Executive Summary
As debate continues about the potential for a fiduciary duty to be imposed on (most) advisors, either by the Department of Labor or the SEC (or both!), an implicit and sometimes explicit objection to the proposed changes are that it may be extremely "disruptive" to existing business models, and that many advisors couldn't survive without having the opportunity to charge at least some commissions in some circumstances to some clients (or alternatively that a large segment of the public would lose access to an "advisor" altogether if commissions are banned).
However, as today's guest blog post from legislative and regulatory consultant Duane Thompson explores, the reality is that commissions and a fiduciary duty are not entirely inconsistent with one another. In point of fact, even the Investment Advisers Act of 1940 does potentially allow for some commissions, and a look at the history of fiduciary law reveals other situations where a fiduciary duty and at least some forms of commissions have been allowed to co-exist (and client advice or advisor business models haven't necessarily been harmed as a result).
Certainly, the reality is that many forms of today's commissions would not be permissible under a robust fiduciary duty for advisors, but ultimately a fiduciary duty is largely about being able to demonstrate a process that was followed to affirm that a recommendation meant the joint duties of loyalty and care to the client... not that a fiduciary duty explicitly bans any and all forms of commissions. Nor are all commissions necessarily fatal conflicts of interest anyway, as evidenced by the fact that 12(b)-1 fees and investment adviser AUM fees often amount to near-identical compensation for near-identical recommendations to clients (even though technically one is a form of commission and the other is not). At a minimum, though, it's important to recognize that the fiduciary duty is not merely about permitting some types of compensation and banning others, but instead requires a more nuanced look at the advisor and the processes that he/she follows in implementing advice with clients... and that perhaps it's time in the fiduciary discussion to focus less on types of compensation paid for advice, and more on the standards and processes that advisors are expected to adhere to in delivering that advice!
Given the premise that a fee arrangement is inextricably bound with the fiduciary standard, it would seem logical to assume that a salesperson working on commission cannot be a fiduciary. However – spoiler alert – you would be wrong.
That is not to say that working on a commission basis and serving the client’s best interest is an easy thing to do – it’s just far more difficult, at least in legal terms.
In the narrow context of this question, we explore that rare adviser-client relationship in which an adviser is paid a commission while serving in a position of trust and confidence with the client. We exclude the more common situation where the adviser has multiple industry affiliations and may be a fiduciary in developing a financial plan or investment allocation wearing her RIA hat, but implementing some of the recommendations wearing others. For example, nearly nine out of 10 investment adviser representatives are also registered as brokers who work on commission.
Certainly, the switching-hats syndrome is confusing enough for advisers, much less the consumer who believes that all financial intermediaries act in their best interest. But here we explore the question of whether a person who receives a commission can legally serve in a fiduciary capacity. Admittedly those instances are rare, and the fiduciary path laden with pitfalls. Almost always under the law there will be conditions attached that make it difficult to receive traditional commission compensation. Yet there are at least three different ways and perhaps others as well.
Option 1: The Commission-Only RIA
The first approach might seem surprising, since the odds are literally 1 in 2,500 that the RIA shop down the street is commission-only. However, while all investment advisers are held to an underlying fiduciary standard for their investment advice, the definition of an investment adviser in Section 202(a)(11) of the Investment Advisers Act of 1940 is agnostic in how an adviser is paid. The Advisers Act defines an investment adviser in broad terms, such that “[a]ny person who, for compensation, engages in the business of advising others” about investing in securities, and as a central part of the business, would be subject to registration.
Based on a literal reading of the statute, it’s not difficult to understand why the SEC arrived at the conclusion that a commission is compensation, just like an hourly or asset management fee. But what is difficult to fathom, as we shall see when we look at the other options, is the absence of specific SEC guidance for commission-only RIAs, or at least what constitutes reasonable commission compensation under the Advisers Act fiduciary standard that would not violate the fiduciary duty of loyalty.
Since an adviser’s other industry affiliations may pose a conflict in terms of compensation and product sales that benefit the adviser more than the client, Part 2A of Form ADV requires disclosures of these conflicts. In particular, Form ADV singles out commissions and broker-dealer affiliations as conflicts of interest that must be disclosed. As a result, Form ADV requires disclosure of to clients of various forms of compensation. Many adviser registrants will disclose commission arrangements, but it is almost always an adjunct to their asset management fees, the most common form of compensation arrangement for RIAs.
Ironically, the Advisers Act is not completely compensation-neutral. In an odd way one could argue that it discriminates against broker-dealers by requiring them to register as investment advisers if they receive ‘special compensation’ for their investment advice. Of course, most broker-dealers would gladly accept fees as they did under the old Merrill Lynch Rule. That rule allowed them to avoid the blanket fiduciary duty imposed on investment advisers, as well as execute principal transactions with only a smidgeon of disclosure. However, a federal appellate court vacated the Rule in 2007, holding that the SEC erred in carving out a special exemption for broker-dealers separate from the exemption for them written into the law by Congress in 1940.
Generic compensation then – of any form -- is the litmus test for registration of a person or firm that dispenses investment advice as a core part of their business. That said, the commission-only RIA is a rare breed. In fact, of the 11,475 adviser firms registered with the SEC today, only four of them are commission-only. Their numbers were reduced several years ago when Bernie Madoff went to jail. No, I am not suggesting guilt by association with the handful of current commission-only RIAs. Madoff stole money from his clients and the standard of conduct did not really matter. But in 2006 the SEC required him to register as an investment adviser – ironically under the same Merrill Lynch Rule -- because he held discretion over client accounts. As such Madoff was technically an investment fiduciary who joined the ranks of commission-only advisers. Today, even though 99.97 percent of advisers registered with the Commission are fee-only, salaried, or a fee-and-commission blend, in the eyes of the SEC, at least, all are fiduciaries, including the handful of commission-only RIAs.
From the legislative history of the Advisers Act, we also know that starting in the 1920s, investment advisers had always distinguished themselves from stockbrokers by charging fees and affirming a duty to act in the clients’ best interest. Although the fiduciary duty was never formally incorporated in the statute, in 1963 the U.S. Supreme Court affirmed this duty in SEC v. Capital Gains Research Bureau (1963). In Capital Gains, the Supreme Court concluded that some employees of the adviser’s newsletter, which offered investment tips, had engaged in front-running, thereby breaching the adviser’s fiduciary duty under the Adviser Act’s anti-fraud provisions. While Capital Gains is commonly championed as a landmark decision in the fiduciary arena, it can also be argued that the facts in the case highlighted only the duty of loyalty and not the duty of care, resulting in a standard in which the SEC focuses principally on the former, not on the duty of care, or prudence.
The anti-fraud provisions under Section 206 of the Advisers Act do not help in making a connection between reasonable compensation methods and the duty of loyalty. Section 206 simply prohibits “any device, scheme, or artifice to defraud any client or prospective client” or to “engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client.” (Sections 206(1) and (2) of the Advisers Act.) Such conflicts presumably include fees that are unreasonable in light of services provided, but SEC guidance rarely addresses the reasonableness of adviser fees. However, SEC rules address a whole host of other conflicts, in Form ADV and elsewhere, including failure to omit information about an adviser’s disciplinary history, failure to seek best execution, and among other things, failure to adopt a proxy voting policy when holding trading authority over client accounts.
If you are still unconvinced that an investment fiduciary (at least in legal terms) can accept commissions, Congress confirmed the legality of commission compensation in the Dodd-Frank Wall Street and Consumer Protection Act. According to Section 913 of the Act, if the SEC were to adopt a uniform fiduciary standard, the “receipt of compensation based on commission or fees shall not, in and of itself, be considered a violation of such standard applied to a broker, dealer, or investment adviser.” (Dodd Frank, Sec. 913(g)(1))
Option 2: Stockbroker Fiduciaries under the Common Law
The second way to receive commissions as a fiduciary, interestingly enough, is as a registered representative of a broker-dealer. This may seem implausible since the federal securities laws and the Supreme Court have never recognized an underlying fiduciary duty for brokers. Ironically, under the laws of agency, brokers are held to be fiduciaries of the principal, in this instance the broker-dealer or insurance company. However, over the decades many state courts have in effect diluted the agent loyalty-to-principal duty where the broker is found to have acted in a position of confidence and trust to the customer, or held discretionary trading authority over the account. Many years ago FINRA added to the dynamic tension between principal and agent by injecting a suitability standard that ends up dividing the broker’s loyalties between the firm, the customer, and himself.
In 2012 a Texas Tech study analyzing the costs of a fiduciary standard for brokers confirmed that a form of fiduciary duty is applied broadly around the country under common law precedent. Indeed, the appellate or high courts in four states (California, Missouri, South Carolina and South Dakota) expressly impose a fiduciary duty on brokers. Another 32 states have applied a form of fiduciary standard depending on the ‘facts and circumstances’ of each customer relationship. Courts in only 14 states have declined to apply a fiduciary standard under almost any circumstances, the one exception being discretionary authority.
The common-law test, however is impaired for a number of reasons. The body of law has not been consistent across the states, nor is it easy to understand or apply to all customer accounts. More importantly, the development of a uniform standard has been stunted by the universal use of binding arbitration in securities disputes that started in the early 1990s. Arbitration panels usually do not provide a written explanation for their judgments, and even when they do, these are often sketchy, and no substitute for legal precedent. Still, if FINRA followed CFP Board’s lead in offering a summary description of the facts involved in arbitration decisions, it would serve as useful compliance and best practice tools since fiduciary breach claims are the most common complaint filed in broker arbitration. However, the extent to which fiduciary breach claims are upheld or used as a basis for awards in FINRA’s arbitration forums is completely unknown.
Option 3: Fiduciary Adviser Rule under ERISA
The third way to accept commission as a fiduciary is under ERISA’s current fiduciary adviser rule, as adopted by the U.S. Department of Labor in 2011. Perhaps a better characterization of this arrangement would be receipt of commission by the fiduciary adviser’s firm, not the adviser. Under the rule the fiduciary adviser interfacing with participants can only receive ‘level compensation,’ meaning compensation that does not vary, no matter the investment recommendation. However, the adviser’s affiliated firm may receive variable compensation, i.e., commissions, under certain carefully prescribed conditions. For example, under the rule’s other option permitting computer advice, variable compensation may be received by the firm, such as 12b-1 fees.
However, fiduciary restraints apply to the selection of the plan’s designated investment options, making it difficult for firms to rest assured that their advisers will steer participants into their preferred funds. Construction of a diversified portfolio based on Modern Portfolio Theory is required, as well as relying on traditional suitability factors such as age, risk tolerance, time horizon, life expectancy, and current investments in developing investment recommendations. Under either arrangement – human or computer model -- disclosure of compensation to the participant must include any commissions or other revenue received by the affiliated firm. Other constraints include annual certification by an independent auditor that the algorithms used in the computer model, or advice formulated by the human adviser, is not biased, nor “inappropriately” favors options that generate greater income for the firm. Additionally, like any ERISA fee, the overall investment expenses must be ‘reasonable.’ Hence the ability of a firm to receive commissions in connection with advice provided by an agent has numerous strings attached. For these reasons, not to mention the cost of due diligence cost in developing individual investment recommendations, not many of the firms that lobbied vigorously for a broad safe harbor use it.
Separate from the fiduciary adviser rule, broker-dealer reps sometimes unknowingly accept 12b-1 fees for their advice to retail clients with 401(k) accounts. However, with growing awareness of the need to ‘levelize’ ERISA fees, today, many broker-dealers in this situation simply rebate 12b-1 fees from those accounts to the plan, thereby avoiding a prohibited transaction under ERISA.
Private Trusts and Other Issues
It is unlikely that advisors to private trusts are able to accept commissions or compensation other than ‘level’ fees. However, additional legal research is needed to confirm this view. It is fair to say, though, that because the Uniform Prudent Investor Act (UPIA) and Uniform Prudent Management of Institutional Funds Act encourage trustees to delegate investment responsibilities to an expert, the experts then become co-fiduciaries who must also act solely in the interest of the trust beneficiaries.
Like all investment fiduciaries, advisers to trusts should carefully benchmark their fees to ensure they are reasonable. A 2010 survey by a trust newsletter reported directed trust service fees at a number of large firms ranged from 40 to 110 basis points and, separately, investment management services for trust accounts ranged from 90 to 133 basis points on the first million in assets.
Additionally, the legislative notes for the UPIA require the fiduciary to control and account for investment expenses. However, nowhere in either model law are commissions directly prohibited.
Finally, there is one other obscure registration in the financial services industry that often imposes a fiduciary duty - and that is the body of 30 state insurance consulting laws. Although the definition of an insurance consultant varies across these states, for the most part the consultant definition usually includes a fee to distinguish the licensing requirement from insurance producers. While there is little in the way of disclosure requirements, commission-based compensation would not appear to be an issue.
Complying With Fiduciary Duty While Earning Commissions And Differences Amongst Fiduciary Standards
Having made the argument that investment fiduciaries can receive commission compensation, we can see that the instances when this happens are indeed rare and usually with stringent fiduciary-like conditions attached.
Unfortunately, the Advisers Act and the SEC are more forgiving than the Department of Labor in the treatment of conflicts, no matter the form of compensation. For example, under the Advisers Act, disclosure of a conflicted compensation arrangement will often serve as an adequate remedy. Boilerplate disclosure as a standard remedy, though, may be inadequate. According to the Instructions for Form ADV, if a conflict arises or the adviser engages in an activity that was not previously disclosed, or if the activity is disclosed but the client requires more detail, then additional disclosure is needed to obtain the client’s consent. The facts also must be described with enough detail so that the client is able to understand the conflict and give informed consent. Since most clients reportedly skim Form ADV at best, the effectiveness of boilerplate disclosure as a way of managing conflicts is questionable absent an additional follow-up discussion with the client. That is why many financial planners carefully document their in-person meetings with clients, to ensure there is mutual understanding so that the client is able to make an informed decision regarding a conflict, and for the planner’s benefit in mitigating potential liability.
Form ADV disclosures, however, confirm that the SEC recognizes the clear conflicts of interest posed by commission compensation. For example, if an adviser primarily recommends mutual funds to its clients, it must disclose whether no-load funds are also considered. Similarly if the adviser charges a fee for a financial plan in addition to a commission for implementing a planning recommendation, the adviser must disclose on Form ADV whether planning fees are reduced to offset the commission.
That said, as one fiduciary adage goes, the best way to manage conflicts is to avoid them. The Advisers Act falls short in this regard compared to ERISA and state trust laws.
One can debate why the Advisers Act has a lower standard of fiduciary care than ERISA, but in many ways Congress set the stage by modeling ERISA on the common law of trusts, which has had centuries of legal precedent, and requires ERISA and trust fiduciaries to act solely in the plan or trust beneficiaries’ interest, a much higher standard than the Advisers Act’s ‘best interest’ standard.
As an example, if I were dually registered and clearly disclosed to my retail client that I may receive 12b-1 fees in a taxable account, I can legally do so under the Advisers Act (as long as the fee is reasonable). However, I could not receive the same 12b-1 fee for the same mix of investments in a 401(k) or other qualified plan account, no matter how reasonable the fee or willing the client is to grant consent.
Another reason why ERISA has a more robust fiduciary standard is that, unlike the opaque nature of arbitration forums, fee and other disputes can be litigated under ERISA’s private right of action. In other words, individuals can sue under ERISA based on an alleged violation of the law. Cases that are decided in a court of law provide reasoned decisions open to the public. The decisions must follow precedent, building upon decades of earlier decisions. There is no private right of action under the Advisers Act or other federal securities law. Thus, we have to rely on the spotty guidance that the SEC offers from time to time and on occasion, enforcement cases that directly address a breach of fiduciary duty. Citing court cases, one former SEC attorney suggests that an AUM fee of more than 2 percent would be excessive, and require the adviser to disclose that its fees are higher than average. In contrast, under ERISA, disclosure would not be an adequate remedy. Whether a fee is reasonable under ERISA would have to be documented by benchmarking fees to peers. The penalties under ERISA would include possible sanctions from the DOL and damage claims in court for which the fiduciary is held personally liable.
Accordingly, it is safe to conclude that commission-based compensation under the law – including ERISA – is not a per se breach of fiduciary conduct. However, it’s also clear that financial incentives such are commissions are not a best-fit in a fiduciary environment. If one were to insist on using the commission model, at a bare minimum it would seem that substantial documentation would be necessary in order to defend in a court of law that the commission rate was reasonable and in line with the cost for similar services based on a fee arrangement. Additionally, further documentation would be needed to demonstrate that less-expensive courses of action were impractical. But as we can see, the time and effort needed to justify commissions in a fiduciary relationship underlines just a few of the many reasons why the fiduciary advice model is flourishing and the sales model is not.
