By DAVID MOON, Moon Capital Management
An old riddle asks, 'if you had five dogs and decided to call two of them
cats, how many cats would you have? None, because calling a dog a cat doesn't
make it a cat.'
It's a pretty simple lesson some folks in my industry ought to embrace.
When dealing with the Securities and Exchange Commission, your brokerage firm
argues that it is not in the business of providing financial advice. So it wants
to be exempt from the fiduciary and disclosure requirements required of
registered investment advisers. For six years the SEC has agreed. But does that
make it so? Or are the SEC and brokerage firms merely calling a dog a cat?
The historic business of a brokerage firm was to sell a product to a
customer. Brokers were, in fact, once known as 'customers' men.' Your broker
might give you advice about a particular issue, but it was incidental to the
sales process, much like a car salesman might suggest a diesel engine if you
planned to put 200,000 miles on an automobile.
Consumers and brokers both realized that the commissions brokers received on
every transaction helped create the perception of conflicts of interest. In many
situations, they decided, a better business model would be for the broker to
charge a flat fee for his or her service, normally a percentage of the assets
managed for a client. In 1999, despite its push toward asset-based fees, Merrill
Lynch asked the SEC for an exemption from having to register its brokers as
investment advisers. 'We're focused on financial planning and all of its
components,' said Chairman David Komansky, yet he wanted the SEC to act as if
Merrill was not giving advice at all.
The SEC granted Merrill's request.
Despite ads about planning for your daughter's wedding or buying that home on
the beach, your broker has not been in the business of giving you investment
advice, at least according to the regulators and the brokerage executives''the
lawyer-executives, that is, not the ad executives. Most brokerage firms now rely
on this exemption.
You may think that the difference is only semantics. Not so. Without this
exemption, your broker and his firm would have to register as investment
advisors and provide much more extensive disclosure about their disciplinary
history. Registered investment advisers have legal fiduciary responsibilities
mandated by the Investment Advisers Act of 1940, requiring them to place the
interests of their clients above their own and to disclose all potential
conflicts and sources of income. Brokers are generally exempted from this
fiduciary duty and disclosure standard.
Barbara Roper, the director of investor protection at the Consumer Federation
of America, asks a fair question: 'What good can it possibly do to tell
investors that an account is a brokerage account if most investors mistakenly
believe that brokers are advisers?'
Brokerage firms are holding themselves out as advisors and money managers but
aren't regulated as such. Legally, they aren't providing these
services. But you can't tell that from their ads. And you can't tell
it from their services.
It is silly to pretend otherwise.
In last week's column, I incorrectly used the term 'non-correlated' in place
of 'negatively correlated.' Thanks to Dr. William Wallace of
Fairfield Glade for my remedial statistics lesson.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).