Alert March 12, 2013

SEC Requests Information on Standards of Conduct for Broker-Dealers and Advisers When Advising Retail Customers

The SEC issued a request for data and other information (the “Request”) to inform its consideration of whether to exercise rulemaking authority granted by the Dodd-Frank Act to (a) adopt uniform standards of conduct for broker-dealers and investment advisers when they provide personalized investment advice about securities to retail customers, and (b) otherwise harmonize broker-dealer and investment adviser regulation.  The Request follows on a Dodd-Frank Act mandated study conducted by the SEC staff (the “Study”) recommending that broker‑dealers and investment advisers be subject to a uniform fiduciary standard of conduct in providing personalized investment advice about securities to retail investors, and that the SEC consider harmonizing certain regulatory requirements for broker-dealers and investment advisers where such action appears likely to enhance investor protection.  (The Study was described in the January 25, 2011 Financial Services Alert.)

The Request seeks information on many different aspects of the current retail market for personalized investment advice and how it might be affected by the various alternative regulatory changes the Request posits or that might be suggested by commenters.  The Request also sets forth in significant detail a broad range of different types of information, particularly quantitative data, sought by the SEC, and includes suggested submission guidelines.  This article focuses on the Request’s discussion of possible standards of fiduciary standards of conduct for providing personalized investment advice about securities to retail customers, and areas of possible regulatory harmonization for broker-dealers and investment advisers.

Rulemaking Authorized But Not Mandated; Retail Customer Context

Section 913 of the Dodd-Frank Act gives the SEC discretionary rulemaking authority under the Securities Exchange Act of 1934 (the “Exchange Act”) and the Investment Advisers Act of 1940 (the “Advisers Act”) to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.  Section 913 specifies that such standard of conduct “shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice” and that the standard “shall be no less stringent than the standard applicable to investment advisers under Sections 206(1) and 206(2) of the Advisers Act when providing personalized investment advice about securities.”  Section 913 defines retail customer to mean a natural person, or the legal representative of such natural person, who (1) receives personalized investment advice about securities from a broker-dealer, or investment adviser; and (2) uses such advice primarily for personal, family, or household purposes.  The Request emphasizes that the SEC is under no obligation to take action in this area, even after consideration of the information it receives in response to the Request. 

Uniform Standard of Fiduciary Conduct – Duty of Loyalty and Duty of Care

The Request presents a uniform standard of conduct for providing personalized investment advice about securities to retail customers as the basis for public comment, but disclaims it as a policy view or an indication of the ultimate direction of any regulatory action, should any be taken.  This uniform standard consists of two components, a duty of loyalty and a duty of care.  

Assumptions.  A number of assumptions would apply to the uniform standard, including the following:  (a) “personalized investment advice about securities” would include (i) a “recommendation,” as interpreted under existing broker-dealer regulations, and (ii) any other actions or communications that would be considered investment advice about securities under the Advisers Act, but would not include (A) “impersonal investment advice” as defined in the Advisers Act or (B) general investor educational tools that are not otherwise “recommendations”; (b) the uniform standard would accommodate different business models and fee structures, and would permit broker-dealers to continue to receive commissions (and would not have to charge an asset-based fee) and engage in principal trades; (c) the offering or recommending of only proprietary or a limited range of products would not, in and of itself, be considered a violation of the uniform standard; (d) the uniform standard would not generally require a broker-dealer or investment adviser to either (i) have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice about securities, or (ii) provide services to a retail customer beyond those agreed; and (e) existing law and guidance governing broker-dealers, including SRO rules and guidance, would continue to apply to broker-dealers.

Duty of Loyalty.  The duty of loyalty element of the uniform standard would require an investment adviser or broker-dealer to eliminate any material conflicts of interest arising in connection with providing personalized investment advice about securities to retail customers, or provide full and fair disclosure to retail customers about those conflicts.  This duty would involve disclosure to retail customers in the form of a “general relationship guide” similar to Form ADV Part 2A, supplemented as necessary from time to time either orally or in writing.  The proposed standard would not subject broker-dealers to the transaction-by-transaction disclosure and consent requirements of Section 206(3) of the Advisers Act for principal trades (although these requirements would continue to apply to investment advisers), but would at a minimum, as with other conflicts of interest, require a broker-dealer to disclose material conflicts of interest arising in principal trades with retail customers.  The uniform standard would prohibit certain sales contests and the receipt or payment of non-cash compensation (e.g., trips and prizes) in connection with the provision of personalized investment advice about the purchase of securities.  The uniform standard would incorporate, and apply to broker-dealers, prior guidance and precedent under the Advisers Act regarding (A) the allocation of investment opportunities among clients and among a firm’s client and proprietary accounts and (B) the aggregation (“bunching”) of client orders.

Duty of Care.  The duty of care element of the uniform standard would impose the following obligations on an investment adviser or broker-dealer when providing personalized investment advice about securities to retail customers:

Suitability - The uniform standard would require an investment adviser or broker-dealer “to have a reasonable basis to believe that its securities and investment strategy recommendations are suitable for at least some customer(s) as well as for the specific retail customer to whom it makes the recommendation in light of the retail customer’s financial needs, objectives and circumstances”;

Product-specific requirements - The uniform standard would impose “[s]pecific disclosure, due diligence, or suitability requirements for certain securities products recommended (such as penny stocks, options, debt securities and bond funds, municipal securities, mutual fund share classes, interests in hedge funds and structured products)”;

Best execution - A broker-dealer, or an investment adviser responsible for selecting broker-dealers to execute client trades, would have a duty to “seek to execute customer trades on the most favorable terms reasonably available under the circumstances”; and

Fair and reasonable compensation - Compensation for services would have to be “fair and reasonable, taking into consideration all relevant circumstances.”

The Request briefly describes alternatives to the uniform standard, including:

  • imposing a uniform disclosure requirement for broker-dealers and investment advisers addressing key facets of products or services they offer, and related conflicts of interest;
  • imposing the uniform fiduciary standard of conduct described above, but without subjecting broker-dealers to existing Advisers Act guidance and precedent regarding fiduciary duty;
  • applying the uniform fiduciary standard described above only to broker-dealers, possibly establishing a broker-dealer specific “best interest” standard of conduct no less stringent than the current standard under Advisers Act Sections 206(1) and 206(2); and
  • specifying certain minimum professional obligations under an investment adviser’s duty of care not currently specified by rule.

The Request notes that commenters may formulate additional alternative approaches to the uniform standard and the other approaches it describes.

Regulatory Harmonization

The Request outlines potential areas for harmonization of the regulatory schemes for broker-dealers and investment advisers.  As with its discussion of a possible uniform standard of fiduciary conduct, the Request notes that the identification of potential areas for harmonization is not meant to suggest a policy view on the SEC’s part, the direction of any proposed action, or that any action will ultimately be taken.  The general areas cited (with selected examples) are as follows:

Advertising and Other Firm Communications – harmonizing requirements related to the content of advertising and customer communications rules and establishing consistent internal pre-  and post-use review and filing requirements for similar materials.

Finders and Solicitors - establishing similar disclosure requirements regarding any conflict associated with a solicitor’s or finder’s receipt of compensation for referring a retail customer.

Supervision - establishing a “single set of universally applicable requirements versus scaling requirements based on the size (e.g., number of employees or a different metric) and nature of a broker-dealer or an investment adviser.”

Licensing and Registration of Firms - harmonizing the disclosure requirements in Form ADV and Form BD to the extent they address similar issues and conducting a substantive review of investment advisers prior to registration.

Continuing Education Requirements for Adviser and Broker-Dealer Personnel - subjecting investment adviser personnel to federal qualification examinations and continuing education requirements.

Books and Records – expanding the recordkeeping requirements for investment advisers to match the broker-dealer obligation to retain all communications received and sent, as well as all written agreements (or copies thereof), relating to a firm’s “business as such.”

Submission Deadline

The deadline for submission of data and other information and for public comment in response to the Request is July 5, 2013.