Although most of the rulemakings required to be proposed and adopted pursuant to the Dodd-Frank Act have now been addressed by regulators, a fiduciary duty or other heightened standard for broker-dealers remains an unknown. Chair White has announced that addressing a fiduciary standard remains a high priority for the SEC. The recent release by the Department of Labor of a reproposed definition of a “fiduciary” under pension plans under the Employee Retirement Income Security Act, or ERISA, has raised significant concerns for the broker-dealer community.
The precise contours of any heightened standards that the SEC will propose for broker-dealers remain unclear. However, broker-dealers that offer structured products may want to focus on the effect that a “fiduciary” standard would have on structured products compared to other asset classes.
Given the fact that in the United States at present, structured products are issued by a relatively small number of financial institutions and are distributed at least initially by the broker-dealer affiliates of the issuers, a few potential conflicts of interest are almost unavoidable.
- As noted above, the products are frequently issued by an affiliate (typically, the parent corporation) of the broker- dealer, and the broker-dealer usually acts in a principal capacity in respect of the offers of the products.
- The broker-dealer will earn compensation from the sale in a variety of ways, including its underwriting commission, and any profits that it or its affiliates receive from providing a related hedge transaction to the issuer.
- The broker-dealer frequently will act in a variety of different capacities in connection with the transaction, including serving as calculation agent for the note, and in the case of a proprietary index, serving as calculation agent for the index, and may receive license fees for providing the index.
The manner of sale of these products is also more likely to raise questions if brokers are subject to the same fiduciary standard as that of investment advisers. These products are typically underwritten by the relevant broker-dealer, and resold to the investor in a principal transaction. Accordingly, the new rules will need to address or replace the principles and procedures set forth in temporary Rule 206(3)-3T. Without this temporary rule or a similar provision, Section 206(3) of the Advisers Act would prohibit registered investment advisers from engaging in principal transactions with their clients unless they obtain written consents for each individual principal transaction.
Once the securities are outstanding, if there is a secondary market, it is typically maintained only by the relevant broker- dealer. As a result, the relevant broker-dealer will typically be the only entity that is setting a resale price for the product, and the investor will be forced to accept this price if it seeks liquidity.