Posted by on May 18, 2010 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | May 15, 2010 12:01 a.m. ET



As Congress enters the final rounds of mud-wrestling over financial reform, small investors might end up splattered and trampled yet again.

At issue is whether a financial adviser — which nowadays means anybody from a stockbroker or insurance agent to a financial planner or “wealth manager” — should be held to higher standards of conduct.

Many brokers and insurance agents are obligated only to have reasonable grounds for believing that any investment they recommend is “suitable” for you. They need not inform you of conflicts of interest that might bias their judgment; you might never find out, say, that they sold you a particular fund primarily because it paid them a fatter commission than others would have.

Other financial pros, however, bear a “fiduciary duty,” meaning that they must put their clients’ interests ahead of their own and disclose potential conflicts. After the rolling calamities of the past decade, wouldn’t this be an improvement over business as usual?

A measure in the Senate’s earlier reform bill would have imposed a fiduciary duty on all financial advisers. It has been superseded by one that would merely study whether the current standards are adequate. An amendment introduced last week would exempt many insurance agents, and brokers selling their firms’ own products, from being fiduciaries.

According to a recent investigation by The Wall Street Journal, Congress may not be in a very good position to tell the difference between suitable and unsuitable financial advice.

Some members of Congress permit brokers to trade their accounts hundreds of times a year; others trade too much themselves. The accounts of 38 members of Congress or their spouses showed at least 100 trades apiece in 2008, according to public records; 15 had more than 300 trades each.

Such activity is just what long-term investors try to avoid. Regulations have long sought to protect small investors from “churning,” or excessive trading.

In a recent interview with the Journal’s Brody Mullins, Sen. Tom Coburn (R., Okla.) said that most of his money is managed by a professional adviser. The senator explained that his portfolio is heavy on oil and natural-gas stocks because energy is big business in his home state of Oklahoma.

Sen. Coburn added that he has his own account at TDAmeritrade, valued at about $70,000. He said he trades actively based on tips he gleans from Jim Cramer‘s “Mad Money” show on CNBC.

In 2008, Sen. Coburn traded Transocean four times in less than a month on Mr. Cramer’s advice. “I lost my shirt,” the senator said. He fared better with Tyson Foods, which he bought on Nov. 20, 2008, and sold less than three weeks later. “I bought it and got out because it went up,” Sen. Coburn said. He added that he regretted selling Tyson so quickly, because its price kept rising after he sold.

While it’s far from clear that Congress has the courage and knowledge needed for reform, it’s quite clear what shape the reform should take.

Arthur Laby, a professor at Rutgers School of Law-Camden and a former assistant general counsel at the Securities and Exchange Commission, points out that securities salespeople are usually exempted from a fiduciary duty if their advice is “solely incidental” to their brokerage services and if they receive “no special compensation” for providing advice.

But that exemption, says Mr. Laby, is “an antiquated concept embedded in an antiquated statute.” When the law was enacted, in 1940, many brokers acted as custodians for cash or securities, and trading was much more cumbersome than it is now. “Today, advice is the main dish,” points out Mr. Laby, “and it’s brokerage that’s become ‘solely incidental’ to advice.” Therefore, he says, anyone providing individualized investment advice should bear a fiduciary duty toward his clients — putting their interests first and disclosing any conflicts of interest.

Going one step further, Mr. Laby suggests that Congress could require investment banks to bear a fiduciary duty toward anyone who buys the stocks or bonds they underwrite. Instead of having a primary duty toward the issuers of the securities, Wall Street would first have to do right by the purchasers.

While that might not completely prevent underwriters from generating the kind of toxic waste that poisoned investors over the past decade, it might well cut back on the volume of sewage. It’s a reform well worth considering.

Source: The Wall Street Journal, 




For further reading:


Chapter Ten, “The Investor and His Advisers,” in The Intelligent Investor


On Fiduciary Duty

It’s Time for a Revolution in Investor Disclosures

Financial Advisers: Show Us Your Numbers