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STOCK ISSUES

Broker Breach of Fiduciary Duty ...

A fiduciary is a person or business entrusted with the power and obligation to act in the best interests of another party (beneficiary) in a relationship of complete trust, good faith, honesty and responsibility. Common examples include estate trustees, financial advisers, attorneys, real estate agents and others including stock brokers who may under certain circumstances enter relationships in which the other party has total confidence that the fiduciary is acting on their behalf, often because of specialized knowledge or expertise.

The fiduciary must at all times exhibit a standard of conduct above and beyond that of a stranger or casual business relationship. Notably, the fiduciary must not have undisclosed conflicts of interest with the beneficiary nor engage in self-dealing in which the fiduciary’s interests are placed above those of the beneficiary. Any benefit the fiduciary derives from the relationship, e.g., fees or commissions, must be fully disclosed and acceptable to the trusting party.

A breach of fiduciary duty may occur in any number of circumstances in which the fiduciary acts inappropriately to the beneficiary’s detriment. For example, trustees of an estate must be actively engaged in the proper management and administration of the estate’s assets or risk legal action that may result in removal, financial reparations or even criminal charges.

New York law as it developed over the years is illustrative of the duties of a stock broker to his customer. If the agreement with the customer is discretionary, the broker owes the customer a general fiduciary duty. If the agreement is non-discretionary, the broker’s fiduciary duty to the customer is limited to the duties entrusted to him related to orders including the duty to achieve best execution. In normal circumstances there was historically no on-going duty to the customer including any duty to supply the customer with advice relating to his positions. However, where special circumstances exist by virtue of the age or lack of sophistication of the beneficiary, the fiduciary duty of a stock broker could be expanded beyond that indicated above.

Evolving changes

In 2016 the US Department of Labor (DOL) promulgated regulations requiring brokers and financial advisers to act as fiduciaries when providing advice relating to retirement accounts including IRAs. While well meaning, those changes prompted various brokerage firms to alter the structure of retirement accounts including those over which their brokers previously exercised no control. These changes included the elimination of commission-based transactions in favor of fee-based accounts at potentially much higher cost, which harmed both the broker who acquired greater responsibility of accounts over which he had no control and for customers who now had to pay increased fees to manage their own accounts no matter how knowledgeable they might be. This DOL fiduciary rule was struck down by a federal court in 2018. When the DOL declined to appeal after the change of administrations following the 2016 presidential election, the end of the rule became permanent.

The SEC has now adopted a "best interest" standard to be applied to all retail brokerage accounts in an effort to both replace the earlier DOL standard and to expand its reach. It carries a compliance deadline of June 30, 2020 and much litigation is likely to result from such changes in the investment area. The "best interest" standard is, of course, a fiduciary standard.

SEC Regulation Best Interest

SEC  Regulation Best Interest  (Regulation BI) requires that "A broker, dealer or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person  of a broker or dealer making the recommendation ahead of the retail customer." This best interest obligation is satisfied if obligations of 1) disclosure, 2) care, and 3) conflicts of interest are adequately met.

The first thing to notice about the SEC standard — like the older National Association of Securities Dealers (now FINRA) suitability standard — is that it applies to situations in which a recommendation is being made. A second is that it applies only at the time a recommendation is made, and creates no ongoing duty in the general case. The SEC standard also does not deal directly with the level of sophistication of the investor or the amount of control the broker, dealer or associated person exercises over the account although some particularization is possible based on the retail customer investment profile gathered from the customer. This profile includes, but is not limited to, customer age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance and any other information disclosed by the customer. However, so far as the regulation stands, the broker owes the duty of best interest to every customer (which is not further defined) in recommending a transaction or investment strategy.

This differs from, say, the widely-adopted New York fiduciary standard noted above where a general  fiduciary duty is owed only to those where the broker has control over the account or, in certain circumstances, to those lacking in sophistication where it can be said that the broker has de facto control. Where the New York fiduciary standard is narrow in the case of an sophisticated investor having control of his own account and is often said to involve only the duty to give such a customer best execution on his transactions, Regulation BI imparts broader duties such as the need to recognize, and then mitigate, or eliminate, material conflicts of interest. While SEC press releases and the like, as well as the general "feel" of Regulation BI and its surrounding atmosphere, suggest broad interpretation of its three requirements for satisfaction noted above, it remains to be seen what future arbitration panels and courts will make of the regulation and its legislative intent for sophisticated investors. This, of course, with its attendant costs and uncertainty for future claimants or plaintiffs, must be worked out in future arbitrations or court cases.

A second comparison of Regulation BI is to the fiduciary standard applicable to investment advisers under the 1940 Investment Advisers Act who have a continuing duty to act as a fiduciary to their clients where Regulation BI generally applies only at the time of a transaction. Critics of the SEC have argued that the standard should be the same based in part on provisions of the Dodd Frank Wall Street Reform & Consumer Protection Act (See Securities Rules and Regulations for more on both Acts). This situation closely parallels the needs of the sophisticated or experienced investor managing his own account who may still wish to partake of broker advice. While customers of investment advisers have generally granted discretion to those who manage their accounts and therefore are in need of a fiduciary context for that management is it possible to imagine any person managing his own account who would want anyone else to have a fiduciary duty over his investments under any circumstances? Such a situation leads immediately to conflict.

An example will suffice: With his own money, a customer wants to make a trade which he has researched and feels is appropriate for his account. His broker feels he has a fiduciary duty under the revised Regulation toward all clients where his advice has been sought and a recommendation made. He further believes the transaction in question is not in the customer's "best interest". Who controls and for how long? That is the issue, and "control" of the account as well as investor sophistication are concepts that frustrate attempts to formulate a proper fiduciary duty or "best interest" standard for such investors without these concepts being directly dealt with in the Regulation.

Said another way, a broker's conception of "best interest" is not generally a proper investment standard for all retail customers who may seek the advice of a broker. Individual control by investors who think they know what they are doing is not only the essence of capital formation and democracy in the markets but such diversity of opinion is also the engine that gives rise to price discovery and market efficiency. Such diversity of opinion among sophisticated individual investors each in control of his/her own account is one of the factors that creates the buyer for every seller. (See Compulsory Arbitration: Its Impact on Market Efficiency.)

Related to all this and adding to the confusion relating to fiduciary duty is the tendency of certain brokerage firms to use terms like "financial advisor" in referring to their brokers whose role is primarily sales oriented. While this has long been recognized as leading to great customer confusion, the SEC has failed to act in this area in spite of an earlier court order to rectify the problem. The possibility for the retail customer to obtain relief from broker use of titles unrelated to actual function seems unobtainable.

A final comment: Regulation BI applies to retail investor accounts. While that is a great expansion over the DOL fiduciary standard which was to apply only to retirement accounts it does not reach so far as customer business accounts which achieve no new protection under Regulation BI.