When managing investments and strategies for personal financial goals, retail investors often seek guidance from their investment advisers, and on an increasing basis, from their broker-dealers. Broker-dealers and investment advisers are regulated extensively, but the regulatory requirements differ. Broker-dealers and investment advisers are also subject to different standards under federal law when providing investment advice about securities.
The Investment Advisers Act of 1940 regulates specified financial professions, including financial planners, money managers, and investment consultants. Under the Advisers Act, an investment adviser is any person who, for compensation, is engaged in a business of providing advice to others or issuing reports or analyses regarding securities. With regard to the required standard of care applied to investment advisers when providing advice to their clients, applicable case law requires a fiduciary standard which, essentially, requires that the advisor put the client’s interests first, ahead of his or her own interest.
The Securities Exchange Act of 1934 and its implementing rules comprise the most central regulatory apparatus for broker-dealers. The Exchange Act defines a broker as a “person engaged in the business of effecting transactions in securities for the account of others,” while a dealer is a “person engaged in the business of buying and selling securities for his own account.” In comparison to the fiduciary obligation of an investment advisor, broker-dealers currently have a less stringent “suitability standard” that requires that investment products they sell fit an investor’s financial needs and risk profile.
Under the Investment Advisers Act, registered broker-dealers are excluded from its terms so long as (1) any advice that the broker-dealer gives to clients is “solely incidental” to its business as a broker-dealer, and (2) the broker-dealer does not receive any “special compensation” for rendering the advice.
The suitability standard poses some risk for conflicts between a broker-dealer and its client. For example, under a fiduciary standard, an investment advisor may be strictly prohibited from buying a mutual fund or other investment because it would garner a higher fee or commission. Under the suitability requirement, however, this would not necessarily be the case, because as long as the investment is “suitable” for the client, it can be purchased for the client. Such a rule can also incentivize broker-dealers to sell their own products ahead of other, lower cost (and competing) products.
Generally, retail investors are not aware of these differences or their legal implications. Many investors are also confused by the different standards of care that apply to investment advisers and broker-dealers. That investor confusion, as well as the 2008 financial meltdown, has been a source of concern for regulators and Congress.
Accordingly, Section 913 of Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the SEC to study the need for establishing a new, uniform, federal fiduciary standard of care for brokers and investment advisers providing personalized investment advice. The Dodd-Frank Act further authorized the SEC to establish a fiduciary duty for brokers “no less stringent than the standard applicable to investment advisers” when providing personalized investment advice about securities to retail customers.
The SEC Staff published a Section 913 Study in January 2011. The Staff recommended “the consideration of rulemakings” that would establish a uniform fiduciary standard for both broker-dealers and investment advisers. Notably, the Study explicitly rejected two other approaches that Section 913 required the SEC to consider: (1) eliminating the broker-dealer exclusion from the definition of “investment adviser” under the Advisers Act, and (2) applying the duty of care and other requirements of the Advisers Act to broker-dealers.
In an unprecedented attempt to obtain public comment prior to the release of a specific rule, the SEC in March 2013 requested data and other information from the public and interested parties about the benefits and costs of the current standards of conduct for broker-dealers and investment advisers when providing advice to retail customers, as well as alternative approaches to the standards of conduct.
In light of the potential effect a new standard can have on the industry and investors alike, the SEC has taken a very careful approach with its rulemaking in this area and should continue to do so. Because while it may be apparent that a stronger duty may be needed for broker-dealers, the risks associated with imposing a larger regulatory burden (including, for example, increased costs to investors) should also be considered. In addition, in order for retail investors to get the sound financial advice and guidance they need, advisers and broker-dealers need clear guidance that allows them to serve their clients with confidence that they are complying with their regulatory requirements. In this regard, the ideal outcome would be a standard that provides clear guidance for client care to both independent broker-dealers and investment advisers based on the realities of both groups’ business models and client relationships.
The SEC’s fact gathering represents the SEC’s acknowledgement that broker-dealers, advisers, advocacy organizations and regulators must work together to ensure that any resulting rules achieve the right balance between increased investor protection and costs for investors. While the SEC’s fact gathering exercise has its critics, the SEC’s commitment to conduct an extensive cost-benefit analysis is a positive sign that the new standard will strengthen protections for investors while also allowing advisers to continue to serve their clients with confidence and clarity.