Customer or Client? For Now, The Court Says Client

by | May 18, 2007 | Weekly Column | 2 comments

Customer Vs. ClientIn the past I’ve written about the important difference between a registered investment advisor (RIA), who typically is advice driven, and a traditional stockbroker, who is typically product driven. A recent court decision may help clarify that difference.

Any professional truly engaged in financial planning is also registered with the SEC as an investment advisor and makes a living disbursing unbiased advice. A stockbroker is registered instead with the National Association of Securities Dealers and is a sales person who makes a living primarily selling products.

To a financial planner, you are the client. The financial planner has a fiduciary responsibility to put your interests above his and disclose conflicts of interest in the same way your attorney or accountant does.

To a stockbroker, you are a customer, because the broker’s fiduciary duty is to the company he or she works for. The broker does not have to fully disclose conflicts of interest and must put his company’s interest ahead of yours.

The problem is that brokers have a built-in conflict of interest. They make most of their money from commissions on products they sell, so their recommendations to customers are inherently biased toward investments that will be the most profitable for them. Theoretically at least, customers are protected against malfeasance because brokers are required by the SEC and NASD to comply with a complex set of rules to treat customers fairly and disclose the commissions they receive.

Financial planners and investment advisors who are RIAs with the SEC are held to a much higher standard.SEC

Ironically, the SEC has not required brokerage firms to register as investment advisors under the Investment Advisers Act of 1940. This applied as long as their investment advice was “solely incidental” to their brokerage activities and as long as they were not receiving “special compensation” such as fees for that advice.

Over the years, however, large brokerage firms have increasingly spun their advertising and communications to leave the illusion that they were doing unbiased financial planning. They decided to try to have the best of both worlds by charging fees for advice as well as selling in-house products. Even though this was done in many cases by separate divisions within the companies, the inherent conflict of interest remained. For the public, the line between brokers and RIA/financial planners has become more and more blurred.

The Financial Planning Association eventually sued the SEC over its exempting brokerage firms from the fiduciary requirements that applied to registered investment advisors. Recently, a three-judge panel for the U.S. Court of Appeals ruled in favor of the FPA.

The result of this ruling is that large brokerage firms can no longer claim they are doing financial planning unless they register with the SEC as investment advisors. This will require them to change the relationship with their customers, elevating them to the status of clients whose interests must come first.

Some of the firms may do this, but most will not. It is also possible that they may move away from offering advising services and go back to the commission model with its built-in conflict of interest.

The brokerage industry is also likely to lobby Congress for legislation to reverse the effects of the court’s ruling. The SEC exemption has been important for these companies, and they aren’t likely to allow it to disappear without a fight.

What impact does this court decision have on the average small investor? For now, at least, it requires a plainer definition of whether one is a customer or a client. It is a momentary clearing of the smoke and mirrors. Whether that clearing lasts remains to be seen.

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