It comes as no surprise that a lot of people out there are somewhat skeptical about hiring an investment advisor. After all, we’ve all heard the stories about the victims of the Bernie Madoff Ponzi scheme. We’ve watched movies like “Wall Street” and “Boiler Room” that leave us confused about who we can trust with our money.   

So, how do you select an investment advisor that you can trust? And how do you find an advisor that legitimately puts your interest above theirs?

If you’ve done some research into finding an ideal advisor, you may have stumbled upon two words that sound like they might mean the same thing, but in actuality have very different definitions. These words are fiduciary and suitability. 

It’s important to understand the difference between those advisors who are held to a fiduciary standard versus those who are held to a suitability standard, particularly before choosing someone who you are going to trust to manage your money.

• What is Fiduciary Standard?
• What is Suitability Standard?
• What is the Difference Between Suitability and Fiduciary Standards?
• Should my Financial Advisor be a Fiduciary?
• Is Financial Advisor better than Fiduciary?
• What are the Fiduciary Duties?
• What are the main Suitability Obligations?

What is Fiduciary Standard?

Investment advisers are bound to a fiduciary standard that is regulated by the Securities and Exchange Commission (SEC) or state securities regulators, both of which hold advisers to a fiduciary standard that requires them to put their client’s interests above their own.

Read Also: Your 6 Step Checklist When Picking a Financial Manager

The act is pretty specific in defining what a fiduciary means, and it stipulates that advisers must place their interests below that of their clients. It consists of a duty of loyalty and care. For example, advisers cannot buy securities for their accounts prior to buying them for clients and are prohibited from making trades that may result in higher commissions for themselves or their investment firms.

It also means advisers must do their best to make sure investment advice is made using accurate and complete information and that the analysis is thorough and as accurate as possible. Avoiding a conflict of interest is important when acting as a fiduciary, which means that advisers must disclose any potential conflicts.

Additionally, advisers need to place trades under a “best execution” standard, meaning they must strive to trade securities with the best combination of low cost and efficient execution.

The SEC has stringent rules for investment advisers. Advisors are allowed to assist in the financial decisions of individuals and institutions who make financial decisions in order to plan for retirement, college payments, or in building their own, often taxable, investment portfolios. The SEC also determines how advisers are able to charge their clients.

What is Suitability Standard?

Broker-dealers have to fulfill what is called a “suitability obligation,” which is loosely defined as making recommendations that suit the best interests of their client. Some broker-dealers feel this is unfair as it may affect their ability to sell investment vehicles that benefit their bottom line, but all a suitability obligation means is that the broker-dealer needs to believe that the decisions they make truly benefit their client.

Suitability also includes making sure transaction costs are not excessive—referred to as “churning” an account or racking up unnecessary trading fees—and that all recommendations benefit the client.

The SEC considers broker-dealers to be financial intermediaries who help connect investors to individual investments. They play a key role in enhancing market liquidity and efficiency by linking the capital with investment products that range from common stocks, mutual funds, and other more complex vehicles, such as variable annuities, futures, and options.

One activity a dealer may carry out is selling a bond out of his or her firm’s inventory of fixed-income securities. The primary income for a broker-dealer comes from commissions earned from making transactions for the underlying customer.

What is the Difference Between Suitability and Fiduciary Standards?

The fiduciary standard requires that an adviser put the clients interest first and is adhered to by Registered Investment Advisors and enforced by the Securities and Exchange Commission (SEC).

The suitability standard requires that a broker make recommendations that are suitable based on a client’s personal situation, but the standard does not require the advice to be in the client’s best interest. Brokers, also known as registered representatives, are held to this suitability standard, which is enforced through a self-regulatory organization called the Financial Industry Regulatory Authority (FINRA).

Imagine you need a new car, but you don’t know much about different options. You head to the closest car dealer, which happens to be a Ford dealership. The dealer asks you to describe what kind of car you need, and you begin listing features and attributes that are best described as a Toyota Highlander.

Under the suitability standard, the dealer could say, “A Ford Explorer would meet all of your needs and we have some of those right over here.”  The dealer makes the sale and gets the commission.  You have a car that is suitable for your needs, but it isn’t necessarily what’s best for you.  Since you don’t have a great deal of knowledge about the auto market, you are in the dark.

Under the fiduciary standard, the dealer would be obligated to say, “It sounds like you are describing a Toyota Highlander.  We don’t sell those.  In order to get exactly what you described, you would have to go down the street to Toyota and ask for a Highlander.  

I can sell you a similar model called a Ford Explorer, it’s more expensive and it isn’t exactly what you described.”  In this scenario, you have more information about your options and the conflicts driving the dealer.

The Ford dealer has a clear conflict of interest in this situation.  He can only sell Fords and will lose the opportunity to earn a commission if the client buys a Toyota Highlander.  

Under the suitability standard, the client ends up with a product (Ford Explorer) that isn’t the best fit given their situation and it costs more than the better-fitting product (Toyota Highlander).  Worst of all, the client probably has no idea that they weren’t given advice that put their own interests first.

Should my Financial Advisor be a Fiduciary?

In today’s financial services industry, the terminology is becoming ever more confusing: advisor, broker, chartered financial analyst, certified financial planner, certified investment management analyst and, more recently, fiduciary. Understanding this last term can make a huge difference in how you choose what kind of advisor you have and how they manage your money.

As we have already mentioned above, a fiduciary is a person given the power to act on behalf of another and put their interests first. The Investment Advisors Act of 1940 is a law that was enacted in order to regulate advisors who, for compensation, give advice to others as to the value of securities or as to the advisability of investing in, purchasing or selling securities.

The law establishes principles for how advisors should treat their clients, which courts have interpreted to be fiduciary obligations.

The advisor, as a fiduciary, owes the client a duty of loyalty, which means they must act in the best interest of the client. If a conflict of interest exists, the advisor must make full and fair disclosure of all material facts so the client can make an informed decision whether to proceed with a transaction.

Additionally, the advisor owes the client a duty of care, which means the advisor’s advice, based on a reasonable inquiry of the client’s financial situation, investment experience and investment objectives, is in the client’s best interest.

In other words, according to the Securities and Exchange Commission rules and the Investment Advisors Act of 1940, the five responsibilities of a fiduciary are:

1. Put client’s interests first.
2. Act with the utmost good faith.
3. Provide full and fair disclosure of all material facts.
4. Do not mislead clients.
5. Expose all conflicts of interest.

The Department of Labor, not the SEC or Financial Industry Regulatory Authority, has broadly redefined financial advice to include investments and insurance recommendations, for compensation, to plans, participants and IRA owners.

Currently, only independent registered investment advisors are required to act in a fiduciary capacity. Brokers or financial advisors working for a broker-dealer firm or an insurance company are held only to a suitability standard (not a fiduciary standard).

Is Financial Advisor better than Fiduciary?

Financial professionals who aren’t fiduciaries are held to a lower set of standards known as the “suitability standard.”

This means that the financial advisor needs to have nothing more than an adequate reason for recommending certain products or strategies, based on obtaining adequate information about the investment and the client’s financial situation, other investments, and financial needs.

For example, when an advisor has two different, comparable investment vehicles for his client, a fiduciary must choose the one with the lowest fees since this is in the client’s best interest. The non-fiduciary advisor, adhering only to suitability standards, would likely choose whichever investment pays him the highest commission, as long as it’s still “suitable” to meet his client’s investing needs.

If an advisor states that they have FINRA Series 7, 65 or 66 licenses, this is usually a sign that they don’t always act as a fiduciary, because they are licensed to sell securities that charge commissions.

Does the Fiduciary Rule Affect Retirement?

Investors who have deepened their understanding of the difference between fiduciary and non-fiduciary advisors may feel that their investments involve a risk that had been present before, but that they were not made aware of.

If the fiduciary rule were still in force, it may have saved many clients from being placed into investments that charged them high commissions or had fees hidden in the fine print, which could cost them thousands in lost retirement savings over time.

One of the key differences between working with a fiduciary advisor and a financial professional bound only by the suitability standard is the depth of conversation each has with their clients.

Before recommending a product or strategy, a fiduciary uses a targeted and prudent method to discover their client’s needs and best interests. After presenting recommendations, a fiduciary will thoroughly cover the rationale behind the recommendations and ensure that the client completely understands, leaving no room for misinterpretation or misunderstanding.

A non-fiduciary financial professional is not required to have this same depth of conversation, and any duty they have towards a client’s investments may well end as soon as they place a trade or get the client to sign on the dotted line. These types of advisors have no obligation to keep tabs on the client’s financial situation or account status going forward.

How to Protect Your Portfolio

The best way to protect your portfolio is to learn as much as you can about your own investing needs, understand how to uncover expensive fees and hidden costs on investment products, and know-how to spot a fiduciary versus a non-fiduciary advisor.

Fiduciary advisors will still cost you money, but they’ll disclose their fees and you’ll pay them separately, instead of having fees taken out of the earnings on your investments, such as sales commissions and management fees for some mutual funds.

If you’re an experienced investor who is familiar with the investment products you need and know where to look for fees and other investment costs, you may be fine working with a non-fiduciary advisor.

If you aren’t interested in the learning curve for many investment products and want to work a fiduciary, you can:

• Look for advisors who are registered with state securities regulators or the Securities Exchange Commission (SEC).
• Check your advisor’s client agreement, or just ask them if they’re a fiduciary.
• Locate fiduciary advisors by searching for fee-only advisors. Fee-based financial advisors are bound by the fiduciary standard (any talk of commissions means they’re not a fiduciary).
• Search the Investment Advisors Association (IAA) directory for advisors. Membership in trade associations such as the IAA can indicate that your advisor is acting as a fiduciary.

Non-fiduciary advisors are not necessarily looking to take advantage of their clients, and if you have an advisor you like and trust, have an open discussion of fees and commissions with them, and how much those costs are impacting the earnings on your retirement portfolio each year.

You may find it helpful to find out how much you’d pay for a fiduciary advisor and see how that cost stacks up against what you’re currently paying.

What are the Fiduciary Duties?

To have fiduciary duty means to ensure the party you are serving can trust you.  It sounds very simple, and that is true, but its simplicity is greatly overshadowed by its importance.  One who acts as a fiduciary for another requires the actor to exercise a paramount level of selflessness.  Although states may differ as to who they consider a fiduciary, there are at least five types of persons the law invariably always denominates as fiduciaries:

• Partners
• LLC Managers
• Corporate Directors
• Corporate Officers
• Controlling Stakeholders—not
  1. Stakeholder – Someone who has a legitimate interest in serving the company (selfless act) so that the company performs well overall; e.g., the CFO.
  2. Shareholder – Someone who has invested in the company for the sole reason of hopefully making a profit off of the company’s performance (selfish act).

A person’s fiduciary duties are bundled into three, sometimes four, different specific duties.

Duty of Care

An officer or director’s duty of care is found in his duty to exercise good business judgment—thus using care—when making decisions for the business. Exercising proper duty of care looks like prudently considering business options and making a reasonable decision based on the information after proper due diligence has been applied to the situation. 

Furthermore, duty of care looks like acting in good faith, meaning that the officer genuinely believes the choice he is making for the company is a beneficial decision.

The standard for the duty of care is based on what a person “in a like position would reasonably do under similar circumstances.”  This standard is a fairly subjective one.  However, under tort law, the standard is reverted to the traditional, objective standard of “what would a reasonable person do?” 

The former, more flexible standard better protects a director accused of abusing his duty of care because it takes into consideration the fact-specific circumstances that influenced his business decision.

Duty of Loyalty

This duty exemplifies the selflessness that defines a fiduciary duty as a whole.  The duty of loyalty commands a director to act responsibly for the company at all times and to always act in the best interests of the company rather than oneself.  Not only is the duty of loyalty expected when making decisions, but also when refraining or excluding oneself from making business decisions. 

For example, if a particular business deal is brought to the board of directors’ attention, any director who may have a conflict of interest with the deal is expected to recuse himself from weighing in on the discussion. This is to protect both himself and the company because a conflict of interest for a director may tempt him to act in a way that would allow the director to personally gain from the business deal.

Duty of Act Lawfully

This duty is fairly self-explanatory.  Part of an officer’s fiduciary duty lies in the fact that he is expected to act in accordance with the law.  Reasonably, one would not merit trust from the shareholders of the company if an officer did not follow the law when making his business decisions for the company.

Duty of Act With/in Good Faith

This final duty is not always specifically recognized because it can be inherent to the first duty.  As briefly described above, this duty represents an officer or director’s genuine belief and trust that his decision for the business will be beneficial to the business.

This blog’s purpose was to provide the basics of fiduciary duties, but like we said above, states differ in some ways regarding their expectations from fiduciaries.  The rule of thumb is to “act in the best interests of the company and shareholders.”  Don’t worry that you will suddenly be blindsided with criticism or a lawsuit if you are following that rule of thumb; but it’s still simply better to know more than the basics.

If you are in a position that requires fiduciary duties to your company and shareholders, it is important that you consult with competent legal counsel so that you are aware of the nuances this area of the law can sometimes contain.

Breaches in Fiduciary Duty

Case law indicates that breaches of fiduciary duty typically happen during the time when a binding fiduciary relationship is in effect and actions are taken which violate or are counterproductive to the interests of a specific client. Typically, the actions are often somehow taken to benefit the fiduciary’s interests or the interests of a third party instead of a client’s interests.

A breach can also stem from a failure to provide important information to a client that may lead to misunderstandings, misinterpretations, or misguided advice. Identification or disclosure of any potential conflicts of interest is usually important in fiduciary relationships because all types of conflicts can be a source for undesired intentions.

Elements of a Breach of Fiduciary Duty Claim

As is expected with most all case law, certain precedents and elements have been established in the legal industry to help govern against fiduciary breaches and to protect those who have been harmed by unlawful actions. Each jurisdiction may have different elements, but in general, the following four elements are essential in helping a plaintiff to prevail in a breach of fiduciary duty claim.

• Duty: The plaintiff must show that a fiduciary duty existed. Fiduciary duty can be required in multiple situations so identifying the legality of the fiduciary duty is of utmost importance.
• Breach: The plaintiff must show that breach of the fiduciary duty occurred. The type of breach can vary in each case depending on the actions taken by a defending fiduciary. Examples of a breach may include failed disclosure of important information causing misinterpretation, negligence, or unlawful use of funds.
• Damages: The plaintiff must show that damages occurred from the breach. Without damages there is typically no basis for a breach of fiduciary duty case.
• Causation: Causation is usually also an element associated with a breach of fiduciary duty cases. Causation shows that any damages incurred by the plaintiff were in direct association with the breach of fiduciary duty actions taken by the defendant.

Consequences of a Breach in Fiduciary Duty

There can be a variety of repercussions, outcomes, and consequences incurred from a breach of fiduciary duty. Not all breaches may be discussed in a court of law. Accusations of a breach of fiduciary duty can simply hurt the reputation of a professional. Clients can choose to leave a professional relationship because they do not trust in a professional’s care of the required fiduciary duty.

Clients may also leave a professional relationship if there are accusations of a breach or any potential breach of duty damages.

If a breach of duty case does proceed to the courts, steeper consequences can exist. A successful breach of fiduciary duty lawsuits for a plaintiff can result in monetary penalties for direct damages, indirect damages, and coverage of legal fees. Court rulings can also lead to industry discrediting, loss of license, or removal from service.

Example of Breach of Fiduciary Duty Case

From Virginia, one example of a breach in fiduciary duty case is 2007 Banks v. Mario Indus., 274 Va. 438, 650 S.E.2d 687. In this case, the defendant was an employee of Mario and admitted that he owed Mario a duty of loyalty. Those admissions, combined with the fact that the employee’s job was to faithfully represent Mario’s interest support the claim for breach of fiduciary duty.

Examples of Fiduciary Duty-Defined Relationships

Trustee/Beneficiary

Estate arrangements and implemented trusts involve a trustee and beneficiary fiduciary duty. An individual named as a trust or estate trustee is the fiduciary, and the beneficiary is the principal. Under a trustee/beneficiary duty, the fiduciary has legal ownership of the property and holds the power necessary to handle assets held in the name of the trust.

However, the trustee must make decisions that are in the best interest of the beneficiary as the latter holds equitable title to the property. The trustee/beneficiary relationship is an important aspect of comprehensive estate planning, and special care should be taken to determine who is designated as trustee.

Guardian/Ward

Under a guardian/ward relationship, legal guardianship of a minor is transferred to an appointed adult. The guardian, as the fiduciary, is tasked with ensuring the minor child or ward has appropriate care, which can include deciding where the minor attends school, that he has suitable medical care, that he is disciplined in a reasonable manner, and that his daily welfare remains intact.

A guardian is appointed by the state court when the natural guardian of a minor is not able to care for the child any longer. In most states, a guardian/ward relationship remains intact until the minor child reaches the age of majority.

Principal/Agent

A more generic example of fiduciary duty lies in the principal/agent relationship. Any individual person, corporation, partnership, or government agency can act as a principal or agent as long as the person or business has the legal capacity to do so. Under a principal/agent duty, an agent is legally appointed to act on behalf of the principal without conflict of interest.

A common example of a principal/agent relationship that implies fiduciary duty is a group of shareholders as principals electing management or C-suite individuals to act as agents. Similarly, investors act as principals when selecting investment fund managers as agents to manage their assets.

Attorney/Client

The attorney/client fiduciary relationship is arguably one of the most stringent. The U.S. Supreme Court states that the highest level of trust and confidence must exist between an attorney and his client and that an attorney, as fiduciary, must act in complete fairness, loyalty, and fidelity in each representation of and dealing with clients.

Attorneys are held liable for breaches of their fiduciary duties by the client and are accountable to the court in which that client is represented when a breach occurs.

Controlling Stockholder/Company

In certain circumstances, fiduciary duties may also apply to control stockholders who possess a majority interest in or exercise control over corporate business activities. A breach of fiduciary duty may result in personal legal liability for the director, officer, or controlling shareholder.

What are the main Suitability Obligations?

An investment must meet the suitability requirements outlined in FINRA Rule 2111 prior to being recommended by a firm to an investor. In most parts of the world, financial professionals have a duty to take steps that ensure the investment is suitable for a client.

For example, in the United States, the Financial Industry Regulatory Authority (FINRA) oversees and enforces these rules. Suitability standards are not the same as fiduciary requirements.

Understanding Suitable (Suitability)

Any financial firm or individual dealing with an investor must answer the question, “Is this investment appropriate for my client?” The firm, or associated person, must have a legally reasonable basis, or high degree of confidence, that the security that they are offering to the investor is in line with that investor’s objectives, such as risk tolerance, as stated in their investment profile.

Both financial advisors and broker-dealers must fulfill a suitability obligation, which means making recommendations that are consistent with the best interests of the underlying customer. The Financial Industry Regulatory Authority (FINRA) regulates both types of financial entities under standards that require them to make appropriate recommendations to their clients. 

However, a broker, or broker-dealer, also works on behalf of the broker-dealer firm, which is why the concept of suitability needed to be defined to safeguard investors from predatory practices.

FINRA Rule 2111 states the customer’s investment profile “includes, but is not limited to, the customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, [and] risk tolerance” among other information. An investment recommendation by a broker, or any other regulated entity, would automatically trigger this rule.

No investment, other than outright scams, are inherently suitable or unsuitable for an investor. Suitability depends on the investor’s situation based on the FINRA guidelines. To illustrate, for a 95-year-old widow who is living on a fixed income, speculative investments, such as options and futures, penny stocks, etc., are extremely unsuitable.

The widow has a low risk tolerance for investments that may lose the principal. On the other hand, an executive with significant net worth and investing experience might be comfortable taking on those speculative investments as part of their portfolio.

No matter the investor type, suitability requirements cover abnormally high transaction costs and excessive portfolio turnover, called churning, to generate commission fees.

Suitability vs. Fiduciary Requirements

People may confuse the terms suitability and fiduciary. Both seek to protect the investor from foreseeable harm or excessive risk. However, the standards of investor care are different. An investment fiduciary is any person who has the legal responsibility for managing someone else’s money. 

Investment advisors, who are usually fee-based, are bound to fiduciary standards. Broker-dealers, customarily compensated by commission, generally have to fulfill only a suitability obligation.

A financial advisor has the responsibility to recommend suitable investments while still adhering to the fiduciary standards. The standards require advisors to put their client’s interests above their or their firm’s interests.

For example, the advisor cannot buy securities for their account before recommending or buying them for a client’s account. Fiduciary standards also prohibit making trades that may result in the payment of higher commission fees to the advisor or their investment firm.

Read Also: The 7 Types of Financial Planners you Need to know about

The advisor must use accurate and complete information and analysis when giving a client investment advice. To avoid conflict of interest, the fiduciary will disclose potential conflicts to the client and then will place the client’s interests before their own. Additionally, the advisor initiates trades under the best execution standard, where they work to execute the transaction at the lowest cost and with the highest efficiency.

Final Words

If you are interested in finding an investment advisor who is required to uphold the Fiduciary Standard, a great place to begin is by looking for a fee-only financial planner. Fee-only planners and advisors do not sell investment products, nor do they make commissions. 

Fee-only planners charge a fixed price and aren’t driven by selling any kind of product. Their advice is held to the highest standard, and they are required to put their clients’ interests above their own. 

That’s different from a fee-based advisor. Fee-based advisors make their money through a combination of fees and commissions. Meaning if you purchase a particular investment that they recommend, they earn a percentage of what you invest as a commission.

To find a fee-only financial planner near you, check out the Nation Association of Personal Financial Advisors.