U.S. News

Struggling Over a Rule for Brokers

Tara Siegel Bernard|The New York Times

While most of the debate about financial overhaul legislation has focused on the impact on how big banks do business, one piece that would affect consumers directly has received little public notice: a requirement that stock and insurance brokers act in their customers’ best interest.

And that provision may not make it into the final overhaul plan.

The insurance industry, in particular, has been fighting the requirement. In addition, Senator Tim Johnson, Democrat of South Dakota, is considering whether to recommend a study of the brokerage and adviser industries, a move that consumer advocates say would wipe out the proposed requirement.

Chairman Christopher Dodd, and Sen. Tim Johnson participate in a Senate Banking, Housing and Urban Affairs Committee hearing.
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“The intent of this amendment is not to improve investor protections, but to delay and deflect meaningful reform,” said Barbara Roper, director for investor protection at the Consumer Federation of America.

At issue is whether brokers should be required to put their clients’ interest first — what is known as fiduciary duty. The professionals known as investment advisers already hold to that standard. But brokers at firms like Merrill Lynch and Morgan Stanley Smith Barney , or those who sell variable annuities, are often held to a lesser standard, one that requires them only to steer their clients to investments that are considered “suitable.” Those investments may be lucrative for the broker at the clients’ expense.

Over the years, it has become more difficult for consumers to understand where their advisers’ loyalties lie, especially as the traditional stock-peddling brokers have started to look and act more like financial advisers. The fact that some brokers can wear two hats with the same client — that is, provide advice as a fiduciary in one moment, but recommend only “suitable” investments in the next — only adds to the confusion, experts said.

So as part of the more sweeping effort to overhaul Wall Street, both houses of Congress included measures that would subject brokers to the tougher standard. On the surface, both the brokerage and financial planning industry appear to agree that advisers of all stripes should be subject to a consistent fiduciary standard. But behind the scenes, the groups are divided on how exactly it should work, while the insurance industry is opposed to a fiduciary standard altogether.

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“Brokers would love to be called fiduciaries,” said Tamar Frankel, a professor at Boston University School of Law. “That is not the issue. The issue is what stands behind it.”

The study being considered by Senator Johnson would examine the gaps and overlaps in regulation within the brokerage and adviser industries. Consumer groups say the issue has already been examined, most recently in 2008, when the Securities and Exchange Commission asked the RAND Corporation, a nonprofit organization, to study the business practices of broker-dealers and investment advisers. The study found that investors had trouble distinguishing among industry professionals.

A spokesman for Mr. Johnson said a study was on the table, but that it was still early in the process. “There certainly has been some concern raised on how to appropriately harmonize the fiduciary standard for investment advisers and broker-dealer to eliminate consumer confusion,” Jeff Gohringer, the spokesman, said. “And Senator Johnson is looking for ways to address it.”

The debate over brokers’ responsibility to their clients and how much they have to disclose has been evolving since the Depression, as Congress and the courts have weighed in.

The first efforts to regulate financial professionals came in 1934 and 1940, with first the Securities Exchange Act and then the Investment Advisers Act, which set out rules for brokers and advisers. The advisers were held to the stricter fiduciary standard. But the 1940 law made an exception for brokers: as long as their advice was “solely incidental” to their service as a broker, and they did not receive special compensation for advice, they were not required to act as fiduciaries. Instead, they must provide only “suitable” investments.

“Consumers are generally not aware that there are these different standards,” said Daniel J. Barry, director of government relations for the Financial Planning Association, an advocacy group for the advisers’ industry.

The planners, along with consumer advocates, support the proposal in the original draft of the Senate financial reform bill by Christopher J. Dodd, the Connecticut Democrat who is chairman of the Senate Banking Committee. That proposal would simply erase the brokers’ exemption from the Investment Advisers Act and require them to register as advisers, making them fiduciaries.

“The Dodd bill is broader and stronger,” said John C. Coffee, a professor of securities law at Columbia Law School. “In the full-scale House bill, you see how limited it is. The House makes a new limited fiduciary standard to broker dealers, but only when they are giving personalized investment advice” about securities to a retail customer.

Consumer advocates say the phrase “personalized investment advice” leaves too much room for interpretation. What is more worrisome, they say, is that the House version would also not require brokers to “have a continuing duty of care or loyalty to the customer” after providing that advice. That could lead to “hat switching,” they say, where the broker wears his fiduciary hat when giving advice, but changes to the suitability hat when recommending products.

Who wants regulation?

The hat switching “is a real problem, and it is particularly a real problem because the S.E.C. has accepted that position in the past and appears likely to do so in the future,” said Mercer Bullard, an associate professor at the University of Mississippi School of Law who serves on the S.E.C. and Exchange Commission’s Investment Advisory Committee. “If someone has presented a full range of financial planning options, it is absurd to think the client will not expect that relationship of trust and confidence to continue.”

Mary L. Schapiro, the chairwoman of the S.E.C., has said she supports a fiduciary standard that is at least as strong as the one that investment advisers follow. For its part, the brokerage industry has said it is not advocating a weaker rule.

“We certainly don’t want a watered-down standard,” said Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association, a trade organization. He said the association preferred the House version.

The insurance industry, however, is opposed to any additional regulation. In a letter in November to the Senate Banking Committee, three trade groups representing the insurance industry said some of their agents must already pass one or more regulatory exams and are subject to the rules and exams conducted by the Financial Industry Regulatory Authority, the regulatory organization known as Finra.

Mr. Bullard said the insurance industry was “apoplectic because if they sell a variable annuity and they are subject to fiduciary duty, that means they will probably have to fully disclose the compensation they are getting.” This, he added, “would make clear the excessive incentives they have to mis-sell the variable annuity, which has been the cause of regulatory problems in that area.”

Richard G. Ketchum, the chief executive of Finra, said there had long been problems with how brokers disclosed their conflicts and how they pushed products “and whether they push products because they have an employee incentive or if it’s a proprietary product.”

The House bill makes sense, he added, in that it outlines a fiduciary standard and then leaves it to the S.E.C. to define it.