Understanding a Financial Advisor’s Standard of Care

The sale of a business, a divorce, inheritance or retirement marks major turning points in someone’s life. Wealth is in transition; its purpose is likely changing. The financial adviser plays a critical role during these times.

The term ‘financial adviser’ is a generic expression applied to a variety of financial industry service providers. Stock brokers, formally referred to as Registered Representatives (RRs), and SEC Registered Investment Advisers (RIAs) both fit under the financial adviser label.

Yet, RRs and RIAs have historically had different standards of care when it comes to their duties to the client. RRs have an agency relationship with the client which means that investment recommendations must meet a suitability standard. Registered Investment Advisers (RIAs) have a fiduciary standard.

An agency relationship describes a situation in which the client directs their agent to do their bidding. The simplest example would occur when a client calls his RR and directs her to buy or sell 1000 shares of xyz stock.

The RR may be knowledgeable about investing and the client may rely on that knowledge however the client must bear in mind that it is the client that is typically responsible for monitoring the investment and its outcome.

A RR is required by industry (FINRA*) regulations to make investment recommendations that are suitable for the client. For example, recommending aggressive growth stocks to a widow in need of income would not be suitable investment. However, if that widow had, in the past, invested in aggressive growth stocks or mutual funds and indicated to the RR a desire for some aggressive growth, it could be considered suitable based on her past experience, investment objective and risk tolerance.

It should be noted that risk tolerance is not expressed in terms of potential loss but in terms investment objective on the client account application. Potential loss is implied but never explicitly stated.

I find this industry practice very misleading. After all, who doesn’t want ‘Growth’? However, if your client was informed that checking “Growth” on the account application meant that the client was agreeing to accept potential losses that could be 25% or more, perhaps, they’d view ‘Growth’ differently.

Lawsuits against brokers based on unsuitable investment claims for client losses rely heavily on the past investment experience of the client to either support or invalidate the claim. This is where it gets tricky for the client.


A few years ago we were hired as an expert witness in a securities arbitration case. The client was a financially unsophisticated ex-wife of a former major league baseball player. She knew that financial matters weren’t her strength.

For many years she took the RR ‘Jones’ recommendations at face value and implemented them because in her mind, her financial adviser was the expert. She had invested in limited partnerships and other illiquid investments because she trusted the adviser. Her investment outcomes were sub-par (she had both made and lost money) but she was happy with the relationship.

After several years, she left RR Jones after Jones handed her off to another person in the firm with whom she didn’t have any chemistry. She found another RR “Smith” based on a friend’s recommendation. She subsequently purchased a financial plan implemented the advice and lost a lot of money with the new adviser, Smith.

The respondent’s attorney (representing Smith and his brokerage firm) aggressively argued that she knew what she was getting into based on her past investment experience with the previous RR Jones.

The irony was that she didn’t really understand her investments with RR Jones and now her trust in Jones’ recommendations was being used to argue that: 1) she was a sophisticated investor and 2) that the money losing investments with Smith were suitable because of her past experience with Jones.

Her past experience represented a weak point in her case. Fortunately, other aspects of the case were in her favor and it was settled before going to arbitration. Nevertheless, the amount of damages collected will be affected by an assessment of the client’s previous experience even if the client ‘wins’.

Business owners may have a much tougher time claiming a lack of suitability even though many are unsophisticated when it comes to investing in financial markets. The business owner’s use of attorneys, CPA’s and other advisers can work against her if the investments do poorly and the owner decides to take legal action to recover losses based on poor financial advice.

Invariably, the respondent’s counsel argues that the fact that the owner had their own business and uses advisers are proof of the owner’s financial sophistication. In addition, the business owner’s willingness to take risk ‘proves’ that the losses are tough luck; the owner knew what she was doing. The irony is that the business owner hires experts because she doesn’t know everything.

The business owner’s ego may work against them as well, after all who wants to admit that they are financially unsophisticated?

The client’s profession or occupation alone can raise the bar in terms of suitability.


I remember a serving on an arbitration panel hearing a family law attorney bringing an arbitration claim that included unsuitable investments. A fellow arbitrator (who was an attorney) doubted the claimant’s lack of investment experience because the claimant was an attorney.

Practice Tip:

If you don’t want your client’s past experience to be used against her in the event of a bad investment outcome, make clear in writing to the financial adviser the amount of loss that is acceptable to the client. For example, the client letter might state that the maximum amount of acceptable annual account loss is 15%. (Tell the client to be prepared to have an illuminating conversation with their adviser.)

In summary, the RRs duty to the client is to recommend suitable investments. The assessment of what constitutes ‘suitability’ can be thought of as a sliding scale based on the client’s business or profession, past investment experience, education and risk tolerance representations.

RIAs are regulated under the 1940 Investment Advisers Act and are subject to examination and enforcement by the Securities & Exchange Commission (SEC). Under the 1940 Act, a RIA has a fiduciary obligation to the client. This means that unlike suitability standard, the client’s past investment experience may not be relevant at all to the current circumstances. Therefore, liability for imprudent investment advice would be based on the current and prospective circumstances of the client.

A fiduciary relationship represents a much higher legal obligation to the client than does an agency relationship applying a suitability standard. A fiduciary must put the client’s interest before the interests of the adviser. The fiduciary will have a prudent man standard or if an investment professional a prudent expert standard of care.

In some states, state law may impose a fiduciary obligation upon a RR if it can be shown that the client was highly dependent on the RR’s advice. In California, for example, a sliding scale may be used to determine the degree or extent of the fiduciary relationship and hence potential liability of the adviser.

NASD firms and the RR’s they employ may go to great lengths to avoid becoming a fiduciary. These lengths may include contractual language that attempts to limit their liability by reinforcing their agency relationship (and hence suitability standard) with the client. The basic objective is to limit the RR’s and RR’s Broker dealer’s legal liability for the financial advice provided.

To add to the confusion some advisers are dual registered; both as RRs and RIAs. In a recent case, in which I s
erved as expert witness for the claimant, the respondent’s expert asserted that when the financial plan was created, the adviser was regulated as a RIA, however when the investments were made (and large losses incurred), the adviser was acting as a RR and therefore wasn’t a fiduciary. The RR was ultimately held to a fiduciary standard in Oregon due to the client’s lack of investment experience.

New World Order?

Temporarily in force since 1999, in April of 2004, the SEC unanimously (5-0 vote) adopted Rule 202(a) (11)-1, pejoratively known as the ‘Merrill Lynch Rule’, that in effect, allowed two standards of care to exist for the fee-based advisory services depending upon whether a RR or RIA was providing the advice. Under the rule, NASD Broker Dealers and their RRs were exempted from fiduciary and disclosure standards of the Investment Adviser’s Act of 1940. The Rule allowed RR’s to sell $300 billion dollars worth of asset management “Wrap” accounts offering unlimited ‘free’ trades for a set annual fee; typically between 2 and 3% of assets. The RR Wrap accounts were a very successful competitive response designed to look very similar to asset management services provided by a RIA.

The Financial Planning Association (many of whose members are regulated under the stricter Investment Advisers Act of 1940) challenged the rule and in a 2-1 decision, the U.S. Court of Appeals for the District of Columbia Circuit in Washington overturned the SEC ruling on March 30, 2007. On May 21, the SEC granted a stay until October 1, 2007 to give Broker Dealers (BDs) and their RR employees more time to comply with the court ruling. The court ruling forces BD’s to either stop offering fee based managed asset accounts or, alternatively, assume fiduciary liability for those accounts.

Nevertheless, the issues regarding the differences between RRs and RIAs are far from resolved. The SEC has provide emergency funding to accelerate an in depth study by the RAND Corporation of the differences between RRs and RIAs and how to best regulate them. The study is due in December 2007 rather than 2008. In addition, the SEC is now requesting comments by Nov 2 2007 on proposed SEC interpretation changes of Rule 202 in light of court opinion vacating the original SEC interpretation.

The table below illustrates some of the differentiating characteristics frequently found between the two relationships.

Agency Relationship

  • Non discretionary; client approves all securities transactions prior to purchase or sale
  • Suitability; retrospective assessment of client’s experience
  • Disclosure to client of fees and risks via prospectus usually sufficient to minimize liability for poor advice
  • Client implements the investment strategy based on the client’s judgment of the RR’s recommendation

Fiduciary Relationship

  • Fiduciary; mostly prospective assessment of client’s situation
  • Must place client’s interests first
  • Fiduciary responsible for reading prospec- tus and understanding risks
  • Advisor held to prudent man or prudent expert standard when executing client investment strategy
  • Client’s significant reliance on the adviser’s ‘expertise’




The financial advisory business is under going tremendous change. This change has blurred the distinction between RR and RIA services. The services provide by RIAs ten years ago were easier to differentiate from those provided by RRs. RRs operated under an investment transaction based business model whereas RIAs offered an ongoing fee for investment management / advice model. NASD broker dealers who employ RRs recognized the advantages of fee based business models; the revenue is more dependable and client relationships tend to last longer.

As a result, the financial services offerings of RRs look similar to the services provided by RIAs. Nevertheless, broker dealers have sought to minimize their legal liability to clients for bad investment out- comes based on the RR’s advice.

Practice Tip:

So, how do you know what standard of care your client’s financial adviser must adhere to? Simple, ask the adviser to confirm in writing whether or not he or she has fiduciary relationship with the client.

Ask your client: What kind of financial advisory relationship do they want and help the client evaluate what kind of relationship is actually taking place.

  •  If the client likes calling their own shots, enjoys investing, and generally wants to take responsibility for their investment outcomes, an RR relationship with a suitability standard may be the most appropriate.
  •  If the client usually delegates responsibility for investing to their financial adviser, who is seen as the expert, then an RIA is a better choice. The RIA has a very high legal standard of care and would be liable for making imprudent investments on behalf of the client.

Additional questions to consider;

  •  What is the client’s comfort level with their investments?
    • How knowledgeable does the client feel regarding investments?
    • Would the client feel confident in describing how financial markets worked?
    • Does the client ‘trust’ the financial markets?
  •  What is your client’s relationship with the adviser?
    • Does the client accept most or all of adviser’s recommendations? 
    • Does the client generate their own investment ideas for the adviser to implement? Are they successful? 
    • Does the client feel he or she needs an expert?
*Financial Industry Regulatory Authority (FINRA) is a combination of the NYSE and National Association of Securities Dealers: self-regulating organizations which establish and enforce rules and standards of practice of Broker Dealers and their employees.