Financial Reforms Being Considered by Congress: The Duty of Investment Firms to Act in the Best Interests of Their Clients

Attorney Chris Vernon

According to the Investment News,  recent political wrangling over financial reform by Congress now includes a long discussed amendment being proposed that would require broker dealers to act in the best interests of their clients — the same rule that true investment advisors already follow.

Although Goldman and other Wall Street firms seem resigned to the reality that they must now acknowledge that they have a duty to act in the best interest of their “retail” clients, these same money firms and their lobbyists continue to fight efforts to embrace this duty toward larger investors – which may ultimately include pensions, endowments, governments, etc. The fact that much of the money being invested by these larger clients belong to retirees, workers, charities, local governments, and other Main Street investors is getting lost in the shuffle, and a lot of industry terminology is being used by Wall Street and its lobbyists to oppose this broader reform. 

If Congress can strip away the industry doubletalk, it will be easy to see why lawmakers from both parties should support broad reform on this issue.

Wall Street and its lobbyists – including investment firms heavily marketing the concept that they want a relationship of “trust” with each client – are confusing the issue by injecting terms such as “market maker” and “discount broker” into the congressional dialogue. While these roles should not absolve investment firms from avoiding conflicts of interest — or at least the duty to fully and accurately disclose conflicts of interest and other material facts and other duties to investors — these terms really do not affect the core issue. 

Specifically, the core issue is the level of duty all investment professionals should have to their clients when the relationship includes advice, recommendations or investment direction. In these situations, regardless of claims of “market maker” or “discount broker” status or the like, investment professionals have a duty to their clients. The issue now before Congress is the level of that duty.  

The current problem, which Congress can fix, is that financial firms want to continue attempting to hide behind a lesser duty called the “suitability” rule when dealing with an investor who is not what they call a “retail” investor. For a good, detailed discussion of the difference between the “suitability” rule and the higher fiduciary duty, see:  "Congress Drops the "F-Word" (Fiduciary)."

FINRA arbitrations are now littered with investments hawked by firms that are now claiming that these products were “suitable” even though more and more evidence continues to emerge that many Wall Street firms continued to promote products based on the investment firms’ profit motivations rather than the best interests of their clients who purchased these products. Examples include billions worth of a bond mutual fund product called YieldPlus sold by Schwab, over $1 billion in Lehman Brothers principal protected notes sold by UBS, and products sold by other firms such as reverse convertibles, annuities oversold to retirees, and municipal bonds sold at inflated prices due to conflicts of interest and sold without adequate due diligence.  

It may not surprise you to learn that this “suitability” rule does not come from elected members of Congress or even the SEC, but rather it is a FINRA (Financial Industry Regulatory Authority) rule that is a creation of the securities industry itself. Specifically, the “suitability” rule is Wall Street’s self-imposed and outdated lower standard of care. Despite the industry’s hand in wrecking our economy, what you see is a big swath of the securities industry and its lobbyists continuing to market to the American people that the industry provides trustworthy and independent guidance, advice, and recommendations, but that it should not be legally required to act in the best interests of its own clients.

Of course, FINRA (formerly the NASD) as the securities industry rule-maker could simply seek the permission of the SEC – or the SEC could persuade FINRA – to amend its rules to impose a fiduciary duty on its brokerage firm members, leaving Congress free to focus on serious macro market issues such as systemic risk. But since FINRA is effectively a creation of the securities industry and since the SEC has difficulty being reactive – much less proactive – these days, it is perhaps naïve to think that either FINRA or the SEC would move aggressively in the investing public’s best interest.

It is now up to Congress to cut through all the doubletalk and effectively replace the “suitability rule” with a fiduciary duty rule with respect to all situations – regardless of the client – when they are in situations where a suitability rule already applies. I hope this amendment will not get lost in the shuffle of more high profile issues such as derivative regulation and dealing with banks that are allegedly “too big to fail.”