Obama Reform Proposal Would Enhance SEC Investor Protection Role

In its draft plan to overhaul US financial regulation, the Obama Administration endorses the SEC as an experienced federal regulator with comprehensive responsibilities for protecting investors against fraud and abuse. To further the SEC’s mission, the Administration proposes legislation modernizing the financial regulatory structure and improving the SEC's ability to protect investors, focusing on principles of transparency, fairness, and accountability.

The SEC should require that certain disclosures (including a summary prospectus) be provided to investors at or before the point of sale, if the Commission finds that such disclosures would improve investor understanding of the particular financial products, and their costs and risks. Currently, most prospectuses (including the mutual fund summary prospectus) are delivered with the confirmation of sale, after the sale has taken place. Without slowing the pace of transactions in modem capital markets, the SEC should require that adequate information is given to investor to make informed investment decisions.

The SEC can better evaluate the effectiveness of investor disclosures if it can meaningfully engage in consumer testing of those disclosures. The SEC should be better enabled to engage in field testing, consumer outreach and testing of disclosures to individual investors, including by providing budgetary support for those activities.

New legislation should also bolster investor protections and bring important consistency to the regulation of two types of financial professionals, brokers and advisers, by: requiring that broker-dealers who provide investment advice about securities to investors have the same fiduciary obligations as registered investment advisers; providing simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment professionals; and prohibiting conflict of interests and sales practices that are contrary to the interests of investors.

Currently, investment advisers and broker-dealers are regulated under different statutory and regulatory frameworks, even though the services they provide often are virtually identical from a retail investor's perspective.

Retail investors are often confused about the differences between investment advisers and broker-dealers. Meanwhile, the distinction is no longer meaningful between a disinterested investment advisor and a broker who acts as an agent for an investor. Current regulations are based on antiquated distinctions between the two types of financial professionals that date back to the early 20th century. Brokers are allowed to give incidental advice in the course of their business pursuant to an exemption in the Investment Advisers Act, and yet retail investors rely on a trusted relationship that is often not matched by the legal responsibility of the securities broker. In general, a broker-dealer's relationship with a customer is not legally a fiduciary relationship, while an investment adviser is legally its customer's fiduciary.

From the vantage point of the retail customer, however, an investment adviser and a broker-dealer providing incidental advice appear in all respects identical. In the retail context, the legal distinction between the two is no longer meaningful. Retail customers repose the same degree of trust in their brokers as they do in investment advisers, but the legal responsibilities of the intermediaries may not be the same.

Thus, the Administration proposes legislation allowing the SEC to align duties for intermediaries across financial products. Standards of care for all broker-dealers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers. In addition, the SEC should be empowered to examine and ban forms of compensation that encourage intermediaries to put investors into products that are profitable to the intermediary, but are not in the investors' best interest.

Mandatory Arbitration

Broker-dealers generally require their customers to contract at account opening to arbitrate all disputes. Although arbitration may be a reasonable option for many consumers to accept after a dispute arises, the Administration believes that mandating a particular venue and up-front method of adjudicating disputes, and thereby eliminating access to courts, may unjustifiably undermine investor interests.

Thus, legislation should authorize the SEC to prohibit mandatory arbitration clauses in broker-dealer and investment advisory accounts with retail customers. The legislation should also provide that, before using such authority, the SEC would need to conduct a study on the use of mandatory arbitration clauses in these contracts. The study must consider whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate.

Historically, claims for violations of the federal securities laws were considered to be non-arbitrable based on the doctrine enunciated by the US Supreme Court in Wilko v. Swan (US Sup Ct 1953), 1952-1956 CCH Dec.¶90,640. In Wilko, the Court held that an agreement to arbitrate claims under Section 12(2) of the Securities Act was not enforceable. However, as arbitration gained increasing judicial favor, the Court began to chip away at the Wilko doctrine and in 1989 expressly overruled it. The Court ruled that a pre-dispute agreement to arbitrate an investor’s securities claims against a brokerage firm was enforceable in view of the strong federal policy favoring arbitration. Rodriguez v. Shearson/American Express, Inc. (US Sup Ct 1989), 1989 CCH Dec. ¶94.407.

Whistleblower Protection

Legislation should authorize the SEC to establish a fund to pay whistleblowers for information that leads to enforcement actions resulting in significant financial awards. Currently, the SEC has the authority to compensate sources in insider trading cases; but that authority should be extended to compensate whistleblowers that bring well-documented evidence of fraudulent activity. The Administration supports the creation of this fund using monies that the SEC collects from enforcement actions that are not otherwise distributed to investors.

Sanctions

Noting that improved sanctions would better enable the SEC to enforce the federal securities laws, the Administration proposes legislation authorizing the SEC in pursuing enforcement to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC's jurisdiction, the similar grounds for exclusion from each, and the SEC's overarching responsibility to regulate these activities all argue in favor of the imposition of such collateral bars.

Improved sanctions would better enable the SEC to enforce the federal securities laws. The Administration supports the SEC in pursuing authority to impose collateral bars against regulated persons across all aspects of the industry rather than in a specific segment of the industry. The interrelationship among the securities activities under the SEC's jurisdiction, the similar grounds for exclusion from each, and the SEC's overarching responsibility to regulate these activities support the imposition of collateral bars.

Liability Standards

The legislation should also amend the federal securities laws to provide a single explicit standard for primary liability to replace various federal circuit courts of appeal formulations of different tests for primary liability.

Investment Advisory Committee

The SEC recently established an Investor Advisory Committee, made up of a diverse group of well-respected investors, to advise on the SEC's regulatory priorities, including issues concerning new products, trading strategies, fee structures, and the effectiveness of disclosure. The administration proposes legislation making the Investor Advisory Committee permanent.

Financial Consumer Coordinating Council

Similarly, in order to address potential gaps in investor protection and to promote best practices across different markets, the Administration proposes the creation of coordinating council composed of the heads of the SEC, the FTC, the Department of Justice, and the new Consumer Financial Protection Agency. The Coordinating Council should meet at least quarterly to identify gaps in consumer and investor protection across financial products and facilitate coordination of consumer protection efforts.

Congress should help ensure the effectiveness of the Coordinating Council for the benefit of consumers by empowering the Council to establish mechanisms for state attorneys general, consumer advocates, and others to make recommendations to the Council on issues to be considered or gaps to be filled. Legislation should also require the Council to report to Congress and the SEC and other member agencies semi-annually with recommendations for legislative and regulatory changes to improve consumer and investor protection, and with updates on progress made on prior recommendations. The Council should also be authorized to sponsor studies or engage in consumer testing to identify gaps, share information and find solutions for improving consumer protection across a range of financial products.