Stock brokers are not advisors according to SEC

By DAVID MOON, Moon Capital Management
April 3, 2005

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.

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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).

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