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Bar News - July 16, 2014


Investment Advisor Fiduciary Duty: Why It Matters

By:


Michael Hatem
Lawyers frequently work with or at least know of a clientís financial advisor. What we donít know is whether that advisor is acting as a fiduciary.

As a lawyer, it seems impossible that a clientís financial advisor would not owe the client a duty to act in their best interests. The reality is that this is often the case. There is a battle going on now as to whether the fiduciary duty will extend to broker-dealers (aka stock brokers). Currently, the standard of care for broker-dealers is simply suitability, a much lower standard. It is unclear how regulators will address this issue. Although there has been a lot of legislation to protect investors, the industry is resisting any change on this front.

Why does it matter? There are two types of financial professionals; brokers and investment advisors. A broker-dealer does not owe his client a fiduciary duty. He only has to make sure the products he sells are suitable for the client. Selling derivatives to a grandmother is likely to be found unsuitable. Selling mutual funds with a higher commission is suitable, but likely a breach of a fiduciary duty. A broker-dealer is paid a commission on sales of financial products; no sales means no payment. It may be in a clientís best financial interest to simply hold his or her positions, but that is not in the best financial interest of the broker-dealer.

Fee-based advisors owe clients a fiduciary duty and therefore are paid a fee and are not usually paid on commissions. (Some products, like insurance policies or some annuities, do pay a commission and, therefore, before an advisor sells that product, he should disclose the commission component.) By being fee-based, there is no conflict of interests in the selection of products. Conflict is inherent in the commission-based model.

To demonstrate the differences, assume your client just inherited $1 million that he needs to invest. If he hires a broker-dealer to assist in his financial planning, he will pay a commission on the investments. Assuming the entire million is invested, the commission for that would be about $52,500.

If he went with a fee-based investment advisor, the money would be invested and the fees based on assets. The annual fee in that case would be around $12,500 a year.

In the second year, if there were no sales, the broker gets no pay and the advisor gets another $12,500+/-.

In the third year, the portfolio would probably need to be rebalanced, so assume a third of the portfolio is bought or sold, to keep it properly balanced. The broker will get another $17,000 on those sales, and the advisor will rebalance the portfolio as part of the annual fee. The advisor most likely would rebalance the portfolio annually or semi-annually, as part of his management fee. This will continue for the life of the portfolio.

Not only does the commission-based advisor charge the client more over time, but because he only has to meet a suitability standard, he also is more likely to call your client with a hot stock tip to invest in. It is in the brokerís own best interest to make sales, not manage money. That conflict is obvious to lawyers, but it is standard business practice in the financial industry today.

For lawyers, it is a good idea to advise clients of the potential pitfalls associated with picking a financial advisor. This is especially true for clients who, because of divorce, death or settlement, have sudden wealth. A good first question to ask your advisor is, ďAre you a fiduciary?Ē If not, find someone who is.


Michael Hatem is an attorney and principal at Core Guidance Financial Services in Hampstead.

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