Business Memo: Are You A Fiduciary? Why Do You Care?

Joseph R. Soraghan

By Joseph R. Soraghan

A lawn care service company sells products and provides services. Registered representatives (“RRs”) and broker-dealers (“B-Ds”) also provide services and sell products (securities, etc.) to their customers. The question here is whether RRs and B-Ds have a significantly higher duty—a fiduciary duty—to their customers.

Most RRs and BDs would automatically react that they provide much more sophisticated services and products than a lawn care service and therefore treat their customers with a higher level of care. However, when that customer complains about their service, and perhaps brings a claim in arbitration or litigation, well-advised B-Ds and RRs argue that their duty was not that of a fiduciary.  Liability on such a claim frequently turns on whether, and is much more likely if, the arbitrators or court believes that the B-D and RR had a fiduciary duty to the customer.

What is a Fiduciary Duty?Fiduciary duties go beyond mere fairness and honesty; they oblige the RR to act to further the beneficiaries’ best interest.  Importantly, they require the RR not to act in his own or his B-D’s best interest when that best interest conflicts with the best interest of the customer. It requires the RR to give the customer all information which the customer may reasonably believe relevant to his investment decisions, even if giving such information may conflict with the best interest of the RR and his B-D. This is a significantly higher order of duty than is imposed on most salesperson and service providers, and creates liabilities that do not exist otherwise. Doctors and lawyers, for example, owe fiduciary duties to their patients and their clients.  (E.g. under Missouri law, a lawyer, upon demand of his client, must return the client’s files to the client even if the client refuses to pay for the lawyer’s past services.)

Are B-Ds and RRs fiduciaries? It is always held that RRs and B-Ds are fiduciaries when the account is discretionary, allowing the RR to make the investment decisions and enter transactions without the approval of the customer for each transaction.  The question arises whether and when the RR and B-D have a fiduciary duty to customers in non-discretionary accounts, under which the RR recommends trades but must get the customer’s approval.

Court cases are at best confusing on this issue, and arbitrators almost never make findings, and so are of no assistance on this question.  Court cases are confusing on whether a RR is a fiduciary, on what the duties of a fiduciary are, and in which particular differing situations a RR has a fiduciary duty and in which he does not.  For example, some cases have held that RRs are not fiduciaries but then hold them to duties which in fact appear to be fiduciary; one stated that they “owe customers duties of a fiduciary nature.”  A detailed analysis of the cases indicates that the courts hold RRs to high levels of duties which appear to be fiduciary in nature, even when those courts deny that the RR is a fiduciary.  The duties required are almost always much higher than in sales of products other than securities.

It is almost always held that an RR has a fiduciary (or other very high level of) duty when he or she is in virtual control of the functions he or she is to perform for the customer.  As prior newsletters have discussed (e.g., February 2004) the factors in determining “control” are not only whether the account is “discretionary” but whether in a non-discretionary account the customer virtually always follows the recommendation of the RR, or clearly does not understand investment risk or the markets, even if he acts sophisticated.

Missouri Law. State law controls this issue. The two or three applicable cases in Missouri on it do not address all the nuances of the questions. They have simply stated that RRs and B-Ds are fiduciaries to their customers. As one case stated:

Where the account is non-discretionary . . . the stockbroker’s duties are . . .  fiduciary duties. The broker must study a stock before recommending it and inform the customer of the risks involved in the particular transaction. Beyond that, the duties are to refrain from self dealing and misrepresentation, follow the customer’s order and disclose any personal interest in the transaction.

A significant number of cases have held, it is true, that in a non-discretionary account these fiduciary duties do not apply after the trade has taken place.  That is, the RR’s duty with respect to a recommended investment ends upon completion of that investment, different from the continuing duty in a discretionary account.  However, the initial recommendation is much more often the subject of claims by customers, and the fiduciary duty does usually apply to the purchase or sale itself in a non-discretionary account.

And, although I have been unable to find cases directly on this point, the fiduciary duty of an RR does undoubtedly require him or her to monitor and advise the customers after a trade in “fee-based” and “fee-for-service” accounts (in which the contract or the understanding with the customer is that the RR will do so.)

The courts have generally held that even though an RR is in reality a salesperson who typically derives compensation from the commissions or otherwise from transactions for his customers, the RR stands in a different legal relationship to his customers from that of other kinds of salespersons.  Securities brokerage customers, the cases say (different from the recipient of lawn services) either lack the knowledge and experience to knowingly make their own decisions, or have entered into a relationship with the RR and B-D in which is it understood that the RR will do the analysis, and the customer will not, and that the customer thus becomes dependent on the RR and vulnerable to abuse by him.

Of course, there are well made arguments accepted in a minority of cases by some courts and arbitration panels that, at least in some situations, there is on the part of RRs and B-Ds no fiduciary duty or duty any greater than that of salespersons of any other products. And good attorneys, in defending claims, will make this argument and will sometimes prevail.  But the thrust of this newsletter is to set forth guidelines to minimize the likelihood of being found liable while optimizing (not necessarily maximizing) the RRs and B-Ds earnings.

Conclusion

Probably, if an RR is in a position to take advantage of his customer, either because of his or her significantly greater experience and knowledge, or simply from a knowledge that the customer will accept his recommendation (even if the customer has the ability to analyze it himself or herself) the RR is thus in “control” even of non-discretionary accounts and will be held to a very high standard of conduct.  They will be held to this standard in order to ensure that the customer’s, not his or his B-D’s, best interest is protected.  Therefore, B-Ds and RRs should treat each customer as he or she would wish another B-D and RR to treat his or her parent or sibling in a similar situation.

Reprinted from The St. Louis Broker-Dealer newsletter, January 2007.

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