Executive Summary
Should fiduciary wealth management firms have minimum capital requirements, to ensure they can make good to clients if they do fail in their fiduciary duties? One of the professed strengths of the RIA model is the fact that such firms are held to a fiduciary standard, providing a higher level of legal accountability for firms that fail to put their clients' interests ahead of their own. But strictly speaking, that really only holds as a consumer protection if the firm has the financial wherewithal to actually pay damages, should they arise.
The inspiration for today's blog post comes from a Bloomberg article I read this morning, somewhat controversially entitled "Safeguards are Scant as Ranks of Registered Investment Advisers Swell 39%". Unlike some of the other criticism against RIAs in the fiduciary debate - which focuses on whether there is sufficient proactive oversight of RIAs and their actions compared with the compliance-oversight-intensive FINRA world - this article highlighted an interesting (and probably not totally unique) case where an investment advisor took an arguably inappropriate position for his clients, who suffered significant losses, but now find they have limited recourse because the advisor simply doesn't have the business and personal assets and net worth to actually make them whole.
Net Capital Requirements For Broker-Dealers... And RIA Firms Too?
As the article points out, brokerage firms do have requirements for the amount of capital they must hold, based on the size of their business and the types of trading and business activities they engage in - in part, to ensure that at least if a client is defrauded, the firm has the financial wherewithal to make the client whole. Yet in the world of RIA firms - especially very small independent RIAs - the money may simply not be there to make the client whole, should an incident occur.
Of course, one solution to this is to at least ensure that the RIA firm have sufficient professional liability/Errors & Omissions insurance coverage to protect against damages. But such policies can be very expensive for a smaller/newer RIA firm, and/or may have deductibles that are still tens of thousands of dollars that may still dwarf any capital the firm has that could be obligated to a damaged client. To my knowledge (correct me if I'm wrong!), there is no legal requirement that, as a part of RIA registration, a firm must have a minimum amount of E&O coverage in place (although if registering as an IAR of a larger RIA, the firm may put forth such a requirement to their IARs for the very reason of protecting the firm from the potential for damages from a client problem).
Does that mean something actually should change? Is the fiduciary standard watered down in some way if there is not also a rule that either requires firms to maintain a certain minimum level of capital so that they can make good if a problem occurs with a client, and/or some minimum adequate level of E&O/professional liability coverage for the same purpose?
So what do you think? Should firm capital and/or insurance protection requirements be a part of the fiduciary discussion for RIAs and the broader regulatory reform movement for the fiduciary oversight of financial advice, and part of the platform for the Financial Planning Coalition and/or the Committee for the Fiduciary Standard? Does this represent a new-business-inhibiting barrier to entry for firms that don't have the capital to meet a requirement and/or the cash flow to pay for insurance to cover it? Or would it be a necessary evil for the sake of consumer protection? Does the fiduciary standard need an accompanying capital or insurance requirement to have real "teeth" as a consumer protection?
Michael,
I think you might be surprised that many states already have requirements.
RIA’s registered in Hawaii have a capital requirement (it’s minimal at $5K), and if you have discretion on your client’s accounts you are also required to have E&O coverage in the 6 figure range (the exact amount escapes me at the moment) and to be bonded (around $50K if memory serves).
David,
Interesting.
Ron Rhoades also pointed out to me that some states have capital requirements, but apparently they tend to be very low ($2,500, $5,000, etc) – at least, relative to the amount of “damage” that could occur for a client who receives bad investment advice (not to mention outright acts of fraud).
I may try to poke around a bit and see if I can find a list of this state-by-state somewhere… if such a list exists!
– Michael