Two Different Business Models, Two Different Outcomes for Investors

The motivations under the non-fiduciary and fiduciary business models are vastly different, which results in the recommendation of quite different financial products for clients, writes Scott Simon.

W. Scott Simon


At the encouragement of an astute reader, this month I thought it would be interesting to delve more deeply into a subject area that I merely touched on in a column earlier  this year. A more complete exploration of this area will hopefully highlight further the differences between a business model grounded in fiduciary law and behavior, and one based on non-fiduciary law and behavior.

In the earlier column, I said this: “A B/D [broker/dealer] is in the business of manufacturing products and selling them to anyone who wants to buy them. There’s nothing wrong with that. In fact, it’s the same as if a B/D were a car dealer employing salespeople attempting to sell, say, a Ford to anyone who steps on the lot. But there’s a big difference: the car buyer already knows what the dealer wants to do–sell him a Ford–even before setting foot on the lot.”

Although the foregoing was true of B/Ds, say, 15 years ago, it is less so today. Due to pressures exerted by the marketplace, B/Ds have been forced to back away from manufacturing products somewhat. In addition, the “independent B/D” business model has been built purely as a distributor, not a manufacturer. Still, all B/Ds–whether traditional wirehouses or independents–remain as product distributors even while wirehouses have reduced their product manufacturing activities.

My example of a consumer stepping onto a Ford dealer’s lot and being pushed into a Ford is not quite as complete as it could be. Perhaps a better example would be one where a consumer “hires” an auto sales broker to shop for a car for him. When the nice broker says to the consumer, “ItellyouwhatI’magonnadoforyou,” and then delivers on that promise by finding a car for the consumer that’s suitable for the consumer’s needs–while at the same time not charging the consumer anything–well, what a deal! This is akin to “free” 401(k) plans, which many plan participants appear to believe they are invested in.

The kicker in all this, though, is that few consumers have any idea that this seemingly “cleaner” business model is still rife with conflicts of interest. In fact, different automobile manufacturers pay different commission rates to auto brokers, so brokers can receive additional compensation for recommending one product over another. And that’s where the conflict arises: The auto sales broker is tempted to go for the highest commission and then rationalizes why the car that comes attached to that commission is the most suitable and is the best deal for the consumer.

Many brokers protest vehemently at this base characterization of their motives by insisting that they truly care about their customers. Such protestations are beside the point. The real point is that brokers’ personal feelings don’t enter into this equation, because the non-fiduciary business model they follow allows them legally to reach for the highest commission despite whatever good (or bad) feelings they may harbor for their customers. In a very real sense, then, under this model brokers have no way to prove their “innocence” (i.e., that no monetary considerations entered into their decision-making) because the model–given it inherent conflicts–does not allow for it.

If the auto brokers’ business model were truly known and understood by consumers, they would reject it outright due to the simple fact that they could never be sure they were getting the best deal for their money. Assuming (unrealistically) that such complete knowledge and understanding were to be the case, it’s likely that brokers would also reject this model outright because it guarantees that they would always be distrusted–whatever their personal feelings–and would therefore always fail in their sales efforts.

In the same way, the business model followed by, say, a non-fiduciary registered representative (e.g., a stockbroker) necessarily creates conflicts of interest with its customers when those interests intersect. A representative is under a legal requirement–the suitability standard of conduct under the Securities Exchange Act of 1934 (’34 Act)–to maximize revenue (within the bounds of suitability) for its B/D employer. This is why, for example, some wirehouses have been known to hold pizza parties (or other far greater inducements) for its rookies while they get those dog stocks out of inventory and push them onto unsuspecting investors.

Such stories, which arise from time to time in the media, describe the kind of activities that can result from the machinations of the non-fiduciary model. Anyone ever trained as a stockbroker knows about–and many have participated in–such activities, despite statements from corporate flacks that their B/D employers would never allow it. And that’s why the interests of customers must always legally come second to those of a representative’s B/D when they intersect. As Professor Ron Rhoades so eloquently phrases it, the non-fiduciary model results necessarily in a “loosening of restraint on greedy conduct.”

In the business model followed by a fiduciary, the fiduciary legally must live up to the sole-interest fiduciary standard under section 404(a) of the Employee Retirement Income Security Act (ERISA) or, in the realm of individual retail investors, the best interest fiduciary standard pursuant to the Investment Advisers Act of 1940. The fiduciary standard in either realm necessarily requires a restraint on greedy conduct on the part of those subject to it. For example, a discretionary ERISA fiduciary, such as a section 3(38) investment manager, has an incentive to, say, lower the costs of a 401(k) plan if for no other reason than it has no incentive to act otherwise due to a lack of conflicts of interest.

I can personally attest that I get a small thrill when I’m able to lower the cost of a model portfolio in a 401(k) plan and/or lower its risk by offering a more broadly and deeply diversified portfolio at the same–or lower–cost. Apart from such activities helping to satisfy the deep-seated feelings of that part of my heritage that’s Scottish, I have no financial or other incentive to do otherwise under the fiduciary business model followed by our firm. In fact, even if I were to harbor nothing but bad feelings for all the retirement plans and plan participants for which our RIA firm provides fiduciary protection pursuant to ERISA section 3(38), those feelings would be irrelevant since we are charged legally to place the ERISA section 404(a) sole interests of plan participants above all others. As ERISA discretionary fiduciaries, our firm has no room to legally wiggle.

Under the non-fiduciary and fiduciary models, of course, an entity is involved that interacts with the customer/client/plan participant, et al. Because the entity under each model is compensated in a different way, though, their motivations are vastly different, which results in the recommendation of quite different financial products for their clients. A fiduciary entity is generally driven, for example, to lower costs. A non- fiduciary entity (vis-à-vis its clients) is driven to increase revenues for its B/D employer because it’s legally required to do so, given the fiduciary duty it owes to the B/D. This often results in greedy conduct on the part of the non-fiduciary that’s wholly acceptable as long as the financial products it recommends meet the suitability requirements of the ’34 Act. Of course, the non-fiduciary’s clients are on the other end of that greedy conduct and bear its detrimental consequences.


Fiduciary entity –> fiduciary standard –> produces restraint on greedy conduct –> results in no conflicts of interest –> creates incentives to help clients get the best deal

Non-fiduciary entity –> suitability standard –> loosens restraint on greedy conduct —

> results in conflicts of interest due to the fiduciary duty owed by the non-fiduciary entity (vis-à-vis its clients) to its B/D employer–> creates disincentives to help clients get the best deal

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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