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Navigating the Financial Markets: Part I.

Byline: Rochester Business Journal Staff

Falling equity markets. Rising interest rates. Geopolitical forces. These and other factors contributed to the substantial volatility in our domestic financial markets as 2018 came to a close. Navigating the markets in the year ahead may be equally, if not more, challenging. Even if you are working with a financial professional who can help you stay the course, it might be a good time to take a look at how that relationship is structured. Many investors are satisfied with their financial advisors, but do not know what types of accounts they have. In this first column of 2019, we outline important considerations relating to account structure. It's important to know whether your accounts are structured as advisory accounts or brokerage accounts.

RAND Report

Numerous calls for regulatory reform followed the market-timing and late trading scandals that occurred early in the new millennium. The financial services marketplace had grown more and more complex, and regulators realized that the bright line which once separated traditional brokerage services from traditional investment advisory services had begun to disappear. Investors were confused. It had become clear that regulatory reform was needed. As a first step, the U.S. Securities and Exchange Commission (SEC) engaged the RAND Corporation to conduct a study of investor experience with broker-dealers and investment advisers. One important aspect of the study sought to determine whether investors understood the substantial differences between these market participants.

The Report, which was delivered to the SEC in 2008, concluded that that most survey respondents and focus-group participants did not. It revealed that even those individuals who had worked with financial professionals for years were often confused about job titles, the types of firms with which they were associated, and the manner in which they were compensated. Now, ten years later, investors are still confused.

Dual registrants

The disappearance of the bright line which had once been drawn between broker-dealers and investment advisers can be traced to the competitive pressures felt by the retail securities brokerage industry following the elimination of fixed commissions in 1975. Once brokers were free to negotiate commissions, the marketplace became more competitive and diverse. New entrants included a multitude of discount brokers. The emergence of the internet as a trading platform also expanded the lower-cost options available to investors.

These events resulted in a fundamental transformation of the retail securities brokerage industry. Large, full-service broker-dealers responded to the challenge by introducing a variety of new offerings including discount brokerage programs and other ancillary services. As competitive pressures increased, they recognized the appeal of fee-based accounts offered by investment advisers that produced recurring revenues. Over time, they gained access to this lucrative market by registering with the SEC as investment advisers, thereby becoming asset gatherers. As these "dually registered" firms began to assign more generic titles, such as "financial advisor" and "financial consultant" to their financial professionals, the term "stock broker" virtually disappeared from the industry lexicon. This "dual registrant" model continues to be a source of considerable confusion among investors.

Today an investor working with a financial professional at a firm that is registered both as a broker-dealer and as an investment adviser may have both brokerage accounts and advisory accounts, and not even realize that. The distinction between a brokerage account and an advisory account is one with many differences that are not well understood by investors. It's important to have an understanding of these differences at the outset of the account opening process. The most critical differences relate to trading authorization, the standard of care owed by the financial professional to the customer, and the manner in which the financial professional will be compensated. Because dually registered firms permit their financial professionals to wear two hats, and it's important to know which hat he or she is wearing when you open an account.

The suitability standard

Financial professionals that are registered representatives with a brokerage firm, are required to obtain and maintain certain licenses that permit them to purchase and sell securities for customer accounts. If a registered rep makes a recommendation, it must be a "suitable" recommendation that takes into account various factors such as the customer's financial circumstances and goals, as well as the customer's risk tolerance and investment time horizon. The registered rep must have a reasonable basis for believing that the recommendation is suitable for a particular customer. In evaluating their responsibilities with respect to brokerage accounts, broker-dealers have long taken comfort in case law that has defined the scope of their professional duties narrowly. Having made a "suitable" recommendation, the broker has no further responsibility with respect to a trade once it occurs. This limitation on the scope of responsibility between a broker and its customers is the defining characteristic of the brokerage account. As one court put it:

"On a transaction-by-transaction basis, the broker owes duties of diligence and competence in executing the client's trade orders, and is obliged to give honest and complete information when recommending a purchase or sale. The client may enjoy the broker's advice and recommendations with respect to a given trade, but has no legal claim on the broker's ongoing attention."

Many investors do not understand that because registered reps do not act in a fiduciary capacity with respect to their customers, they are not, under existing regulations, required to act in the best interests of their customers. Last year, however, the SEC proposed new rules which, if adopted, would replace that lower standard of conduct. The proposed standard of conduct would require that firms and their registered reps act in the best interest of the retail customer at the time a recommendation is made without placing the financial or other interest of the broker-dealer or its registered rep making the recommendation ahead of the interest of the retail customer. Regulation Best Interest has not yet become a reality.

The fiduciary standard

Unlike broker-dealers, investment advisers are subject to a "fiduciary" standard, which includes both a duty of loyalty and a duty of care that applies throughout the entire relationship between an investment adviser and its client. This fiduciary duty requires investment advisers to act in the best interest of their clients. Investor confusion occurs in situations where a financial professional is affiliated with a firm that is dually registered as a broker-dealer and an investment adviser. That financial professional may function as a registered representative in connection with the delivery of brokerage services and as an investment adviser representative in connection with the delivery of advisory services. Even though these scenarios are more and more commonplace today, they continue to be a source of great confusion for investors. Much of the confusion relates to the type of account that is established.

Understanding the options

An understanding of the differences between brokerage accounts and advisory accounts is an essential navigation tool. All too often, during the account opening process, investors sign documents without actually reading them. Questions to ask your financial advisor might include:

How is a brokerage account different from an advisory account?

What type of account are you recommending?

How will you be compensated for the services that you provide?

Will you need my consent prior to placing trades in the account?

Will your role be that of a fiduciary?

The status of a financial advisor as a fiduciary does not necessarily mean that an advisory account will be more appropriate than a brokerage account. Under circumstances where both types of accounts are available, economic considerations are extremely important. Advisory accounts are typically structured to compensate the financial advisor as a percentage of assets under management, whereas brokerage accounts are structured to compensate the financial advisor in the form of commissions as transactions are placed. The services provided are different and the compensation structures are different.

Firms have been disciplined for placing clients with "buy and hold" strategies in advisory accounts where little trading will occur. That's because the financial advisor will earn fees even when there is no active account management. For example, regulators fined a major firm $23.3 million under circumstances where it charged a 91-year old client more than $35,000 for just four trades over a period of two years (approximately $8,800 per trade) substantially more than the same client would have paid in a traditional brokerage account. Caveat emptor!

Patricia Foster is a securities law attorney who represents clients in various sectors of the financial services industry, including broker-dealers, investment advisers and investment companies. This column is a collaborative work by Patricia Foster and David Peartree. David Peartree is a registered investment adviser offering fee-only investment and financial planning advice. The information in this article is provided for educationalpurposes and does not constitute legal or investment advice.

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Publication:Rochester Business Journal
Date:Jan 22, 2019
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