Will Brokers Have to Put Your Interests First?

Last Updated May 5, 2010 12:00 PM EDT

Goldman Sachs is the gift that keeps on giving. Financial reform was getting as watered down as a carafe of cheap wine until the SEC charged Goldman with fraud. That put Wall Street's owned-and-operated Senators on the defensive. Maybe -- just maybe -- Jill and Joe Investor will catch a break. Brokers might have to be more careful about what they do and say.

An amendment newly up for debate would require brokers -- for the first time -- to put their clients' interest ahead of their own. The proposal covers only the retail brokers who give you advice on stocks, bonds, and variable annuities. Senator Susan Collins of Maine wants to add broker-dealers who sell to pension funds, mutual funds, and other institutions. (Maine got burned by some advice it took from Merrill Lynch.)

Technically, the fight is over what's called a fiduciary standard.  "Fiduciary" is such a boring word that it turns people off, so think of it as a banana. Investors deserve bananas -- a healthy, honest fruit -- when their brokers are serving lunch.

This idea was dead when the Senate reform bill came out of committee.  News that Goldman might have swindled its client has brought the "f" word back.

A fiduciary is required to propose investments that are in your best interest, putting his or her personal financial interests second. Conflicts of interest have to be managed in the client's favor and disclosed.

At present, registered investment advisers have to be fiduciaries but brokers don't. Brokers can (and do) suggest that you buy securities that pay them high commissions even if you'd be better off with a similar, cheaper investment that also meets your goals.

A broker's only legal duty is to sell you something "suitable." For example, take a 529 college investment plan. Your own state's plan might give you a state tax deduction for contributions. But a broker might claim it's a bad plan and switch you to another state's 529, which pays higher sales commissions. That's legal. Any 529 is "suitable" for parents saving for college. But it's not in your interest to lose a state tax deduction. You didn't get a banana.

And take the sale of mutual funds. Brokers don't have to tell you that their firm earns fees for pushing certain funds, including funds aren't doing very well. If they were fiduciaries, they'd have to disclose their interest and you might make a different choice.

And take the sale of municipal bonds. The broker might say, I can get a great bond and you don't have to pay anything. But, without telling you, the broker has marked up the price by two percentage points.

After the dot-com bust 10 years ago, it was revealed that analysts for blue-chip firms had been praising stocks to the public that they privately derided as dogs. The SEC clamped down on the practice but stopped short of ordering brokers who sold the products to act as fiduciaries.

Now it turns out that Goldman was doing something similar, at the institutional level. It sold, to a German bank, a mortgage security that was secretly designed to fail. Goldman knew it was a dog but the Germans didn't.

Whether Goldman bet against this security is beside the point. What matters is that, when a broker suggests an investment, you should be able to assume that it's being offered in good faith. The price might fall, but that should be an accident of the market, not an element of the security itself.

The financial reform bill passed by the House of Representatives brings retail brokers under a fiduciary standard if they supply investment advice. The Senate blew this provision off but, thanks to Goldman, it's back.  "Amendments to the bill face an uphill battle, says John Coffee Jr., a professor at Columbia University Law School who testified in favor of bananas yesterday, "but they sometimes win."

In his Senate testimony, Goldman CEO Lloyd Blankfein, said that the German bankers had a list of all the securities, so it was up to them to discover the game. In other words, Wall Street's standard of conduct is "catch me if you can." That's a con man's standard. It would be shameful to let it go.

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