Background

On January 22, 2011, the Securities and Exchange Commission released a staff study (the "Study")1 on the effectiveness of the existing standards required of broker-dealers and investment advisers providing personalized investment advice about securities to retail customers. The Study was required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act").2 As discussed below, the Study recommends the adoption of a uniform fiduciary standard of conduct for both broker-dealers and investment advisers that is no less stringent than the current standard applicable to investment advisers under the Investment Advisers Act of 1940 ("Advisers Act").

In the Study, the Staff notes that although investment advisers and broker-dealers are regulated extensively under different regulatory regimes, many retail investors do not understand and are confused by the roles played by investment advisers and broker-dealers. The study also finds that "many investors are also confused by the standards of care that apply to investment advisers and broker-dealers" when providing personalized investment advice about securities. The Study further states that retail investors "should not have to parse through legal distinctions to determine" the type of advice they are entitled to receive. Instead, retail customers should "be protected uniformly when receiving personalized investment advice or recommendations about securities regardless of whether they choose to work with an investment adviser or a broker-dealer." At the same time, the Study notes that retail investors should "continue to have access to the various fee structures, account options, and types of advice that investment advisers and broker-dealers provide."

Uniform Fiduciary Standard

Historically, broker-dealers have not been considered "fiduciaries," even when dealing with retail customers. Investment advisers, on the other hand, are considered "fiduciaries" and are subject to an obligation to act in their customers' best interests. Because broker-dealers are excluded from the definition of "investment adviser" unless they charge separately for their advice, broker-dealers are not required to comply with these "fiduciary" standards. The standards of conduct currently applicable to broker-dealers derive from many sources, including agency law, antifraud provisions of the securities laws and the rules and regulations of the SEC and self-regulatory organizations such as FINRA. Broker-dealers owe duties of fair dealing and best execution, and are subject to both suitability requirements and various disclosure requirements. While such duties and requirements provide some degree of investor protection, they fall considerably short of the "fiduciary" standards described by the SEC.

The Study recommends that the SEC establish a uniform fiduciary standard for broker-dealers and investment advisers when they provide personalized investment advice about securities to retail customers. Under the proposed standard:

  • Both broker-dealers and investment advisers must act in the best interests of their customers  
  • In doing so, they must act without regard for their own financial interests  
  • Broker-dealers would be held to a fiduciary standard no less stringent than the existing fiduciary standard for investment advisers under Sections 206(1) and 206(2) of the Advisers Act  
  • "Personalized investment advice" would include, at a minimum, a "recommendation" as defined in existing broker-dealer regulations, and exclude "impersonal investment advice" as used under the Advisers Act  
  • "Retail customers" would include individual retail customers and groups of retail customers  
  • Existing guidance under the Advisers Act regarding fiduciary duty would apply to investment advisers and broker-dealers  
  • The duty of loyalty would require that an investment adviser or broker-dealer provide full and fair disclosure about material conflicts of interest  
  • SEC would develop a uniform approach to disclosure, which may include requiring broker-dealers to provide a general relationship guide at the outset of the relationship3  

The Study recommends that the SEC identify specific examples of potentially material conflicts of interest and consider imposing an outright prohibition on certain conflicts of interest. Broker-dealers would continue to be permitted to trade in a principal capacity with their retail customers notwithstanding the obvious conflict of interest. The Study recommends that the SEC adopt rules to govern how principal trading could take place under the new fiduciary duty standard; however, the Study notes specifically that broker-dealers should not be subject to the rules applicable to investment advisers under Section 206(3) of the Advisers Act, which requires disclosure and customer consent on a transaction by transaction basis.

The duty of care would require that investment advisers and broker-dealers meet specified professional standards. The study recommends that the SEC provide detailed guidance that delineates minimum expectations for the appropriate standard of conduct, which would include specifying the basis for a recommendation to a retail customer. The study emphasizes that these minimum standards would not establish a safe harbor or prevent the SEC from imposing a higher standard based on specific facts or circumstances.

Harmonization of Regulation

In addition to recommending adoption of a uniform fiduciary standard, the Staff also made recommendations with respect to harmonizing laws and regulations that apply to investment advisers and broker-dealers, which has long been on the SEC's radar screen. The Study recommends that when broker-dealers and investment advisers are performing the same or substantially similar functions, the SEC should consider whether to harmonize the regulatory protections applicable to such functions. Specifically, the Study recommends that the SEC consider the following initiatives:

     Advertising and Other Communications: The SEC should consider articulating consistent substantive advertising and customer communication rules and/or guidance for broker-dealers and investment advisers regarding the content of advertisements and other customer communications for similar services. In addition, the SEC should consider, at a minimum, harmonizing internal pre-use review requirements for investment adviser and broker-dealer advertisements or requiring investment advisers to designate employees to review and approve advertisements.

     Use of Finders and Solicitors: The SEC should review the use of finders and solicitors by investment advisers and broker-dealers and consider whether to provide additional guidance or harmonize existing regulatory requirements to assure that retail customers understand the inherent conflicts associated with the solicitor's and finder's receipt of compensation for introducing a retail customer to an adviser or broker-dealer.

     Supervision: The SEC should review supervisory requirements for investment advisers and broker-dealers, with a focus on whether any harmonization would facilitate the examination and oversight of these entities (e.g., whether detailed supervisory structures would not be appropriate for a firm with a small number of employees) and consider whether to provide any additional guidance or rulemaking.

     Licensing and Registration of Firms: The SEC should consider whether the disclosure requirements in Form ADV and Form BD should be harmonized where they address similar issues, so that regulators and retail investors have access to comparable information.

     Licensing and Continuing Education Requirements for Persons Associated with Broker-Dealers and Investment Advisers: The SEC could consider requiring investment adviser representatives to be subject to federal continuing education and licensing requirements.

     Books and Records: The SEC should consider modifying the Advisers Act books and records requirements, including adding a new requirement to retain all communications and agreements related to an adviser's business, such as that applicable to broker-dealers.

Evolving Process

The Study is an important step in the process initiated by the Dodd-Frank Act. However, the opposition to the Study's main recommendation reflected by the separate joint statement of SEC Commissioners Casey and Parades4 and the significant changes in the composition of the Congress as a result of the 2010 mid-term elections may portend a lengthy and contentious debate before the SEC takes any action based on the Study.