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Posted by Mr. Joel W. on Oct 24th, 2014 9:38am

                   Financial Advisors: Sales Representatives or Professionals?

                                   -  a new paradigm for the securities industry –


                                                       Joel Wiesenfeld



Should the securities registration of financial advisors be uncoupled from investment and mutual fund dealers?  Before automatically rejecting this concept, consider the historical context and the ramifications of such a change.


Once upon a time, as far back as the 1980’s, a stockbroker was an individual employed by a brokerage firm to give investment advice and provide trade execution services to the investing public.  At times the stockbroker also became involved in corporate finance activities, and then participated in the distribution of the resulting securities to his investor clients, an activity that rarely occurs today.  The standard issue stockbroker was termed by securities regulators a ‘registered representative’ or, simply, an ‘rr’.  The individual was registered, or licenced, by the regulator through his, or rarely, her, firm.  The firm’s stockbrokers acted as the distribution arm for the dealer’s corporate finance products, and so, were commonly referred to as sales representatives. 


Rrs were (and still are) clearly differentiated, by securities regulations and in their legal duties and responsibilities, from investment counsel or portfolio managers (‘ICPMs’).  Individuals in this latter category of registration had significantly greater qualifications and perceived abilities, allowing them to actually make investment decisions on behalf of their clients.  Along with the higher level designation and powers came a higher level of duty owed to investor clients, an automatic categorization of the advisor/client relationship as fiduciary in nature.  ICPMs could form their own type of dealer, providing portfolio management services, while contracting with stockbrokerage firms for trade execution custodial lending and transaction reporting services.  Legal and regulatory liability for the ICPM’s investment advice rested with the ICPM and not with the contracting dealer.  All of this is still the case.


In contrast, rrs were (and still are) required to obtain instructions from their clients for each transaction conducted in their accounts.  Back in the 1980’s, initial licensing and ongoing regulatory requirements for rrs were far less robust than today; the then Manual for Registered Representatives was a thin small sized binder, easily digested.  Now, the Conduct and Practices Handbook, together with dealer policy and procedure manuals and regulatory mandated continuing education requirements, constitute a significant upgrade in the qualifications of what are now commonly referred to as financial or investment advisors.


The historical stockbrokerage firm has given way to investment dealers and mutual fund dealers, the latter limited to dealing in mutual funds (and restricted from transacting in equities and bonds) with its retail investor clients.  The norm is that financial advisors are employees of investment dealers, and contract as independent contractors with mutual fund dealers.  In any event, financial advisors are agents of both types of dealers.  Generally mutual fund financial advisors are insured, carrying errors and omissions (ie, for negligence) insurance, while investment dealer financial advisors are not.  Both investment and mutual fund dealers are required by securities regulators to have insurance for fraud, although the policies typically only cover misappropriation of securities or monies, or other forms of fraudulent activity, within the client’s accounts at the dealer, and not so-called off book fraudulent conduct. 


In the 1990’s, changes to securities regulations created the opportunity for financial advisors to become independent of investment dealers through the mechanism of being licensed as introducing brokers.  As an introducing broker (‘IB’), the financial advisor contracts with a financial services company acting as a carrying broker (‘CB’)to provide all of the traditional services of a stockbrokerage firm (trade execution, custodial, lending and account activity reporting), save for the provision of investment advice.  As an introducing broker, the financial advisor has the direct client relationship with the retail investor, gives financial advice, receives the client’s trade instructions, and, in turn, bears the regulatory know your client, know your product, suitability and compliance obligations.


The concept put forward at the start of this piece is therefore in the continuum of the ICPM and IB/CB models already in use for many years.  By constituting each financial advisor as his or her own introducing broker, the concept recognizes the primacy of the advisor/client relationship over that of the dealer/client relationship. 


Should the legal and regulatory liability for a financial advisor’s investment advice to retail investor clients rest solely with the advisor?  Focusing regulatory and civil liability for negligent investment advice, misconduct relating to a client’s accounts or portfolio, and/or fraudulent conduct by a financial advisor (whether in the accounts or off-book), clarifies for everyone where legal and regulatory responsibility lies.  A financial advisor would no longer be able to rely on the assumed deep pockets of the dealer to cover the risk of incompetent or inappropriate investment advice or fraudulent conduct.  A financial advisor would be required by regulation to carry both errors and omissions and fraud insurance (with the latter policy to include both on and off book conduct) – just as every other professional is obligated to be insured for professional risk, so as to protect investors from financial harm. 


Decoupling the financial advisor’s license from a dealer is an important element of ensuring professional over sales conduct.  Investor loss disputes and ensuing litigation would no longer be weighed down with issues such as a dealer’s vicarious liability for the acts of its financial advisor, dealer liability for failure to supervise the advisor, whether the conduct in question was reasonably a part of the advisor’s employment, and whether the solvency of the dealer is sufficient to meet the monetary obligations of a judgment.  The issue that has plagued the investment dealer world as to whether financial advisors should be allowed to incorporate would also become moot.  Another area of frequent dispute and litigation, arising from financial advisor recruitment by one dealer from another, would also become redundant.


Best of all, financial advisors would clearly be recognized as professionals and not as sales persons, removing the taint from a constituency which provides important advice relied upon by so many investors.




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