| An Analysis of the Potential Impact of a Uniform Fiduciary Standard Upon Broker-Dealers, Registered Investment Advisers, and Dually-Registered Advisers |
| Posted on Friday, June 21, 2013 at 1:10 PM |
Widely considered to be the most sweeping financial regulatory reform of the modern era, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was signed into law nearly three years ago. Section 913 of Dodd-Frank granted the Securities and Exchange Commission (“SEC”) “discretionary rulemaking authority under the Securities Exchange Act of 1934 (“Exchange Act”) and the Advisers Act to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing investment advice.”[1] Section 913 of Dodd-Frank further required that “any standard of conduct [adopted by the SEC] shall be no less stringent than the standard applicable to investment advisers under Sections 206(1) and 206(2) of the Advisers Act.”[2] Since the SEC published its study of Investment Advisers and Broker-Dealers as mandated by Section 913 of Dodd-Frank[3] over two years ago (“Study” or “SEC Study”), the financial industry has been awaiting a determination by the SEC as to whether it will impose a heightened standard of care upon broker-dealers, similar to the fiduciary duty impliedly imposed on investment advisers pursuant to The Investment Advisers Act of 1940 (“Advisers Act”). The primary recommendations of the SEC Study were that the SEC should “engage in rulemaking to implement a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers” and should “consider harmonizing certain regulatory requirements of broker-dealers and investment advisers where such harmonization appears likely to enhance meaningful investor protection.”[4] The Study did not, however, provide information regarding the costs and benefits of the current regulatory regime as compared to the costs and benefits that would likely be realized if the SEC were to exercise its rulemaking authority. Similarly, the Study did not generate comments regarding either of the aforementioned cost-benefit analyses. Recently, the SEC took the next step towards a potential heightened standard when it released a Request for Data and Other Information regarding the Duties of Brokers, Dealers and Investment Advisers (“Request”). The Request specified that the SEC intends to use the data and information collected to inform its “consideration of alternative standards of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers,” such as the potential establishment of a uniform fiduciary standard, as well as to inform its consideration of the “potential harmonization of certain other aspects of the regulation of broker-dealers and investment advisers.”[5] Importantly, the Request also calls upon commenters to provide the SEC with a cost-benefit analysis for a uniform fiduciary standard of conduct, and the various alternative approaches thereto, as outlined in the Request. As will be discussed in detail below, the potential implementation by the SEC of a uniform fiduciary standard, alternatives thereto and/or various other aspects of regulatory harmonization will have a substantial impact not only on financial service professionals, but also on their customers and their employers. This article will provide an overview of the current regulatory regime and traditional duties of a fiduciary, as well as an overview of the practical implications of both a uniform fiduciary standard and alternative approaches to such a standard, as well as the overall effect of the potential standards on the various stakeholders in the industry.
Under the current framework, broker-dealers and investment advisers are subject to different regulatory regimes, despite the fact that many of the services offered by both groups overlap. Investment advisers are subject to the Advisers Act and, as a result, owe fiduciary duties to their clients. Broker-dealers, on the other hand, are subject to the Exchange Act and are not generally considered to be fiduciaries to their customers, with some exceptions.[6] Broker-dealers are also subject to the rules of each and every self-regulatory organization (“SRO”) of which it is a member. However, applicable antifraud provisions and federal securities laws are applicable to both broker-dealers and investment advisers. Notably, studies have reflected that many retail customers are not aware of the differences between broker-dealers and investment advisers, and the corresponding duties owed to the customer.[7] This is most true in recent years where the “lines between full-service broker-dealers and investment advisers have become blurred,” a fact that is especially troublesome when “specific regulatory obligations depend on the statute under which a financial intermediary is registered instead of the services provided.”[8] The SEC Study and Request are an effort to both “enhance retail customer protections and decrease retail customers’ confusion about the standard of conduct owed to them when their financial professional provides them with personalized investment advice,”[9] potentially through the establishment of a uniform fiduciary standard or some variation thereof.
In its Request, the SEC set forth various assumptions that presumably would underlie any standard it ultimately decides to impose. The general assumptions below would, for the purposes of the SEC’s Request, underlie any proposed approach to adopting a uniform standard of conduct.[10]
As with all the assumptions in the Request, including but not limited to those listed above, the SEC has expressly stated that such assumptions should not be taken as a suggestion of the agency’s policy view or the ultimate direction of any proposed action.[23] It seems clear, however, that at a minimum, the assumptions provide a road map of the various factors that the SEC is taking into account while analyzing the potential implications of a uniform fiduciary standard, or alternatives thereto.
As discussed above, Section 913 of Dodd-Frank requires the SEC, if it determines to exercise its rulemaking authority to enact a uniform fiduciary standard (or some variation thereof), to adopt a standard no less stringent than the standard applicable to investment advisers under Sections 206(1) and 206(2) of the Advisers Act.[25] These sections of the Advisers Act have been interpreted by the Supreme Court as “requiring an investment adviser to fully disclose to its clients all material information that is intended to eliminate, or at least expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.”[26] The SEC Study recommended that any uniform standard should necessarily include both a duty of loyalty and a duty of care, as well as the extension of “existing guidance and precedence under the Advisers Act regarding fiduciary duty…where similar facts and circumstances would make guidance and precedent relevant and justify a similar outcome.”
Section 913(g) of Dodd-Frank addresses the duty of loyalty as a crucial component of a uniform fiduciary standard, indicating that, at a minimum, when a broker-dealer or investment adviser provides personalized investment advice, “any material conflicts of interest shall be disclosed and may be consented to by the customer.”[27] Consistent with Dodd-Frank, the establishment of a uniform fiduciary standard would necessarily be “designed to promote advice that is in the best interest of a retail customer”[28] by eliminating the “material conflicts of interest of a broker-dealer or investment adviser, or by “providing full and fair disclosure to retail customers about those conflicts of interest.”[29] The SEC has stated that it should be assumed that the agency would provide specific guidelines as to how broker-dealers and investment advisers could comply with the duty of loyalty component of the uniform fiduciary duty standard. The SEC has further articulated that commenters may make several assumptions regarding the duty of loyalty. Firstly, any standard the SEC would impose would include details of various disclosure requirements[TD1] , including, but not necessarily limited to, the disclosures listed below.[30] a) A generalized obligation to disclose all material conflicts of interest with regard to that specific retail customer, which “could be made largely through the general relationship guide” described below.[31] b) A “general relationship guide similar to Form ADV Part 2A” which would be delivered to the customer “at the time of entry into a retail customer relationship” and would contain, at a minimum, a description of the firm’s “services, fees and the scope of its services with the retail customer.”[32] The description of the scope of the firm’s services would need to include, but not be limited to, the following: i) Whether “the advice related duties are limited in time or are ongoing, or are otherwise limited in scope (e.g. limited to certain accounts or transactions)”[33] ii) Whether “the broker-dealer or investment adviser only offers or recommends proprietary or other limited ranges of products;”[34] and iii) Whether “the broker-dealer or investment adviser will seek to engage in principal trades with a retail customer”[35] and if so, the circumstances in which he or she would seek to do so. c) Any rule imposed upon broker-dealers and investment advisers would “treat conflicts of interest arising from principal trades the same as other conflicts of interest.”[36] This is in contrast to “transaction-by-transaction disclosures and consent requirements of Section 206(3) of the Advisers Act for principal trading.”[37] Any rule established would expressly state that the aforementioned disclosures under Section 206(3) are not applicable, however “at a minimum, as with other conflicts of interests, the broker-dealer or investment adviser would be required to disclose material conflicts of interest arising from principal trades with retail customers.”[38] d) Any rule would prohibit the “receipt or payment of non-cash compensation (e.g., trips and pries) in connection with the provision of personalized investment advice.”[39]
The SEC indicated in its Request that it could utilize the duty of care to specify “certain minimum professional obligations of broker-dealers and investment advisers” in order to promote the dissemination of investment advice that is in the “best interests of the retail customer.”[40] The duty of care likely would be used to set a minimum standard of care under both existing law and any new law imposed by the heightened standard. Additionally, as set forth in the SEC Request, the duty of care likely would incorporate the components below.[41] a) Similar to the current regulatory regime, broker-dealers and investment advisers would be required to have a reasonable basis to “believe that [their] securities and investment strategy recommendations are suitable for at least some customer(s) as well as for the specific retail customer to whom it makes the recommendation in light of the retail customer’s financial needs, objectives and circumstances.”[42] b) Certain products recommended by investment advisers and broker-dealers would be subject to additional requirements, such as “specific disclosure, due diligence or suitability requirements.”[43] Examples of products that would be subject to these product-specific requirements may include, but not be limited to, penny stocks, options, debt securities and bond funds, municipal securities, mutual fund share classes, interests in hedge funds and structured products.[44] c) Broker-dealers and investment advisers (in cases where “the investment adviser has the responsibility to select broker-dealers to execute client trades”[45]) would be required to “seek to execute customer trades on the most favorable terms reasonably available under the circumstances.”[46] d) Broker-dealers and investment advisers would be required to receive fair and reasonable compensation for their services, taking into account “all relevant circumstances.”[47] 3. Continuing Application of Existing Fiduciary Principles The SEC Study did recommend that “existing guidance and precedent under the Advisers Act regarding fiduciary duty should continue to apply to investment advisers and be extended to broker-dealers, as applicable, under a uniform fiduciary standard of conduct.”[48] Nonetheless, the SEC noted in the Request that application of relevant guidance and precedence is a fact-specific determination based upon the circumstances surrounding each case and consequently, the guidance and procedures may not apply to broker-dealers in certain cases. At a minimum, the SEC Request identified the principles listed below as those that would “continue to apply to investment advisers and be extended to broker-dealers.”[49] a) The duty of loyalty inherent in a fiduciary duty standard would generally “require a firm to disclose to a retail customer how it would allocate investment opportunities among its customers, and between customers and the firm’s own account.”[50] This would include, but not be limited to, disclosures regarding the firm’s “method of allocating shares of initial public offerings, as well as its methods of allocating out of its principal account to its customers when agency orders are placed on a riskless principal basis.”[51] b) Orders may be aggregated or “bunched” by a firm on behalf of two or more retail customers, “so long as the firm does not favor one customer over another.”[52] The firm would be required to disclose that it aggregates orders, and under what conditions it does so. If the firm does not aggregate orders, it would then be required to state why it does not when it has the opportunity to aggregate, as well as the practices and costs associated with not aggregating orders. B. Alternative Approaches In its Request, the SEC also identified several alternatives to the uniform fiduciary standard previously discussed. The SEC hopes that it will receive comments, as well as a cost-benefit analysis of the alternative approaches detailed below. The purpose is to help the SEC evaluate whether the various alternatives meet the goals of enhancing retail customer protections and decreasing retail customers’ confusion about the standard of conduct owed to them in connection with the rendering of personalized investment advice. The SEC suggests the following alternatives in the Request:
In order to determine how the various approaches discussed above would affect the personal finance industry, it is important to highlight the various obligations traditionally associated with a fiduciary, as these duties will likely be incorporated, to some degree, into any heightened standard which may be imposed on broker-dealers and investment advisers. An excellent resource for doing so is the Institute for the Fiduciary Standard (the “Institute”) which has identified six core duties inherent in a fiduciary standard, and the various attributes accompanying each of the duties.[61]
A fiduciary is defined as “someone acting in a position of trust on behalf of, or for the benefit of, a third party.”[62] As such, a fiduciary owes the utmost duty of loyalty to his/her clients. This duty requires the fiduciary to place the client’s best interests first, ahead of the interests of all other stakeholders, including the adviser and the firm. In order to satisfy, a fiduciary must ensure that there is no option available to the client which is “materially better.”[63] In connection with serving the client’s best interests, there are several responsibilities that a fiduciary must undertake, including, but not limited to the following:[64] i) “Determining investment goals and objectives; ii) Choosing an appropriate asset allocation strategy; iii) Establishing an explicit, written investment policy consistent with [the client’s] goals and objectives; iv) Monitoring the activities of the overall investment program for compliance with the investment policy.”[65] A fiduciary also has the duty to select asset classes that are consistent with the identified risk, return and time horizon specified by the client.[66] The “key fiduciary inputs” involved in asset allocation strategy may be defined by the acronym “TREAT: tax status, risk level, expected return, asset class performance and time horizon.”[67]
A fiduciary is required to act in the utmost good faith of the client. This includes, but is not limited to, the duty to be truthful and straightforward in all communications. Communications include not only direct statements spoken to the client, but all statements, whether spoken or written, regarding the adviser, the adviser’s experience and recommendations, and the adviser’s firm.[68]
Historically, concerns regarding conflicts of interest in large part prompted the enactment of the Advisers Act of 1940, as conflicts of interests abounded after the stock market crash of 1929.[69] Since the enactment of the Advisers Act, the duty to avoid conflicts of interest has been a bedrock principle for fiduciaries. It has been noted that “even well-meaning advisers often cannot overcome a conflict and give objective advice.”[70] It is essential that advisers closely monitor any potential conflicts they may have. While it is impossible for an advisor to avoid every potential conflict of interest, all advisers should take reasonable steps to avoid material conflicts and must “sharply minimize unavoidable [conflicts of interest] and effectively mitigate or manage conflicts in the best interests of the client.”[71] As a practical matter, if a fiduciary suspects that he or she may have a conflict of interest, it is likely such a conflict does exist and it is the duty of the adviser to end and/or avoid the conflict.[72] To evaluate whether a conflict exists, prior to selecting a particular investment or making a certain decision with regard to the client’s account, an adviser should determine who stands to benefit most from the transaction or decision.[73] If the adviser determines that anyone other than the client stands to gain the most benefit, that fiduciary is on the verge of breaching his or her duties to the client.
As part of their fiduciary duty, investment advisers have a duty to disclose and manage all material conflicts they encounter in the course of the relationship with their clients. What an adviser is required to disclose to his or her clients depends upon the surrounding facts and circumstances. Disclosure of all material facts and conflicts required to be made by an adviser must be “clear, complete and timely.”[74] When an adviser discloses material facts and conflicts in this manner, it helps the adviser to manage the material conflict. The adviser must have a reasonable basis to “think that the client fully understands the disclosure and the implication of the conflict(s), prior informed written consent if the client wishes to proceed with a transaction, and continued demonstration by the adviser that the recommendation is reasonable, fair and in the client’s best interests.”[75] Pursuant to a recent rule proposal promulgated by the Financial Industry Regulatory Authority, Inc. (“FINRA”), brokers soon may be required to disclose incentives “to anyone they solicit for one year following their transfer to a new firm.”[76] These incentives would include, but not be limited to, signing bonuses, upfront or back-end bonuses, loans, accelerated payouts and transaction assistance, and would only apply to incentives totaling $50,000 or more.[77] In response to FINRA’s proposal, SIFMA stated that, consistent with its support of a uniform standard of conduct, “in the context of recruiting-related bonus payments, the most important and relevant information for the client is to understand the potential conflict associated with the payment.”[78] In the event the proposed FINRA rule is adopted, brokers would have the duty to disclose compensation incentives, as such incentives would constitute conflicts of interest.
The requirement that advisers act prudently, and with due care, with regard to his or her clients encompasses not only following “a prudent process” but also having the requisite “knowledge to make appropriate recommendations.”[79] Advisers not only must possess the requisite knowledge, but also must ensure that their knowledge base and expertise are regularly updated. In order to exercise due care, an adviser’s process with regard to making and monitoring investments must be prudent, and requires “investigating and assessing an investment’s or firm’s characteristics based on objective criteria”, as well as employing industry best practices to “investigate, evaluate and construct a portfolio or recommendation.”[80]
A fiduciary also has an obligation reasonably to control investment-related costs and expenses. Inherent in this duty is the obligation of the adviser to ensure all investment-related expenses are both “fair and reasonable in relation to the services and investments offered.”[81] Importantly, any inappropriate or unnecessary expenses are unambiguously considered to evidence a breach of the duty of loyalty.[82] To fulfill its duty to manage investment decisions with the “requisite level of care, skill and prudence”, a fiduciary is required to establish a process by which to ensure that the client is responsible only for reasonable and necessary expenses.[83] Such expenses may include, but are not limited to, trading costs, consulting and administrative fees and custodial charges.[84] Finally, another key principle of the concept of a fiduciary is that the fiduciary duty is incapable of being superseded by agreement. A fiduciary is under an absolute obligation to “act in good faith and deal fairly with and for the principal.”[85] Consequently, a “principal could not authorize a fiduciary to act in bad faith.”[86]
In response to the SEC Study, several industry groups have filed comment letters advocating the adoption of various standards. In particular, an analysis of two notable commentators, SIFMA and the Institute for the Fiduciary Standard (the “Institute”), provides insight into several important considerations regarding the aforementioned approaches. SIFMA has taken the position that a wholesale extension of the fiduciary standard currently applicable to investment advisers pursuant to Section 206 of the Advisers Act would result in adverse consequences for both investors and the industry. While the Institute advocates for a uniform standard as well, its position differs fundamentally from the position of SIFMA. SIFMA SIFMA supports “the adoption of a new uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.”[87] To support its position, SIFMA notes that a wholesale extension of the current fiduciary standard would not be in the best interests of retail customers, as it would “impact choice, product access and affordability of customer services.”[88] Moreover, according to SIFMA, wholesale extension of the current standard would also cause commercial, legal, compliance and supervisory”[89] problems for broker-dealers. SIFMA notes that the inherent difficulty in extending the standard is evidenced in part by the core differences between the services provided by investment advisers and broker-dealers. While investment advisers are generally “engaged in the business of providing advice about securities for a fee, or managing assets on a discretionary basis,”[90] broker-dealers provide securities-related advice in addition to a host of other products and services which are beneficial to customers and securities markets as a whole. Those additional activities engaged in by broker-dealers “often carry inherent (though generally accepted and well-managed) conflicts of interest” and the current fiduciary duty standard implied under the Advisers Act “provides incompatible and insufficient guidance for broker-dealers on how to manage, disclose or obtain consents to these conflicts.”[91] Notably, the fact that commission-based brokerage accounts are the “preferred model for retail customers”[92] could result in reduced access for customers, as numerous potential conflicts may arise in such accounts. Although Dodd-Frank provides that commission-based compensation in and of itself would not constitute a violation of a uniform fiduciary standard, SIFMA’s position is that “undifferentiated application of existing Advisers Act case law, guidance and other precedents to broker-dealers could result in reduced access to brokerage accounts”[93] since presumably such precedence may support a finding that a material conflict existed in a commission-based account, depending upon the circumstances. SIFMA has outlined several key reasons why, in its opinion, the fiduciary standard under the Advisers Act should not extend to broker-dealers. Notably, Congress “recognized that the uniform fiduciary standard should ‘appropriately adapt to the differences between broker-dealers and registered investment advisers.’”[94] Also, SIFMA has stated that extending the “inability to gauge compliance with, or legal exposure under, the Advisers Act” would undermine the current business model of broker-dealers.[95] In situations where the “business and legal risks are unmanageable, broker-dealers will withdraw from offering the affected products and services, which would disserve the interests of retail customers.”[96] The undifferentiated extension of the current fiduciary standard also would significantly increase the costs associated with retail customers’ accounts and consequently would reduce the affordability of advisory services, in SIFMA’s opinion, as such an extension would reduce both options and access to certain products for retail investors.[97] According to SIFMA, the optimal approach would be a new uniform standard that would prioritize and protect investors’ interests and preserve the choice and access investors currently have. The new standard also would need to be capable of adapting to the different business models employed by broker-dealers and investment advisers, meaning that any standard enacted would be business-model neutral. Another guiding principle of SIFMA’s approach would be that in the case of a material conflict of interest, the SEC should articulate ways for broker-dealers and investment advisers to provide clear and effective disclosures to customers in a manner which would comport with the new standard, and receive the customer’s consent, if required. With regard to disclosure, SIFMA suggests that customers may consent to a material conflict of interest, subsequent to mandatory disclosure by the broker-dealer or investment adviser. Not only should disclosures be required to be clear and concise, but SIFMA’s position is that the SEC should also take a “layered approach to disclosure” in order to “provide retail customers with the clearest, most relevant information at the time it is most important to [the customers’] decision making, and therefore most likely to be read, with greater detail simultaneously made available to the customer if desired.”[98] Any disclosure updates would be provided through an annual notification to customers, where such disclosures were deemed “necessary or appropriate.”[99] In articulating the new standard of conduct, under SIFMA’s approach, the SEC necessarily would provide the “detail, structure and guidance necessary to enable broker-dealers to apply the fiduciary standard to their distinct operational model.”[100] The success of the new standard of conduct will depend in important part upon the SEC’s articulation of the scope of the obligations of broker-dealers and investment advisers, including but not limited to: 1) when the standard of conduct should commence;[101] 2) specification of the broker-dealer’s obligations under the new standard in the customer agreement,[102] including but not limited to which disclosures are required and when such disclosures are required; 3) application of the uniform standard on an “account-by-account basis”;[103] and 4) “inclusion of traditional product sales and compensation arrangements for broker-dealers.”[104] SIFMA further stated that while the current legal precedence and guidance pursuant to the Advisers Act still would apply to investment advisers, it would not apply to broker-dealers.[105] In particular, SIFMA noted that broker-dealers should continue to have the ability to engage in principal transactions under the new standard, as it was the intent of Congress to preserve this ability.[106]
The Institute Contrarily, the Institute stated that “the rich history of law, policy and experience provides a backdrop for extending the fiduciary standard to brokers rendering personalized investment advice to retail investors.”[107] The Institute calls into question SIFMA’s aim to prioritize investors’ interests by highlighting areas in which SIFMA’s suggested framework seeks to “ensure that the fiduciary standards adopted by the SEC will fit broker-dealers’ existing business practices and business models”[108] instead of promoting and protecting investors’ interests. According to the Institute, the fact that SIFMA does not advocate for a modification or discontinuation of the products and services offered by broker-dealers to investors is problematic as SIFMA advocates the articulation of a new standard “without any corresponding change in the advice and recommendations that may be provided [to investors].”[109] In essence, the Institute takes issue with SIFMA’s position that “suitable product recommendations suffice, and that a fiduciary ‘due care’ screening and investment selection process to meet the ‘best interest’ standard is not required”[110], as such a position is not consistent with putting investors’ interests first. With regard to conflicts of interests, the Institute’s view of SIFMA’s position is clear, stating that “at its core, SIFMA, it appears, unabashedly champions the benefits of conflicted advice.”[111] Moreover, the Institute states that: “SIFMA’s absolute and unconditional support of broker-dealers’ ability to continue to have conflicts with customers’ interests makes it hard not to conclude that SIFMA’s (1) position is based more on the economic and business concerns associated with a fiduciary standard than on customers’ best interests and (2) argument that customers interests would be harmed if broker-dealers decided not to provide certain products or services that involve conflicts of interest is based on the economic and business repercussions of imposing a true fiduciary standard on broker-dealers.” |
