How Conflicts of Interest in the Investment Industry can Impact You

A power struggle is brewing within the regulatory bodies and Congress. The issue concerns the very important question of how investors get their financial advice. On one side are agents of banks, brokerage firms, insurance companies, and independent advisors who have a sales license to sell securities or insurance. On the other side are Financial Planners or Registered Investment Advisors (RIA) who often work for themselves or small boutique firms such as L&S Advisors.

Brokers are regulated in their sales functions both by the Securities & Exchange Commission (SEC) and by the Financial Industry Regulatory Authority (FINRA), which is funded by the brokerage business itself and conducts audits of its member firms. While we feel there are conflicts with this arrangement, it is not a topic for this discussion. Financial Planners and Registered Investment Advisors are regulated by the individual states or the Securities & Exchange Commission (SEC).

The general rules for FINRA brokers state that brokers must recommend only investments that are “suitable” for clients. The question is what does suitable mean? In plain English it means that brokers can sell you any investment they have “reasonable” grounds for believing is suitable for you. Reasonable means information based on your risk tolerance, investing objectives, tax status, and financial position.

Key factors that we see missing from these guidelines are conflict & cost. Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund that is suitable for you. He would be under no obligation to tell you that the annual expenses his firm charges on their fund are 10x higher than an essentially identical fund from, say, Vanguard. Brokers get no commission for recommending Vanguard products.

If brokers had to take cost and conflict of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before selling some of the products that we often see in portfolios today. Today’s standards do not require brokers to act as fiduciaries when making sales recommendations.

Registered Investment Advisers on the other hand are required to act out of a “fiduciary duty”, or the obligation to put their clients’ interests first. Advisers always have a duty to mitigate conflicts of interest when possible and if not possible to disclose in a formal notice the potential conflict.

Part of the fiduciary duty means that the adviser is responsible for taking into consideration the cost of transactions and to recommend the most efficient structure. This is the reason that advisers acting as investment adviser representatives of an RIA cannot receive commissions when making recommendations in that capacity. The receipt of commissions on investments recommended represents a clear conflict of interest, and would hinder the objectivity and impartiality of the adviser. Therefore, an investment adviser representative, when also licensed as a registered representative of a broker-dealer or as an insurance agent, would be required to disclose their conflict of interest to the client at the time of making a recommendation for the sale of a product.

I don’t want to sound too harsh about the role of salesmen. These men & women have a role in the business world. I use a variety of professional salespeople in doing my work and value their comments. However, for the same reason that medical doctors cannot own the pharmacy that fills your prescription, I strongly believe that there should be a separation between investment advice and those who sell financial products.