Tuesday, June 29, 2010

Conference Committee Struck Compromise on Uniform Duty of Care for Brokers and Advisers

The current regulatory regime treats brokers and advisers differently and subjects them to different standards of care even though the services they provide investors are very similar and investors view their roles as essentially the same. This regime was established during the New Deal and, although amended many times since, remains rooted in the last century. An ultimate goal of financial regulatory reform has been to allow the SEC to align duties for financial intermediaries across financial products. A corollary of this goal is that standards of care for all brokers when providing investment advice about securities to retail investors should be raised to the fiduciary standard to align the legal framework with investment advisers.

The House bill would have imposed a uniform federal fiduciary duty on brokers and advisers, while the Senate bill directed the SEC to conduct a study on the matter. The House-Senate conference committee struck a compromise, vetted by Senator Tim Johnson, a senior member of the Banking Committee, under which the SEC will conduct a study under what Senator Johnson called strict parameters and the SEC is also authorized to impose a uniform federal fiduciary standard on brokers and investment advisers. (Sec. 913 of the Dodd-Frank Act)
The legislation requires the SEC to conduct a study to evaluate the effectiveness and efficacy of the existing standards of care for brokers and investment advisers and whether there are regulatory gaps in the protection of retail customers with regard to the standards. (Sec. 913(b) of the Dodd-Frank Act.

The SEC must consider if retail customers understand that there are different standards of care applied to brokers and advisers in the provision of personalized investment advice and whether retail customers are confused about the quality of the personalized investment advice they receive. The Act defines retail customers as natural persons who receive personalized investment advice about securities from a broker or investment adviser and uses them advice primarily for personal, family or household purposes. (Sec. 913(a) of the Dodd-Frank Act).

The SEC study must also examine the regulatory and enforcement resources available to enforce the standards of care for brokers and advisers when providing personalized investment advice about securities to retail customers, including the frequency and effectiveness of examinations. The substantive differences in the regulation of brokers and investment advisers when advising and recommending securities to retail customers must also be examined, and any specific instances when the oversight of brokers provided greater protection to retail investors than the oversight of advisers, and the converse. The existing state regulatory standards for protecting retail securities customers must also be studied.

The study must examine the potential impact on retail customers and their access to a range of services and products of imposing the investment adviser standard of care on brokers, as well as the impact of eliminating the broker and dealer exclusion from the definition of investment adviser in the Advisers Act, including on retail customers and state and federal resources. The varying level of services provided by brokers and investment advisers must be reviewed, as well as the varying scope and terms of retail customer relationships of brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers with such retail customers.

Finally, the SEC must examine the potential impact upon retail customers that could result from potential changes in the regulatory requirements or legal standards of care affecting brokers, and investment advisers relating to their obligations to retail customers regarding the provision of investment advice, including any potential impact on protection from fraud, access to personalized investment advice, and recommendations about securities to retail customers or the availability of such advice and recommendations.

Within six months of enactment, the SEC must submit a report on the study to Congress describing its findings and conclusions and recommendations. The report must set forth the considerations, analysis, and public and industry input that the Commission considered, as required by the statute, and include an analysis of regulatory gaps in the protection of retail investors relating to the standard of care of brokers and advisers.

The legislation goes on to authorize the SEC to impose a uniform federal fiduciary standard of care on brokers and investment advisers. (Sec. 913(g) of the Dodd-Frank Act. The receipt of compensation based on commission or other standard compensation for the sale of securities will not, in and of itself, be considered a violation of such standard applied to a broker or dealer. Moreover, there will be no continuing duty of care or loyalty owed by the broker to the retail customer after the providing of personalized investment advice about securities.

The Commission may require a broker selling only proprietary or a limited range of products to provide notice to each retail customer and obtain the consent or acknowledgment of the customer. But the sale of only proprietary or other limited range of products will not, in and of itself, be considered a violation of the standard of care.

The Commission must facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers and investment advisers, including any material conflicts of interest and, where appropriate, promulgate rules prohibiting or restricting sales practices, conflicts of interest, and compensation schemes for brokers and investment advisers that are contrary to the public interest and the protection of investors.

The Dodd-Frank Act is not writing on a blank slate. As the worlds of brokers and investment advisers increasingly converged, the SEC has been attempting to calibrate the regulation of these securities professionals in a flexible and innovative manner consistent with investor protection. More practically, the SEC and Congress are trying to accommodate a regulatory regime erected in the 1930s with the realities of 2010.

Currently, the fiduciary duty imposed by the Investment Advisers Act requires advisers to act solely with the client’s investment goals and interests in mind, free from any conflicts of interest that would tempt them to make recommendations that would also benefit them. Unlike investment advisers, brokers are not categorically bound by statute, regulation, or precedent to a per se rule imposing fiduciary obligations toward clients. Instead, the existence of fiduciary duties within a broker-client relationship has historically been significantly more contingent, turning ultimately on the factual nature of the relationship as interpreted by courts.

Because of the distinct regulatory structures placed on investment advisers and broker-dealers, the dividing line between them has always been an elusive one, albeit an important one. Congress excluded brokers from the Advisers Act so long as the advice they give clients is solely incidental to their business as a broker and they do not receive any special compensation for rendering such advice.

As investor confusion over the roles of brokers and advisers deepened, the SEC commissioned the Rand Center for Corporate Ethics, Law and Governance to prepare a report on investor and industry perspectives on investment advisers and broker-dealers. The report, entitled Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, was released in December 2007 (hereinafter the ``Rand Report’’). It is becoming seminal and certainly informs the debate.

The Rand Report’s essential conclusion is that the regulatory environment for brokers and investment advisers is eroding along with the distinctions between the two types of financial professionals on which it is based, which after all date back to the early 20th century. More broadly, the Report found that the current regulatory regime treats brokers and advisers differently when, in practice, their role is essentially the same, especially from the viewpoint of the investor. This regime was erected during the New Deal and, while amended many times over the years, is still organically rooted in the last century.

The Report found that the bright line between brokers and investment advisers that may have existed in the 1930s has become increasingly blurred. Indeed, whether a financial services professional is a broker or an investment adviser is indistinguishable to most investors. Many investors think that brokers and advisers offer the same products and services. Moreover, most investors do not know the differences between a broker and an investment adviser, and the certainly are not generally aware that the regulatory standards may be different.

One reason cited in the Report for the blurring of the line between brokers and investment advisers is that much of the marketing by brokers focuses on the ongoing relationship between the broker and the investor as brokers have adopted such titles as financial advisor and financial manager.

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