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Broker or Registered Investment Adviser? What’s Best for the ERISA/401k Fiduciary?

October 07
19:33 2009

Here’s an issue that can perplex even the most experienced ERISA/401k fiduciary: What’s the difference between a broker and a Registered Investment Adviser? More importantly, does the difference significantly raise the fiduciary liability for the typical fiduciary? Two recent articles (“Industry Groups Differ On Fiduciary Standard,” Financial Advisor, October 6, 2009 and “Broker-Dealer Standards Must Be Harmonized, Regulators Say,” Sarah Borchersen-Keto, CCH Financial Crisis News Center, October 6, 2009) discuss the current debate in Congress. Every ERISA/401k fiduciary must understand the implications of this debate.

At issue here lies the legal definition of “fiduciary” as it pertains to professionals offering investment advice. Why does this ongoing legislative battle remain critically important to ERISA/401k fiduciaries? Often, a retirement plan fiduciary will try to reduce personal fiduciary liability by hiring a professional investment adviser to act as a co-fiduciary.

Under the terms of both ERISA and the SEC, a registered investment adviser (“RIA”) automatically becomes a fiduciary of the retirement plan as soon as the plan sponsor inks the adviser agreement. While the Investment Advisers Act of 1940 (“40 Act”) clearly defines what type of entity qualifies as a fiduciary, the 40 Act explicitly exempts broker/dealers who provide investment advice “incidental” to their brokerage business. As a result, the SEC does not require broker/dealers to register as investment advisers; hence, broker/dealers do not fall under the definition of fiduciary.

Broker/dealers register under the Securities Exchange Act of 1934 (“34 Act”) and fall under the regulation of FINRA, a self-regulatory body. Rather than being held to the more rigorous fiduciary standard of care, they merely need to consistently practice their service under what’s called the “suitability standard.” The suitability standard only requires the broker/dealer to make recommendations appropriate for the client given the specific circumstances of the client.

Incidentally, I’m leaving banks out of this discussion because the financial reform package currently being pondered in Washington involves the confusion between broker/dealers and RIAs. Banks, while not regulated by the SEC, do offer fiduciary services (they’re called “trust companies” or “trust departments”) but may also offer brokerage services. So, just because a retirement plan fiduciary receives service from a bank does not necessarily guarantee that bank acts as a fiduciary. It all depends on which banking department provides the service.

Whether ERISA/401k fiduciaries reduce their personal fiduciary liability or actually increase it might well depend on whether those fiduciaries hire RIAs or broker/dealers. While the former clearly serves as a fiduciary, the latter does not. There can be instances, therefore, where plan fiduciaries firmly believe they have delegated investment decision making to a professional fiduciary, but, in reality, they have merely agreed to place certain trades through a broker. If the fiduciary places the trades – in other words, picks the specific investments – then that fiduciary assumes the full liability risk. Because in this case the ERISA/401k fiduciary uses no intermediary to act as fiduciary, no other agent exists to absorb the fiduciary liability.

Worse, broker/dealers tend to receive compensation based on investment products sold (ERISA prohibits a fiduciary from receiving self-dealing compensation). Such payment arrangements could leave the plan vulnerable to conflicts-of-interest. So, not only do 401k fiduciaries fail to reduce their liability when using a broker/dealer in lieu of a professional fiduciary, they may actually increase their fiduciary liability.

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About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA

4 Comments

  1. Dean Piccirillo
    Dean Piccirillo October 20, 04:44

    Chris – This is a rather concise summary of the some of the fundamental challenges facing the industry now. It will be a very interesting couple of years as these issues are clarified in through the legislative and regulatory process. Dean

  2. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author October 20, 14:07

    Dean, thanks for the kind words. You’re right. We may witness some tug-of-war as legislation progresses on this matter. The question is: Will regulators act first?

  3. Jan Sackley
    Jan Sackley October 25, 21:30

    Chris, You are certainly correct about the lack of understanding about the fiduciary duties of those who take securities instructions for a 401k. One clarification, though, is that a bank cannot act as a broker. It can have a separate legal subsidiary or a holding company affiliate that is registered as a broker-dealer, but the bank itself does not act as a broker. And the brokerage firm owned by a bank must clearly disclose that it is providing the brokerage services, and not the bank itself. Where a bank trust department offers a self-directed trading platform to a 401k plan, they are often channeling the participant’s instructions through a registered unaffiliated broker.
    Jan Sackley, Principal
    Fiduciary ForesightSM
    Fiduciary risk and regulatory compliance consultants
    http://www.fiduciaryforesight.com
    Twitter@jansackley

  4. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author October 26, 09:30

    Jan:

    Thanks. You are 100% correct regarding the legal construct of banks and their B/D affiliates. This is why so much confusion exists. Depending on the jurisdiction (state/federal) of the bank, while the fine-print certainly addresses this legal construct, the delivery of the services is commingled in such a way as to make it appear the bank is offering brokerage services. Unfortunately, just because fiduciaries ought to know this distinction doesn’t necessarily mean they do. Ergo, I think you’ve given me a great idea for another article. Thanks!

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