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The Doctor And the Drug Dealer: A Parable About Registered Investment Advisors and Broker-Dealers

You go to your doctor. And the doctor says Take this drug for what ails you It will help your head! Then later that week, you see him around town And the good doc asks… Did I help your frown? Is that awful pain in the past? You say yes!  He says great!! You say thanks for caring. He says it’s great for you and Great for my estate! You ask, what do you mean? He explains, I don’t just prescribe the meds I also own shares In the company whose medicine fixed your head.

If you go to the doctor and the doctor prescribes medicine made by a company that the doctor owns shares in, does the doctor have a conflict of interest?   What if the doctor is paid for every pill she prescribes?  Is that a conflict?

Let’s assume you go to a doctor like this.  The doctor, however, discloses the conflict by saying “Look, I am a doctor and as such I put my patients’ care first.  But I am also a drug salesman and as such it is appropriate to put my own interests first. But don’t worry.  I will tell you when I am speaking to you as your doctor and when I am speaking to you as your drug dealer.”

All good, right?  Nope.  Not even close.  And the above is a pretty unrealistic scenario, right?  Yet something like it happens all the time.   And while the context is not as important as your health, it is pretty close:  your money.

With whom do you invest your money?  What I mean is this:  do you have a “broker”? An “investment advisor”?  A “financial planner”?  Do you know the difference?

 You can click here for an excellent overview but in short here is what you need to know- at a minimum: 

  • An RIA (that is, a Registered Investment Advisor) and its employees, known as investment advisors, provide advice and guidance about investments to their clients.  RIAs are regulated under the Investment Advisors Act of 1940, and they are subject to a fiduciary duty of loyalty, a duty to fully disclose conflicts of interest, and a duty to act in their clients’ best interests.  An RIA is generally compensated by fees not tied to whether a transaction happens. 
  • A broker-dealer (commonly just called a “broker”) on the other hand, and its employees, known as registered representatives, engage in the business of buying and selling securities on behalf of her customers.  Broker-dealers are regulated under the Exchange Act of 1934, are overseen by the SEC, and typically are members of FINRA (the Financial Industry Regulatory Authority). While not fiduciaries, brokers do have a duty to deal fairly with customers and to make a suitability determination before offering a customer any investment.  On the other hand, brokers are compensated when transactions happen, are permitted to recommend investments that put their own interests ahead of the interests of their customers, and do not have a duty to disclose conflicts of interest. 

A broker is required to register as an RIA if she provides investment advice unless that advice is “solely incidental” to her core transactional business.  Brokers who do not register as RIAs nonetheless commonly identify themselves as “financial advisors” or “financial consultants” in their marketing materials even though they rely on the “solely incidental” exemption to avoid becoming RIAs.  This is wrong, in my view, but happens because of the lax enforcement of the exemption’s limits.

The distinction is muddied even more because many firms operate today as both an RIA and a broker.  This is referred to in the industry as being a “dual registrant” and it is the point of my parable in a poem above.  It is utter silliness to think that one firm (and even one person at one firm) can speak to a client/customer as an RIA one moment then change hats and speak to the same customer/client the next moment, and that the person on the receiving end will be able to understand whether she is getting trusted advice from a fiduciary or not.  In other words, no amount of disclosure can prevent confusion. 

There are moves afoot to change some of the applicable rules.  And some commentators are concerned that the changes could make matters more confusing for investors.   An excellent white paper I read recently by David Colton and Wally Head, both of Gresham Partners, LLC, an investment and wealth management firm, which advises on about $4 billion, states in part: 

Rather than develop new fiduciary rules or adopt a uniform fiduciary standard [which for reasons explained in the Gresham white paper would require the adoption of a lower standard than RIAs are currently subject to] … our preferred approach would be for the SEC to simply enforce the Advisers Act … and narrowly interpret its ‘solely incidental’ exemption so that brokerage firms must register as RIAs if they hold their employees out to the public as advisors … [and that] the concept of dual registrants as it is employed today should be eliminated so that one firm cannot provide both Exchange Act and Advisers Act services to the same client

I agree with Colton and Head and, indeed, this piece was directly influenced by their white paper.  In fact, even my “doctor” analogy, I must admit, was first articulated (I did my best to remember the way he stated it; anything about it that is inarticulate is my fault, not his) by David Colton earlier this week over drinks.  The poem, however, is all mine.


About Jonathan Friedland

Jonathan Friedland is a partner with Sugar Felsenthal Grais & Hammer, a law firm with offices in Chicago and New York City. Born and raised in a New York suburb, Friedland graduated SUNY-Albany magna cum laude in three years and then earned his law degree from the University of Pennsylvania Law School. Friedland clerked for…

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