The financial reform legislation recently passed in Congress includes a provision regarding the necessary degree of care that a financial advisor must provide to clients.

This issue was debated in the House Financial Services Committee and Senate Banking Committee and the reform bill was forged from two very different bills that emerged from these committees. The legislation addresses a wide variety of issues, but the segment that affects financial advisors the most is the standard of care required of financial advisors in dealing with clients. This decision comes under the investor protection provision (Title IX, Section 913, Study and Rulemaking Regarding Obligations of Brokers, Dealers, and Investment Advisors) of the financial services reform package.

The financial reform legislation is an enormous document (2,319 pages) and the standard of advisor care issue is only one of many addressed in the bill. Even larger issues such as curbing excesses by too big to fail institutions, establishing a consumer protection agency, limiting proprietary trading, bringing transparency to hedge funds and derivatives trading, reforming executive pay, controlling abuses in the mortgage market, and addressing systemic risks, among others, were also before the committee. The goal of this legislation is to protect consumers and prevent another financial crisis.

Suitability standard

The issue of concern in the bill regarding financial advisors is that currently advisors are held to one of two standards, based on their registration. An advisor may be registered as an agent or broker (registered representative of a broker-dealer), or as a registered investment advisor (RIA). Broker-dealers and associated persons are regulated under the Securities Exchange Act of 1934 and are held to a suitability standard that requires them to make recommendations that are appropriate for a client’s risk tolerance, investment objectives, time horizon and financial status.

Fiduciary standard

On the other hand, RIAs (investment advisors) are held to a fiduciary standard under the Investment Advisors Act of 1940, meaning the advisor must recommend what is in the client’s best interest when providing personalized investment advice. They must place the interests of the customer ahead of their own. They must act with prudence, with the skill, care, diligence and good judgment of a professional. The fiduciary standard imposes the utmost duty of good faith, loyalty, and full and fair disclosure of all material facts, including potential conflicts of interest. Conflicts of interest should be avoided, and unavoidable conflicts must be managed in the client’s favor. The suitability standard does not have these requirements. It requires only that the product sold suits the needs of the consumer.

One standard for all?

The House-Senate conference committee in late June came to an agreement to include language in the final version of the legislation that would hold broker-dealers to the same fiduciary standard as investment advisors. Only one standard would apply to all advisors providing investment advice, so brokers, insurance agents and others who provide investment advice to retail customers would also be regulated by the fiduciary standard of the Investment Advisors Act of 1940.

The House, on June 30, passed the compromise conference committee’s bill. The Senate passed the conference committee bill on July 15, 2010 and the President signed the bill on July 21.

The House-Senate compromise legislation requires a six-month study by the SEC to determine if a universal standard is necessary, and if so, what rulemaking would be required to address regulatory overlaps, shortcomings and gaps in oversight of broker-dealers and RIAs. The study will examine the impact on consumers and financial transactions that could be negatively impacted by implementing a broader fiduciary standard, including product availability, costs, and enforcement.

Should recommendations be made, the legislation includes a provision that gives the SEC the authority to make rule changes and create a universal fiduciary standard, since it previously did not have that authority. The legislation does not require the SEC to make rule changes, but it does require the SEC to take the findings of the study into account if new rules are imposed. The investment advisor, financial planning, broker-dealer and insurance communities will undoubtedly push hard in the coming months to influence the outcome of the study through the public comment that the SEC will seek, as required in the bill.

Consumer groups, the SEC, the financial planning community, and the Obama administration have supported the fiduciary standard, whereas the broker-dealer and insurance communities (including NAIFA) have supported the suitability standard. This standard of care issue has created vigorous and heated debate between the interested parties because of the significant impact it will have on various segments of the financial services industry.

Currently, consumers have a choice of paying a fee to a RIA or fee-only financial planner for investment advice on a fiduciary basis, or to a broker-dealer, who pays a commission to the advisor on a suitability basis.

Fiduciary supporters argue that the standard better protects consumers while consumer advocates argue that the public is confused by different standards being applied to different advisors. (For a more detailed explanation of the differing perspectives, see Arguments from each side on page 24). Suitability supporters say that a universal fiduciary standard will limit affordability and access for middle-income consumers, who have lower cost access through commission-based producers. They say it would threaten their ability to charge commissions and force them to charge more for their services while limiting product choices.

Fiduciary advocates maintain these issues would not prevent broker-dealers from charging commissions or limit the sale of proprietary products. The House-Senate compromise bill allows agents and brokers to work within the jurisdiction of their companies and does not require them to go outside of those products. Under the fiduciary standard of the compromise bill, the client’s best interest will not force an agent to sell a product from outside his or her company. Charging a commission or offering a limited variety of products will not necessarily violate the new standard, if new rules are established. Under the legislation, the fiduciary standard would apply only at the time services and investment advice is provided, and would not impose a continuing duty of care unless another transaction occurs. This represents a liberal interpretation of the fiduciary standard that limits the scope of engagement to a transaction rather than that inferred within an ongoing client-advisor relationship.

With passage of the financial reform bill, a great deal of leadership will be needed from the SEC to provide clarity on what the fiduciary standard means and how it will be applied to interactions between clients and advisors. Additionally, clarifying what best means when requiring the financial advisor, under the fiduciary standard, to act in the best interest of the buyer, must be spelled out. It has never been clearly defined. The requirement to provide the best advice and recommendations may likely result in additional litigation and compliance risks unless this issue is made clear. Most certainly, compliance and legal departments at financial institutions will be very busy, and sales practices and disclosure rules and requirements will be carefully scrutinized and revised based on the final legislation and SEC interpretation.

This legislation could potentially change the nature of providing financial advice. Everyone who provides investment advice to retail customers will have to act in the client’s best interest and disclose conflicts of interest, leveling the playing field between investment advisors and broker-dealers. This may affect, for example, the way variable annuities are sold, where more detailed and transparent disclosure of commissions, surrender fees and other ongoing fees will be required. It may require that a client acknowledge that the fees, commissions and product features have been explained and are understood.

Other notable reform components

In other developments affecting insurance advisors, the current state-based insurance regulatory system will remain virtually intact. An amendment to the bill would retain state regulation of equity-indexed annuities rather than the SEC, which made a bid to regulate them as securities rather than as insurance products. A provision contained in the legislation settles the matter, barring the SEC from oversight. The bill also creates a new Federal Insurance Office within the Treasury Department to monitor insurers, and requires a study that will recommend ways to further overhaul regulation of the industry.

Although we have passage of this law, we are a long way from having clarity on its impact and significance on financial advisors. You should become familiar with and incorporate these higher standards of care, regardless of the outcome of the SEC study, and follow developments in this important legislation in the coming months. See this as an opportunity to reinforce trust and loyalty in your client relationships. It makes good business sense.

Glenn E. Stevick Jr. CLU, ChFC, LUTCF, is Assistant Professor of Insurance at The American College in Bryn Mawr, Pa.