The Perils of Suitability

As the debate continues as to whether all who offer investment advice should be held to the fiduciary standard, a recent New York Times article brings to light a stark example of the conflicts that may arise when an advisor is not required to act only in the best interest of their clients.

The article, “A Crack in Wall Street’s Defenses” by Gretchen Morgenson, tells the story of two clients of Smith Barney whose experience was so egregious that they were awarded a total of $54.1 million (including $17 million in punitive damages) in a securities arbitration case against the unit of Citigroup.

As you may recall, all Registered Investment Advisors (including Truepoint) are not only legally required to uphold this fiduciary duty by placing the client’s interests in front of their own, they also must disclose any conflicts of interest that may arise from a transaction. While many investors understandably assume that this standard applies universally, many brokers and sales representatives in the financial services industry are instead subject to the less stringent “suitability” standard.

As outlined in our September 2009 Commentary, the critical distinction between these two standards is that those operating under the suitability standard are not required to place the client’s interests ahead of their own. In practice, this often means that potential conflicts of interest, such as any additional compensation a broker or agent may be receiving for selling certain investment products, are not disclosed.

In this case, Smith Barney clients Gerald Hosier and Jerry Murdock Jr. were advised to invest in municipal bond strategies that promised higher returns than a traditional municipal bond portfolio. Unfortunately for Hosier and Murdock, the only ones that ultimately profited from this investment were Smith Barney and their brokers. While many of these municipal bond portfolios lost up to three-quarters of their value, Smith Barney and its representatives earned a 0.35% annual fee on the total value of the portfolio and a 20% fee on all income earned over an annual threshold of 5.5%. More importantly, though, the strategy employed massive borrowing to inflate the amount of each investment by eight to ten times; Smith Barney applied their fees to this inflated value.

The amplified fees created a tremendous incentive for Smith Barney’s brokers to promote these strategies:  the commission paid for each sale equaled 40% of the total fees paid by the investor, generating dramatically higher compensation than that associated with selling standard municipal bonds.

Fortunately for Hosier and Murdock, this conflict was ultimately resolved in their favor. But for the many other investors who may be similarly unsuspecting, these conflicts of interest will continue to be prevalent until all players in the financial industry are held to the fiduciary standard.

Earlier this year, the Securities Exchange Commission (SEC) concluded a study required by the Dodd-Frank financial reform law about the fiduciary standard, coming to the conclusion that a universal fiduciary standard is needed because the majority of investors are unaware of the differences between the two standards. This study was presented to the SEC commissioners and Congress with this recommendation, but no actions have been taken to date. While current operators under the suitability standard continue to fight this regulation because of the impact it would have on their fee structure and profits, this study is viewed as progress in the fight for a universal fiduciary standard.

Truepoint Wealth Counsel is a fee-only Registered Investment Adviser (RIA). Registration as an adviser does not connote a specific level of skill or training nor an endorsement by the SEC. More detail, including forms ADV Part 2A & Form CRS filed with the SEC, can be found at Neither the information, nor any opinion expressed, is to be construed as personalized investment, tax or legal advice. The accuracy and completeness of information presented from third-party sources cannot be guaranteed.

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