because the broker can purchase a greater number of securities with the borrowed funds and thereby generate greater commissions, the recommendation to trade on margin may be in conflict with the customer’s best interest and may expose the account to greater risk.
  • Proprietary Funds: Broker-dealers commonly create and promote their own brand of funds. These are referred to as proprietary funds. Typically, these proprietary funds can be sold only by the broker-dealer who created them. Because broker-dealers have an interest in promoting their own brand, brokers may be pressured to recommend the proprietary funds over other funds that may be more suitable for the investor. Additionally, the proprietary funds may offer brokers a different (and better) commission structure than other nonproprietary funds offered by the broker-dealer.

Types Of Financial Professionals

In general, two distinct groups of financial professionals service retail consumer investment accounts—investment advisers and broker- dealers. As the name suggests, investment advisers are companies that are paid to provide investment advice to clients. Individuals who work for investment advisory firms are called investment adviser representatives and their firms are called Registered Investment Advisers (RIAs). Broker-dealers or brokerage firms are companies that engage in the business of buying and selling securities. Unlike investment advisory fi rms, broker-dealers are permitted to have custody over client funds.

Proving Breach-Of-Fiduciary-Duty Claims

Breach-of-fiduciary-duty claims are brought pursuant to federal and state common law. The elements of a breach-of-fiduciary-duty claim are (1) duty, (2) breach of duty, and (3) damages.

Is There a Fiduciary Duty? The determination of whether a fiduciary relationship exists is a fact- driven question. In general, the answer is driven by state common law and is dependent on whether the financial adviser holds a position of trust or confidence. If financial advisers hold themselves out to the public as a fiduciary, state common law principles will dictate that a fiduciary duty exists. This concept is known as the “shingle theory,” a legal theory that stands for the principle that a financial adviser who holds him- or herself out to the public as a trial professional should be held to that standard.

In securities disputes, the legal status of whether an individual is acting as an investment adviser or broker may also impact whether a fiduciary duty exists.

Investment Advisers

Investment advisers manage portfolios for individuals, hedge funds, pension funds, and registered investment companies. They are different from most brokers in that they commonly manage assets in discretionary accounts. A discretionary account is an account where the financial adviser has “discretion” to make investment decisions with- out first getting permission from the client. Most investment advisers charge their clients a fee for investment advisory services based on the amount of the assets under management. Some investment advisers charge by the hour.

The conduct of investment advisers is governed by the Investment Advisers Act of 1940. Section 206 of that act establishes a federal fiduciary standard governing the conduct of advisers. Under section 206 an adviser is prohibited from “employing any device, scheme or artifice to defraud any client or prospective client” and “from engaging in any transaction, practice, or course of business that operates as a fraud or deceit on a client.” An adviser is a fiduciary under the Investment Advisers Act of 1940, and that fiduciary standard applies to the entire relationship with clients and prospective clients. Investment advisers have an affirmative duty to act with utmost good faith and to provide full and fair disclosure of all material facts. Advisers also have a duty to employ reasonable care to avoid misleading their clients and prospective clients. The duty of loyalty also requires advisers to place their client’s interests above their own as well as to make a reasonable investigation to determine that the adviser is not basing recommendations on materially inaccurate or incomplete information.

Broker-Dealers

Broker-dealers are not governed by the Investment Advisers Act of 1940 even though their job duties may include providing investment advice to customers. Even though broker-dealers are not bound by the Investment Advisers Act, they still owe a fiduciary obligation to their customers. Financial advisers and their firms are required to be members of FINRA (Financial Industry Regulatory Authority), which is a self-regulatory organization (SRO) authorized to regulate broker-dealers and their advisers. As such, all financial professionals are subject to a comprehensive set of rules and regulations that govern their conduct and that are designed to promote business practices that protect investors from abuse. These obligations cannot be waived or contracted away. In addition, all broker-dealers and advisers are required to be registered in each state in which they do business, and as a result, are subject to state regulation as well.

Federal, state, and SRO rules and regulations impose fiduciary obligations on brokerage firms and their advisers. The United States Securities and Exchange Commission (SEC) has held that a fiduciary relationship exists between a brokerage firm and its customers. According to the SEC, the common law of agency and the rules of self- regulatory organizations, such as the NASD, give rise to the fiduciary duty owed by brokers. See In re E.F. Hutton & Co., Inc., Exchange Act Release No. 25,887 [1988-89 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 84,303 (July 6, 1988) (“The concept of just and equitable principles of trade embodies basic fi duciary responsibilities. . . .”).

It is well-settled that the fiduciary responsibilities of a broker include

  1. The duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price, and financial prognosis;
  2. The duty to carry out the customer’s orders promptly and in a manner best suited to serve the customer’s interests;
  3. The duty to inform the customer of the risks involved in purchas- ing or selling a particular security;
  4. The duty to refrain from self-dealing;
  5. The duty not to misrepresent any material fact to the transaction; and
  6. The duty to transact business only after receiving authorization from the customer. Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d at 1049, quoting Lieb v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F. Supp. 951, 953 (E.D. Mich. 1978).

This fiduciary duty arises from the trust relationship between the broker and client. The scope of this duty can vary based on the level of influence and control the broker has over the client’s account.

Broker-dealers and their advisers are required by FINRA’s rules to deal fairly with their customers. This duty is derived from the anti- fraud provisions of the federal securities laws. Under these federal laws, broker-dealers and advisers who hold themselves out to the public as investment professionals are held to a higher standard (i.e., the shingle theory).

Investment professionals are also required under FINRA Rule 2010 to “observe high standards of commercial honor and just and equitable principles of trade.” This obligation includes the duties to recommend suitable investments, to engage in fair and balanced communications with the public, to provide timely confirmations of transactions, to pro- vide account statements, to disclose conflicts of interest, to receive fair compensation, and to give customers the opportunity to resolve their disputes through arbitration. SEC Study on Investment Advisers and Broker Dealers (January 2011).

The antifraud provisions of state and federal securities laws prohibit financial professionals from making misrepresentations and omissions in connection with the purchase or sale of securities. Federal and state common law differs in regard to whether there is a common law fiduciary duty between the broker and investor. Under federal and state common law, courts generally have found that broker-dealers owe a fiduciary duty under certain circumstances.

The scope of the fiduciary duty depends on how much discretion and control the firm has over the investment decisions made in customer accounts. Brokerage firms have attempted to limit the scope of their fiduciary duties by making a distinction between nondiscretionary and discretionary accounts.

Federal and state courts have generally held that financial advisers owe a broad fiduciary duty in discretionary accounts. A nondiscretionary account is an account in which the financial professional must obtain approval from the customer prior to making a trade. In this context, courts have looked at the issue of how much control and influence the adviser had over the investment decisions made in the account to determine the extent of the fiduciary duty. In short, the more control and influence the broker has over the investments in a nondiscretionary account, the broader the scope of the fiduciary obligation to the customer.

Defenses To Breach-Of-Fiduciary-Duty Claims

Respondents defend breach-of-fiduciary-duty claims by attempting to negate at least one element of the legal claim (i.e., duty, breach of duty, or damages). If a claimant fails to prove any one of the required elements, the claim fails.

With regard to investment advisers, respondents cannot attack the first element (i.e., whether a fiduciary duty exists) because all investment advisers have a statutory fiduciary duty under the Investment Advisers Act of 1940. Therefore, with regard to investment adviser respondents, they are limited to negating the second and third elements, i.e., breach of duty and damages.

With regard to brokers, under some circumstances, respondents often have a difficult time arguing that they owed no fiduciary duty to the customer because the facts of the case and the broker’s control over the investment decision dictate that a fiduciary duty existed.

With respect to whether an investment adviser or broker breached his or her fiduciary duty or whether the claimant suffered damages, respondents simply attempt to negate the allegations made by the claimant. In many circumstances, disproving allegations requires respondents to hire an expert witness.

If you have experienced investment losses involving possible breach of fiduciary duty, call The Doss Firm for a free consultation at (770) 578-1314.