Believe it or not, the people you pay to advise you at Wall Street investment houses aren't required to act in your best interests. Soon they will be.
Update 7/15/10: The article below was written prior to final passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule discussed in the article below regarding investment advisers acting in a fiduciary capacity wasn’t included in the final bill – instead, the new law directs the SEC to study the issue for six months, then act according to the results of their study. For more information, see What Financial Reform Means to You.
After a contentious debate, the new financial reform legislation will include a provision requiring stockbrokers and other Wall Street advisers to provide advice in the best interests of their clients.
The obvious question: if investment advisers at Wall Street firms like Merrill Lynch are only now being required to do the right thing for their clients, what have retail investors been paying them for over the last century?
As it turns out, the little guys have been paying for a lesser standard, known in the industry as “suitability”. Investment recommendations made by retail stock brokers – often working on commission – had only to be suitable for the client, not necessarily in their best interests.
The duty to act in someone’s best interests is called a “fiduciary” duty.
Example: your broker calls and recommends you buy a particular mutual fund, and the mutual fund would generally fit your investment profile: it’s suitable for someone with your risk tolerance, tax bracket and investment objectives.
What you don’t know, however, is they’re recommending that fund because it pays them more commission and thus costs you more in fees than other similar funds. Under the old rules of suitability, that’s OK, because the fund recommended was suitable. But not under the new rules, because they know there are better choices, and thus aren’t acting in your best interests.
The fact that people being paid to provide you with objective advice for the last century weren’t required to do so is amazing. What’s more amazing is that many in Congress wanted to keep it that way – this provision barely made it into the final bill. Instead of simply requiring all investment advisers to give honest advice, some Wall Street-friendly Congresspeople wanted to just “study” the problem instead, effectively burying it.
From the Huffington Post:
The Senate proposal, pushed by Sen. Tim Johnson, Democrat from South Dakota, called for a study to examine whether brokers — middlemen between sellers and buyers of securities — should act in the best interests of their clients when peddling securities and investment advice. Investment advisers are held to this standard, known as a fiduciary duty. Yet brokers for Wall Street firms, even when performing the exact same function, currently are not.
Investor advocates blasted Johnson, and the Senate conferees negotiating the final financial reform bill, for adopting the proposal late Tuesday.
(Rep. Barney) Frank, however, was able to persuade Johnson and his Senate colleagues to support the House version of the same provision. Conferees from both chambers adopted the measure, ensuring its place in the final bill.
While this provision of the financial reform bill won’t take effect for six months after passage, it promises to bring big changes to Wall Street.
Imagine that: people who historically have been exceedingly well-paid for providing objective advice will soon actually have to do so.
What will they think of next?