3
Ronald Reagan once quipped, “The most terrifying words in the English language are: ‘I’m from the government and I’m here to help.’”
Today, an equally frightening pronouncement is, “I’m a financial advisor and I’m here to help.”
You know this to be true. Think of yourself at a social function. When you meet a financial advisor, you nearly snap a tendon trying to move in the opposite direction. The presumption is that financial advisors are trying to sell you something that will fatten their wallet more than yours.
Just look to the recent civil fraud case that the Securities and Exchange Commission filed against the greatest financial advisor of all, Goldman Sachs.
Essentially, Goldman participated in the creation and marketing of a subprime mortgage derivative security that Goldman believed was likely to lose value. And then Goldman sold this product to its client. This alone was legally permissible.
The SEC, however, contends that Goldman went a step further and made a material misrepresentation about the security. The SEC claims that Goldman failed to disclose to the buyers of the security that hedge fund manager John Paulsen, a notorious subprime mortgage bear, helped choose the mortgages that the security tracked. Paulsen was, all along, planning to bet that the security would lose value.
But why is Goldman Sachs, acting as a broker, legally allowed to sell an inferior security to its client in the first place?
As a broker, the legal standard that Goldman must follow is that of suitability. A product doesn’t have to be all that good as long as it is considered suitable.
Goldman argues that its client was a huge, sophisticated German bank and, therefore, the product was inherently suitable. Effectively, the argument contends that the German bank knew what it was getting when it purchased the security in question. And while testifying before Congress last week, several current and former Goldman employees suggested that the German bank purchased the low-quality asset to balance its risk profile by gaining exposure to the U.S. housing market.
Goldman Sachs says that the German bank’s purchase of the security, in and of itself, proved suitability. The SEC, therefore, has to evidence a material misrepresentation; essentially establish that Goldman lied to sell the investment.
To offer an everyday example of the suitability standard, it is helpful to consider a more pedestrian product than a complex mortgage derivative-based instrument. Take variable annuities, which are often so complex in nature that the buyer and the seller don’t understand the product. A variety of more straightforward investments may satisfy the buyer’s goals with substantially lower fees. The fact that a variable annuity may be the worst option available does not mean it is unsuitable. Hence, wildly opaque and confusing financial products are legally sold every day.
In order then for the public to put aside suspicion and fear of financial advisors, there should exist a legal requirement for “all professionals who provide investment and financial advice or who hold themselves out as providing financial or investment advice, without exceptions and without exemptions” to act only in the best interest of their clients. Such is the goal of the Committee for the Fiduciary Standard, a group of financial professionals who are lobbying Congress to include a provision in comprehensive financial reform legislation that would require a fiduciary standard.
The Committee for the Fiduciary Standard promotes five core principals to define a fiduciary standard: 1) Put the client’s best interest first; 2) Act with prudence; that is, with the skill, care, diligence and good judgment of a professional; 3) Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts; 4) Avoid conflicts of interest; and 5) Fully disclose and fairly manage, in the client’s favor, unavoidable conflicts.
Today only a minority of financial advisors are legally or ethically required to adhere to a fiduciary standard, by which, at all times, they must act for the sole benefit and interest of each client. It is wise to directly ask financial advisors to which standard they are required to comport, a suitability standard or a fiduciary standard. If they say a fiduciary standard, insist that the advisor acknowledge this claim in writing. After all, you want people working for your interests rather than their own.
All professionals rendering advice to others should think of the words of Albert Einstein who said, “Try not to become a man of success but rather try to become a man of value.”
Our investment approach is straightforward, transparent, low-cost, tax-efficient and independent. We invite you to work with us.