One of the shocking things I learned about the personal investment industry during the years I worked as a Registered Investment Advisor was how often even the most reputable stockbrokers acted against their clients’ best interests.
Recent suits against the Securities and Exchange Commission (SEC) may change all this — but this remains to be seen. The industry has successfully fought off attempts at real reform for decades.
How to Mismanage Client Funds (and Get Away With it)
I’ve written about this kind of problem before, but, briefly, here’s what I’m talking about: One client came to me after several years of having his account with Fidelity, certainly one of the good guys — or at least “better guys” — in the business.
A substantial part of his portfolio was invested in mutual funds with a back-end load — basically funds with a second sales commission. A wealth of research shows that load funds provide no discernable benefit over the widely available, more cost-effective no-load funds the broker could have bought for the client — and should have if he were acting in the client’s best interests.
Another client came to me with a portfolio with a value of little under $1 million. The portfolio held many hundreds of different stocks, almost all of them small purchases of 100 or 200 shares. Looking next at the account history, I realized that the portfolio was also in a constant state of turnover.
The result was thousands of dollars of transaction fees every year that went into the broker’s pocket and should have remained in the account. Historically, the account had substantially underperformed what could have been achieved with a single broad-based index fund costing thousands of dollars less.
Why This Is Considered “OK”
In neither case, nor in hundreds of thousands of cases like it, were the brokers acting in their clients’ best interests. No problem — they don’t have to. For years, Congress (with different degrees of motivation) has attempted to get the SEC to improve matters simply by holding brokerages to the same fiduciary standard the SEC requires for Registered Investment Advisors — to always act in the client’s best interests.
Instead, the SEC has responded to industry pressure by repeatedly developed new rules that increase disclosure but do nothing to require brokers to engage in an actual fiduciary duty to its clients. Instead, they are only required to act “reasonably.”
You can’t sell them fake gold mine stocks, but you’re welcome to sell them as many underperforming load funds as it takes to send your kids to a very expensive prep school.
The New Sheriffs in Town?
This may be about to change. In the absence of federal action, seven states have recently sued the SEC for failing to protect investors. This month, attorneys general from New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon and the District of Columbia filed a complaint against the SEC in The United States Southern District of New York.
It alleges that the SEC’s current (and toothless rule) “makes it easier for brokers to market themselves as trusted advisors…while nonetheless permitting to engage in harmful conflicts of interest.”
The brokerage business is a trillion-dollar industry with all kinds of political clout provided by thousands of lobbyists and billions of dollars in political donations to members of Congress. But for the first time, entities large enough to provide a real challenge — the states’ attorneys general — have stepped into this longstanding fight.
It’ll be interesting to see how this develops. In theory, it would seem the states have the law on their side, namely the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.
But President Trump has promised to get rid of the act entirely and in May 2018 did succeed in rolling back crucial portions of it. And, even before the rollback, the brokerage industry had succeeded in persuading the SEC not to impose a fiduciary duty on brokers. Dodd-Frank only authorized the SEC to require it; it never required the SEC to actually do it.
