Source: http://scholarfp.blogspot.com/2013/04/shhh-brokers-are-already-fiduciaries.html
Timestamp: 2017-06-24 15:37:52
Document Index: 494441475

Matched Legal Cases: ['art 1', '§80', '§ 78', '§ 874', '§ 2', '§ 1', '§ 8', '§ 8', '§ 874', '§ 874']

SFP: Shhh!!! Brokers Are (Already) Fiduciaries ... Part 1: The Early Days
initial draft of a white paper being prepared on the status of brokers as
fiduciaries when providing personalized investment advice. This draft is
released, prior to additional revisions and completion, as a means of informing
the debate regarding the SEC’s Request for Comments issued on March 1, 2013.]
“The relationship between a customer and the financial
practitioner should govern the nature of their mutual ethical obligations.
Where the fundamental nature of the relationship is one in which customer
depends on the practitioner to craft solutions for the customer’s financial
problems, the ethical standard should be a fiduciary one that the advice is in
the best interest of the customer. To do otherwise – to give biased advice with
the aura of advice in the customer’s best interest – is fraud. This standard
should apply regardless of whether the advice givers call themselves advisors,
advisers, brokers, consultants, managers or planners.”[1]
“The duty of loyalty requires an adviser to serve the
best interests of its clients, which includes an obligation not to subordinate
the clients’ interests to its own.”[2]
On March 1, 2013 the U.S. Securities and
Exchange Commission issued a request for data and information regarding the
“Duties of Brokers, Dealers, and Investment Advisors.”[3]
The SEC desires this information to inform its rule-making processes under
Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act[4]
(“Dodd-Frank Act”), specifically as to whether and how to impose fiduciary
standards upon brokers (i.e., registered representatives of broker-dealer
firms). However, often lost in this debate is the fact that brokers providing
personalized investment advice are already
fiduciaries, possessing broad duties of due care, loyalty and utmost good faith
to their clients, and it has been this way for over a century. This paper
explores this topic, as to the jurisprudence and understandings which developed
largely during the first half of the 20th Century. A later blog post
will explore later developments.
The delivery of investment advice in the
United States primarily occurs through broker-dealers or investment advisers.[5]
It is generally believed that registered investment advisers[6]
and their investment adviser representatives (hereafter collectively referred
to as “RIAs” or “investment advisers”) are subject to a higher standard of
(fiduciary standard of conduct) than broker-dealers and their registered
representatives (hereafter collectively referred to as “brokers”) (subject
to the lower “suitability” standard and certain other specific rules)
when engaging in activities involving the furnishing of investment
recommendations and advice to clients.[7]
Yet, often lost in the “debate” regarding
whether brokerage firms and their registered representatives should be required
to be fiduciaries to their individual customers is the fact that – for nearly a
century - courts across the country have found brokers to be fiduciaries
through the application of state common law. Moreover, early statements from
both the SEC and the National Association of Securities Dealers (NASD), now
known as the Financial Industry National Regulatory Authority (FINRA), embraced
the view that brokers – when providing personalized investment advice – were fiduciaries
(Advisers Act) was widely believed, at the time of its enactment and
thereafter, to apply broad fiduciary standards upon investment advisers.
However, the Advisers Act provides for an exemption of brokers from the
definition of “investment adviser”[8]
provided the advice provided by brokers is “solely incidental” to the conduct
of the broker’s activities and no “special compensation”[9]
is received. Yet, the Advisers Act, while providing a limited exception from
the application of its registration requirements for brokers,[10]
did not negate the potential status of brokers[11]
as fiduciaries under state common law.[12]
This paper explores cases arising under
state common law in which brokers and their registered representatives are held
to broad fiduciary standards of conduct similar to those applicable to
investment advisers,[13]
and not the lower standard of suitability,[14]
arising due to the nature of the advisory activities undertaken. This paper
also explore the limits of disclosure as an effective means of consumer
protection in this area, the Financial Industry National Regulatory Authority’s[15]
(FINRA’s) longstanding failure to acknowledge and enforce the fiduciary
standards of brokers who are in relationships of trust and confidence with
their clients, the rise of trust-based selling, the use of titles denoting
relationships of trust and confidence, and the consequences of dual
registration.[16]
As a result of regulatory missteps over
many decades, substantial consumer confusion now abounds as to the standard of
conduct consumers can expect from their providers of investment advice.[17]
Section 913 of the Dodd-Frank Act provides the SEC with the legal authority to
correct this situation through the imposition of fiduciary standards upon
broker-dealers. This paper concludes by suggesting a course of action which the
SEC may follow in applying the fiduciary standard to the personalized
investment advisory activities of brokers and their registered representatives,
with specific attention paid to understanding and methods for the elimination
and/or proper management of conflicts of interest which arise from current
broker-dealer methods of compensation.[18]
What Does a “Confidential
Relation” Exist, Thereby Meriting the Imposition of Fiduciary Status?
“A fiduciary
relationship may exist under a great variety of circumstances. Reliance may
engender a duty of loyalty. Where the confidence and trust of another is
accepted and is the basis for the guidance of another's affairs, a duty of
loyalty is required. A disloyal adviser could have and should have declined to
give advice.”[19]
The fiduciary principle has its roots in antiquity. It is clearly reflected in the provisions of
the Code of Hammurabi nearly four millennia ago, which set forth the rules
governing the behavior of agents entrusted with property.[20]
Ethical norms arising from relationships of trust and confidence also existed
in Judeo-Christian traditions,[21]
in Chinese law,[22]
and in Greek[23]
and Roman[24]
Time and again our courts have enumerated the fiduciary maxim:
man can serve two masters.”[25] As stated
early on by the U.S. Supreme Court, “The two characters of buyer and seller are
inconsistent: Emptor emit quam minimo potest, venditor vendit quam maximo
potest.”[26]
As the U.S. Supreme Court has also opined, “the rule … includes within its
purpose the removal of any temptation to violate them….”[27]
Through elaboration in English law and U.S. law, fiduciary law has evolved
over the centuries to refer to a wide range of situations in which courts have
imposed duties on persons acting in particular situations that exceed those
required by the common law duties of ordinary care and fair dealing which
exist in arms-length relationships.[28] Fiduciary duties find their origin in a mix
of the laws of trust law, tort law, contract law, and agency law. And, through the gradual expansion of the
situations in which fiduciary duties are required as our society evolves,[29]
today fiduciary status attaches to many different situations.
The fact that control of property (as would exist
in a trustee-beneficiary relationship) or the management of property (as in the
grant of discretion over securities) is nonexistent does not mean that
fiduciary status does not attach. There has long been recognition that the mere
provision of advice may result in a fiduciary relationship.[30]
It is curious that so many financial intermediaries today are unaware
of their fiduciary status, or those situations in which it might attach. The many paths to fiduciary status include:
(1) common law fiduciary status arising from a relationship of “trust and
confidence” between the financial advisor and client; (2) application of the Investment
Advisers Act of 1940 (“IAA”); (3) application of ERISA[31];
(4) limited fiduciary duties imposed upon brokers under agency law, relating
to best execution and safeguarding of custodied assets, for brokerage
accounts; (6) discretionary accounts, now leading to the application of the
Investment Advisers Act of 1940 and its imposition of broad fiduciary duties; (5)
de facto “control” amounting to
“discretion” over a brokerage account, also leading to the
imposition of broad fiduciary duties; (6) state statutory law and regulations in
a few states (including those stating that financial planners are investment
advisers); (7) express acceptance of fiduciary duties through contractual
terms; (8) service as trustee, custodian; guardian, or conservator; and (9)
acting as attorney-in-fact.
Agency law dictates that agents are subject
to certain limited fiduciary duties to act on behalf of their principals. It is
under agency law that many of the early cases find fiduciary obligations
pertinent to the broker’s duty of best execution or holding the client’s funds
as a custodian.[32]
However, the broad fiduciary duties of a
broker toward his or her customer are more likely to be found by courts when a confidential relation exists, as may occur
when personalized investment advice is provided. In the United States, our state
courts have long applied broad fiduciary duties upon those in relationships of
“trust and confidence” with entrustors. As
stated by one early 20th Century court:
In equity the court looks to the relationship of the
parties -- the reliance, the dependence of one upon the other. Where a relationship
of confidence is shown to exist, where trust is justifiably reposed, equity
scrutinizes the transaction with a jealous eye; it exacts the utmost good faith
in the dealings between the parties, and is ever alert to guard against unfair
advantage being taken by the one trusted.[33]
is this “relationship of trust and confidence,” sometimes referred to as a
“confidential relation,” which merits the imposition of the fiduciary standard
of conduct? First, let us examine what a “confidential
relation” under the law is not; we should not confuse the existence of a longstanding friendship or
an intimate relationship with a “relationship
of trust and confidence” under the law sufficient to impose fiduciary status
upon one of the actors in such a relationship:
Friendly relations or even
intimacy of relationship present
an entirely different question from what is understood as a confidential
relation in law. One may have confidence in another's integrity and honesty of
purpose, and likewise believe that he will live up to any of his contracts,
without having any confidential relations with such person that would void any
agreement or transactions entered into between them, on the theory of
constructive fraud or undue influence. We think the record shows that the
Harrises did have confidence in the honesty and integrity of the Jacksons, and
believed that the Jacksons would comply with any agreements into which they
entered; but there is absolutely no testimony showing anything further, or that
there were any confidential business relationships,
or relationships existing
between the Jacksons and the Harrises which would constitute a basis for a
charge of constructive fraud. There must be something further than mere
confidence in another's honesty and integrity to sustain the presumption of
constructive fraud.[34]
For a “confidential
relation” to occur under the law, there is typically the placement of trust by
one person in another, often the result of asymmetric information or disparate
skill. One court described
the situation in which parties deal with each other from substantially different positions,
resulting in the possibility of abuse of the superior position:
Confidential relation is not
confined to any specific association of the parties; it is one wherein a party
is bound to act for the benefit of another, and can take no advantage to
himself. It appears when the circumstances make it certain the parties do not
deal on equal terms, but, on the one side, there is an overmastering influence,
or, on the other, weakness, dependence, or trust, justifiably reposed; in both
an unfair advantage is possible.[35]
However, placement of trust in another, by a person in an inferior position, is not sufficient to impose fiduciary status. We trust most men with whom we deal. Trust must be justifiably
reposed – i.e., there must be something reciprocal in the relationship
before the rule applying fiduciary status can be invoked. In other words, it
is not just the placement of trust, but the acceptance
of that trust by either words
or conduct or both, which form the basis of the fiduciary relation. As stated by a
federal court applying California law:
It is true that one party
cannot create a legal obligation or status by pleading ignorance and
inexperience to an opposing party in a business transaction. Those who have in
the law's view been strangers remain such, unless both consent by word or deed
to an alteration of that status. The communicated desire or intention of one to
impose upon the other a different status, involving greater obligations, is
ineffective, unless the other consents to
the changed relation. It is true that consent
may find expression in acts as readily as in words. But such consent cannot be implied from a
bare procedure with the transaction, after one party has declared his or her
inexperience and reliance upon the other. The knowledge of this state of
mind in a party may be an important consideration in determining the existence
of fraud, as indicating what effect might be anticipated from statements made;
but it cannot establish a confidential legal status.[36] [Emphasis
The 1933 case of Hancock v. Anderson[37]
illustrates this principle of acceptance or consent to the fiduciary relation,
in the situation where the customer of a banker was advised to enter into an
extension and renewal of a first mortgage held by the customer. Subsequently
the banker acquired an adverse interest by representing the holder of the
second mortgage on the same property. While there had been a history of advice
provided by the banker to the customer over the years with respect to the
purchase of bonds, with respect to a later transaction involving a suggestion
to reduce the principal amount of the customer’s first mortgage, the banker
stated to the customer, “I am not in a position to advise you.”[38]
The banker advised the customer to seek advice from another businessman with
respect to the particular transaction at hand.[39]
alone, however, is not sufficient. We trust most men with whom we deal. There must be something reciprocal in the
relationship before the rule can be invoked. Before liability can be
fastened upon one there must have been
something in the course of dealings for which he was in part responsible that
induced another to lean upon him, and from which it can be inferred that the
ordinary right to contract had been surrendered. If this were not true a
reputation for fair dealing would be a liability and an unsavory one an asset.
A sale of bonds made by the Bank of England can be set aside no more quickly
than a sale made by a "bucket-shop" … In
Pomeroy's Eq. (3d ed.) section 902, it is said that when a contract is not in
its nature essentially fiduciary, a trust, to be established, must be expressly reposed or necessarily implied …
is said that a man cannot be at once agent for a buyer and seller, that loyalty
to his trust is an elementary duty, and that where confidential personal
relations exist a full and fair disclosure is imperative …
presumption is that people who deal with each other, grown men and women, deal
with each other as such, and this presumption is not destroyed by disparity in
age nor by the ties of blood ….[40]
words, a provider of investment advice must “consent to be bound” – by words or conduct – for fiduciary status to attach under state common law. In the sections
which follow are explored the types of words, representations, or conduct which
merit the imposition of broad fiduciary obligations upon brokers. It will be
demonstrated that holding out as a trusted advisor, such as through the use of
the title “financial advisor,” or by means of an invitation to accept and/or
follow “objective” advice, is sufficient conduct to provide such “consent to be
Authorities: Brokers as Fiduciaries
Federal courts look to state common law to
determine whether brokers should be deemed fiduciaries and the scope of the fiduciary
duties thereby imposed.[41]
Indeed, it is from state common law that fiduciary principles arose. State
common law, derived from judicial opinions over hundreds of years, melds
together the state common law of trust law,[42]
agency law,[43]
some aspects of contract law, [44]
and tort law[45]
to define fiduciary relationships and to explore the duties that arose
In early England, the term
"brokers" was used by persons who engaged in the then-disreputable
pawnbroker's business.[46]
“It was not until the latter part of the
17th century, when the East India Company came prominently before the public,
that trading in stock became an established business in England.”[47]
This new breed of brokers became known as "stockbrokers."[48]
Early evidence of fiduciary-like
prohibitions imposed upon stockbrokers in England can be found in the
fiduciary-like restriction imposed upon brokers in 1697 by the English Parliament
in An Act to Restrain the Number and Ill Practice of Brokers and Stock Jobbers.[49]
The statute, enacted in response to “unjust practices” which had evolved in the
selling of stock,[50]
was in existence for a little over ten years,[51]
required brokerage firms and their employees to take a verbal oath to comply
with the law, which required brokers to eschew compensation not permitted under
the Act.[52]
upon or regulated by the usages of” a stock exchange.”[53]
in stocks, etc., on their own account.”[54]
Moreover, stockbrokers were known to
possess duties akin to those of trustees, including the duty of utmost good
faith and the avoidance of receipt of hidden forms of compensation. As stated
in the 1905 edition of an early treatise:
He is a Broker because he has no interest in the
transaction, except to the extent of his commissions; he is a pledgee, in that
he holds the stock, etc. as security for the repayment of the money he advances
in its purchase; so he is a trustee, for the law charges him with the utmost
honesty and good faith in his transactions; and whatever benefit arises
therefrom enures to the cestui que trust.[55]
By the early 1930’s, the fiduciary duties of
brokers (as opposed to dealers[56])
By the early twentieth century, the body of common law
governing brokers as agents was well developed. The broker, acting as an agent, was held to a fiduciary standard
and was prohibited from self-dealing, acting for conflicting interests,
bucketing orders, trading against customer orders, obtaining secret profits,
and hypothecating customers' securities in excessive amounts -- all familiar
concepts under modern securities law. Under common law, however, a broker
acting as principal for his own account, such as a dealer or other vendor, was
by definition not an agent and owed no fiduciary duty to the customer. The parties,
acting principal to principal as buyer and seller, were regarded as being in an
adverse contractual relationship in which agency principles did not apply.[57]
The non-imposition of fiduciary duties upon dealers
was further explained by Matthew P. Allen:
At the time the ’34 Act was passed, broker-dealers
performed clearly defined functions, which are defined under the Act: a
‘broker’ ‘effected transactions in securities for the accounts of others,’
while a ‘dealer’ bought and sold securities for his own account. Brokers filled
a customer’s buy order by going into the market and purchasing designated
securities ‘from an exchange specialist or an over-the-counter marketmaker.’ As
such, courts treated brokers as agents of
their principal customers before enactment of the ’34 Act, and thus applied
fiduciary principles to impose duties of care and loyalty on stockbrokers.
But ‘dealers’ filled a customer’s order by selling the customer securities from
the dealer’s own inventory of securities. Thus a dealer and customer are acting
at arm’s-length as buyer and seller, or principal to principal, and ‘were
regarded as being in an adverse contractual relationship in which agency
principles did not apply.’ So a dealer, acting as a principal rather than an
agent, owed only ordinary duties of care to the customer, not fiduciary duties.[58]
The fact that stockbrokers were known to be
fiduciaries at an early time in the history of the securities industry
(when acting as brokers and not acting as dealers) should not come as a
surprise. To a degree it is simply an extension of the laws of agency. One might
then surmise that, if the broker provides personalized investment advice, then
a logical extension of the principles of agency dictates that the
fiduciary duties of the agent also extend to those advisory functions, as the
scope of the agency has been thus expanded.[59]
Yet, not all early commentators agreed that
the fiduciary duties of brokers extended to their advisory functions. As
Professor Arthur B. Laby recently observed:
One would expect a broker acting as an agent to be held to
a fiduciary standard. According to both the Restatement (First) of Agency from
1933 and the Restatement (Second) from 1958, an agency relationship is a
fiduciary relationship. Many early cases stated that broker-dealers owed
fiduciary duties not because they served in an advisory capacity, but rather
because they were entrusted as agents with the customer’s cash or securities
and owed a duty to carry out the customer’s instructions in good faith and with
due diligence. An influential study from this era entitled The Security Markets – prepared by a team of thirty economists and
associates of the Twentieth Century Fund [in 1938] – stated that a broker acts
as a fiduciary to a customer account when the broker has custody of the funds
or securities in the account. Otherwise, a broker’s liability is limited to the
proper execution of the customer’s orders.[60]
Indeed, there are numerous cases which apply
fiduciary duties upon brokers due to their custody of customer’s cash or securities[61]
or the existence of discretion over a customer’s account, either de jure discretion[62]
through the exercise of “control” (de facto discretion).[63]
These types of cases, however, are not the primary focus of this article.
Rather, this inquiry seeks out those decisions which impose fiduciary status
upon brokers due, at least in part, to the advice which is provided and the
resulting relationship of trust and confidence which thereby exists.
Even modern commentators have stated that the mere
furnishing of advice by a broker, without more, does not give rise to a
fiduciary relationship between a broker and its customer. As stated by one
The prevailing view is that the mere rendering of advice by a
broker-dealer that is excluded from the definition of an investment advisers is
not by itself sufficient to establish a fiduciary relationship with its
customer. Most of the decisions hold that, in addition to the giving of advice,
some other element must be present to establish a fiduciary relationship, such
as discretionary authority, control of the account by the broker, or the reposing of trust and confidence in the
broker by the customer. A fiduciary relationship is formed where a
brokerage firm holds itself to its customer out as a fiduciary.[64]
When does, under state common law, an arms-length relationship between a
broker and his or her customer become transformed into a fiduciary
relationship? The answer requires an examination of the history of the stock
brokerage function and early statutes and cases in which the fiduciary status
of brokers was considered, when advice was provided.
In the 1934 case of Birch
v. Arnold,[65]
broker, the relationship
between a client and her stockbroker was found to
be a fiduciary relationship, as it was one of trust and confidence. As the
counsel as to investments … She unquestionably had it in her power to
give orders to the defendants which the defendants would have had to obey.
relied wholly on him.[66] [Emphasis
The Massachusetts Supreme Court held that, in these
and confidence”[67] and
therefore the broker could not make a secret profit from the transactions for
which the advice was provided. The Birch decision therefore rests not upon
the finding of discretion (real or de facto)
over the account, but rather results from the finding that advice was provide
in a relationship in which trust and confidence was reposed. In the 2000 case
of Patsos v. First Albany Corp., the
Massachusetts Supreme Court discussed further the 1934 Birch case and other Massachusetts cases, noting that: “Read
together, Vogelaar, Berenson, and Birch recognize that in Massachusetts a relationship between a
stockbroker and a customer may be either a fiduciary or an ordinary business
relationship, depending on whether the customer provides sufficient evidence to
prove ‘a full relation of principal and broker.’"[68]
The Patsos court then went on discuss
the decisions of other state courts, and to contrast discretionary and
non-discretionary accounts:
Courts in other States have not been of single mind
whether fiduciary duties inhere in every relationship between a stockbroker and
his customer … Other courts have suggested that a broker always owes his customer
some fiduciary obligations …. because the relationship between a customer and
stockbroker is that of principal and agent, the broker, as agent, has a fiduciary
duty to carry out the customer's instructions promptly and accurately … There
is general agreement, however, that the scope of a stockbroker's fiduciary
duties in a particular case is a factual issue that turns on the manner in
which investment decisions have been reached and transactions executed for the
account … Where the account is ‘non-discretionary,’ meaning
that the customer makes the investment decisions and the stockbroker merely
receives and executes a customer's orders, the relationship generally does not
give rise to general fiduciary duties … For nondiscretionary accounts, each
transaction is viewed singly, the broker is bound to act in the customer's
interest when transacting business for the account, but all duties to the
customer cease ‘when the transaction is closed’ … Conversely, where the account
is ‘discretionary,’ meaning that the customer entrusts the broker to select and
execute most if not all of the transactions without necessarily obtaining prior
approval for each transaction, the broker assumes broad fiduciary obligations
that extend beyond individual transactions.[69]
The Patsos court then went on to state that
an account termed “non-discretionary (by written or oral agreement)” could
become subject to the control of the
stockbroker later, in which case the “trier of fact may still find that the
broker assumed the fiduciary obligations associated with a discretionary
account.”[70] This
would be the equivalent of de facto
discretion over an account, one way of finding broad fiduciary duties to exist.
Then the Patsos court went on to
explain when an advisory relationship, not involving actual nor de facto discretion (i.e., control over
the account) may result in the assumption of broad fiduciary duties: Other factors
may also support a finding that a stockbroker has assumed general fiduciary
obligations to a customer. A customer's lack of
investment acumen may be an important consideration, where other factors are
present. See, e.g., Broomfield v. Kosow,
349 Mass. 749, 755, 212 N.E.2d 556 (1965); Birch
v. Arnold & Sears, Inc., 288 Mass. 125, 129, 136, 192 N.E. 591 (1934); Romano v. Merrill Lynch, Pierce, Fenner & Smith, 834 F.2d at 530, citing Clayton Brokerage Co. v. Commodity
Futures Trading Comm'n, 794 F.2d 573, 582 (11th Cir. 1986) (trier of fact
must consider "the degree of trust placed in the broker and the
intelligence and personality of the customer"); Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F.
Supp. at 953, 954 (where customer is particularly young, old, or naive with
regard to financial matters, courts are "likely" to find that broker
assumed control over account). An inexperienced or naive investor is
likely to repose special trust in his stockbroker because he lacks the
sophistication to question or criticize the broker's advice or judgment. Paine, Webber, Jackson & Curtis, Inc. v. Adams, supra at 517. This may be particularly true where the
broker holds himself out as an expert in a field in which the customer is
unsophisticated. See, e.g., Burdett
v. Miller, 957 F.2d 1375 (7th Cir. 1992); Paine, Webber, Jackson & Curtis, Inc. v. Adams, supra at 517, citing Merrill Lynch, Pierce, Fenner &
Smith, Inc. v. Boeck, 127 Wis. 2d 127, 145-146, 377 N.W.2d 605 (1985)
(Abrahamson, J., concurring) ("By
gaining the trust of a relatively uninformed customer and purporting to advise
that person and to act on that person's behalf, a broker accepts greater
responsibility to that customer"). Social or personal ties between a
stockbroker and customer may also be a consideration because the relationship
may be based on a special level of trust and confidence. Leib v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 461 F.
Supp. at 954.[71] [Emphasis added.]
explained the Birch holding, noting that even in cases of non-discretionary (de jure or de facto) brokerage accounts, “other factors” may lead to broad
fiduciary duties imposed upon a broker. However, the Patsos Court noted that fiduciary duties in such instances are not
imposed by courts lightly:
“[A] business relationship between a broker
and customer does not become a general fiduciary relationship merely because an
uninformed customer reposes trust in a broker who is aware of the customer's
lack of sophistication. Cf. Broomfield
v. Kosow, supra at 755 (catalyst in
transformation of business relationship into fiduciary relationship is
defendant's knowledge of plaintiff's reliance upon him). In this respect,
as others, our law is consistent with other States. See, e.g., Hill v. Bache Halsey Stuart Shields, Inc., supra at 824
("A fiduciary duty . . . cannot be defined by asking the jury to determine
simply whether the principal reposed 'trust and confidence' in the
agent").”[72] [Emphasis added.]
Winslow (1935). Another early case points out that brokers possess fiduciary
obligations – which were not possessed, in contrast, by dealers in securities.
“[A] stock broker may also become a stock dealer toward his customer in any one
transaction, even though he has acted as broker in other transactions … Where the course of dealings between the
parties has established a relationship of customer and broker, the customer is
justified in assuming that that relationship will continue, and will not become
one of buyer and seller, unless he is notified by the broker of the latter's
intention to change the relationship … A broker, on the other hand, must
confirm the purchase or sale to his customer at the exact price at which he
himself buys or sells. He is not permitted by law to make a secret profit; nor
is he permitted to supply his own stock in fulfillment of a purchase made for a
customer, or take for his own account stock which he has sold for a customer …
In the instant case the plaintiff was a layman, and was not fully acquainted
with all the technicalities of the street or dealings on the exchange. She had
a right to assume that the relationship of customer and broker, a fiduciary,
would protect her, to the end that in acting for her, they would do all in
their power to protect her account with them, and that in so doing she would
get the full advantage of the knowledge of the defendants as such brokers in
the management and care of the account. This she had a right to assume, and
this she was entitled to … The law is well settled that the fiduciary
relationship between the customer and broker requires full faith and confidence
be given to the acts of the brokers in the belief that they would at all times
be acting for their customer in all his dealings, and the plaintiff had a right
to assume and to rely upon the fact that they were acting for her benefit at
all times during the existence of such relationship.” Johnson v. Winslow, Supreme Court of New York, New York County, 155
Misc. 170; 279 N.Y.S. 147 (1935).
Norris v. Beyer
(1935). In another early case the customer, “untrained in business – she had
been a domestic servant for years – was susceptible to the defendant's
influence, trusted him implicitly ….” The court stated: “We are persuaded from the facts of the case that a
trust relationship existed between the parties … The [broker] argues that he
was not a trustee but a broker only. This argument finds little to support it
in the testimony. He assumed the role of
financial guide and the law imposed upon him the duty to deal fairly with the
complainant even to the point of subordinating his own interest to hers.
This he did not do. He risked the money she entrusted to him in making a market
for hazardous securities. He failed to inform her of material facts affecting
her interest regarding the securities purchased. He consciously violated his
agreement to maintain her income, and all the while profited personally at the
complainant's expense. Even as agent he could not gain advantage for himself to
the detriment of his principal.” Norris
v. Beyer, 124 N.J. Eq. 284; 1 A.2d 460 (1938). [Emphasis added.]
v. First National Bank Of La Verne (1940). In another early case, in a time
where banks often acted as the sellers of securities, the facts – which so
often are paralleled in modern-day broker-customer relationships, are
informative. “Following the death of her
husband and the receipt of his insurance money, she went to respondent bank,
where she and her husband had done business. She went there for the purpose of
investing the insurance money that she had received. She trusted respondent
Boly, the cashier of the bank, whom she had known over a period of years, to
advise and assist her in making the desired investments so that, as she said,
she and her son might have some income upon which to live. Subsequently, when the
investments defaulted in payment of interest, she went back to the bank to
inquire the reason therefor. While the occurrence of such defaults might prompt
her to question the soundness of respondent Boly's judgment, surely it was no
ground for her to question the integrity of the same. She inquired the reason
for the defaults in the payment of interest, and respondents, still concealing
from her the fact that they had sold her bonds at par when the same were upon
the market at prices much less than par, informed her both in conversations and
by letter that the failure of the corporation did not necessarily mean she
would lose her money, and that these reorganization plans were due entirely to
the business depression. That appellant relied upon respondents'
representations and believed in the integrity thereof is indicated by the fact
that she continued to apply to respondent Boly for advice and continued to keep
her account in the bank until … 1936 … We hold that the evidence in this case
is reasonably susceptible of the conclusion that there existed a continuing
confidential and fiduciary relationship between the parties ….” Laraway v. First National Bank Of La Verne,
39 Cal. App. 2d 718; 104 P.2d 95 (1940).
Early Statements and Actions
In its 1940
‘[T]he old line should be
who would deal at arm's length must stand at arm's length. And he must do so openly as an adversary, not
cannot commingle his trusteeship with merchandizing on his own account…’” Seventh Annual Report of the Securities and Exchange
SEC opined in its Seventh Annual Report: “The preceding case [Hope & Co.] is one of a series of
fiduciary character of the relationship where this was clearly established from the other facts and
circumstances surrounding the transaction.
The case of Geo. W. Byron &: Co.
involved transactions in which the
firm acted as agent for both parties to the transaction and accepted commissions from each without the other's knowledge and consent, which constituted an abuse
‘A broker-dealer exercising
supervision over a discretionary account is; Of course, an agent and under the
principles already discussed these transactions constitute a violation of the
statutory provisions cited …’
‘A broker is an agent and it
is, of course, a general principle of law that an agent may not, in the absence
of consent of the person whom he purports to represent, deal with such person
as a principal. This is so irrespective of any injury or loss to the principal.
It follows that when a broker-dealer represents to a customer that he is
effecting a transaction as broker, and, without the knowledge or consent of the
customer buys from or sell to the customer as a principal, he is making a
misrepresentation of a material fact and is engaging in a fraudulent practice
which violates Section 17(a) of the Securities Act, Section 15(c) of the
Securities Exchange Act and Rule X-15Cl-2 thereunder.’
opinion the Commission quoted the following statement of the law by the Supreme
Judicial Court of Massachusetts in Hall
v. Paine [224 Mass. 62, 112 N. E. 153.]:
‘A broker's obligation to
his principal requires him to secure the highest price obtainable, while his
self-interest prompts him to buy at the lowest possible price … The law does
not trust human nature to be exposed to the temptations likely: to arise out of
such antagonistic duty and influence. This rule applies even though the sale
may be at auction and in fact free from any actual attempts to overreach or
secure personal advantage, and where the full market price has been paid and no
harm resulted * * *’”
Seventh Annual Report of the Securities and Exchange
Commission, Fiscal Year Ended June 30, 1941, at p. 158.
The SEC summarized a court decision finding that the
furnishing of investment advice by a broker was a “fiduciary function.” The SEC stated: “In the Stelmack case the evidence showed that the firm obtained lists of
holdings from certain customers and then sent to these customers analyses of
their securities with recommendations listing securities to be retained, to be
disposed of, and to be acquired … The [U.S. Securities and Exchange] Commission
held that the conduct of the customers in soliciting the advice of the firm,
their obvious expectation that it would act in their best interests, their
reliance on its recommendations, and the conduct of the firm in making its
advice and services available to them and in soliciting their confidence,
pointed strongly to an agency relationship and that the very function of
furnishing investment counsel constitutes a fiduciary function.” – from the
1942 SEC Annual Report, p. 15, referring to In the Matter of Willlam J.
Stelmack Corporation, Securities
Exchange Act Releases 2992 and 3254.
may have in transactions he effects for his customer … [BD advertising] may
create an atmosphere of trust and confidence, encouraging full reliance on
The SEC has also opined: “[T]he merchandising
emphasis of the securities business in general, and its system of compensation
in particular, frequently impose a severe strain on the legal and ethical
restraints.” – 1963 SEC Study
See also Arleen W. Hughes, Exch. Act Rel. No. 4048, 27 S.E.C. 629 (Feb. 18,
1948) (Commission Opinion), aff’d sub nom. Hughes v. SEC, 174 F.2d 969 (D.C.
Cir. 1949) (broker-dealer is fiduciary where she created relationship of trust
and confidence with her customers);
Early FINRA (formerly known
as NASD) Statements
Prior to FINRA’s creation the necessity for high standards
of conduct for brokers was noted in the courts: “The ethical standards of the
exchange are perforce the ethical standards of its members. Its standards rise
no higher and sink no lower than their standards. It is the member who must
create and maintain high standards if he would permanently succeed, because his
is a fiduciary relation to his customers. So that if the practices of any
proposed customer are distasteful to the broker member he must correct such
practices, not the exchange.” Pirnie,
Simons & Co., Inc. v. Whitney, 144 Misc. 812; 259 N.Y.S. 193; 1932 N.Y.
Misc. LEXIS 1216 (Sup.Ct.NY, 1932).
In 1938 the Maloney Act authorized the
creation of the self-regulatory organization for broker-dealers. By 1940 the
NASD had been formed. In an opinion issued by
this self-regulatory organization for broker-dealers, in only its second
newsletter to members, the NASD pronounced that brokers were fiduciaries:
“Essentially, a broker or agent is a fiduciary and he thus stands in a position of trust and
confidence with respect to his customer or principal. He must at all times, therefore, think and
circumstances.” – from The
Bulletin, published by the National Association of Securities Dealers,
Volume I, Number 2 (June 22, 1940).
In a later newsletter, the NASD, in
discussing the decisions of two cases, the NASD wrote that it was “worth
subsequent allegation that the parties acted as principals.’” - from N.A.S.D. News, published by the National
Association of Securities Dealers, Volume II, Number 1 (Oct. 1, 1941).
self-regulatory association for broker-delears has also noted that a dealer in securities was not a
he buys or has bought for himself and the price at which he sells for
himself. A member when acting as a
dealer or principal is thus not subject to the common law principles of agency
which apply to a broker, but a dealer must at all times make it clear to his
customer that he is acting as a dealer or principal, if that is the fact. He must
be ever careful in such transactions not to make misrepresentations, directly
or indirectly, with respect to the particular security being purchased or sold,
and he must buy from or sell to his customer at a price which is fair….” –
The (Non-)Impact
of the Investment Advisors Act of 1940
1930’s, investment advisers (often called “investment counselors” at the time)
were “viewed as providing investment advice and counsel to what were perceived
as largely less knowledgeable retail customers. Investment advisers therefore
were envisioned as having superior knowledge than, and thus greater
responsibility for, their customers.”[73]
Investment Advisers Act of 1940 was enacted, early cases and speeches from the
U.S. Securities and Exchange Commission (SEC) clearly stated the SEC’s belief
that the new legislation imposed fiduciary status upon all those required to
register as investment advisers (or representatives thereof).
seminal case 1963 of SEC v. Capital Gains
the U.S. Supreme Court confirmed this longstanding understanding, when it
construed Advisers Act Sections 206(1) and (2) as establishing a federal
fiduciary standard governing the conduct of advisers.[74]
recently, the SEC has expressed its view that Sections 206(1) and (2) of the
Investment Advisers Act of 1940 sections 206(1) and (2) incorporate the common
law principles of fiduciary duties.[75]
application of fiduciary duties has important implications for investment advisers.
While investment advisors governed by the Investment Advisers Act of 1940 are
not subject to the strict “sole interests” fiduciary standard imposed by trust law[76] and by ERISA (when investment advisers are not subject to
ERISA’s provisions), they are required by the courts to act in the “best
interests” of their advisory clients. Under the “best interest” fiduciary
standard, an adviser may possess certain conflicts of interest and thereby
benefit from a transaction with or by a client, but the transaction must be
fully disclosed in a manner which ensures client understanding, and client must
provide informed consent to the proposed transaction, and even then the
transaction must remain substatively fair to the client (i.e., the client
should not be harmed). In addition, a broad range of other fiduciary duties are
imposed upon investment advisers.
it should be emphasized that the Advisers Act, while providing an exemption
from the application of the Advisers Act to broker-dealers in certain
circumstances, did not overturn state common law principles which had
already held that brokers (and their registered representatives), when in a
relationship of trust and confidence with their client, are also fiduciaries.
Brokers may have been exempted under the Advisers Act from registration as investment advisers; but this exemption did not,
either expressly or by inference, negate the fiduciary status of brokers when
they developed relationships of trust and confidence with their clients.
Nor did either various federal securities
acts of the 1930’s and 1940 preempt state common law. In fact, it should be
noted that that breach of fiduciary duty arising under state common law is now
the most commonly asserted complaint by consumers in arbitration proceedings
against brokers and dual registrants, and has been for the past five years.
later blog post will explore developments affecting brokers providing
personalized investment advice since the middle of the 20th Century.
It will be demonstrated that the courts still apply fiduciary duties to brokers
who provide personalized investment advice to their clients.
receive notification of subsequent blog posts, please follow me on Twitter
(@140ltd), or connect with me through LinkedIn. Thank you. – Ron Rhoades.
* Program Director for the Financial Planning Program
at Alfred State College, Alfred, NY; Chair of the Steering Group for The
Committee for the Fiduciary Standard (www.thefiduciarystandard.org). The Committee,
led by a volunteer Steering Group of practitioners and experts, seeks to help
inform and nurture a public discussion on the fiduciary standard. The Committee’s objective is “to ensure that
any financial reform regarding the fiduciary standard: 1) meets the
requirements of the authentic fiduciary standard, as presently established in
the Investment Advisers Act of 1940; and 2) covers all professionals who
provide investment and financial advice or who hold themselves out as providing
financial or investment advice, without exceptions and without exemptions.”
This article is submitted on behalf of The Committee for the Fiduciary
Standard. Please submit any comments or suggestions regarding this publication
to rhoadera@alfredstate.edu. Thank you.
[1] James J. Angel, Ph.D., CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers:
Fiduciary or Suitability? (Sept. 30, 2010).
[2] Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and
Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Jan. 2011) (hereafter “SEC Staff 2011 Study”),
available at www.sec.gov/news/studies/2011/913studyfinal.pdf, at p. 22.
[3] SEC Release No. 34-69013; IA-3558; File No. 4-606,
Duties of Brokers, Dealers, and Investment Advisers (March 1, 2013), available
at http://www.sec.gov/rules/other/2013/34-69013.pdf. [4] Section 913 of the Dodd–Frank Wall Street Reform and
Consumer Protection Act. Pub. L. 111-203, 124 Stat. 1376 (2010). Specifically,
the SEC may extend the fiduciary standard to broker-dealers in situations
involving “a natural person, or the legal representative of such natural
person, who (A) receives personalized investment advice about securities from a
broker, dealer or investment adviser; and (B) uses such advice primarily for
personal, family, or household purposes.” 15 U.S.C. 80b–11(g)(2).
[5] Other regulated actors also provide investment advice,
including the trust departments of banks and their trust officers, separate
trust companies and their trust officers, and, on occasion, insurance agents
with respect to sales of cash value life insurance products and various forms
of annuities. This paper does not seek to address the regulation of these
[6] Webster’s
Revised Unabridged Dictionary (1913) defines “adviser” as “One who
advises.” The term “advisor” is not found in this dictionary. However, the
common practice in the United State is to use the spelling “advisor.” However,
the text of the Investment Advisers Act of 1940 and regulations adopted
thereunder use the spelling “adviser.” Both spellings are now generally deemed
acceptable by many dictionaries.
[7] See, e.g., James J. Angel, On the Regulation of Advisory Services: Where do we go from here (Oct.
31, 2011), stating, “Advisers have a higher standard of care in that their
recommendations must be in the best interest of the client, whereas broker
recommendations are held to a slightly weaker suitability standard.”
[8] Advisers Act Section 202(a)(11) defines “investment
adviser” to mean “any person who, for compensation, engages in the business of
issues or promulgates analyses or reports concerning securities.” Advisers Act
Section 202(a)(11)(C) excludes from the investment adviser definition any
broker or dealer (i) whose performance of its investment advisory services is
“solely incidental” to the conduct of its business as a broker or dealer; and
(ii) who receives no “special compensation” for its advisory services.
Accordingly, broker-dealers providing investment advice in accordance with this
exclusion are not subject to the fiduciary duty imposed by the Advisers Act,
but remain subject to the fiduciary duties imposed by state common law.
[9] The SEC staff noted the ways that brokers receive
compensation in its 2011 Special Study: “Generally, the compensation in a
broker dealer relationship is transaction-based and is earned through
commissions, mark-ups, mark-downs, sales loads or similar fees on specific
transactions, where advice is provided that is solely incidental to the
transaction. A brokerage relationship may involve incidental advice with
transaction-based compensation, or no advice and, therefore no charge, for
advice.” SEC Staff 2011 Study, supra
n. 2, at pp. 10-11. Interestingly, the SEC Staff did not note the fact that
“investment advisory fees in drag.” See
Ron Rhoades, “7 reasons why wirehouses shouldn’t milk the old business model,”
RIABiz, Jan. 28, 2010 (available at http://www.riabiz.com/a/114009/7-reasons-why-wirehouses-shouldn39t-milk-the-old-business-model).
The U.S. Court of Appeals decision in Financial Planning Association vs. SEC,
No. 04-1242 (D.C. Cir., March 30, 2007),
possesses potentially far-reaching implications. Three times in that decision
the Court emphasized that the term “investment adviser” was “broadly defined”
by Congress. Additionally, in discussing
the exclusion for brokers (insofar as their advice is solely incidental to
brokerage transactions for which they receive no special compensation), the
U.S. Court of Appeals stated: “The relevant language in the committee reports
suggests that Congress deliberately drafted the exemption in subsection (C) to
apply as written. Those reports stated that ‘investment adviser’ is so defined
as specifically to exclude ... brokers (insofar as their advice is merely
incidental to brokerage transactions for which they receive only brokerage commissions) ….” [Emphasis added.]
As a result of this language, all arrangements in which
broker-dealer firms and their registered representatives receive compensation
other than commission-based compensation should be reviewed to see if the
definition of “investment adviser” found in 15 U.S.C. §80b-2.(a)(11) applies:
“Investment adviser” means any person who, for compensation, engages in the business
of advising others, either directly or through publications or writings, as to
the value of securities or as to the advisability of investing in, purchasing,
or selling securities, or who, for compensation and as part of a regular
business, issues or promulgates analyses or reports concerning securities ….”
For example, does the receipt of 12b-1 fees by
broker-dealer firms and their registered representatives, which by the SEC’s
own admission are asset-based fees and relationship compensation, run afoul of
the IAA when received by those outside investment advisory relationships with
their customers. The written submissions to the SEC by many brokerage industry
representatives acknowledge that 12b-1 fees are utilized in large part to
the provision of advice over time with respect to a customer’s personal
circumstances, and including financial planning, estate planning, and
investment advice (not specific to any transaction). Moreover, the SEC has in
the past acknowledged that, to meet the “compensation” test under the Advisers
Act: “It is not necessary that an adviser's compensation be paid directly by
the person receiving investment advisory services, but only that the investment
adviser receive compensation from some source for his services.” SEC Release
IA-770 (1981).
While industry representatives have argued that the
12b-1 fee “compensation” received by the broker-dealer firm is not paid by the
adviser which says that compensation must be directly paid by an investor. Moreover, there is a common law principle
which attorneys were taught when they were in law school: “You cannot do indirectly what you cannot do
directly.” In other words, “if it walks
like a duck….” While admittedly Class C
shares in particular, and fee-based compensation in general, might at times
better align the interests of investors with those of financial intermediaries,
such an alignment is not the basis of any exclusion from the application of the
IAA. Given the significance of this
issue, all ongoing payments to advice-providers deserve close scrutiny – including
ongoing payments for shelf space, variable annuity product provider annual fees
to broker-dealers, and – as stated above – 12b-1 fees.
12b-1 fees also may violate the Sherman Act and its
anti-trust prohibitions, inasmuch as they negate the ability of a customer to
effectively negotiate, in many instances, the compensation for advisory
services. This issue, involving unlawful restraint of trade, is beyond the
The Advisers Act excludes from the investment adviser
definition any broker or dealer: (i) whose performance of its investment
advisory services is “solely incidental” to the conduct of its business as a
broker or dealer; and (ii) who receives no “special compensation” for its advisory
services. To rely on the exclusion, a broker-dealer must satisfy both of these
Generally, the ‘solely incidental’ element amounts to a
recognition that broker-dealers commonly give a certain amount of advice to
their customers in the course of their regular business as broker-dealers and
that “it would be inappropriate to bring them within the scope of the [Advisers
Act] merely because of this aspect of their business.” On the other hand,
“special compensation” “amounts to an equally clear recognition that a broker
or dealer who is specially compensated for the rendering of advice should be
considered an investment adviser and not be excluded from the purview of the
[Advisers] Act merely because he is also engaged in effecting market transactions
in securities.” Finally, the Commission staff has taken the position that a
registered representative of a broker-dealer is entitled to rely on the
broker-dealer exclusion if he or she is providing investment advisory services
to a customer within the scope of his or her employment with the broker-dealer.
[11] The products and services offered by broker-dealers
fall into two broad categories: brokerage services and dealer services.
Generally, a broker is one who acts as an agent for someone else, while a
dealer is one who acts as principal for its own account. A firm can act as both
a broker and a dealer. The licensed employees of a broker-dealer are referred
to as “registered representatives” and, until recent years, were often commonly
referred to as “stockbrokers.”
[12] The SEC’s March 1, 2013 release acknowledges that
brokers and their registered representatives may possess a fiduciary duty under
state common law: “A broker-dealer may have a fiduciary duty under certain
circumstances. This duty may arise under state common law, which varies by
state. Generally, courts have found that broker-dealers that exercise
discretion or control over customer assets, or have a relationship of trust and confidence with their customers,
are found to owe customers a fiduciary duty similar to that of investment
advisers.” [Emphasis added.]
See also 2011 SEC Staff Study, supra n.2, at pp.10-11. “While broker-dealers are generally not
subject to a fiduciary duty under the federal securities laws, courts have
Moreover, broker-dealers are subject to statutory, Commission and SRO
requirements that are designed to promote business conduct that protects customers
from abusive practices, including practices that may be unethical but may not
necessarily be fraudulent.” It should be noted that the views expressed in the
Study were those of the staff and do not necessarily reflect the views of the
Commission or the individual Commissioners.
See also A Joint Report
of the SEC and the CFTC on Harmonization of Regulation (Oct. 2009),
available at http://www.sec.gov/news/press/2009/cftcjointreport101609.pdf, stating: “While the statutes and regulations do not
uniformly impose fiduciary obligations on a [broker-dealer (BD)], a BD may have
a fiduciary duty under certain circumstances, at times under state common law,
which varies by state. Generally, BDs that exercise discretion or control over
customer assets, or have a relationship
of trust and confidence with their customers, are found to owe customers a
fiduciary duty similar to that of investment advisers … State common law
imposes fiduciary duties upon persons who make decisions regarding the assets
of others. This law generally holds that
a futures professional owes a fiduciary duty to a customer if it is offering
personal financial advice.” Id.
at pp.9-10. [Emphasis added.]
[13] Registered investment advisers are separately licensed
under the Investment Advisers Act of 1940. Their licensed employees are
referred to as “investment adviser representatives.” However, many financial
services firms offer both broker-dealer and investment advisory services, which
leads to the connotation of the firm (and its licensed employees who also
possess both Series 6/7 and 65 licensure) as “dual registrants.” As of
mid-October 2010, approximately 88% of investment adviser representatives were
also registered representatives of a FINRA-registered broker-dealer.
[14] The suitability standard imposes both additional
substantive (fairness) and procedural (disclosure) obligations upon
broker-dealers, in addition to the requirements of good faith applicable to the
performance of contracts between all those in arms-length relationships. The
SEC and the U.S. Consumer Futures Trading Commission (CFTC) recent summarized
the broker-dealers suitability obligation as follows:
Under the federal securities laws and SRO rules, broker-dealers
are required to deal fairly with their customers. This includes having a
reasonable basis for recommendations given the customer’s financial situation
(suitability), engaging in fair and balanced communications with the public,
providing timely and adequate confirmation of transactions, providing account
statement disclosures, disclosing conflicts of interest, and receiving fair
compensation both in agency and principal transactions. In addition, the SEC’s
suitability approach requires BDs to determine whether a particular investment
recommendation is suitable for a customer, based on customer-specific factors
and factors relating to the securities and investment strategy. A BD must
investigate and have adequate information regarding the security it is
recommending and ensure that its recommendations are suitable based on the
customer’s financial situation and needs. The suitability approach in the
securities industry is premised on the notion that securities have varying
degrees of risk and serve different investment objectives, and that a BD is in
the best position to determine the suitability of a securities transaction for
a customer. Disclosure of risks alone is not sufficient to satisfy a
broker-dealer’s suitability obligation.
of the SEC and the CFTC on Harmonization of Regulation (Oct. 2009), available at http://www.sec.gov/news/press/2009/cftcjointreport101609.pdf, at p.9.
[15] The North American Securities Dealers Association
(NASD) was founded in 1939 and was registered with the SEC in response to the
1938 Maloney Act amendments to the Securities Exchange Act of 1934, which
allowed it to supervise the conduct of its members subject to the oversight of
the SEC. See Maloney Act of 1938, 15
U.S.C. § 78o-3 (2006) (adding Section 15A to Securities Exchange Act of 1934
and establishing system of self-regulation for broker-dealers). FINRA succeeded
to the regulatory functions of NASD in 2007.
[16] As stated in the SEC’s March 1, 2013 release: “Many
financial services firms may offer both investment advisory and broker-dealer
services … See Letter from Angela
Goelzer, FINRA, to Lourdes Gonzalez, Assistant Chief Counsel, Securities and
Exchange Commission (Nov. 16, 2012). Further, as of mid-November 2012,
approximately 41% of FINRA-registered broker-dealers had an affiliate engaged
in investment advisory activities. Id.
Many of these financial services firms’ personnel may also be dually registered
as investment adviser representatives and registered representatives of
broker-dealers. As of October 31, 2012, approximately 86% of investment adviser
representatives were also registered representatives of a FINRA-registered
broker-dealer. Id.” SEC Release, supra n. 3, at p. 5 (footnote).
[17] See SEC
Release No. 34-69013; IA-3558; File No. 4-606, Duties of Brokers, Dealers, and Investment Advisers (March 1,
2013) (“Today, broker-dealers and investment advisers routinely provide to
retail customers many of the same services, and engage in many similar
activities related to providing personalized investment advice about securities
to retail customers. While both investment advisers and broker-dealers are
subject to regulation and oversight designed to protect retail and other customers,
the two regulatory schemes do so through different approaches notwithstanding
the similarity of certain services and activities … Studies suggest that many
retail customers who use the services of broker-dealers and investment advisers
are not aware of the differences in regulatory approaches for these entities
and the differing duties that flow from them.”) Id. at pp. 3-4 (citations omitted).
[18] “Currently, broker-dealers are compensated in various
ways that pose multiple conflicts of interests with customers: they are paid by
the issuers, underwriters, and sponsors of the securities products they sell
(e.g. insurance companies sponsoring variable annuities); they earn higher
commissions for selling certain (sometimes riskier) securities over other (sometimes
less volatile) securities; and they may earn a commission for each security
purchased or trade effected for the customer, among other conflicts. But as
long as the broker-dealer does not recommend the sale, or recommends the sale
of a security suitable for the customer, these conflicts of interest are not
unlawful.” Matthew P. Allen, A Lesson
from History, Roosevelt to Obama — The Evolution Of Broker-Dealer Regulation:
Litigation, and Fiduciary Duty, 5 Entreprenurial Bus.L.J. 1, 9 (2010), at
p. 23. Additional conflicts of interest arise when mutual funds provide
additional compensation in the form of “payment for shelf space” and soft
dollar compensation, or when mutual funds or other investment or insurance
product providers sponsor events at educational conferences attended by
[19] Cheryl Goss Weiss, A Review of the Historic
Foundations of Broker-Dealer Liability for Breach of Fiduciary Duty, 23 Iowa J.
Corp. L. 65, 68 (1997).
[20] See Blaine F. Aikin, Kristina A. Fausti, Fiduciary: A Historically Significant
Standard, 30 Rev. Banking & Financial Law 155, 157 (2010-11).
[21] “[C]ourts have linked the fiduciary duty of loyalty to
the biblical principle that no person can serve two masters.” Id., at pp.157-8. See also Beasley v. Swinton,
46 S.C. 426; 24 S.E. 313; 1896 S.C. LEXIS 67 (S.C. 1896) (“Christ said: ‘No man
can serve two masters, for either he will hate the one and love the other, or
else he will hold to the one and despise the other. Ye cannot serve God and
Mammon [money].’") Id. at ____,
quoting Matthew 6:24.
[22] “Chinese historical texts also recognize fiduciary
principles of trust and loyalty. One of the three basic questions of
self-examination attributed to Confucius (551 BC–479 BC) asks: ‘In acting on
behalf of others, have I always been loyal to their interests?’” Aitkin and Fauti, supra n.__,. at p.158.
[23] “Aristotle (384 BC–322 BC) consistently recognized
that in economics and business, people must be bound by high obligations of
loyalty, honesty and fairness and that society suffers when such obligations
are not required.” Id.
[24] “Cicero (103 BC–46 BC) noted the relationship of trust
between an agent and principal (known to Romans as mandatory and mandator,
respectively), and emphasized that an agent who shows carelessness in his
execution of trust behaves very dishonorably and ‘is undermining the entire
basis of our social system.’” Id. at
158-9. [25] See, e.g., Carter v. Harris,
25 Va. 199; 1826 Va. LEXIS 26; 4 Rand. 199 (Va. 826) (“It is well settled as a
general principle, that trustees, agents, auctioneers, and all persons acting
in a confidential character, are disqualified from purchasing. The characters
of buyer and seller are incompatible, and cannot safely be exercised by the
same person. Emptor emit quam minimo potest; venditor vendit quam maximo
potest. The disqualification rests, as was strongly observed in the case of the
York Buildings Company v. M'Kenzie, 8
Bro. Parl. Cas. 63, on no other than that principle which dictates that a
person cannot be both judge and party. No man can serve two masters. He that it
interested with the interests of others, cannot be allowed to make the business
an object of interest to himself; for, the frailty of our nature is such, that
the power will too readily beget the inclination to serve our own interests at
the expense of those who have trusted us.”). Id. at 204.
[26] Wormley v. Wormley, 21 U.S. 421; 5 L. Ed. 651; 1823 U.S.
LEXIS 290; 8 Wheat. 421 (1823). See also
Michoud v. Girod, 45 U.S. 503; 11 L. Ed. 1076; 1846 U.S. LEXIS 412; 4 HOW
503 (1846) (“[I}f persons having a confidential character were permitted to
avail themselves of any knowledge acquired in that capacity, they might be
induced to conceal their information, and not to exercise it for the benefit of
the persons relying upon their integrity. The characters are inconsistent.
Emptor emit quam minimo potest, venditor vendit quam maximo potest.”]
[27] SEC v. Capital Gains Research Bureau, 375 U.S.
180; 84 S. Ct. 275; 11 L. Ed. 2d 237; 1963 U.S. LEXIS 2446 (1963) (“This Court, in discussing conflicts of interest, has
‘The reason of the rule inhibiting
a party who occupies confidential and fiduciary relations toward another from
assuming antagonistic positions to his principal in matters involving the
subject matter of the trust is sometimes said to rest in a sound public policy,
but it also is justified in a recognition of the authoritative declaration that
no man can serve two masters; and considering that human nature must be dealt
with, the rule does not stop with actual violations of such trust relations,
but includes within its purpose the removal of any temptation to violate them ….’
‘. . . In Hazelton v. Sheckells, 202 U.S. 71, 79, we said: 'The objection . .
. rests in their tendency, not in what was done in the particular case. . . .
The court will not inquire what was done. If that should be improper it
probably would be hidden and would not appear.'’ United States v.
Mississippi Valley Co., 364 U.S. 520, 550, n. 14.”) Id. at p. 249 (fn.50).
[28] Generally, relationships between two parties fall into
one of two categories. The first
category is that in which arms-length negotiations between the parties take
place. Sometimes the consumer is aided
by specific laws which impose some additional duties on the other party. For
example, upon broker-dealers there is imposed the requirement that investment
products sold to an investor be “suitable,” at least as to the risks associated
with that investment. Additionally, various disclosures may be required of
broker-dealers under federal securities laws. Yet, even with enhanced
safeguards, the arms-length relationship of the parties involved in the sale of
an investment product can still be described as:
By contrast, the fiduciary relationship
arises in situations where the law has clearly recognized that fiduciary duties
attach, such as principal and agent relationships, or where there exists the
actual placing of trust and confidence by one party in another and a great
disparity of position and influence between the parties. In these situations,
mere disclosure of material facts is thought to be inadequate as a means of consumer
protection, and hence the fiduciary standards of conduct are imposed. The
relationship of the parties in a fiduciary relationship is reversed, as
[29] See e.g., Tamar Frankel, Fiduciary Law, 71 Calif. L. Rev. 795 (1983) (“Another social trend
which increases the importance of fiduciary law is the change in perception of
power, and the emergence of new forms of power … Specialization of labor has
become one of the main features of our modem society. Specialization is
important because it maximizes the benefits from labor … pooling: the transfer
of resources by many persons to a small number of experts. Pooling benefits the
participants because it may produce economies of scale … Financial institutions
present one example of the benefits of pooling … Relations that stem from
specialization and pooling are often classified as fiduciary because they pose
the problem of abuse of power that is common to fiduciary relations….”) Id. at 803-4.
[30] See, e.g., Restatement (Second) of Torts § 874 cmt. a (1979) (“A fiduciary relation exists
between two persons when one of them is under a duty to act for or to give
advice for the benefit of another upon matters within the scope of the
relation.” citing Restatement, Second, Trusts § 2).
[31] The Employee Benefits Securities
Administration of the U.S. Department of Labor is expected to re-promulgate, in
the second half of 2013, its “Definition of Fiduciary” proposed rule, which
would greatly expand the situations in which those providing investment advice
to plan sponsors and/or plan participants would be regarded as fiduciaries and
subject to ERISA’s strict “sole interests” fiduciary standard and its
prohibited transaction rules. EBSA’s re-proposal is also likely to extend
ERISA’s fiduciary obligations to IRA accounts. See Melanie Waddell, “3 Issues That Will Dominate DOL Fiduciary
Debate,” AdvisorOne (Feb. 28, 2013),
available at http://www.advisorone.com/2013/02/28/3-issues-that-will-dominate-dol-fiduciary-debate. [32] NEED CITATION.
[33] Jothann v. Irving
Trust Company, 151 Misc. 107; 270 N.Y.S. 721, citing Wendt v. Fischer,
215 A.D. 196; 213 N.Y.S. 351 (1926).
[34] Jackson v. Gorham, 98 Cal. App. 112,
276 P. 391, 393 __________xxxxxxxxxxx
[35] Leedom v. Palmer, 274 Pa. 22, 117 A.
[36] Southern Trust
Co. v. Lucas (C.C.A.) 245 F. 286, 288 (____).
[37] Hancock v.
Anderson, 160 Va. 225; 168 S.E. 458; 1933 Va. LEXIS 201 (Va. 1933)
[38] “I
can't advise you in this matter as I have told you I am representing the second
mortgage man and therefore I can't give you any advice. You will have to go
somewhere else and get your advice in the matter because I am interested in it.” Id. at 236.
[41] Arthur C. Laby, Fiduciary
Obligation of Broker-Dealers and Investment Advisers, 55 Vill.L.R. 701, 714
(2010), noting that since the Investment Advisers Act of 1940 and the federal
common law promulgated thereunder does not apply to broker-dealers, federal
courts must look to state law to determine brokers’ fiduciary status.
[42] Trust law, largely followed by the Employee Retirement
Income Security Act’s (ERISA’s) application of its “sole interests” fiduciary
standard, seeks to solve the problem of agency problems by placing limits upon
the fiduciary’s conduct, and prohibiting certain forms of action. “The problem
with problem with disempowerment is that in protecting the principal from mis-
or malfeasance by the agent, the law also disabled the agent from undertaking
acts useful for the principal.” Robert Sitkoff, The Economic Structure of Fiduciary Law, 91 Boston U.L.Rev. 1039,
1042 (2011).
[43] “Agency is the fiduciary relationship that arises when
one person (a "principal") manifests assent to another person (an
"agent") that the agent shall act on the principal's behalf and
subject to the principal's control, and the agent manifests assent or otherwise
consents so to act.” § 1.01 “Agency Defined,” Restatement
(Third) of Agency (2006). “An agent has a fiduciary duty to act loyally
for the principal's benefit in all matters connected with the agency
relationship.” § 8.01 “General Fiduciary Principle,” Restatement (Third) of Agency (2006).
[44] The incorporation of aspects of contract law into
fiduciary duties has led to a broad academic discussion regarding whether
fiduciary duties are default rules. Over two decades have passed since Cooter
and Freedman (1991) and Easterbrook and Fischel (1993) espoused the
contractualists’ model of fiduciary law. See, e.g., Sitkoff, supra
n.___, at , 1041.
Yet, the contractualists’ theory of fiduciary law
appears misplaced, at least in the context of advisory relationships.
“[C]ontract law concerns itself with transactions while fiduciary law concerns
itself with relationships.” Rafael Chodos, Fiduciary
Law: Why Now! Amending the Law School Curriculum, 91 Boston U.L.R. 837, 845
(and further noting that “Betraying a relationship is more hurtful than merely
abandoning a transaction.” Id. See also Laby, The Fiduciary Obligation as the Adoption of Ends, 56 Buff. L. Rev.
99, 104-29 (2008) (rejecting contractual approach as descriptive theory of
fiduciary duties, and at 129-30 (arguing that signature obligation of fiduciary
is to adopt ends of his or her principal). The author posits that there may be greater flexibility
in contracting around fiduciary duties where the entrustor is an employer of a
non-expert employee (i.e., in an employer-employee relationship) and has
greater control and, presumably, knowledge than the employee. Even then, the
“tendency of courts to construe fiduciary limitations narrowly and to be
suspicious of provisions purporting to eliminate all fiduciary duties is
understandable given the long tradition of treating business partners and
managers as fiduciaries.” Chodos, at p.894 (further noting that: “This approach
also is consistent with the general drafting principle that limitations on
fiduciary duties are strictly construed. See,
e.g., Gotham Partners, L.P. v. Hallwood Realty Partners, L.P., 817 A.2d
160, 171–72 (Del. 2002); Restatement
(Third) Of AgencY § 8.06 (2006).”)
Hence, greater emphasis on the contractual nature of
fiduciary obligations may exist when contracting parties enter into a partnership
agreement or a limited liability company operating agreement, given that most
state statutes permit these parties, upon entry into the relationship, to
negotiate (to a degree) the legal duties owed to one another. Yet, in
relationships of an advisory-client nature, where there exists a vast disparity
in knowledge between the advisor and the client, and where clients do not
normally seek legal advice prior to entry into such relationships, the ability
of the advisor to negate fiduciary duties by contract is properly more
Other scholars appear reject the contractualist theory
of fiduciary duties more broadly. See,
e.g., Tamar Frankel, Fiduciary Duties
as Default Rules, 74 Or. L. Rev. 1209 (1995) (“[C]ircumstances exist where
fiduciary duties are not waivable for reasons such as doubts about the quality
of the entrustors' consent (especially when given by public entrustors such as
shareholders), and the need to preserve institutions in society that are based
on trust. Further, non-waivable duties can be viewed as arising from the
parties' agreement ex ante to limit their ability to contract around the
fiduciaries' duties. Under these
circumstances fiduciary rules should generally be mandatory and non-waivable …
I conclude that private and public fiduciaries should be subject to a separate
body of rules and reject the contractarian view..”) Id. See also Scott FitzGibbon, Fiduciary
Relationships Are Not Contracts, 82 MARQ. L. REV. 303, 305 (1999) (“This
Article explores the nature of fiduciary relationships, shows that they arise
and function in ways alien to contractualist thought, and that they have value
and serve purposes unknown to the contractualists.”)
[45] As Professor Laby notes, “Historically, providing
advice has given rise to a fiduciary duty owed to the recipient of the advice.
Both the Restatement (First) and Restatement (Second) of Torts state,
“[a] fiduciary relation exists between two persons when one of them is under a
duty to act for or to give advice for
the benefit of another upon matters within the scope of the relation” [citing Restatement (Second) Of Torts § 874 cmt.
a (1979) (citation omitted) (emphasis added); Restatement
(First) Of Torts § 874 cmt. a (1939) (citation omitted) (emphasis
added)].
[46] John R. Dos Passos, A Treatise on the Law of
Stock-Brokers and Stock Exchanges, The Banks Law Publishing Co., 2ND
Edition (1905), Vol. 1, p.2 (available at http://ia700303.us.archive.org/28/items/lawofstockbroker01dosp/lawofstockbroker01dosp.pdf). [47] Id. at
[48] Id. See also
Banta v. Chicago, 172 Ill. 204; 50 N.E. 233; 1898 Ill. LEXIS 2855 (Ill. 1898) (“the business of brokers continued to expand, and they
subsequently undertook to effect the negotiation of bonds and other evidences
of indebtedness, and certificates of shares in the capital stock of
incorporated companies. The advent of brokers into this branch of business is
referred to by Chief Justice Beck in the early case of Gibbons v. Rule, 12 Moore, 539, (13 E.C.L. 444,) which was decided
in 1827, as follows: ‘The
statute 8 and 9 William III, chap. 20, by which the first government loan was
raised, speaks of a new description of brokers, -- persons employed in buying
and selling tallies, the government securities of those days. These have since
been called stock brokers.’ The
statute referred to was enacted by the Parliament of England in the year 1697.”) Id. at 237.
[49] See An Act
to Restrain the Number and Ill Practice of Brokers and Stock Jobbers, 1697, 8
& 9 Will. 3, c. 32 (Eng.) [hereinafter Statutes], available at http://www.british-history.ac.uk/report.aspx?compid=46880. [50] John R. Dos Passos, supra n.__, at p.4.
[51] See James A.
Klimek, A Brief History of Securities Law, available at http://www.klimek-law.com/Brief%20History.shtml (“In 1707
Parliament was in a deregulatory phase and allowed the statute to lapse.”).
[52] The Act permitted brokers to receive not more than ten
shillings per cents for a brokerage fee, and imposed a stiff penalty for
receiving additional compensation not permitted by the Act, stating: “if any
such Broker or Brokers so to be admitted as aforesaid shall directly or
indirectly deal for him or themselves in the Exchange or Remittance of Moneys
or shall buy any Talleys Orders Bills or Share or Interest in any Joint Stock
to be assigned or transferred to his owne Use or buy any Goods Wares or
Merchandizes to sell againe for his owne Benefitt or Advantage or shall make
any Gain or Profitt in buying or selling any Goods over and above the Brokage
allowed by this Act hee or they so offending shall forfeit the Su[m]m of Two
hundred pounds and being convicted of [any] such Offence shall be for ever
incapable to trade act or deal as a Broker for any Person or Persons
whatsoever.” Id. at section IX. The
Act ws only in existence for approximately ten years. See James A. Klimek, A Brief
History of Securities Law, available at
http://www.klimek-law.com/Brief%20History.shtml (“In 1707 Parliament was in a
deregulatory phase and allowed the statute to lapse.”).
[54] Id., at
p.176, citing Banta v. Chicago, 172
Ill. 201.
[55] John R. Dos
Passos, supra n.__, at pp. 180-1.
[56] As was well-known in the early case law: "The principle is undeniable that an agent to sell
[57] Cheryl Goss Weiss, A
[58] Matthew P. Allen, supra n. ___, at p.21. See
also Frederick Mark Gedicks, Suitability
Claims and Purchases of Unrecommended Securities: An Agency Theory of
Broker-Dealer Liability, 37 ARIZ. ST. L.J. 535, 586-87 (2005).
See also Angela
Hung, Noreen Clancy, Jeff Dominitz, Eric Talley, Claude Berrebi, & Farrukh
Suvankulow, Perspectives
on Investment Advisers and Broker Dealers, RAND INST. FOR CIV. JUST., 49,
t.4.9 (2008) [hereinafter RAND Study], at 7.
scope in which fiduciary duty operates.”). [60] Laby, supra n.__,
[61] See, e.g. In
re Ruskay (U.S. Ct. App. 2nd Cir.), 5 F.2d 143; 1925 U.S. App.
LEXIS 2618 (1925) (“Equity regards a fund so paid and received as impressed
with a trust in favor of the one who paid it over and who is beneficially
entitled.”) Id. at p. 144.
[62] CITE NEEDED. NOTE SEC RULEMAKING ON THIS ISSUE, BUT THE
[65] Birch v. Arnold, 88 Mass. 125; 192 N.E. 591; 1934 Mass.
[67] Birch v. Arnold , citing Reed v. A. E.
Little Co., 256 Mass. 442, 152 N.E. 918, and Wendt v. Fischer, 243 N.Y. 439,
[68] Patsos vs. First Albany Corp., 433 Mass. 323;
741 N.E.2d 841; 2001 Mass. LEXIS 19 (Mass. 2001), at pp. 322-3.
[72] Id. at p.335. In Romano v. Merrill Lynch, Pierce, Fenner & Smith, 834 F.2d 523;
1987 U.S. App. LEXIS 16820; Fed. Sec. L. Rep. (CCH) P93,693; 9 Fed. R. Serv. 3d
(Callaghan) 1318; Comm. Fut. L. Rep. (CCH) P24,179 (C.A. 5th Cir.
1987), the Court stated: “It is clear that the nature of the fiduciary duty
owed will vary, depending on the relationship between the broker and the
investor. Such determination is necessarily particularly fact-based. And
although courts draw no bright-line distinction between the fiduciary duty owed
customers regarding discretionary as opposed to nondiscretionary accounts, the
nature of the account is a factor to be considered.” Id. at 530. See also
Broofield vs. Kosow, 349 Mass. 749; 212 N.E.2d 556; 1965 Mass. LEXIS 804
(1965) (“the plaintiff alone, by reposing trust and confidence in the
defendant, cannot thereby transform a business relationship into one which is
fiduciary in nature. The catalyst in such a change is the defendant's knowledge
of the plaintiff's reliance upon him. In redressing an abuse of trust and
confidence equity will review such factors as the relation of the parties prior
to the incidents complained of, the plaintiff's business capacity or lack of it
contrasted with that of the defendant, and the readiness of the plaintiff to
follow the defendant's guidance in complicated transactions wherein the
defendant has specialized knowledge. Equity will, in sum, weigh whether unjust
enrichment results from the relationship.”) Id.
[73] Matthew P. Allen, A
Lesson from History, Roosevelt to Obama — The Evolution Of Broker-Dealer
Regulation: From Self-Regulation, Arbitration, And Suitability To Federal
Regulation, Litigation, and Fiduciary Duty, 5 Entreprenurial Bus.L.J. 1, 9
[74] SEC v. Capital
Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963). See also Transamerica Mortgage Advisors, Inc., 444 U.S. 11, 17
(1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended
to impose enforceable fiduciary obligations.”). As stated by SEC staff, “The
adviser’s fiduciary duty is enforceable under Advisers Act Sections 206(1) and
(2), which prohibit an adviser from “employ[ing] any device, scheme, or
artifice to defraud any client or prospective client” and from engaging in “any
transaction, practice or course of business which operates as a fraud or deceit
on any client or prospective client.” SEC Staff 2011 Study, supra n.__, at pp. 21-2.
[75] Brandt, Kelly
& Simmons, LLC, Admin. Proc. File No. 3-11672 (SEC Sept. 21, 2004), citing SEC v. Capital Gains Research Bureau,
Inc., 375 U.S. 180, 180 (1963).
[76] “A main theme in the cases that developed
the sole interest rule was the fear that without the prohibition on trustee
self-interest, a conflicted trustee would be able to use his or her control
over the administration of the trust to conceal wrongdoing, hence to prevent
detection and consequent remedy. Lord Hardwicke, sitting in 1747, before the
sole interest rule had hardened in English trust law, was worried about a
self-dealing trustee being able to conceal misappropriation. In 1816 in Davoue v. Fanning, the foundational
American case recognizing and enforcing the then-recently-settled English rule,
Chancellor Kent echoed this concern: “There may be fraud, as Lord Hardwicke
observed, and the [beneficiary] not able to prove it.” In order “to guard
against this uncertainty,” Kent endorsed the rule allowing the beneficiary to
rescind a conflicted transaction “without showing actual injury.” In his
Commentaries on American Law, Kent returned to the point that the sole interest
rule “is founded on the danger of imposition and the presumption of the
existence of fraud, inaccessible to the eye of the court.” John H. Langbein, Questioning the Trust Law Duty of Loyalty:
Sole Interest or Best Interest, 114 Yale L. J. 929, 944 (2005).