Investment advisers and investment brokers, who work for broker-dealers, both tailor their investment advice to individuals and institutional clients. However, they are not governed by the same standards. Investment advisers work directly for clients and must place clients’ interests ahead of their own, according to the Investment Advisers Act of 1940.
Brokers, however, serve the broker-dealers they work for and must only believe that recommendations are suitable for clients. This suitability standard is set by the Financial Industry Regulatory Authority (FINRA).
- Investment advisers are bound by a fiduciary standard that places their clients’ interests ahead of their own.
- Brokers work for broker-dealers, whose interests they serve. They follow a suitability standard, which means only that transactions must be suitable for clients’ needs.
- Broker-dealers can sometimes find themselves in conflict with their clients, who feel that selling one of their own instruments or adding unnecessary transaction charges breaks the standard and isn’t in the best interest of the client.
Investment advisers are bound to a fiduciary standard that is regulated by the Securities and Exchange Commission (SEC) or state securities regulators, both of which hold advisers to a fiduciary standard that requires them to put their client’s interests above their own.
The act is pretty specific in defining what a fiduciary means, and it stipulates that advisers must place their interests below that of their clients. It consists of a duty of loyalty and care. For example, advisers cannot buy securities for their accounts prior to buying them for clients and are prohibited from making trades that may result in higher commissions for themselves or their investment firms.
It also means advisers must do their best to make sure investment advice is made using accurate and complete information and that the analysis is as thorough as possible. Avoiding a conflict of interest is important when acting as a fiduciary, which means that advisers must disclose any potential conflicts. Additionally, advisers need to place trades under a “best execution” standard, meaning they must strive to trade securities with the best combination of low cost and efficient execution.
The SEC has stringent rules for investment advisers. Advisors are allowed to assist in the financial decisions of individuals and institutions who make financial decisions in order to plan for retirement, college payments, or in building their own, often taxable, investment portfolios. The SEC also determines how advisers are able to charge their clients.
The SEC defines a broker as someone who acts as an agent for someone else, and a dealer as someone who acts as a principal for their own account.
Broker-dealers have to fulfill what is called a “suitability obligation,” which is loosely defined as making recommendations that suit the best interests of their client. Some broker-dealers feel this is unfair as it may affect their ability to sell investment vehicles that benefit their bottom line, but all a suitability obligation means is that the broker-dealer needs to believe that the decisions they make truly benefit their client.
Suitability also includes making sure transaction costs are not excessive—referred to as “churning” an account or racking up unnecessary trading fees—and that all recommendations benefit the client.
The SEC considers broker-dealers to be financial intermediaries who help connect investors to individual investments. They play a key role in enhancing market liquidity and efficiency by linking the capital with investment products that range from common stocks, mutual funds, and other more complex vehicles, such as variable annuities, futures, and options. One activity a dealer may carry out is selling a bond out of their firm’s inventory of fixed-income securities. The primary income for a broker-dealer comes from commissions earned from making transactions for the underlying customer.