Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, March 16, 2010

Dodd Punts on Harmonizing Regulation of Investment Advice Providers

An important issue in any financial reform package adopted by Congress is the so-called "harmonization" of regulatory treatment of broker-dealers and investment advisers that provide personalized investment advice to retail customers.  While "harmonization" can be subject to many interpretations, there is broad consensus among the broker-dealer and investment adviser industries that the standard of care applicable to those providing investment advice to retail customers should not turn on whether they are registered as broker-dealers, investment advisers or both.  However, this broad consensus has not translated into agreement about how to accomplish the harmonization.  Investment advisers have campaigned on the slogan that the fiduciary duty applicable to investment advisers is a higher standard than the "watered-down" suitability standard applicable to broker-dealers.  While this is a highly debatable assertion in my mind, a sensible legislative solution would be for Congress to adopt a broad principle of comparable regulation and leave to the SEC the appropriate, context-specific standards.  

Unfortunately, this is not the approach taken in Senator Dodd's legislative proposal.  Instead, his proposal calls for the SEC to conduct yet another study and prepare an exhaustive report.  Then,

"If the study . . . identifies any gaps or overlap in the legal or regulatory standards in the protection of retail customers relating to the standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers for providing personalized investment advice about securities to such retail customers, the Commission, not later than 2 years after the date of enactment of this Act, shall . . . commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers, to address such regulatory gaps and overlap that can be addressed by rule, using its authority under the Securities Exchange Act of 1934 . . . and the Investment Advisers Act of 1940 . . . and . . . consider and take into account the findings, conclusions, and recommendations of the study required under this section."

Section 913(f), Restoring American Financial Stability Act of 2010.

Frankly, it's hard for me to see this as another more than a stalling for more time.  RAND did a comprehensive report on the broker-dealer and investment adviser industries a few years ago, at the SEC's request, which provides unrefuted evidence of investor confusion about the differences among advice providers.  Industry representatives and academics have fully explored the legal and regulatory issues. We don't need another study, and the SEC has better uses for its time.  Most importantly, retail investors deserve prompt action.

Just as a reminder of how this issue has  played out to date --  In December 2009 the House passed legislation that requires the SEC to promulgate rules to provide that the standard of conduct for all brokers, dealers and investment advisers, "when providing personalized investment advice about securities to retail customers…, shall be to act in the best interest of the customer without regard to the financial or other interest of the [advice provider]."   The proposed legislation goes on to state that the "standard of conduct shall be no less stringent than the standard applicable to investment advisers under section 206(1) and (2) of the [IAA] when providing personalized investment advice about securities…."   The provision, however, specifically excepts broker-dealers from having a "continuing duty of care or loyalty to the customer after providing personalized investment advice about securities."   "Retail investor" is defined as a natural person who receives personalized investment advice about securities from an advice provider and who uses such advice "primarily for personal, family, or household purposes."
 In contrast, the earlier, pre-Dodd Senate version, which was never voted out of committee, took a more straightforward approach and simply eliminated the broker-dealer exclusion from the definition of "investment adviser" in the IAA.   The SEC would have the authority to exempt any person or transaction from the principal trades prohibition if it finds that the adviser protects investors against conflicts of interest or principal transactions that are not in the best interests of the interests of the investor.  Under both the House and Senate versions, the SEC is supposed to promulgate rules enhancing disclosure of conflicts of interest.

This issue is an important one affecting the interests of retail investors, but, given the broad consensus on its advisability, it should not be difficult to accomplish.  It does not bode well for significant financial reform if Congress cannot address this issue promptly and directly.

(Thanks to Michael Keefe, UCin '10, for his research assistance.)

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The financial regulation reform package defers a lot of important measures to the rule making process.

The regulated prefer this, I think, because they believe that institutional capture gives them a better shot at a favorable result on the merits in that forum.

Congress prefers this because it takes many political hot potatos off their hands and frees them of a lot of the need to do the tedious and technical work of figuring out what legal regulation of the industry really makes sense. It also allows them to show results in a time frame close enough to the financial crisis to be responsive to it.

Those favoring regulation may prefer this because it increases that likelihood that some serious and effective regulation will ultimately be imposed, rather than none, because regulatory agencies respond to lobbying in a forum where campaign cash isn't a factor in nearly the same way, and because if serious and effective regulation is put in place it is much harder for the industry to fight than it would be if the proposed regulation were proposed legislation instead. Yet, it is harder to mobilize opposition to a bill that could create industry unfriendly regulations than one that definitely does contain industry unfriendly regulations.

Stalling for more time, per se, may not help much. Regulations rarely have bite in booms. But, busts reveal all sins. As long as the regulations are in place before the next bust, the impact may not be much different.

Posted by: ohwilleke | Mar 16, 2010 3:22:42 PM

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