Current Events and Commentary

Broker/Dealers May Have To Comply With A Higher Standard That Many Retail Customers Believe Already Exists

February 2011
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The staff of the Securities and Exchange Commission (SEC) issued a report required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It recommends significant changes regarding how broker/dealers transact business with their retail investment customers.

Investment advisors and security broker/dealers are both highly regulated. But their regulations are quite different. The SEC staff report is 166 pages long, plus a ten page executive summary and an appendix - 208 pages in total. Most of this length is devoted to summarizing these numerous existing regulations. Many have questioned whether these regulation differences are sensible, particularly when it comes to providing investment advice to retail investors.

The thrust of the controversy is that investment advisors are held to a higher standard of conduct when dealing with their customers. According to the SEC staff report:

“An investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care. An adviser that has a material conflict of interest must either eliminate that conflict or fully disclose to its clients all material facts relating to the conflict.”

The SEC staff concluded:

“… there is robust recent evidence that many retail investors do not understand or are confused by the different standards of care applicable to investment advisers and broker-dealers and their respective associated persons.
…Retail customers do not understand and are confused by the roles played by investment advisers and broker-dealers, and more importantly, the standards of care applicable to investment advisers and broker-dealers when providing personalized investment advice and recommendations about securities. This lack of understanding is compounded by the fact that retail customers may not necessarily have the sophistication, information, or access needed to represent themselves effectively in today’s market and to pursue their financial goals. Retail investors are relying on their financial professional to assist them with some of the most important decisions of their lives. Investors have a reasonable expectation that the advice that they are receiving is in their best interest. They should not have to parse through legal distinctions to determine whether the advice they receive was provided in accordance with their expectations.”

Based on this confusion, the SEC staff recommended a single fiduciary standard be applied; specifically the SEC suggested:

“rulemakings that would apply expressly and uniformly to both broker-dealers and investment advisers, when providing personalized investment advice about securities to retail customers, a fiduciary standard no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2).”

Broker/dealers often own the securities that are being sold or otherwise have a conflict of interest with their customers who are purchasing what the broker/dealer is selling. At its core, the SEC staff believes broker/dealers should have to stop holding themselves out as having the best interests of their customers in mind, when that is practically impossible in light of the nature of the transactions(s) being conducted. The SEC staff concluded:

“Clarification will be particularly important in applying the obligation to eliminate or at least disclose all material conflicts of interest, as contemplated by the Dodd-Frank Act. With investment advisers, the Commission and Staff have identified numerous conflicts of interest over time through interpretive guidance, rulemakings, enforcement actions and no-action letters. The Staff believes that the Commission should help broker-dealers similarly identify their conflicts of interest as specifically as possible so as to facilitate broker-dealers’ smooth transition to compliance with the uniform fiduciary standard. Similarly, the Commission should continue to help advisers further identify their conflicts of interest….
Broker-dealers also must make a variety of disclosures, but the extent, form and timing of the disclosures are different. They are not subject to a comparable requirement for a general disclosure of conflicts at the time the relationship is established, as well as other information contained in the investment adviser brochure. Instead, when recommending a security, they generally are required to disclose (though not in writing) any material adverse facts or material conflicts of interest, including any economic self-interest, so that customers may evaluate their overlapping motivations. Broker-dealers also are required to make certain specific disclosures, such as whether they are acting as market makers for a recommended security, or if they have any other control, affiliation or interest in the security In executing customer trades, broker-dealers must provide customers with specific disclosure in confirmation statements at or before the completion of the transaction, including the price at which the trade was executed, the capacity in which a broker acted (i.e., as principal or agent), and the compensation it received, including any compensation it received from third parties.”

The week before issuance of this SEC staff report on a uniform fiduciary standard, the SEC issued its Study on Enhancing Investment Adviser Examinations, as required by Section 914 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In this study, the SEC flatly told Congress that (i) it does not have the resources to oversee investment advisors, and (ii) the best option is to empower a self-regulatory organization such as FINRA to do the job. Not surprisingly, FINRA was delighted by the opportunity to expand. FINRA announced:

“The SEC has thoughtfully evaluated the need for additional oversight of investment advisers and has rightly concluded that having the ability to leverage SRO resources could be advantageous to assisting the Commission. We agree with the SEC that an SRO can augment government oversight programs through more frequent examinations. As we have consistently stated, customers of investment advisers would benefit from the additional protection afforded by SRO oversight. Investors deserve the same level of protection regardless of whether they are dealing with a broker or investment adviser. We also appreciate the SEC's recognition that SROs have played an important role in protecting investors in the regulation of broker-dealers.”

These changes have been brewing for years, and have been resolutely resisted by the investment brokerage industry. Representative of this controversy, the SEC received more than 3,500 letters while working on the fiduciary study.

It will be interesting to see whether the broker/dealers’ past comments of gloom and doom will continue, or whether the industry will more carefully select other issues that it believes can be realistically challenged. In this regard, on January 22, 2011, the Securities Industry and Financial Markets Association (SIFMA) - an industry organization of hundreds of securities firms, banks and asset managers – issued a conciliatory statement supporting the SEC staff’s recommendations, as follows:

“We support a uniform fiduciary standard of care for broker-dealers and investment advisers, and upon initial review we believe that the SEC has appropriately articulated a workable comprehensive approach for personalized investment advice for retail customers. “

Despite this support, the SIFMA statement also included warnings that the SEC should:

  1. “not pick business model winners and losers” (Translated – Let broker/dealers continue as-is as much as possible.)
  2. “provide leadership in applying comparable oversight, examination and enforcement to retail registered investment advisers” (Translated – Be just as demanding with the investment advisors with whom we compete.)
  3. “ensure that the broker-dealer role is not hindered”.

As with any SEC rulemaking, changes will occur slowly, only after hearings, proposals, and additional comments.

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