Fiduciary and Suitability – Industry Standards, Investor Choice

By Ronald P. Bernardi

When is a bond manager a good fit for you?
What is the most economical way to pay for bond portfolio management services?
Does the manager adhere to a fiduciary or suitability standard?
What is the difference and does it matter to you?
Are you willing to pay ongoing fees for a fiduciary standard?

These are vexing questions for many investors and the appropriate answers depend on the differing needs and preferences of investors.

Today, regulators and industry participants are attempting to address disclosure, standards and transparency issues in a comprehensive manner.  Balancing differing interests among investors makes this a difficult issue.  How can investors be protected and offered choices without imposing anti-free market and overreaching rules on an already rules burdened financial services industry?  Therein lies the rub.

At Bernardi, we regularly address these issues in discussions with our clients.  Over the years, we have improved our portfolio management process and the way we offer and price our specialized management services.  The objective of our Standards Committee is to design and implement processes that balance clients’ interests with ours.

A primary goal is to offer investors a choice while removing any confusion about our role and standards within the context of the available options.  We offer investors two different bond portfolio management models because we believe a “one size fits all” approach to portfolio management does not benefit investors.  We hold this view based on 30 plus years of specializing in the bond market, interacting with thousands of investors during this time and hearing from them which services best suit their needs.

First, let’s start with a few definitions.

A “fiduciary” standard requires the investment manager to put their client’s interest ahead of its own and fully reveal all compensation (direct and soft dollar payments) for investments it recommends.  This is the gold standard in our industry and typically a more expensive option for investors.

A “suitability” standard requires a broker-dealer to recommend investments that are suitable (FINRA rule 2111).  This standard requires the broker to deal fairly with investors and perform due diligence to ensure an investment is reasonably suitable for a specific client based on his or her needs, sophistication, risk tolerance and financial circumstances. The broker–dealer is also subject to the “Know Your Customer Rule” which requires it to know of and understand a client’s financial situation making it more likely investment recommendations will be suitable (FINRA rule 2090).  Additionally, a broker-dealer will soon be subject to the pending MSRB “Best Execution” rule.

A SEC registered investment advisor (RIA) interacts with clients under the fiduciary standard, while a FINRA/SEC regulated broker-dealer is regulated by suitability, know–your-customer and many other rules protecting investors.

Department of Labor Proposal – Good Intentions, but Misses the Mark

The discussion surrounding these differing standards has been elevated recently because the Department of Labor (DOL) has proposed to expand the application of a best-interests standards (fiduciary) rule for broker-dealers working with retirement accounts.  The proposed rule if adopted as currently written would treat anyone who provides investment advice or recommendations to an employee benefit plan, plan fiduciary, plan participant or beneficiary, individual retirement account or IRA owner as a Fiduciary under ERISA.

Presently, the proposed rule is in its comment phase following a multi-day public hearing in August.

There are differing opinions amongst industry participants and regulators as to which standard is appropriate and whether the standard should be universal.  We support a harmonized multi-agency approach to developing a standard of care for broker-dealers in their interactions with investors based on these principles:

1.  Clear disclosure of fees and mark-ups/mark-downs
2.  Clear disclosure of any principal transaction activity
3.  Clear disclosure of any material conflicts of interest

Our view of the proposed DOL’s rule is that it is confusing and overreaching.  We view the fiduciary mandate rule for retirement advice problematic as currently written and here’s why:

  • It favors an investment advisory (IA) business model over a commission–based model.  This dynamic will reduce investor choice and increase ongoing costs for investors as many IRA accounts, currently at broker-dealers, would be forced to migrate to fee-based RIA accounts.
  • The “Best Interest Exemption” portion of the rule restricts the assets available to investors:  it allows for fixed income investing in U.S. Treasury bonds, corporate bonds and agency debt securities.  It prohibits investors from transacting in taxable or tax-free municipal bonds under the terms of the exemption.  Brokers cannot earn a commission related to a municipal bond transaction and the rule will result in many brokerage managed IRA accounts migrating to an RIA managed platform.  The end result – the Rule will cause certain investors to pay ongoing RIA management fees if they want a laddered bond portfolio.
  • The “Best Interest Exemption” requires two comparable quotes for a principal transaction.  This requirement will delay the trading process.  It is redundant as it ignores the pending “Best Execution” rule recently approved by industry regulator, FINRA and the already existing “Fair Pricing” rule.

The “Best Interest Contract Exemption” clause associated with the DOL proposal requires a broker-dealer to sign and commit to a legally binding fiduciary relationship with a client.  Many broker-dealers will be reluctant, if not unwilling, to take on the additional regulatory and liability costs that flow from the fiduciary standard mandate.

The bottom line is this:  certain investors will experience diminished choice or higher costs.  Smaller retirement accounts, in particular, will experience this dynamic.

Unequivocally, there is a need to strengthen rules applicable to retirement accounts.  However, neither FINRA nor the SEC, the two primary regulatory bodies that oversee broker-dealers, has signed onto the DOL proposal.  Importantly, the rule needs to be uniform, not choice limiting and harmonized with other governmental agency rules.  The DOL proposal, as currently written, fails on all three of these counts.  Here is a link to DOL “Fact Sheet” of the proposed rule.

DOL rule proponents argue it is needed to reduce incentives that allow certain brokers to put clients into high–fee products.  We agree with the DOL this potential for broker misbehavior needs tempering and it can be addressed in a simpler, less intrusive manner than the proposed rule.

The approach regulators took with the recently enacted Municipal Advisor (MA) Rule (MSRB Rule G-42) serves as an excellent template.  The MA rule regulates how broker–dealers and municipal advisors interact with municipal bond issuers.  The rule requires transparency and disclosure from broker-dealers and municipal advisors.  It continues to evolve and municipal bond issuers are better protected because of the rule.  Importantly, issuers decide whether they want to interact with an underwriter (broker-dealer) or prefer instead to pay a fee to have a municipal advisor, acting as a fiduciary, interact with the underwriter on its behalf.  The rule does NOT mandate, but allows issuers a choice.

The DOL should attempt to duplicate the MA rule approach.

An Alternate Approach – Offer Investors Transparent Choices

More than twelve years ago we began offering two distinct bond portfolio management options.  Each adheres to the three disclosure principles cited earlier.  We discovered two things:

  • Offering options eliminates investor confusion as to our role and how we are compensated
  • Most clients appreciate having a choice as to how they engage us to manage their portfolios

Each platform offers our expert management, one under a fiduciary standard and the other under the suitability rule.  A significant difference between the two options is how we are compensated:  either through a fee-only or a one- time mark-up model.

Each option offers different choices to investors.  Both offer a multi-step portfolio management approach ensuring a professional, fair and transparent process.  Investors are made aware of costs and potential conflicts in both cases.  Some investors cede discretion over their portfolio to us, others do not.  Please reference for more details regarding the two platforms.

“ ………the harder the conflict, the more glorious the triumph.”

These are the words of Thomas Paine and are applicable to the topic at hand.  There is a great opportunity for our industry in acting properly and addressing the issues we are discussing.

We recognized the issues years ago and began offering these two platforms.  Doing so has served our clients well.  They like the transparency and choice that each offer.

We believe it is unreasonable to assume someone working under a suitability standard is untrustworthy, interested only in recommending a higher fee investment.  I have heard many fiduciary standard proponents state and imply as much.

Similarly, we believe it is unreasonable to assume someone working under a fiduciary standard is automatically trustworthy and conflict free.  There is a littered landscape of financial industry fiduciaries who lost and stole millions of dollars of their clients’ money.

The notion advanced by some that all fiduciaries are benevolent and anyone acting in another capacity is untrustworthy is nonsense.  That kind of talk is more political than practical.

We are in favor of applying a uniform standard to broker-dealers requiring their interests are aligned with client interests. Candidly, we do not understand how a sustainable business can exist and grow using a different foundation.  Trust and transparency are the foremost principles of a healthy client relationship.  But, conflicts of interest are endemic to any successful enterprise and not inevitably harmful.  There is nothing inherently wrong with conflicts and not all result in bad outcomes.  It is how a conflict is managed that counts.  Lastly, potential conflicts need to withstand a high burden of proof and it is our responsibility to show that, if a conflict exists, it actually serves our client rather than hurts them.

Here is a great example:

A client alerts us they need capital from their bond portfolio.  One of our portfolio managers or traders solicit bids nationwide on portfolio holdings.  Our bid solicitation process is a multi-step process designed to ensure fair, effective and transparent pricing.  But if market uncertainty is elevated and national bidding interest is reduced on that particular day our client will receive below average bids.  Oftentimes in these situations, Bernardi as a broker–dealer, steps in offering to buy a client’s portfolio positions at a meaningfully higher price than the best bid received from the nationwide bidding platform.  We do not have the bonds placed with another client and instead use our capital to make a market and support our client who needs to sell.

Clearly, there is a potential conflict of interest here.  But the fact is, the outcome for our client is better BECAUSE we interject ourselves into the process by using our capital and fulfilling an important marketplace role.  The key to success for our client results from established company policies and a transparent internal process.  Our process guides us to manage the conflict to help our client and it can withstand the burden of proof we are obligated to demonstrate if asked.

Conversely, here is an example currently confronting some advisors acting in a fiduciary capacity:  many fee-only registered investment advisors are collecting fees from custodians for recommending certain mutual funds.


Just as in the first example, the advisor should understand the burden of proof needs to withstand scrutiny.

Investors Benefit from Aligned Interests and Choice

At Bernardi, we operate and design our policies and procedures with an overarching goal to align our interests with our clients’.  This belief is fundamental to the way we operate our business.  We do this by promoting high standards, educating our clients and serving them in a competent and professional manner.  We have adjusted our business model many times over the years to better serve our clients and to conform to new regulations.  We will continue to evolve and change as the world around us requires.

We stated earlier a “one size fits all approach” does not benefit investors.  If a rule mandates such, of course, we will adapt.  But in my nearly 35 year career I have learned this:  investors demand different things and want choice.

Some want a fee only platform, while others prefer a one-time mark-up platform.  Some want fiduciary management and are willing to pay an ongoing fee for the standard.  Other investors are comfortable with managers adhering to suitability and know-your-customer standards and do not want to pay ongoing fees.

Regulatory rules should not dictate these decisions.  Investors should be offered choices and allowed to decide for themselves.

Thank you for your continued confidence in our team.

Ronald P. Bernardi
President and CEO
September 24, 2015