New Jersey has issued a proposal for a new rule that would institute a uniform fiduciary standard for broker-dealers and investment advisers registered with the state. On April 15, 2019, the New Jersey Bureau of Securities proposed amendments to Subchapter 6 of Chapter 47 of the New Jersey Administrative Code.
These amendments, including new Section 13:47A-6.4, would impose a uniform fiduciary standard on broker-dealers and investment advisers when they:
• Recommend a transaction or an investment strategy;
• Recommend opening, or transferring assets to, any type of account; or
• Provide investment advisory services.
The rule proposal would substantially heighten the standard of care required by broker-dealers beyond the current Financial Industry Regulatory Authority suitability standard. It would also exceed the standard of care which the U.S. Securities and Exchange Commission is seeking to create by way of its proposed Regulation Best Interest, or Reg BI.
Under the proposed New Jersey fiduciary standard, brokers would be obligated to recommend securities, investment strategies and accounts that are “the best of the reasonably available options” based upon risks, costs and conflicts of interest. The New Jersey Bureau of Securities expects to adopt a final rule sometime in fall 2019. Firms have an opportunity to comment on the rule proposal until June 14.
When Would Broker-Dealers Owe a Fiduciary Duty?
Broker-dealers would have different obligations under the rule proposal depending on the type of account a customer holds.
Brokerage Customers With Only Commission-Based Accounts
Under the proposed amendments to Section 13:47A-6.3 and new Section 13:47A-6.4, when a customer of a dually-registered firm holds only a commission-based account, a brokerdealer’s fiduciary duty exists only from the time of a recommendation through the execution of the recommended transaction or investment strategy.
Unlike Nevada’s recently proposed fiduciary rule, New Jersey’s proposed fiduciary rule is consistent with the longstanding common-law rule that broker-dealers do not generally owe an ongoing duty to monitor economic or financial developments that could affect the portfolio of a nondiscretionary customer.
In the context of a recommended transaction, the broker-dealer’s responsibilities under the rule proposal cease at the conclusion of the trade. An express contractual provision or the client’s grant of discretionary authority, however, can create an ongoing duty.
Ongoing Duties Owed Toward Brokerage Customers With Advisory Accounts
If a brokerage customer maintains a commission-based account and an advisory account with the firm, under the proposed New Jersey rule, an ongoing fiduciary duty would be owed on the totality of the relationship.
The dually-registered firm would owe an ongoing fiduciary duty to the customer for all accounts and securities. That ongoing duty would extend beyond the point of sale in the commission-based account as well.
Fiduciary Duty Standard
The proposed fiduciary duty would be met by satisfying duties of care and loyalty. The proposed duty of care would require broker-dealers and advisers to (1) act with the care, skill, prudence and diligence of a prudent person in a like capacity and (2) make reasonable inquiries into the risks, costs and conflicts of interest related to the recommendation or investment advice; the customer’s investment objectives, financial situation and needs; and any other relevant information.
The recommendation or investment advice is required by the proposal to be made without regard to the financial or other interest of the representative, firm, affiliated entities or other third parties. The duty of loyalty would be presumptively breached if the broker-dealer or investment adviser recommended or advised the customer to open a specific type of account or buy/sell a security that is “not the best of the reasonably available options.”
A broker-dealer would still be able to charge a commission so long as the fee was reasonable, was the best of the available fee options and the duty of care was met.
The duty of loyalty the rule proposal seeks to impose on broker-dealers and advisers is stricter than the standard proposed by the SEC for SEC-registered advisers. In its investment adviser proposal, released together with Reg BI, the SEC clarified that, at a minimum, the adviser’s existing duty of loyalty requires the adviser to make “full and fair disclosure to its clients of all material conflicts of interest that could affect the advisory relationship.”
The SEC noted that in “some complex or extensive conflicts,” it may be difficult for the disclosure to be specific and clear enough for the client to provide informed consent.
Under New Jersey's rule proposal, disclosing a conflict of interest would not be sufficient to create a presumption that the broker-dealer or adviser met the duty of loyalty. The rule proposal does not contain any provisions that would address how a disclosure or written, informed client consent may cure a conflict.
The Rule Proposal Would Not Change the Bureau’s Enforcement Authority Over SEC-Registered Advisers
The rule proposal would not purport to apply to SEC-registered investment advisers, unless their investment adviser representatives, or IARs, have a place of business in New Jersey. In fact, the New Jersey Bureau of Securities is preempted from applying the rule proposal to SEC-registered advisers.
The National Securities Markets Improvement Act of 1996, or NSMIA, allocated responsibilities over the securities markets between the state and federal governments, and preempted the ability of states to enact substantive regulation on SEC-registered advisers.
Preexisting Section 13:47A-6.1 permits the bureau to regulate “dishonest or unethical practices” by SEC-registered advisers to the extent the “conduct alleged is fraudulent or deceptive” or to the extent permitted by NSMIA.[5] In line with NSMIA preemption, the bureau has not examined SEC-registered advisers for compliance with the items considered to be “dishonest or unethical practices.”
An attempt by New Jersey to indirectly regulate SEC-registered advisers through regulating their IARs might raise NSMIA preemption issues. We do not anticipate that the bureau will change its existing practices to enforce the rule proposal against SEC-registered advisers or their IARs.
Exception for Institutional Investors
Under the proposed new Section 13:47A-6.4, the fiduciary duty would not be owed to the following institutional investors:
• Banks, savings and loan associations, insurance companies or registered investment companies;
• Broker-dealers registered with a state securities commission;
• SEC and state registered investment advisers; and
• Persons (individuals, corporations, partnerships, trusts or otherwise) with total assets of at least $50 million.
ERISA Employee Benefit Plans
Under the rule proposal, the new standard would not apply to broker-dealers or advisers who manage or invest plan assets or provide investment advice to an employee benefit plan, its participants and beneficiaries that are covered by the Employee Retirement Security Act of 1974, or ERISA.
The fiduciary duty would not be owed to profit sharing plans, 401(k) plans, other defined contribution plans or IRAs established solely to hold assets rolled over from an ERISA retirement plan. However, the rule proposal would create fiduciary duties owed to Keogh plans and traditional and Roth IRAs — which are not treated as employee benefit plans by ERISA.
The Rule Proposal Does Not Create a New Record-Keeping Requirement
The proposed amendments would not require firms to maintain records beyond those already required by the Securities Exchange Act of 1934.
Despite the lack of a record-keeping requirement, practically, broker-dealers would be required to maintain documentation to demonstrate compliance with the fiduciary standard. For example, firms will need documents to prove they made a reasonable inquiry into the “risks, costs and conflicts of interest” related to a recommendation.
Conclusion
Although the New Jersey Bureau of Securities' decision to refrain from imposing an ongoing fiduciary duty on broker-dealers for customers with only commission-based accounts is significant, the rule proposal is nonetheless a potential game changer.
It eliminates the historical distinctions between broker-dealers and investment advisers and imposes a standard on broker-dealers that is stricter than the standard proposed by the SEC for SEC-registered advisers. If the rule proposal is adopted, it could impose significant changes in a New Jersey broker-dealer’s relationship with its customers.
The rule proposal would also create a number of significant challenges. Although firms will not be compensated for their ongoing monitoring of an account, dually-registered firms will owe ongoing duties to a brokerage customer who also holds advisory accounts as part of the relationship. In addition, firms will be challenged to make product recommendations to meet the “best of the reasonably available options” standard.
By not allowing disclosure of material facts or informed consent to cure a conflict of interest, the bureau arguably underestimates the ability of investors to make sound investment decisions. It seems likely that these proposed material changes will have certain negative impacts on customers in the form of decreased product options and increased costs.
Investors are better served through a uniform federal standard that raises the standard of care on brokers, as opposed to a patchwork of state regulation that could result in adverse consequences on investors. Firms should closely monitor these legislative developments.
First published in Law360.
