Brokers May Have to Change

“A report by Rand Corp. last year found that 63% of investors think brokers are legally required to act in the best interest of the client; 70% believe that brokers must disclose any conflicts of interest.  Advisers always have those duties, but brokers often don’t.  The confusion is understandable, because a lot of stock brokers these days call themselves financial planners.” – Jason Zweig.

If you are confused by the difference among these titles: Financial Planner, Stockbroker, and Registered Investment Advisor, you are not alone.  The “Name Game” in the financial services industry is downright confusing.  How does your financial advisor operate?  How does she get paid?  What are the advantages and disadvantages of each arrangement?

Many people believe that they are getting financial planning from a stockbroker, when in fact financial planning is usually only an incidental part of what a stockbroker does.  Similarly, many people are not aware that a stockbroker does not have to act in the client’s best interests.

A June 19th Wall Street Journal article Big Change in Store for Brokers in Obama’s Oversight Overhaul brings home this point.

According to the article, stockbrokers might have to change the way they do business; they might have to act in their client’s best interests, the way a Registered Investment Advisor already does.

Wow!  What a concept.

Here are the relevant quotes:

Buried in President Obama’s proposed regulatory overhaul is a change that could upend Wall Street: Brokers would be held to a higher “fiduciary” standard that would compel them to place their client’s interests ahead of their own.

Currently, brokers are only required to offer investments that are “suitable,” which means they can’t put clients in inappropriate investments, such as a highly risky stock for an 80-year-old grandmother. The move could change the way products are sold and marketed and even how brokers are compensated.

Many investors don’t even know the difference between the two standards, believing their brokers already are acting in their best interests.

But requiring brokers to operate under a fiduciary standard could force them to offer products that are less costly and more tax-efficient. They will have to disclose any potential conflicts of interest, such as any fees they may get for favoring one product over another. That could mean clients will be offered fewer proprietary products if the broker can find a lower-cost option elsewhere.

For example, a broker couldn’t put you in a mutual fund with higher fees — or one he gets a bigger commission for selling — if he could get a comparable fund with lower fees elsewhere, says Tamar Frankel, an expert on fiduciary law at Boston University School of Law. (Emphasis added.)

The article implies that some stockbrokers sometimes put their interests above yours.  Hmm.   This might just be worth investigating.

Luckily, I’ve discussed this topic many times, and in fact I have a series called The Dark Side of Wall Street, which lists all of the relevant posts.  If you start with Choosing a Financial Advisor, Part 1 at the bottom of the page, you can read them in order by following the “To be continued” link at the end of each post.

Avoiding Financial Fraud

Ron Lieber’s New York Times column Even Vigilant Investors May Fall Victim to Fraud was quite disturbing and not a little worrying. It recounts how Matthew Weitzman, a founder and principal at AFW Wealth Advisors, a Registered Investment Advisor, and a fee-only firm, is no longer with AFW. The firm informed its clients of “certain irregularities in a limited number of client accounts.”

You can read Lieber’s article for the details. What is not clear, though, is how much money was involved nor how quickly the irregularities were discovered. Though, from my point of view, they are not the most worrying aspects. What concerns me most is that Mr. Weitzman was a member of the National Association of Personal Financial Advisors (NAPFA).

When a member of the advisory community violates the trust that clients place in him, all clients and advisors suffer. What this country does not need right now is any further deterioration in what little confidence we have left in the banking system, the federal government or our financial advisors.

I have been a fee-only planner since 2003, and whenever possible, I recommend that investors seek out financial planners who are compensated directly by their clients, rather than by commissions. In this way, you will avoid obvious conflicts of interest.

Members of NAPFA all practice a fee-only method of compensation and sign a Fiduciary Oath, which means that they swear to act only in their clients’ best interest. So it is with great discomfort that I heard that not one, but two, former members of NAPFA have been accused of bilking their clients.

What to do? As Ronald Reagan once said, “Trust but verify.” And of course, you should never write checks directly to your advisor, but only to an independent custodian. It is the independent custodian who should be providing you with confirmations of all transactions and trades, and a monthly statement. These are sensible precautions in the age of Madoff.

As Lieber says, “Open your mail. Confirm the accuracy of your trades and fund transfers. Read your account statements. Every month. Every number. Every single word.” I am not sure about reading every number, every word, but I get his drift.

Lieber further recommends that you handle all of your stock transactions yourself. I believe most investors will find this “solution” impracticable, inconvenient and unnecessary. I believe a better solution is for you to sign a limited power of attorney, allowing your advisor to enter transactions on your behalf, but which does not allow him to withdraw your funds. Only you should have the ability to withdraw funds from your account. I am not an attorney, but I believe that this provides adequate protection. (Attorneys, please weigh in.)

My mother always said “A promise is a promise.” Unfortunately, there are always people who will promise one thing and do another. It’s disappointing to have your expectations dashed.

I don’t know about you, but I expect firefighters to be brave, judges to be moral and rabbis and priests to comfort the troubled. Yet, there have been judges who, instead of upholding the law, bend it out of shape for personal gain. And there have been priests and rabbis who have preyed upon our young and betrayed our trust.

Lieber says, “I’ve always believed that advisers in the (NAPFA) association were plenty smart and morally upright, but it’s hard to recommend them now without at least including an asterisk.”

In my experience, NAPFA members have the highest standards in the profession. But like every profession, there may be individuals who choose to violate the trust of clients they serve.

It’s not easy to protect yourself against out and out theft, but you can take some small comfort from the fact that if financial advisors break the law, they are subject to prosecution by the regulatory authorities.

In my opinion, a great majority of investors will lose countless dollars because of the continuance of “Standard Operating Procedures” at Wall Street investment firms. Every day these firms peddle ill-conceived, hard-to-understand, expensive investments, because it is profitable for them to do so. Investors will lose more money in the ordinary course of business than they will ever lose due to outright fraud.

Unfortunately, what is legal on Wall Street is bad enough.

And so, I will continue to heartily recommend NAPFA members, because the fiduciary standard is the right way to do business.

And yes, monitor your accounts. Remember, “Trust but verify.”

What We Can Learn from Madoff

“Bernard Madoff was able to pull off what is allegedly the largest investor fraud in history because people trusted him. But why did people believe his lies when there were so many reasons not to?” – Blaine F. Aikin.

For a full month, I have avoided writing anything more about Bernard Madoff; not because there was nothing new to say, but because it seemed that there was so much readily available about the tragedy.

However, an article in the January 18, 2009 edition of Investment News is worth highlighting. What We Can Learn from Madoff  by Blaine F. Aikin discusses how a proper fiduciary investigation should have and did raise many red flags.

Here is a summary:

Good fiduciaries are necessarily skeptical, so they sought verification of key information before they would invest. Their due diligence paid off; they uncovered troubling information in six areas of essential inquiry for fiduciaries.

First, Mr. Madoff didn’t use an independent custodian.

Second, his financial auditing was provided by a tiny, obscure accounting firm.

Third, Mr. Madoff produced his own performance reports and wouldn’t allow independent performance audits.

Fourth, the extraordinary investment success claimed for the fund didn’t jibe with reasonable investment benchmarks, and the results couldn’t be substantiated when subjected to fundamental testing of the trading strategy.

Fifth, the business structure of the fund made little economic sense. Moreover, it seemed designed to avoid regulatory oversight and to frustrate due-diligence efforts by prospects and clients. Rather than organize as a hedge fund and charge a lucrative performance-based fee, Bernard L. Madoff Investment Securities LLC operated as a commission-based broker-dealer with distribution provided through hedge funds of funds.

Finally, he showed little appreciation for, and no processes to apply, fiduciary standards of care. … He rejected potential investors who asked penetrating questions, reacting to such inquiries as an affront to someone so accomplished in creating wealth.

Conclusion

There were many hedge funds which invested their clients’ money with Bernard Madoff. The hedge fund managers collected sizable fees for being conduits or “feeders.” Amazingly enough, they claim that they did their homework and investigated Madoff thoroughly. One firm in particular was quoted in the New York Times on December 14th defending their actions.

The Fairfield Greenwich Group “performed comprehensive and conscientious due diligence and risk monitoring,” Marc Kasowitz, a lawyer for Fairfield, said in a statement. “FGG, like so many other Madoff clients, was a victim of a highly sophisticated massive fraud that escaped the detection of top institutional and private investors, industry organizations, auditors, examiners and regulatory authorities.”

Now, Fairfield is seeking to recover what it can from Mr. Madoff.

The fraud was long lasting, and the red flags should have been apparent. Some investment managers completely missed the warning signs. But not all. According to Blaine Aikin, “a number of dedicated fiduciaries, including several large financial institutions, investment advisers, retirement plan sponsors and endowment administrators, found Mr. Madoff’s magical ability to generate consistently stellar returns to be too good to be true.”

Choosing a Financial Advisor, Part 3

“Fiduciary – A Financial Advisor held to a Fiduciary Standard occupies a position of special trust and confidence when working with a client.  As a fiduciary, the Financial Advisor is required to act with undivided loyalty to the client.  This includes disclosure of how the Financial Advisor is to be compensated and any corresponding conflicts of interest.” – Focus on Fiduciary.

In a previous post, I said that, when looking for a financial advisor, you want someone who puts your interests first, i.e. a fiduciary.  This merits further discussion.  By way of example, lawyers, trustees or doctors are considered fiduciaries. On the other hand, stock brokers, insurance agents and registered representatives are not.

According to the National Association of Personal Financial Advisors (NAPFA) web site, Focus on Fiduciary:

Federal and state law requires that Registered Investment Advisors are held to a Fiduciary Standard.  This law requires that an advisor act solely in the best interest of the client, even if that interest is in conflict with the advisor’s financial interest. Investment Advisors must disclose any conflict, or potential conflict, to the client prior to and throughout a business engagement.  Investment Advisors must adopt a Code of Ethics and fully disclose how they are compensated.

Because broker-dealers are not necessarily acting in your best interest, the SEC requires them to add the following disclosure to your client agreement.  Read this disclosure, and decide if this is the type of relationship you want to dictate your financial security:

“Your account is a brokerage account and not an advisory account.  Our interests may not always be the same as yours.  Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest.  We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

If you see this disclaimer in your contract, you have been warned that you are not working with a fiduciary.  My question to you is, “Why would you even consider working with someone who has issued you this warning?”

After all, you engage a financial advisor to look after your interests. In my opinion, having a trusted relationship is not possible after you have read the warning quoted above.  Since commissioned representatives receive incentives for selling one investment over another, how do you ever know why someone recommends one investment product to you over another? How do you know what it is actually costing you?

I wholeheartedly agree with NAPFA’s conclusion:

NAPFA has always maintained that an advisor who is compensated solely through commissions faces immense conflicts of interest.  This type of advisor is not paid unless a client buys (or sells) a financial product.  A commission-based advisor earns money on each transaction—and thus has a great incentive to encourage transactions that might not be in the interest of the client.  Indeed, many commission-based advisors are well-trained and well-intentioned. But the inherent potential conflict is great.

I believe that a strict fee-only approach is the best way of working with clients.  I want my clients to consider me as a trusted advisor and true partner, not a salesperson.

To be continued.

photo credit: Rui Almeida (Portugal)