(Article from Registered Funds Alert, September 2017)
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Securities and Exchange Commission (“SEC”) Chairman Jay Clayton announced in June that the SEC is seeking comment from the public regarding standards of conduct for investment advisers and broker-dealers. The call for comments is a preliminary step in restarting the SEC’s consideration of a fiduciary rule that would establish a uniform standard of conduct for investment advisers and broker-dealers. It also indicates a new effort to revisit the fiduciary regulations adopted by the Department of Labor (“DOL”) and coordinate better the regulatory agencies’ requirements for conduct by market participants.
If done correctly, adopting an enhanced conduct standards rule, in particular for broker-dealers, could better protect investors and enable greater access to affordable financial advice. It certainly would be a signature accomplishment for Chairman Clayton. If done incorrectly, as has been the case with the DOL’s fiduciary rule, implementing an overly burdensome fiduciary rule could dampen innovation and the industry’s growth, hurting investors and service providers alike.
The Dodd-Frank Act granted the SEC the authority to promulgate a unified investment advice rule, and though the SEC requested comments from the public in 2013 on such an initiative, the rule-making process has never proceeded beyond preliminary stages.
There were significant developments since 2013, of course, that may have finally pushed the SEC to take action. The DOL has now finalized and partially enacted its own fiduciary rule that requires financial advisers to act in the best interest of their clients in commission-based retirement accounts and to operate under a “best interest contract exemption” that creates private rights of action, including class actions. The DOL rule went into effect on June 9th, albeit without enforcement, as the implementation of its enforcement provisions has been proposed to be postponed until July 1, 2019 to facilitate further review called for by President Trump. Still, its current applicability and impending enforcement have further underscored the need for strong action from the SEC in this arena.
Chairman Clayton’s call for comments lists seventeen topics that commenters may address, some of which include specific requests for views on whether the definitions of “investment advice” and “retail investor” should be modified, as well as how regulations might be crafted to address retail investor confusion about the standard of conduct and category of professional or firm providing them advice. Chairman Clayton said that he intends for the SEC to collaborate closely with the DOL in drafting its own rule. This particular call for comments is less formal than the statutory comment period that will precede the adoption of a rule, but offers interested parties a chance to help shape the policy discussion from the start. The rulemaking process is expected to be long, and a final rule is, on an optimistic timeline, years away.
The million-dollar question, though, is what the uniform standard might look like when the process is complete. In answering that question, the perceived problems with the current, dual-standard system may inform the types of reforms that are likely to be proposed.
In 2008, the SEC commissioned the RAND Institute for Civil Justice to conduct a study of investor and industry understanding of the businesses of investment advisers and broker-dealers. In the study, investors were asked to distinguish between the products, service, duties, and obligations of investment advisers relative to those of broker-dealers, and it was apparent from the responses that investors overwhelmingly do not appreciate that there is a meaningful difference between the two. The study also found that investors were commonly unaware of their rights and failed to grasp the significance of conflicts of interest disclosed to them. Furthermore, financial service providers were also found to be unclear about the duties and obligations they owe investors.
The general confusion found in the RAND study is understandable given the complicated statutory regime regulating the two types of service providers. While the Investment Advisers Act of 1940 (the “Advisers Act”) imposes a “fiduciary” standard on investment advisers, meaning that the investment advisers must act in the best interest of their customers, the statutory language explicitly exempts broker-dealers from the same requirement. Broker-dealers are instead subject to a lower “suitability” standard under the Securities Exchange Act of 1934 (the “Exchange Act”). This requires that broker-dealers merely make investment recommendations that fall within the range of what is “suitable” in light of a customer’s stated investment goals and overall financial situation, a notably less onerous standard than the fiduciary standard for investment advisers.
There are two substantive differences between these standards. First, each standard allows for a different range of investment advice that is appropriate for a given customer. Both investment advisers and broker-dealers are required to collect “know your customer” information, which focuses on the customer’s financial situation and investment objectives. This information then forms the basis for investment advice. Under a fiduciary standard, there is only one acceptable recommendation; the one that serves the customer’s best interest. The suitability standard differs in that it allows for a range of possible recommendations, as even though only one recommendation can be the “best” alternative, a whole host of recommendations, some worse than others, will be “suitable.”
Second, the fiduciary and suitability standards require different amounts of disclosure with respect to conflicts of interest that might bias investment advice. Fiduciaries are required to disclose all material facts and conflicts of interest that may influence their advice, but under the lesser suitability standard, broker-dealers are not required to disclose all conflicts of interest when they recommend an investment. The practical result is that if there are multiple suitable options for a client, a broker-dealer need not recommend the “best” option, and instead can recommend whichever “suitable” option is most profitable to the broker-dealer. Further, the broker-dealer is not required to disclose fully the conflicts of interest underlying a profit-maximizing recommendation.
The fact that the fiduciary standard for investment advisers is principles-based also adds some confusion, at least if applied to broker-dealers. The Advisers Act does not explicitly state duties and obligations that arise under a fiduciary standard. Instead, common law principles dictate the extent of an investment adviser’s obligations to its client. This results in those standards occasionally being unnecessarily mysterious to investors and financial service providers alike.
A uniform standard of conduct would remedy much of the confusion simply by making everyone who is providing investment advice subject to the same rules. Investors likely would have a clearer understanding of their rights and financial service providers would have a more complete picture of the duties and obligations they owe to their customers.
The SEC may also codify many of the well accepted common law principles that investment advisers abide by. For example, the rule might state that:
- Fiduciaries have an affirmative duty to disclose all material facts related to conflicts of interest that might influence the investment advice being provided;
- Fiduciaries have an affirmative duty to employ reasonable care to avoid misleading clients; and/or
- Fiduciaries are prohibited from imposing a fee when a customer terminates the advisory relationship.
The SEC may also consider codifying some additional principles to address the broader problem of investors being unable to understand and evaluate conflicts of interest. For example, the rule might state:
- Fiduciaries have an affirmative duty to explain investment risks to the customer;
- Fiduciaries have an affirmative duty to explain whether and why certain investment risks are appropriate based on that customer’s circumstances; and/or
- Fiduciaries have an affirmative duty to test customer comprehension of investment risks and conflicts of interest.
Adding explicit affirmative duties such as these to a uniform standard of conduct rule may be particularly attractive to the SEC but create some new risks for market participants. This is because they would create new avenues for enforcement through which the SEC may curtail practices the SEC alleges to be abusive. Under the current regulatory regime, virtually every enforcement action related to fraudulent practices is predicated on an error, omission, or misstatement with respect to disclosure. There is a serious question among some of the SEC staff as to whether disclosure-based enforcement is serving investors effectively, and the SEC may take this opportunity to change that paradigm.