Pending financial reform legislation, coupled with regulatory initiatives under way at SEC, FINRA, and DOL, move to establish consistent professional standards, improve disclosures, and impose greater requirements on securities professionals
2010 is shaping up to be a watershed year when it comes to regulatory changes affecting retail brokerage and private client services, as Congress gears up to pass major financial reform legislation and the U.S. Securities and Exchange Commission (SEC), Financial Industry Regulatory Authority (FINRA), and the Department of Labor (DOL) actively pursue separate regulatory reform programs and step up their respective examination and enforcement efforts. Although the broader agenda reflects the playbook issued by the Obama administration last summer in the Treasury Department’s (Treasury’s) white paper on financial regulatory reform,1 there has been a substantial evolution of many of the issues. Even as Congress deliberates over financial reform legislation, the SEC, FINRA, and the DOL have each taken up a variety of the issues in advance of any legislative enactment. The fundamental agenda for reshaping how broker-dealers are regulated when providing investment advice—a critical subject for retail brokerage and private client services—advances as the U.S. Senate approved by a 59-to-39 vote a legislative proposal sponsored by Senator Christopher Dodd (D-Conn.). On May 20, 2010, the Senate passed the Restoring American Financial Stability Act of 2010 (RAFSA), which now will be considered by congressional conferees together with The Wall Street Reform and Consumer Protection Act, H.R. 4173 (WSRA). WSRA, sponsored by Representative Barney Frank (DMass.), passed the U.S. House of Representatives on December 11, 2009 by a 223-to-202 vote. RAFSA and WSRA build on the Obama administration’s proposals from summer 2009 to (i) establish consistent standards for all financial professionals who provide investment advice, (ii) improve disclosures, and (iii) as stated by the Treasury last summer, require accountability from securities professionals. The two legislative proposals take different approaches—the House seeks to establish a standard of care for broker-dealers providing investment advice while the Senate takes a study approach—as summarized in the “At a Glance” chart on page 2, and discussed in detail below.
Enactment of either proposal (or the probable fusing of the two) will prompt SEC action to reassess the obligations of broker-dealers giving recommendations, research, and other investment advice, possibly by subjecting them to a standard of conduct comparable to that required of investment advisers. Either proposal, if enacted, will also prompt the SEC to further scrutinize broker-dealer sales practices, conflicts of interest, and compensation arrangements involving both retail and potentially institutional clients. In the retail context, this will intensify focus on mutual fund sales practices and related compensation arrangements (including 12b-1 fees, loads, and revenue-sharing and shelf-space payments)—topics already on the SEC’s and FINRA’s agendas. All told, if the regulatory reforms envisioned by these proposals advance, firms would be required to closely review and revise offered products and services, including those involving investment advice and related conflicts, disclosures, and compensation arrangements; make any needed changes to those products and services, related arrangements, and client-facing documentation; and revamp related supervisory and back-office systems. Below, we discuss the provisions of WSRA and RAFSA that would principally affect retail brokerage and private client services and then survey the separate regulatory reform initiatives pursued by the SEC, FINRA, and the DOL that also affect retail brokerage private client services.
Senate Bill: Restoring American Financial Stability Act of 2010
RAFSA takes a deliberative approach, charging the SEC with studying how broker-dealers should be regulated when providing investment advice and how to harmonize the multifaceted regulatory landscape of financial service providers.2
RAFSA requires that the SEC conduct a study to determine the effectiveness of, and identify any gaps or overlaps in, the existing standards of care for broker-dealers, investment advisers, and their associated persons when providing personalized investment advice and recommendations about securities to retail customers.3 The topics to be addressed include, among others:
- The regulatory, examination, and enforcement resources devoted to, and activities of, the SEC and FINRA to enforce these standards of care, including the frequency and length of time of examinations.
- Substantive differences, “compared and contrasted in detail,” in the regulation of brokers, dealers, and investment advisers, when providing personalized investment advice and recommendations to retail customers.
- Specific instances in which the regulation and oversight of broker-dealers provide greater protection relative to investment advisers and vice versa.
- Potential impact on retail customers (including on access to the range of products and services offered) of imposing upon broker-dealers the standard of care applied under the Advisers Act and other requirements under the Advisers Act.
- Potential impact of (i) imposing on investment advisers the standard of care applied by the SEC and FINRA for recommending securities to retail customers of brokers and dealers and (ii) authorizing the SEC to designate one or more self-regulatory organizations to augment the efforts of the SEC to oversee investment advisers.
- Potential impact of eliminating the broker-dealer exclusion from the definition of ‘‘investment adviser’’ under Section 202(a)(11)(C) of the Advisers Act.
- Ability of investors to understand the differences in terms of regulatory oversight and examinations between brokers-dealers and investment advisers.
- Varying level of services provided by broker-dealers and investment advisers and the varying scope and terms of retail customer relationships.
- Potential benefits or harm to retail customers from changes in the existing standards, including any impact on protection from fraud, additional costs and expenses, and access to and the availability of personalized investment advice or recommendations.
In studying the above, the SEC would be required to seek and consider public input, comments, and data and submit a report to the House and Senate within one year of the bill’s enactment. If the SEC concludes that gaps or overlaps exist, the SEC would be required to commence rulemaking to promulgate rules under its existing statutory authority within two years of the enactment of the bill.
New Disclosure Requirements
RAFSA would amend the Exchange Act to provide that the SEC may issue rules designating documents or information that shall be provided by a broker-dealer to a retail investor before the purchase of an investment product or service by the retail investor.4 Such documents or information are to be in “summary format” and include “clear and concise” information about investment objectives, strategies, costs, and risks, and any compensation or financial incentive received by a broker-dealer or other intermediary in connection with the purchase of retail investment products.
Authority to Restrict or Reaffirm Mandatory Predispute Arbitration
RAFSA proposes to amend the Exchange and Advisers Acts to provide that the SEC may enact rules to reaffirm or prohibit, or impose or not impose conditions or limitations on the use of, agreements that require the customers or clients of any broker-dealer or investment adviser to arbitrate any dispute between them that arises under the securities laws or the rules of a self-regulatory organization.5
Independent Custodian Requirement
RAFSA would amend the Advisers Act to require that registered investment advisers take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the SEC may prescribe by rule.6
Possible Reach of the Bureau of Consumer Financial Protection
RAFSA makes clear that the Bureau of Consumer Financial Protection will have no authority to bring enforcement actions against broker-dealers (among other person regulated by the SEC) and their associated persons “to the extent” they act in a “regulated capacity.” However, rules set by the bureau may bleed into consumer financial products or services provided through broker-dealers as an adjunct to their securities business. For example, if associated persons of broker-dealers provide consumer financial products or services—or example, on a “dual hatted” basis—through another provider regulated by the bureau, they may fall within the bureau’s jurisdiction.
Change in “Accredited Investor” Standard
RAFSA requires the SEC to modify the net worth requirement for an accredited investor under Regulation D to an amount greater than $1 million (individually or with spouse) excluding the value of the investor’s primary residence. The current definition of “accredited investor” includes the value of the investor’s primary residence and, as a result, any such change will require broker-dealers to update “accredited investor” determinations.
RAFSA also mandates a handful of additional studies, including:
- GAO Study on Conflicts of Interest. RAFSA requires the GAO to conduct a study within 18 months of RAFSA’s enactment regarding the potential conflicts of interest between the securities underwriting and securities analyst functions within the same firms.
- SEC Study on Investor Access to Information About Advisers and Broker-Dealers. RAFSA requires the SEC to conduct a study within six months after the date of enactment of the bill regarding ways to improve investors’ access to registration information (including disciplinary actions, regulatory, judicial, and arbitration proceedings, and other information) about investment advisers, broker-dealers, and their associated persons, and requires the SEC to take action to address and implement any recommendations of the study within 18 months of its issuance.7
- GAO Study on Financial Planners and Financial Planning Designations. RAFSA requires the GAO to conduct a study within 180 days after the enactment of the Act to evaluate the effectiveness of state and federal regulations to protect consumers from misleading financial advisor designations, oversight structure, and gaps in the regulation of financial planners.8
House Bill: The Wall Street Reform and Consumer Protection Act
As mentioned, WSRA was approved by the House on December 11 by a narrow 223-202 vote. WSRA does five things in particular as relevant to broker-dealers offering investment advice:
- Frst, it directs the SEC to mandate fiduciary-based standards of conduct for broker-dealers and investment advisers when providing personalized investment advice to “retail” investors.
- Second, it mandates that the SEC facilitate clear disclosures to investors about brokerage and advisory relationships, and authorizes the SEC to require point-of-sale disclosure for mutual funds.
- Third, it mandates the SEC to examine and, as appropriate, prohibit sales practices, conflicts, and compensation schemes for broker-dealers and investment advisers that the SEC views as contrary to the public interest.
- Fourth, it mandates the SEC to limit the ability of broker-dealers and investment advisers to require arbitration of customer disputes.
- Fifth, it would in effect require an independent custodian for advised accounts of $10 million or more.
Each is discussed in turn below.
Standard of Conduct
WSRA directs the SEC to establish both rules under the Investment Advisers Act of 1940 (Advisers Act) articulating the standard of conduct for investment advisers and rules under the Securities Exchange Act of 1934 as amended (Exchange Act) specifying that, in effect, the standard of conduct for broker-dealers is the same as for investment advisers under the Advisers Act.
Specifically, WSRA directs the SEC to promulgate rules under the Advisers Act “to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice to retail customers (and such other customers as the Commission may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.” The SEC is also directed to promulgate rules under the Exchange Act “to provide that, with respect to a broker or dealer, when providing personalized investment advice to a retail customer (and such other customers as the Commission may by rule provide), the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an investment adviser under the Investment Advisers Act of 1940.”
As drafted, the provision is limited in several key respects.
- The provision is limited to “personalized investment advice” to “retail customers.”
- The standard is a “best interest” standard—requiring that a broker-dealer act in the client’s “best interest” when giving investment advice—not the “sole interest” standard that was in the administration’s draft legislation and is comparable to the strict “exclusive purpose” rule under the Employee Retirement Income Security Act of 1974 (ERISA).
- The provision tacitly recognizes that a broker-dealer may have a conflict of interest, but requires that any advice be made “without regard” to any conflicting interest.
WSRA goes on to recognize three key principles:
- New Standards Must Build on Existing Antifraud Concepts under the Advisers Act. WSRA mandates that any standard of conduct set by the SEC must be “no less stringent than the standard applicable to” advisers under the antifraud provisions of the Advisers Act, Section 206(1) and (2). This provision was added in response to lobbying by advisers and consumer groups based on concerns that Congress would “water down” the standard for broker-dealers.
Earlier drafts of the provision would have mandated that the standard established by the SEC be “at least as high” as the “current standard applicable to investment advisers,” which was troublesome given that it might have picked up all the regulatory requirements to which advisers are subject and might have limited the SEC’s latitude in tailoring any standard for broker-dealers given the various and differing roles broker-dealers play.
- Recognition of Disclosure as a Way to Manage Conflicts. WSRA tacitly recognizes disclosure as a way to manage conflicts, although this is done through the codification of an affirmative obligation of disclosure and customer consent. The provision states that “[i]n accordance with such rules [as the SEC shall promulgate], any material conflicts of interest shall be disclosed and may be consented to by the customer.” The provision is helpful in that it is limited to “material” conflicts, but its reference to customer consent (while fortunately free of any reference to consent being in advance or in writing) will have to be narrowed in application.
- Receipt of Commissions Does Not Violate Standard. As applicable to broker-dealers, WSRA recognizes that “[t]he receipt of compensation based on commission or other standard compensation for the sale of securities shall not, in and of itself, be considered a violation of such standard applied to a broker or dealer.” However helpful the provision is, the key concept of “commission or other standard compensation” is unclear.
WSRA tracks the Treasury’s draft legislation9 and would require that the SEC “facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers, including any material conflicts of interest.” This provision is not limited to retail investors. Any required disclosure would presumably be a consolidated disclosure brochure for both broker-dealers and advisers or, in the case of a broker-dealer, a brochure similar to the Form ADV Part II brochure for investment advisers (i.e., a “Form BD, Part II” brochure). Just as with Form ADV, any SECmandated or -approved form for disclosure to investors may provide a positive shield for firms that provide disclosure to investors in accordance with the form’s requirements (that is, if a firm discloses information on a matter in accordance with the criteria promulgated by the SEC, it is harder for the SEC and investors to argue that the firm’s disclosure was lacking).
Sales Practices and Conflicts
WSRA would require that the SEC “examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that it deems contrary to the public interest and the protection of investors.” This provision is not limited to retail investors. It is unclear where this is heading and what the specific focal points of the proposed legislation are aside from the general subjects identified. One likely focus is sales practices and related compensation schemes involving mutual funds now regulated principally by FINRA, including mutual fund 12b-1 fees, sales loads, revenue sharing arrangements with mutual funds and their affiliates, and differential compensation to investment professionals based on firm revenue from mutual funds. Other possible areas of focus may include inter-firm payments, rebates and credits, “pay to play” in the state or municipal pension plan context, and compensation arrangements involving retirement accounts and their service providers.
Authority to Restrict Mandatory Predispute Arbitration
WSRA proposes to amend the Exchange and Advisers Acts to mandate that the SEC initiate rulemaking to prohibit or restrict predispute arbitration agreements with clients of broker-dealers and investment advisers.
Independent Custodian Requirement
Notably, Representative Bill Foster (D-Ill.) submitted an amendment, which was accepted subject to modification to address securities industry concerns that would in effect mandate the use of independent custodians for advised accounts over $10 million.
SEC, FINRA, and DOL Programs: Current Regulatory Initiatives Affecting Retail Brokerage and Private Client Services
The SEC, FINRA, and the DOL are each pursuing separate regulatory reform programs and stepping up their respective examination and enforcement efforts affecting retail brokerage private client services.
1. Reconsideration of Rule 12b-1 (SEC)
The SEC staff has stated that the SEC will propose substantial changes to Rule 12b-1 governing the use of mutual fund assets to finance distribution expenses. The SEC staff has been concerned that the rule has led to complicated fee structures that have made it harder for investors to evaluate overall mutual fund costs. Specifically, the SEC staff has suggested that, although 12b-1 fees evolved as a substitute for sales loads, they are not treated or disclosed in the same way as sales loads. Although the contours of the SEC’s intended proposals remain unclear, SEC staff comments suggest the SEC will propose that 12b-1 fees used as a substitute for front-end sales charges be treated and disclosed on trade confirmations as “asset based sales charges.”
2. Point-of-Sale Disclosure (SEC & FINRA)
SEC Chairman Mary Schapiro has publicly stated that the SEC will focus on point-of-sale issues for retail investors.10 FINRA has a pending (and controversial) rule proposal from mid-2009 to require point-of-sale disclosure concerning compensation received by broker-dealers distributing mutual funds.11
3. Pay-to-Play Restrictions (SEC)
In August 2009, the SEC proposed—and has now signaled it will proceed to adopt—new Rule 206(4)-5 under the Advisers Act aimed at curtailing “pay to play” practices by investment advisers that seek to manage assets of state and local governments.12 The proposed rule would substantially restrict the contribution and solicitation practices of investment advisers and certain of their related persons, restrict the use of placement agents for private funds (although FINRA may step in to regulate this in lieu of the SEC), and possibly impose stringent consequences for slip-ups. If adopted, the proposed rule will significantly affect investment advisers’ compliance policies and procedures as well as recordkeeping requirements.
4. Custody by Investment Advisers (SEC)
The SEC recently adopted substantial amendments to its custody rule under the Advisers Act, which went into effect March 12, 2010.13 The amendments, which have generated considerable interpretive questions, (i) restrict advisers from having omnibus accounts to hold, or from acting as trustee for, client funds or securities unless they are qualified custodians (with limited exceptions), (ii) deem advisers to have custody of client funds and securities held by related person qualified custodians (with limited exceptions), and (iii) impose new surprise examination and internal control review requirements on advisers and related person qualified custodians.
5. Form ADV, Part 2 (SEC)
The SEC staff has recently signaled that it hopes to adopt amendments to Form ADV Part 2 proposed several years ago by the SEC, possibly including a proposed brochure supplement to disclose the background (including disciplinary information) and experience of each investment professional giving investment advice to clients.
6. Current Initiatives Affecting Retirement Accounts (DOL)
We are also seeing an increased interest by the federal government in retirement plans and the regulation of persons who are fiduciaries and service providers to retirement plans, which could affect broker-dealers, investment advisers, and mutual fund companies. This interest is reflected in several current government initiatives.
- Fee Disclosures by Fiduciaries – As part of a larger disclosure project, the DOL is finalizing a regulation that would require more detailed disclosure to plan sponsors by plan fiduciaries and service providers of the fees and other compensation they receive in connection with providing services to plans. (DOL previously adopted requirements for detailed service provider fee disclosure in the annual reports filed by plans with the government, which became effective for reports required to be filed in 2010.) Congress has also been considering legislation that would impose similar disclosure requirements.
- Participant Advice – The DOL also recently proposed rules that would implement a prohibited transaction exemption for the provision of investment advice to participants in participant-directed plans (a matter that is also the subject of pending legislation).
- Definition of “Fiduciary” – In addition, the DOL staff has indicated that it is considering revisions to a regulation on the definition of an ERISA fiduciary that would likely expand the scope of what constitutes “investment advice” that makes a person an ERISA fiduciary, possibly to include pension consultants. Action on all of these regulatory projects is expected in 2010.