On February 21, the Massachusetts Securities Division (the Division) became the first state regulator to finalize a rule to hold broker-dealers and their agents to a fiduciary standard of conduct when making recommendations and providing investment advice to their customers. To meet this fiduciary duty, broker-dealers and their agents must adhere to duties of utmost care and loyalty to the customer. Breaches of the duty could be deemed “unethical or dishonest conduct or practices” and could result in potential enforcement remedies, including fines or registration revocation, and thereby could give rise to other collateral consequences under the federal securities laws.
The Division first proposed a uniform fiduciary standard for both broker-dealer agents and investment advisers in June 20191 and revised that proposal in the fall of 2019 following a period of public comment. The final amended uniform fiduciary standard adopted on February 21, 2020 (hereinafter, the Massachusetts Final Regulations),2 reflects further comment and public hearings and differs significantly from the initial proposal as discussed in more detail below. The Massachusetts Final Regulations will become effective on March 6, 2020, and enforcement will commence on September 1, 2020.
Other states, including New Jersey and Nevada, are working on their own fiduciary rules; however, neither state has adopted fiduciary legislation. Maryland’s proposed fiduciary rule was rejected last year by the state senate’s finance committee.
Who Is a “Customer”?
In the Adopting Release, Amendments to Standard of Conduct Applicable to Broker-Dealers and Agents – 950 Mass. Code Regs. 12.200 (Feb. 21, 2020) (hereinafter, the Adopting Release),3 the Division noted that several commenters requested that the definition of “customer” be limited to “retail investors with a legal address in Massachusetts or who reside in Massachusetts.”3 The Massachusetts Final Regulations define a “customer” to include both current and prospective customers, but to exclude institutions, including banks, savings and loans associations, insurance, trust and registered investment companies, registered broker-dealers and investment advisers, and certain other institutional buyers. See 950 CMR 12.207(3). The Division did not make any changes to the Massachusetts Final Regulations in response to these comments. The Division stated that “[t]he Massachusetts Uniform Securities Act is clear on the scope and applicability of the Final Regulations and does not need further clarification.”3 Critically, the Massachusetts Final Regulations differ in scope from the U.S. Securities and Exchange Commission’s Regulation Best Interest (Reg BI) in their definitions of covered customers. Reg BI applies to “retail customers” defined as
A natural person, or the legal representative of such natural person, who: (i) Receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an associated person of a broker or dealer; and (ii) Uses the recommendation primarily for personal, family, or household purposes.
17 CFR § 240.151-1(b)(1). This creates a potential gap between the scope of customers encompassed by the Massachusetts Final Regulations and Reg BI. For example, Reg BI applies only to natural persons and therefore excludes all non-natural persons regardless of size. On the other hand, customers under the Massachusetts Final Regulations could include non-natural persons that do not qualify as institutional buyers as defined in 950 CMR 12.205(1)(a)6. and 950 CMR 14.401. Firms must be mindful of this distinction when making recommendations and providing investment advice to their customers.
Comparison to SEC’s Regulation Best Interest
In issuing the Massachusetts Final Regulations, Massachusetts’ Secretary of the Commonwealth (the Secretary) suggested in a statement that the SEC’s Reg BI did not go far enough to ensure that investors’ interests are protected. Not surprisingly, the Massachusetts Final Regulations are more stringent than Reg BI in a few material respects.
Reg BI, which goes into force on June 30, 2020, is designed to raise the broker conduct standard above the current suitability requirement. Under Reg BI, broker-dealers, among other things, cannot put their interests ahead of the customer’s interests and are required to mitigate or, in certain instances, eliminate conflicts of interest. See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019). However, the Massachusetts Final Regulations require broker-dealers and their agents to provide investment advice and recommendations “without regard to the financial or any other interests of any party other than the customer.” 950 CMR 12.207(2)(b)3. Indeed, “[d]isclosing conflicts alone does not meet or demonstrate the duty of loyalty.” 950 CMR 12.207(2)(c). Broker-dealers and their agents also have a duty to “make all reasonably practicable efforts to avoid conflicts of interest, eliminate conflicts that cannot reasonably be avoided, and mitigate conflicts that cannot reasonably be avoided or eliminated.” 950 CMR 12.207(2)(b)2.
In addition, Reg BI only prohibits sales contests that are product-specific or limited to particular time periods, while the Massachusetts Final Regulations prohibit all sales contests. See 950 CMR 12.207(2)(d).
In response to concerns expressed by the financial industry during the comment period, the Division did end up excluding or clarifying various provisions in its proposed amendments to the Regulations (the Proposal). The concessions made by the Division in the Massachusetts Final Regulations include the following:
1. Removed Investment Advisers and Investment Adviser Representatives as Regulated Persons
Section 12.207 of the Proposal included broker-dealers, agents, investment advisers and investment adviser representatives. The Division excluded investment advisers and investment adviser representatives from the scope of the Massachusetts Final Regulations, noting that they are already subject to a fiduciary duty.3 The Division explained that the Massachusetts Final Regulations “will continue to make broker-dealers and agents subject to a fiduciary duty when they make recommendations or provide advice with respect to securities.” See id.
2. Removed Presumption That Use of Certain Titles, Purported Credentials or Professional Designations Imposed an Ongoing Fiduciary Duty
Section 12.207(1)(c) of the Proposal imposed obligations, including to monitor the customer’s or client’s account or portfolio on an ongoing basis, for broker-dealers or agents who use certain titles, credentials or professional designations (e.g., financial adviser; financial consultant).3 Given the other protections provided under the Massachusetts Final Regulations, the Division stated that it had removed the presumption that such titles imposed an ongoing duty from the Massachusetts Final Regulations. See id.
3. Clarified When Broker-Dealers and Their Agents Have an Ongoing Fiduciary Duty
In response to various commenters raising concerns about whether the Proposal was imposing an ongoing duty on a broker-dealer or agent where one otherwise would not exist, the Division clarified the scope of the fiduciary duty.
The Division clarified that in Section 12.207(1)(a) of the Final Regulations, “the duty runs during the period in which incidental advice is made in connection with the recommendation of a security to the customer.”3 The Division also clarified that Section 12.207(1)(b) of the Final Regulations will further extend the duty beyond the recommendation period under certain circumstances “based upon ancillary factors that occur outside the traditional broker-dealer customer relationship.” See id. The Division explained that an ongoing fiduciary duty exists if (i) the broker-dealer or agent has discretionary authority over the customer’s account (unless the discretion relates solely to the time and/or price for the execution of the order); (ii) there is a contractual obligation that imposes a fiduciary duty; or (iii) there is an agreement to monitor the customer’s account on a regular or periodic basis. See id.; see also 950 CMR 12.207(1)(b)1-3. The Division stated that it had amended the Massachusetts Final Regulations with respect to this third prong to clarify that “the duration of the fiduciary duty is determined by the agreement with the customer.”3
Section 12.207(1)(b)4. of the Proposal “imposed a fiduciary duty during any time in which the broker-dealer or agent received ongoing compensation or provided investment advice to the customer in connection with other non-brokerage financial advice.” See id. Section 12.207(1)(b)5. of the Proposal also imposed a fiduciary duty when the broker-dealer or agent engaged in any act, practice or course of business that resulted in the customer’s having a reasonable expectation that their accounts would be monitored on an ongoing basis. See id. In response to commenters’ concerns, chiefly, that these extended duties would result in broker-dealers and their agents falling outside the scope of the incidental” exemption in the Investment Advisers Act of 1940, the Division stated that it had removed both provisions from the Massachusetts Final Regulations. See id.
4. Removed Commodities and Insurance Products
Sections 12.207(1)(a) and 12.207(2)(d) of the Proposal included references to commodities and insurance products. In response to multiple commenters reasoning that the Proposal should be limited only to securities, the Division stated it had removed the express language regarding advice on commodities and insurance products from the Massachusetts Final Regulations.3 Insurance lobbyists remained concerned that Massachusetts considered variable annuities to be securities that would fall under the fiduciary rule, based on documents on the Division’s website and the fact that the Division has taken enforcement action against broker-dealers who sell variable annuities. Following adoption, a spokeswoman for the Secretary stated in an email that “[u]nder Massachusetts law, variable annuities are not securities” and “[t]he [Final] [R]egulations cover securities.”
Furthermore, recommendations to sell a security and buy a nonsecurities product (or vice versa) could be subject to the fiduciary rule with respect to the entire transaction.
5. Clarified That Broker-Dealers and Agents Have a Duty to “Reasonably” Eliminate and Mitigate Conflicts of Interest
Section 12.207(2)(b)2. of the Proposal addressed the obligations of a broker-dealer or agent when facing conflicts of interest or potential conflicts of interest.3 In response to several commenters voicing concerns that this section of the Proposal was ambiguous and hard to meet, the Division revised the Massachusetts Final Regulations to clarify that “not all conflicts must be avoided or eliminated.” See id. The Division stated that “conflicts that arguably could be avoided or eliminated do not need to be if it would not be reasonable for a broker-dealer or agent to do so.” See id.
Examples of conflicts of interest that cannot reasonably be avoided or eliminated include (i) receiving compensation in connection with making a recommendation, (ii) making a recommendation or sale of proprietary products and (iii) making a recommendation or sale in a principal transaction.3 The Division explained that such conflicts may be mitigated by “ensuring that the fee earned for the recommendation is reasonable and complying with the remainder of the fiduciary duty.” See id.
6. Excluded Municipal Securities and Government Securities From Duty of Loyalty Provision
Although the Proposal did not specifically address municipal securities, the Division excluded municipal securities and government securities (i.e., securities issued by U.S. federal, state and municipal governments) from the duty of loyalty provision in the Massachusetts Final Regulations pursuant to Section 12.207(2)(e).3 The Division explained that “[r]ecommendations and advice provided in connection with these securities continue to be subject to the duty of care under Section 12.207(2) of the [Massachusetts] Final Regulations, as well as provisions of Section 12.204 of the [Massachusetts] Final Regulations.” See id.
Concerns with the Massachusetts Final Regulations remain on both sides of the aisle. Advocates for investor protection think the Massachusetts Final Regulations represent only a slight upgrade on Reg BI. They expressed dismay over the Division’s retreat from what the Proposal had required with respect to ongoing monitoring of accounts, as well as the Division’s removal of recommendations of annuities and other insurance investments from the Massachusetts Final Regulations.
Industry representatives have said that the Massachusetts Final Regulations could negatively affect investor choice. They stated that more investors may have to rely on fee-based advisory accounts rather than potentially more suitable commission-based brokerage models. Additionally, they noted that the asset minimums often associated with advisory accounts could result in individuals with moderate to low incomes having to manage their money on their own. Furthermore, the differences between Reg BI and the Massachusetts Final Regulations will complicate broker-dealer compliance efforts. The possibility that additional states may also enter into this area is another concern, particularly for firms with substantial customer bases across multiple states.
Ultimately, the broker-dealer industry will have a difficult decision over whether to comply with Massachusetts’ fiduciary rule or challenge its legality in court on federal preemption and other grounds.