The fiduciary standards for institutions and individuals providing investment advice throughout the retail investment and municipal securities markets are currently undergoing significant change. Following on the heels of the issuance of a final Department of Labor (the “DOL”) fiduciary rule is the pending effectiveness of new fiduciary standards for municipal advisors, and the expected release of a proposed uniform fiduciary standard for investment advisers and broker-dealers by the US Securities and Exchange Commission (“SEC”). The election of Donald J. Trump as President of the United States, along with a Republican majority in both the House of Representatives and the Senate, creates uncertainty about the current path, but also increases the possibility of change in respect of one or more of the initiatives noted above. Financial institutions will need to again consider the impact of developments on their current business practices. The following is a brief summary of the current status of the various rules: at Section I, the fiduciary rule promulgated by the DOL; at Section II, the fiduciary rule for municipal advisors promulgated by the Municipal Securities Rulemaking Board (the “MSRB”); at Section III, the “suitability” rule applicable to recommendations made by broker-dealers and their associated persons promulgated by the Financial Industry Regulatory Authority (“FINRA”); at Section IV, the fiduciary standards applicable to registered investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”) and, at Section V, the forthcoming fiduciary proposal to be promulgated by the SEC.
I. US Department of Labor Fiduciary Rule
Final Fiduciary Rule Issued on April 6th, 2016
The DOL issued its final rule regarding ERISA fiduciary standards on April 6th of this year (the “DOL Rule”). The DOL Rule subjects investment recommendations from broker-dealers and certain other financial organizations to Individual Retirement Accounts (“IRAs”) and other retail retirement clients to the ERISA fiduciary standards and remedies. The DOL Rule will be applicable to financial institutions and the financial advisors employed by them on April 10, 2017, and compliance with certain provisions of exemptions promulgated along with the rule will be required in January of 2018.
The DOL Rule Redefines Who Is an “Investment Advice Fiduciary”
The DOL Rule requires a principles-based approach when determining whether an adviser is an “investment advice fiduciary” for purposes of ERISA and the Code. Under this approach, the rule focuses on whether or not a “recommendation” has been made that constitutes “investment advice.” A “recommendation” is defined as a communication, that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular action. Recommendations as to either the investment or management of the securities or investment property constitute “investment advice” under this rule.
As a departure from the current definition of “investment advice fiduciary,” the DOL Rule does not require that investment advice be provided on a regular basis or with the understanding that it will be used as the primary basis for the client’s decision. Further, advisers who are deemed to be fiduciaries are subject to a broad prohibition against conflicts of interest transactions. As a result, in order to continue many past compensation and other commercial practices, advisers will need to qualify for available exemptions, such as the best interest contract exemption.
II. MSRB Application of Fiduciary Duties to Municipal Advisors
Following the SEC’s adoption on September 18, 2013 of a final definition of the term “municipal advisor” under the Securities Exchange Act of 1934 (the “Exchange Act”), the MSRB on January 13, 2016 adopted Rule G-42, which addresses fiduciary standards of conduct for municipal advisors when conducting business as such.
New Rule G-42 Establishes Core Standards of Conduct for Municipal Advisors That Engage in Municipal Advisory Activities
Rule G-42 and the related amendments to Rule G-8 became effective on June 23, 2016. Rule G-42 establishes core standards of conduct and duties of municipal advisors when engaging in municipal advisory activities. The core standards of conduct, as outlined in the rule, are as follows:
Duty of Care: Includes, among other things, requiring that a municipal advisor: possess the expertise necessary to provide municipal-obligated persons with informed advice; make reasonable inquiries into the facts that form the basis of advice or a client’s determination whether to proceed; and have a reasonable basis for advice, certificates and information provided to the client.
Duty of Loyalty: Includes, among other things, requiring that a municipal advisor: deal honestly and with the utmost good faith with the municipal client and act in its best interests without regard to the financial or other interests of the municipal advisor; not engage in any activity if the municipal advisor cannot manage or mitigate embedded conflicts of interest.
In addition, the fiduciary standards set forth under Rule G-42 imposes other requirements on municipal advisors, including requiring the disclosure of material conflicts of interestand imposing a suitability standard for recommendations. It also prohibits municipal advisors from receiving excessive compensation, and from making misleading representations about the advisor’s capacity or knowledge.
III. FINRA Suitability Rule
FINRA Rule 2111 Imposes a Suitability Requirement on All Recommendations Made by Broker-Dealers
Broker-dealers have historically been subject to a “suitability” standard in respect of recommendations, including those made to institutional accounts. The Financial Industry Regulatory Authority (“FINRA”), the principal regulator for the broker-dealer community, has not established a fiduciary standard applicable to broker-dealers, but has rather continued the historical practice of evaluating the suitability of broker-dealer recommendations. FINRA Rule 2111 (“Rule 2111”), otherwise known as the “Suitability Rule,” which was adopted by FINRA after the adoption of the Dodd-Frank Act (including the Dodd-Frank Act requirements in respect of fiduciary standard harmonization discussed below), imposes the basic requirement that a broker-dealer must have a reasonable basis to believe that a recommended transaction or investment strategy is suitable to a customer.In particular, Rule 2111 imposes three suitability obligations on broker-dealers:
(i) Reasonable-Basis Suitability: Means that a broker must perform reasonable diligence to understand the investment products and strategies that are recommended to customers, and must determine that the product or strategy is appropriate for sale in a general sense.
(ii) Customer-Specific Suitability: Means that a broker must have a reasonable basis to believe that a recommendation is suitable for the customer to whom it is made, based on the customer’s investment profile, including such factors as the customer’s age, other investments, financial situation and needs.
(iii) Quantitative Suitability: Means that a broker who has control over a customer’s account (such as a discretionary trading account, or de facto control) must have a reasonable basis to believe that a series of recommended securities transactions is not excessive.
Although Rule 2111 focuses on the suitability of a recommendation by a broker-dealer, rather than a fiduciary duty of care or loyalty owed by a broker-dealer to a customer, the policy behind the rule is intended to achieve comparable results. Rule 2111 states that the basis for the rule lies in the “responsibility for fair dealing” that is “implicit in all member and associated person relationships with customers…” and that the suitability rule “is fundamental to fair dealing and is intended to promote ethical sales practices and high standards of professional conduct.”
IV. SEC Fiduciary Standards Applicable to Registered Investment Advisers
Registered Investment Advisers are Subject to a Broad Fiduciary Duty
Registered investment advisers are subject to a broad fiduciary duty and must generally act in the best interests of their clients. This duty is not specifically set forth in the Investment Advisers Act of 1940 (the “Advisers Act”) and has not been specifically established by SEC rules, however the basic nature of the adviser-client relationship, as well as the anti-fraud provisions of the Advisers Act, are generally viewed as the source of an adviser’s fiduciary duty, which has also been recognized by the courts.
The Fiduciary Duty Imposes Certain Obligations on Investment Advisers
There is no exhaustive list of an adviser’s fiduciary obligations in the Advisers Act or otherwise, but broadly speaking such obligations usually can be considered to fall within a duty of loyalty or a duty of care. Many adviser obligations also have elements of both duties embedded therein.
Obligations flowing from a duty of loyalty include, without limitation:
Full disclosure of Material Facts. An adviser has an affirmative obligation of full and fair disclosure to its clients of all facts material to the client’s engagement of the adviser, as well as a duty to avoid misleading them. In particular, this duty requires an adviser to avoid or disclose any conflicts of interest (or potential conflicts of interest) relevant to the adviser’s services, as well as to disclose certain disciplinary actions involving the adviser.
Suitable Advice. Advisers owe their clients a base-line duty to provide only suitable investment advice. This duty generally requires an adviser to make a reasonable inquiry into the client’s financial situation, investment experience and investment objectives, and to make a reasonable determination that the advice is suitable in light of the client’s situation, experience and objectives.
Obligations flowing from a duty of care include, without limitation:
Reasonable Basis for Recommendations. An adviser must have a reasonable, independent basis for its recommendations.
Best Execution. Where an adviser has responsibility to direct client brokerage, it has an obligation to seek best execution of clients’ securities transactions.
Valuation and Accuracy of Performance and other Calculations. An adviser must exercise due care when calculating client account information.
V. SEC Proposed Uniform Fiduciary Rule
Section 913 of the Dodd-Frank Act Requires the SEC to Evaluate Existing Standards of Care for Providing Personalized Investment Advice to Retail Customers
Section 913 of the Dodd-Frank Act requires the SEC to conduct a study to evaluate the existing regulatory standards of care for providing personalized investment advice and recommendations regarding securities to retail customers. It also grants the SEC authority under the Exchange Act and Advisers Act to adopt rules establishing a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing this personalized investment advice. Under this authority, the SEC completed the required study in 2011 (see the section entitled “2011 SEC Staff Study on Investment Advisors and Broker-Dealers” below) and is moving towards proposing a uniform fiduciary standard (the “SEC Rule”).
In 2015 testimony, SEC Chair Mary Jo White discussed the challenges associated with developing the SEC Rule, which include:
- Defining the standard;
- Providing clear guidance on what that standard would require, and how current business practices would be impacted by such a standard; and
- Providing “for the meaningful application, examination and consistent enforcement of a uniform fiduciary standard.”
2011 SEC Staff Study on Investment Advisers and Broker-Dealers
As a result of the Dodd-Frank requirement to evaluate regulatory standards of care, the SEC released a study on January 22, 2011 (the “2011 Study”) and made several recommendations addressing retail customer confusion about the differing standards of care applicable to broker-dealers and investment advisers.
In the 2011 Study, the staff of the SEC addressed the need for the establishment of uniform fiduciary standards applicable to broker-dealers and investment advisers. The language for this uniform fiduciary standard was based on the SEC’s review of the broker-dealer and investment adviser industries, the regulatory landscape, issues raised by commenters and other considerations required by the Dodd-Frank Act. Additionally, the 2011 Study concluded that the SEC should engage in rulemaking and/or provide interpretive guidance on the following aspects of a uniform fiduciary standard:
- How to prohibit certain conflicts;
- How to facilitate effective disclosures to retail investors about the terms of their relationships with broker-dealers and investment advisers (including any material conflicts of interest);
- Specifying uniform standards for the duty of care owed to retail investors;
- Providing guidance on how to conduct principal trading; and
- Defining “personalized investment advice about securities.”
In determining the practicality of a uniform fiduciary rule, the staff of the SEC also considered the potential alternatives of: (a) eliminating the broker-dealer exclusion from the definition of “investment adviser” in the Advisers Act; and (b) applying the duty of care and other requirements of the Advisers Act to broker-dealers. The SEC determined, however, that these alternatives “would not provide the Commission with a flexible, practical approach to addressing what standard should apply to broker-dealers and investment advisers when they are performing the same functions for retail investors.”
In addition to a uniform fiduciary standard, the 2011 Study suggested harmonizing the laws and regulations applicable to investment advisers and broker-dealers in order to provide retail investors similar protections when receiving like services from these two groups. These suggestions included:
- Rules about the content of advertising and similar communications about services;
- Disclosure requirements related to finders and solicitors;
- The harmonization of oversight of these entities;
- Maintaining consistency between similar disclosures required for registration and licensing; and
- The modification of the books and records requirements of the Advisers Act to be consistent with the rule applied to records requirements applied to broker-dealers.
Addressing certain concerns regarding the impact of a proposed rule, the staff of the SEC noted that “Section 913 explicitly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard of conduct applied to a broker-dealer. Section 913 also provides that the uniform fiduciary standard does not necessarily require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice.”
2013 SEC Release Requesting Data and Comments
After review of the 2011 Study, the SEC followed up with a release on March 1, 2013 (“2013 Release”) requesting data concerning standards of conduct and the potential harmonization of certain other aspects of the broker dealer and investment adviser regulation. Assumptions in the 2013 Release intended to guide commentators provided the public with insight into the alternative proposals being considered by the SEC. Of most importance, commentators were instructed to assume that:
- a broker-dealer or investment adviser would not have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice;
- any action would apply to all broker-dealers and investment advisers; and
- the uniform fiduciary standard would be designed to accommodate various business models and fee structures.
In addition, the 2013 Release provided that a uniform fiduciary standard would not necessarily require all firms to:
- provide the lowest cost alternative;
- stop offering proprietary products;
- charge only asset-based fees (as opposed to charging commissions); and
- continuously monitor all accounts.
Timing of a Rule Proposal: First Quarter of 2017 Now Looking Doubtful?
On March 24, 2015, Chair White told the United States House of Representatives Committee on Financial Services that broker-dealers and investment advisers should be subject to a uniform fiduciary standard of conduct when providing personalized investment advice about securities to retail investors. The Staff of the SEC is now working toward a rule to this effect. As part of its analysis, the SEC is giving consideration to, among other things, the recommendations of the 2011 Study, the views of investors and other interested market participants, potential economic and market impacts and the information received in response to the 2013 Release.
Although the Office of Management and Budget’s fall agenda scheduled the notice of proposed rulemaking for the Personalized Investment Advice Standard of Conduct for October of 2016, multiple news sources have now reported that a proposed fiduciary standard would be substantially delayed. Some news sources have reported that the rule will not be proposed until at least April of 2017, and at least one news source reported that a proposed rule was a couple of years away.
The results of the 2016 Presidential Election have created uncertainty regarding the timing of any proposed fiduciary standard by the SEC, and even whether such a proposal will come at all. However, Candidate Trump, along with Republican legislators in both the House of Representatives and the Senate, have during the election period expressed interest in opportunities to harmonize areas of regulation that are perceived to be duplicative or inefficient. While a uniform fiduciary standard applicable across the financial services industry is an obvious area where harmonization efforts could bear fruit, early signals suggest that the current situation, involving multiple regulators and standards, may worsen somewhat before it improves. Wealth managers and asset managers of all stripes will for some time need to remain abreast of multiple different regulatory schemes in order to sort through parallel standards of care.