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What minimal duties does an investment advisor owe you?

Posted by admin on June 7, 2010 in Investment Information

There is a great deal of debate among policy-makers, regulators and in the blogsphere on whether an investment advisor should be held to a fiduciary duty. In plain English, a fiduciary owes a person a duty of loyalty, not to put his or her personal interest before such duty and not to profit from the duty unless with consent. Those opposing such duties to all financial intermediaries (some class of financial advisors, such as investment counsel, are already are fiduciaries and, depending on the facts, some advisors can be held to be fiduciaries) can be classified into 2 general camps: (i) the usual opposition to change; and (ii) the “how about actually enforcing the current rules” school.

With respect to the latter camp, it has been asserted that the debate about holding investment advisors accountable seems to be occurring in a vacuum. The theory being that it is not that investment advisors are not being regulated but that the current regulation is not being enforced; a very common issue among lawmakers who pass laws to score political points with little thought to implementation or enforcement.

If one subscribes to that theory, what regulations need to be enforced to ensure that investment advisors are meeting their minimum duty of care?

At the very minimum, the law requires investment advisors to act with prudence, diligence, honestly, faithfully and without conflict of interest. What does that mean in the day to day relationship between investment advisor and client?

KNOW YOUR CLIENT

This term is used quite often by the industry. What it means is that an investment advisor must know their client’s personal circumstances, net worth, family situation, risk tolerance, financial sophistication (or lack thereof) and investment objectives.

Flowing from the know your client rule is the duty to follow the objectives as agreed to by the advisor and client and to provide recommendations and products which match the client’s personal circumstances. For example, an advisor should not be recommending a leveraged ETFs to a 63 year old female who has not agreed to any risk taking in her objectives.

ON GOING DUTY TO UPDATE, ADVISE AND REPORT

An advisor has an on-going duty to contact their clients regularly to ensure they continue to know their clients (given that people’s life circumstances change), provide updates as to investment objectives and advise whether their portfolio needs to be changed as time passes.

DUTY TO PROVIDE OBJECTIVE ADVICE FREE FROM CONFLICT OF INTEREST

The advice or recommendations must be prudent and objective (an objective standard is generally what a reasonable advisor would have advised or recommended in similar circumstances without the benefit of 20/20 hindsight) and free from a conflict of interest. With respect to conflict of interests, it is not that an advisor cannot be without a conflict of interest but that the conflict must be declared and the client acknowledge and agree to taking the advice or recommendation having been informed of the conflict.

…the following three heads are a non-exhaustive review of the current standard. It is, in the abstract, a pretty reasonable standard. It requires an investment advisor to understand their clients, keep on-going contact/dialogue and provide prudent, objective advice free from conflicts of interest.

It is worth noting that the standards themselves require a two-way dialogue. An advisor cannot advise a client with unclear investment objectives, who fail to respond to advisor questions or who over-ride otherwise prudent advice. It would be unfair to throw all investment advisors under the bus when investing mistakes are sometimes self-inflicted. Next week, I’ll tackle defenses investment advisors have to client allegations their advisor failed to meet their duty of care (for those with unrealistic expectations, there is no duty to make money for the client-just to provide honest, prudent and reasonable care).

Some believe that because the current standard is reasonable and, if enforced properly, would protect most of the investing public, a movement to a higher fiduciary standard would be a symbolic but hallow gesture. If the regulators and government is doing such a relatively poor job enforcing the current duties of care, what makes one believe merely moving to a higher standard will mean people in charge of protecting the investing public will do their job properly? Should not the emphasis be on better enforcement?

This is not an outlandish objection to moving to a higher duty of care to investment advisors. After all, if you believe the system is broken, to mix metaphors, putting a new coat of paint on a run-down home and calling it a “fixer upper” still doesn’t change the fact the house needs a lot of work. It just sounds better to the public.

On a more practical level, regardless of one’s position on moving to a fiduciary standard, review the above duties of care and see if your advisor is meeting them.  If not, take pro-active action to ensure you have a productive relationship with your investment advisor.

Addendum: I would be remiss in not mentioning Preet’s excellent post on doing a background check on your financial advisor.