Both the U.S. Senate and House of Representatives have passed a version of a very much needed financial reform bill. The two versions need to be reconciled into one before this can be released to be signed by the President. While the final details are being worked out, we want to make a couple of comments.

First comment is that reform of our financial markets has been needed for a long time. We were made aware of this need in 1998 when the Long Term Capital hedge fund almost caused a melt down of the world financial markets because their “bets” on the Russian markets went sour. 

Unsupervised and over leveraged “bets” using derivatives have caused many problems over the years, not the least of which was the huge meltdown that occurred at the end of 2007 and from which we are just now beginning to recover. Making sure that “gamblers” using these instruments are properly capitalized and able to absorb potential losses without dragging the economy of this country or even the world down with them is important and can only be done at a government level. 

New derivatives have made it easier for the “gamblers” to make profits in dropping markets. Previously, most investors had a stake in investments growing and financial institutions worked together to support that long-term growth. With today’s investment vehicles, there is as much money to be made “betting” on certain markets to decline – which provides incentives for the “gamblers” to encourage risky behavior on the part of investment entities. Think of the financial market makers first making money by encouraging Greece to borrow money to finance its profligate spending, and then purchasing derivatives that make money when Greece fails to pay its debts. Said another way, they made money encouraging investors to buy Greek bonds and then made money again when the Greek bonds declined in value and those investors lost money.

This paradox leads to our second key comment which involves how your financial advisor relates to you. As this demonstrates, not all financial advisors have the same standard of duty to their clients. The Advisory Group operates under a “Fiduciary” standard. Many banks and brokerage operations operate under a “suitability” standard. What’s the difference?

Under a fiduciary standard, your advisor is required to “put their clients’ interest before their own.” If there is a conflict of interest, it needs to be disclosed. Since there is no perfect investment, the advisor needs to share the advantages and disadvantages with you. The advisor operating as a fiduciary takes care of the client first.

Under the more common suitability standard, the financial advisor only needs to show that the product provided was not blatantly wrong for the investor – that the investor met the minimum suitability standards set for that investment.  While the House bill proposes the fiduciary standard for all advisors, the Senate bill limits that higher standard of conduct to only those operating, as The Advisory Group does, under a Registered Investment Advisor (RIA).

How does this work in real life? We are seeing this being played out in the Congressional review of large financial Wall Street investment houses. They made money selling certain investments to their customers yet, when those investments seemed poised to go down, rather than advise all those customers to get out while they could, the same firm made money by selling their own holdings and by creating and selling investments betting against the investments being held by their customers – the same investments they had sold them originally. Even worse in our opinion, they did not even advise their clients that they were facing a conflict of interest.

Even if the original investment seemed good and appropriate at the time it was sold to their customers, we would think that the proper response when the market turns around would be to take care of the investors and help them to change their investments. Instead, we are seeing large firm after large firm leaving their original investors high and dry while taking care of their own bottom line first. While the CEO’s of these firms defend their actions as profitable and “good business,” we would argue that their first loyalty should be to their investors.

We at The Advisory Group always try to operate with the best interests of our clients at heart. We take extra time to make sure our clients understand how things work before getting started and then help them monitor the investments as conditions change. We hope that everyone will operate at this standard of care.