Your stock broker or investment adviser could be a straight arrow, scouring the financial world for the very best products, but it’s entirely likely they aren’t. They could just as easily push you into “house” products that help them reap better commissions. The fact is, the latter situation is far from uncommon as brokers are typically not legally bound to find the “best” products for you, merely ones that are considered “suitable.”

There is a conflict here. The so-called “suitability” standard does offer some legal protections for investors, but it’s not the gold standard. No, for that you need to ensure that your investment adviser, or certified financial planner, is considered a fiduciary. What’s the difference, and why is it important?

First let’s start with what goes into the suitability standard. It is typically a legal standard that requires that whoever is handling your investments puts you in products that are suitable for your objectives, means and even age. Of course, this doesn’t always happen. The classic example is of a broker who shuffled his little old lady clients into tech funds a decade back. This would be considered an unsuitable investment, because older people typically need more fixed income, and less in the way of speculative securities. A more recent example would be if your adviser or broker shuffled all your retirement money into derivative-based securities in 2005.

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While suitability offers investors some sort of protection, it falls short in some important ways. For starters, it doesn’t require brokers to find the best products, only ones that are ostensibly suitable for you. If an underwhelming house brand security lines up with the vague outlines of what is considered suitable they can still push it, even if it costs more to own, or underperforms peer securities.

In other words, mere suitability alone falls short of what the fiduciary standard brings to the table. Here are some key differences. Whereas the suitability requirement is about as far as most mainstream investment houses will go, when your financial planner is considered a fiduciary they have the legal obligation to put you in only the very best products they can, and to act in your own best interest, not their own. Becoming a fiduciary, also, takes a lot more work than becoming your typical broker. You have to fulfill a certification process that requires you to uphold prudent investment guidelines and practices as delineated by state regulators. Simply put most mainstream stock brokers do not meet this standard.

That there is in essence a bifurcated level of expertise and responsibility between these players caused some consternation among our industry observers.

“What separates professionals in this business from salespeople is the fiduciary standard,” says Marc Lowlicht, the head of the wealth management division at Further Lane Asset Management and a certified financial planner. He added that many larger firms–known in the business as wirehouses–have gotten legal cover to say that real, honest financial planning is incidental to what they are really there to do, sales.

Because of this he is outraged that some salespeople are posing as financial planners for an investing public that doesn’t know how to tell the difference. “If the wirehouses want to be viewed as planners with an unbiased objective, then they should be held to the same standards as true financial planners, or any other profession such as accountants or lawyers.”

Bill Singer, securities attorney and shareholder at Stark & Stark, adds that even as most brokers merely push what it technically “suitable” they certainly are loathe to admit that such an investment vehicle might not actually be what’s best. “The companies only subject to the suitability standard don’t make much of a point letting you know that what they’re recommending to you may not be your best interests,” he says.

There is one large caveat to all this. Just because someone is a fiduciary it doesn’t mean you are home free. Arbitration statistics from the Financial Industry Regulatory Authority show that in 2008 there were 2,838 cases served that involved breach of fiduciary duty, vs. 1,181 for unsuitability. So, once again, there is no substitute for vigilance on the part of the investor, no matter who handles your finances.

John Osbon, the head of Osbon Capital Management, has his own answers for how to square the circle of suitability versus fiduciary standards. He says that firms that make financial products and distribute said products need only meet the lower suitability standard. But the moment such products touch clients they need to meet the higher fiduciary standard.

Making Suitability More Suitable?

Forbes. Should all financial services be sold under the “fiduciary” standard and the “suitability” standard abolished? Marc, I am sure what you will say about this, as you are a fiduciary.

John Osbon. Absolutely, financial providers should meet the fiduciary standard, which means they are required by law to act in their clients’ best interests. Just as a trustee acts for the recipient, a financial fiduciary acts for the owner of the money.

The question is, where does suitability end and fiduciary begin? Here’s a suggestion. A financial manufacturer should be subject to suitability rules, which means, simply speaking, that he can’t knowingly make toxic products. A distributor also falls under suitability, in my view. But the minute any of the above–manufacturer, distributor, or provider–touches a client, then fiduciary rules apply. Such a system would allow the three different type of players to decide what rules they prefer.

Marc Lowlicht. I believe when it comes to dealing with the public and their wealth, the individuals advising them should be held to the highest standard. The standard that meets this is the fiduciary one. What separates professionals in this business from sales people is the fiduciary standard. Saying that a financial plan is incidental to what the wire houses provide (The Merrill Rule), in my opinion is just a way to circumvent the system and avoid culpability.

The individual investor has to have a clear understanding between the difference of a Financial Planning Professional and a Broker. If the wire houses want to be viewed as planners with an unbiased objective then they should be held to the same standard as true financial planners or any other profession such as an accountant or lawyer. These firms should not be able to hide behind the Merrill Rule at the expense of the investing public.

Bill Singer. Marc and John sort of nailed the initial issues on the head, and it looks like we three veterans are all on the same page here. However, let me first try to set the issue for our readers and then cause a little trouble with some queries (Devil’s Advocate or otherwise).

Right now, when the public deals with what is commonly known as a “stockbroker” (that is a registered person at a broker-dealer), that representative is only required to recommend an investment to you that is “suitable,” whereas investment advisers and financial planners are typically subject to a more demanding “fiduciary” standard. While those in the BD community like to pooh-pooh the difference, let me try to point out the critical point.

You want to buy an automobile. You want something that gets at least 25 mph and costs no more than $20,000. OK, there are likely many models from many manufacturers that will fit those two requirements and, as such, are “suitable” for you. However, most consumers would want to drill down beyond those two attributes.

Which model has the best safety record? Which has the best maintenance/repair performance? Which holds its value after three years? Do you live near a qualified mechanic who can repair your car when necessary and are parts readily available? These questions go beyond whether something merely satisfies your wants or desires–they go beyond the mere suitability of the initial results to your broad query–these additional questions will likely begin to determine what’s the “best” model for you to buy.

Now, it’s possible that there may not be a clear-cut winner. Maybe three models are all great choices and no one emerges as better than the others. Nonetheless, there is a difference between narrowing down the choices to among the best vs. what merely is suitable.

Stockbrokers are typically only required to find stocks, bonds, funds, etc. for public investors that are merely “suitable”; whereas other financial professionals are required to undertake more diligent searches to consider what’s “best” for you. Unfortunately that critical distinction not only gets lost in the shuffle amid all the financial products offered to you, but the companies only subject to the suitability standard don’t make much of a point letting you know that what they’re recommending to you may not be in your best interests.

What’s a key problem here for the average consumer. In a word: Conflict. If a stockbroker finds a dozen or so stocks or funds that are merely “suitable” for you, that registered person may feel pressured to push one of those products because he or she gets paid a higher commission or because their employer pressures them to move so-called “house” product or that of a favored third party. That’s the dirty little secret of Wall Street’s broker dealer community.

On the other hand, and this is a huge however, just because investment advisers/planners are supposedly subject to the more demanding fiduciary standard, isn’t a guarantee that your needs will be met. Standards are only valuable if observed. As we see in the ongoing Madoff scandal and other similar frauds, many fiduciaries were tempted with kick-backs and didn’t always put their clients into what was best for the client.

The challenge going forward is to end this pernicious system of conflict and confusion and make sure that public investors are always sold what’s in their best interests and what is the “best” option for their personal situation. A first step to realizing that vision, is to end the dual standards and put everyone on the same fiduciary standard. The next step is to ensure fair and vigilant regulation by non-conflicted regulators.

Osbon. Great summary. Would the broker dealer community accept the fiduciary standard?

Singer. John, I think there is so much public outrage and so much momentum that the push to a unified fiduciary standard may be inevitable. Where I expect to see game is in the drafting of that universal standard. I’m sure that the larger members of the FINRA community will try to water it down with as many exceptions as possible and to use all their political influence to compromise that definition or its effective regulation. Then there is the even larger issue: Does it make sense in this day and age that an individual can study for a few weeks and pass a registration examination that then effectively allows that person to undertake sales of financial products to the public?

Perhaps we need to enhance the entry-level testing and qualifications that unleashes so many unqualified registered persons on a largely unsuspecting public. However, we must also protect the hundreds of thousands of dedicated, sincere registered persons who have long sought to increase their professional stature but who have been rebuffed by their financial superstore employers who want little more than teleservice operators answering phones rather than skilled professionals. There is a place for a lower level of qualification for folks merely answering phone calls about how to use Web site, how to enter an order, and how to get a check cut–and for a higher level of qualification for a new generation of “professionals” who will interact with investors in a mutual effort to find the best options for their investing dollars.

Lowlicht. Bill makes some great points. I think it is important to understand regardless of weather you are acting as a fiduciary or not it is impossible to remove all conflicts of interest, however the fiduciary standard increases the likelihood of reducing the abuse of these conflicts. As a CFP™, I believe one of the most important issues for fairness to the client is full disclosure. This is a requirement of the Certified Financial Planning Board of Standards. The same is not true of the wire houses which are subject to suitability rather than fiduciary standard. In addition the public has to be educated about the difference between a Financial Planner and a Financial Adviser. Maybe a disclosure on wirehouse statements should read that a Financial Adviser is not held to the same standard as a Financial Planner and as such financial planning is incidental to their service.

Singer. Marc touches on not only the single greatest challenge to developing a system of regulation, but he also points out the single most significant failure of our current regulatory architecture. At its heart, all intelligent regulation must be comprehensible–and not for those who draft it or are regulated but, most critically, for those who are supposed to be protected by a regulatory scheme. In the U.S. we have become entranced by the siren’s song of disclosure–as if sending a public customer a phonebook sized document is a substitute for intelligent regulation. We have become a nation that regulates by the pound of paper rather than by the clarity of the written word (and in plain English).

First and foremost, we need to develop a method and methodology by which products are fairly and sensibly explained–including risks and expenses. We also need to speak to the public–now there’s a novel idea: Maybe you could better draft regulations if you actually ran the language by those who are supposed to be educated by it rather than the lawyers who are paid to obfuscate (myself included) and the politicians who are paid to protect the special interests of their patrons. How about a simple threshold: If a test group of typical investors can’t understand the product that you’re proposing to market to them, you don’t get permission to sell it until they do! Sort of like making sure that folks don’t swallow suppositories!

We also need to begin to focus on trying to simplify the entire financial services industry. No–there will still be very sophisticated products and the need for them, and, yes, we have had far too much of “dumbing down” complex things as it is–but there is a happy medium. We could first start by certifying that some products are available for sale to individual public customers but that others are ONLY to be sold to institutions or specific classes of sophisticated individual investors.

Moreover, we should also consider phasing in the introduction of new products to ensure that we understand their intended (and unintended) impact and use. That might require an FDA-like review of new products but with more attention on quicker approvals. Similarly, such initial authorization could come with a limit on dollar amounts of products to be sold or with a requirement to submit a progress report within a year or quarterly or whatever.

Finally, I would suggest that no better regulation could be drafted than simply imposing a per-transaction tax on all debt, equity and futures trades and to develop a national fund for defrauded investors. Investors would be required to prove their damages, successfully prosecute their cases, and to show an inability to collect compensatory-only damages (no punitives to be repaid from this fund alone).

At that point, the fund would pay out such proven claims and that payment would then be collectible as against the principals of the financial concerns or issuers who defaulted on the payment of the awards. That’s skin in the game. Keep in mind that we’re not talking about reimbursing losses–those are part of the “game” of investing. I’m simply proposing a national fund to reimburse losses caused by proven criminality or fraud.

Lowlicht. Another overlooked issue is that when a regulation is put in place it is done so to protect the individuals from prior abuses. My observation in the past is that the adviser who should have been affected by the new regulations find new ways around it and continue practice unfairly at the clients expense. The advisers who have been doing everything by the book continue to do such. Therefore the new regulation has no affect on curtailing the problem that they were put in place to solve in the first place, they only make the job of the ethical adviser more cumbersome.

Singer. Marc: You just touched on one of my pet peeves–regulating by looking in the rearview mirror. I even have a name for it! You get four gold stars for that one!

Lowlicht. Thank you, Bill. The other issue I have and would love to hear your take on, is that I have found in many cases some of the regulation that is put in place to protect the investor actually has the opposite affect once the unethically adviser finds a new more creative way to circumvent the system.

I will give a specific example. In the late ’90s there was regulation put in place on B class shares about how much could be sold to the investor because there were no breakpoints and in many instances these were sold as no load funds by unethical advisers who hid the fact that this shares class was more expensive then class A shares.

The adviser who sold these B class shares was paid a 6-7% upfront commission but the client may not have been aware of this as the original investment went to work in its entirety unlike an A class share where the commission was deducted from the initial investment. The client in the B class share would have to hold the position for five to seven years in order not to pay a penalty on liquidation. The fund company would recoup the commission in the form of higher expenses compared to other share classes over the course of the required holding period. Once regulation went in place limiting B class share purchases to $50,000 new abuses cropped up in the form of unsuitable sales of annuities which had the similar commission structure without being subject to the same purchase size regulation as the B class shares.

I would also like to point out that I do believe that B class shares do fit for some clients and that the adviser who runs a reputable business would best able to determine who fits the parameters for an investment in one class of share over another. The regulation in this case did not protect the client. If disclosure was the main requirement then a limit on how much could be sold in any type of share class could be determined not through regulation but by the adviser and client coming to terms with what is best in each particular situation with all the facts about the expenses and holding periods disclosed.

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