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Ethical Standards for Stockbrokers: Fiduciary or Suitability?

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Abstract

What are the ethical obligations of the sellers of financial products to their customers? Stockbrokers in the U.S. have a legal and ethical requirement to recommend only “suitable” investments to their customers. This is a fairly weak standard. Currently, there are proposals to raise the standard to a fiduciary one in which the recommendations would have to be in the best interests of the clients. Brokers sell solutions to financial problems. Similar to an auto mechanic or a doctor, the product often consists of both the professional advice and its implementation. There are numerous conflicts of interest between brokerage firms and their customers in that the products that pay the highest commissions may not be the best ones for the customers. The societal perspective adds complications, however. Society depends on modern financial markets to raise capital for productive enterprises and to spread risk. Issuers of financial products need distribution channels for their products just like the producers of any other products. Commissions create powerful incentives for the distribution channels, but at the same time produce conflicts of interest—a type of ethical pollution. Just as our society tolerates some pollution as a byproduct of other useful activities, it may be useful to tolerate some of these financial conflicts of interest. The nature of the relationship should govern the ethical standard. Those selling advice, regardless of how they label themselves, should adhere to a best-interest fiduciary standard. More limited relationships should be limited to the mandate involved in the relationship.

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Notes

  1. This proposal was incorporated in §7103 of the original House version (HR4173, 2009) of what became the Dodd-Frank Wall Street Reform and Consumer Protection Act.

  2. §913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. Although the SEC has studied the issue, it has not yet exercised this new authority. The study can be found at http://www.sec.gov/news/studies/2011/913studyfinal.pdf, accessed May 17, 2012.

  3. Although it is clear that a broker has a duty to obtain best execution, in practice figuring out what best execution is can be problematic. See Macy and O’Hara (1997) for a nice discussion of the complexities and Facciolo (2005) for some of the history behind broker obligations. As brokerage firm customer contracts require arbitration instead of litigation, aggrieved customers can engage in arbitration and FINRA can sanction firms directly. See FINRA (2011).

  4. Investors who feel they have been sold unsuitable investments can seek redress through FINRA-mediated arbitrations. Likewise, FINRA and the SEC can and sometimes do discipline misbehaving brokers. There are a number of law review articles that address suitability in a legal context. See Nichols (1976), Weiss (1997), Libin and Wrona (2001), Gedicks (2005), and Hazen (2010).

  5. We averaged these results over the period from 2001 to 2008, the most recent years available prior to the financial crisis, as trading gains and losses fluctuated significantly from year to year.

  6. One way in which the SEC deals with this conflict is to require brokerage confirmations to disclose where the trade was executed and whether the broker was acting as a principal. See SEC Rule 10b-10 (17CFR240.10b-10). Furthermore, brokerage firms are required under SEC Rule 606 (17CFR242.606) to disclose where they route their equity and option orders, as well as payments received for those orders.

  7. SEC Rule 605 (17CFR242.605) requires market centers to report statistics on the quality of their executions.

  8. For example, E*trade discloses in fine print on its web site: “E*TRADE receives payment from its affiliate, E*TRADE Capital Markets, LLC (“ETCM”), a wholly owned subsidiary of E*TRADE Financial Corp. (“ETFC”), for directing listed equity order flow. Payments received from ETCM averaged less than $0.0008 per share. ETCM executes on a principal basis and may have profited or lost in connection with such transactions.” Although customers theoretically have the right to choose the destination of their orders, the basic E*trade platform does not support such choice. Customers who want to choose the destination of their order either have to use one of E*trade’s more sophisticated higher-end trading platforms or else trade via telephone with a live representative at a much higher price. https://content.etrade.com/etrade/powerpage/pdf/OrderRouting11AC6.pdf, accessed September 30, 2010.

  9. See Battalio and Loughran (2008) for more details.

  10. For example, see FINRA (2004).

  11. See SEC Rule 12b-1 (17CFR240.12b-1).

  12. The common practice in the U.S. is to use the spelling “advisor.” However, the text of the law and most regulations use the spelling “adviser.” Both spellings are generally deemed acceptable by many dictionaries. Google reports approximately twice as many hits for “advisor” as “adviser.”

  13. Smaller advisors doing business in only one state may register with their state instead of the SEC.

  14. FINRA was formed as a result of a merger between the National Association of Securities Dealers (NASD) and NYSE Regulation in 2007.

  15. See §205 of the Investment Advisers Act of 1940, P.L.76-768.

  16. Financial Planning Association v. SEC 482 F.3d 481 (D.C. Cir. 2007). See also SEC (2005a, b) and SEC (2007).

  17. Blankfein (2010, p. 174).

  18. See Weiss (1997) for more details.

  19. The National Association of Securities Dealers (NASD) was a predecessor of FINRA. NASD Rule 2010 stated “A member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade.”

  20. SEC (1963, Part 1, p. 238).

  21. See FINRA (2007).

  22. The NYSE has long had the similar Rule 405, the “Know your customer” rule.

  23. See Goldin (2006) for a concise and readable discussion of Cicero’s and St. Thomas Aquinas’ views on the matter.

  24. For example, SEC Rule 10b-5 (17CFR240.10b-5) makes it a crime with respect to a sale or purchase of a security “To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

  25. Here is a personal anecdote to illustrate how even sophisticated investors knowingly consume commission-based advice. The mother of one of our colleagues obtains financial advice from a commission-based advisor. She then cross checks the advice with her son and asks him what she should buy from the advisor “that is not too bad because I need to buy something to pay him for his advice.”

  26. Financial incentives are central to the operation of most distribution channels, not just financial products. We leave the general discussion of the whether such markets are ethical for another time.

  27. For example, one firm proclaims on its web site: “We are pure agents, with none of the conflicts that plague bulge-bracket firms. There is zero proprietary trading at Rosenblatt.” http://rblt.com/trading.aspx, accessed February 11, 2012.

  28. There are approximately 90,000 CFA charter holders worldwide, compared with 633,000 stockbrokers registered as representatives with FINRA in the U.S. Sources: http://www.cfainstitute.org/about/membership/process/Pages/index.aspx and http://www.finra.org/web/groups/corporate/@corp/@about/@ar/documents/corporate/p122204.pdf, accessed April 25, 2011.

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Authors and Affiliations

  1. McDonough School of Business, Washington, DC, 20057, USA

    James J. Angel & Douglas McCabe

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  1. James J. Angel
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  2. Douglas McCabe
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Correspondence to James J. Angel.

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Angel, J.J., McCabe, D. Ethical Standards for Stockbrokers: Fiduciary or Suitability?. J Bus Ethics 115, 183–193 (2013). https://doi.org/10.1007/s10551-012-1362-y

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