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

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Tuesday, March 5, 2013

Will the SEC Ever Propose a "Uniform Standard of Conduct" for Investment Advice Providers to Retail Investors?

Last week the SEC released its long-awaited Request for Data and Other Information (rel. 34-69013), in connection with its ongoing study on whether to propose rules for establishing standards of conduct for broker-dealers and investment advisers that provide personalized investment advice to retail investors.  (This project is sometimes described as proposing a “uniform fiduciary” standard of conduct, but as discussed below, this is a misnomer.)  Dodd-Frank Section 913 gives the SEC the authority to harmonize the regulation of investment advice providers and establish a standard of conduct for those who provide advice to retail customers.  The debate is a contentious one that predates Dodd-Frank, as broker-dealers and investment advisers compete fiercely for retail investors’ business and assert that their regulatory model best protects their customers.  The SEC staff study required by Dodd-Frank was released in January 2011, with two Commissioners opposing its release because of insufficient empirical evidence supporting the need for change.  In July 2011 the D.C. Circuit tossed the SEC’s proxy access rule for insufficient empirical analysis.  Since then the SEC committed itself to gathering more data before even putting a proposed rule out for public comment. Indeed, the SEC makes clear throughout the release that it has not yet determined whether to exercise its authority under Dodd-Frank section 913 to adopt standards of conduct for broker-dealers and investment advisers that provide personalized investment advice to retail customers. 

The SEC, in particular, seeks quantitative data and economic analysis to bolster the cost-benefit analysis that will surely be subject to exacting judicial review in a subsequent rule challenge.  This emphasis on cost-benefit analysis, however, should not deter retail investors and their advocates from submitting comments.  The SEC welcomes their contributions and acknowledges that retail investors are not likely to have significant empirical and quantitative information.

In addition to setting forth long lists of the types of information that the SEC is looking for, the SEC sets forth a “possible uniform fiduciary standard” that commenters are to assume, only for purposes of quantifying costs and benefits, that the SEC plans to adopt.  This hypothetical standard should come as no surprise to those who have followed this debate. 

The release states that any proposed standard of conduct “would be designed to accommodate different business models and fee structures.”  Indeed, the Dodd-Frank Act restricts the SEC’s flexibility to develop a true uniform fiduciary standard in several respects. Thus, commenters should assume that:
• Broker-dealers may continue to receive commissions (indeed, Dodd-Frank expressly so provides).
• Broker-dealers and investment advisers would not generally owe continuing duties to retail customers after providing advice; rather, “the question of whether a broker-dealer or investment adviser might have a continuing duty, as well as the nature and scope of such duty, would depend on the contractual or other arrangement or understanding between the retail customer and the broker-dealer or investment adviser.”  (Dodd-Frank expressly states that broker-dealers do not have a continuing duty of care or loyalty to the customer after providing personalized investment advice.) 
• Broker-dealers may continue to offer and recommend only proprietary or a limited range of products (again, Dodd-Frank specifically so provides).

In addition, the SEC states that commenters should assume that broker-dealers would continue to be permitted to engage in principal trades and that the antifraud provision of the Investment Advisers Act (section 206(4)) would not apply to broker-dealers (although Dodd-Frank gives the SEC the authority to extend both these regulations to broker-dealers).

The SEC’s assumed “uniform fiduciary standard” would be comprised of two elements: a duty of loyalty and a duty of care.  With respect to the duty of loyalty, commenters should make the following assumptions:
• Required disclosure of all material conflicts of interest;
• Disclosure of the firm’s fees and services (including limitations on scope) and conflicts of interest in the form of a general relationship guide similar to Form ADV Part 2A, to be delivered at the time the customer relationship is entered into;
• Oral or written disclosure of any additional conflicts at the time the advice is provided;
• Prohibition on the use of sales contests (trips and prizes).

The SEC makes clear that conflicts of interest arising from principal trades would be treated the same as other conflicts of interest and would not incorporate the transaction-by-transaction disclosure and consent requirements of section 206(3) of the Investment Advisers Act.

With respect to the duty of care, the assumed standard of conduct would specify certain well-recognized minimum professional obligations for both broker-dealers and investment advisers:
• Suitability obligations, i.e., the investment advice provider must have a reasonable basis to believe that its recommendation about a security or an investment strategy is suitable for at least some customers and that it is suitable for the specific retail customer in light of that customer’s financial needs, objectives and circumstances (the FINRA suitability obligation);
• Product-specific requirements, i.e., specific disclosure, due diligence or suitability requirements for certain products, such as penny stock, options, mutual fund share classes;
• Duty of best execution;
• Fair and reasonable compensation.

The SEC also identifies in the release certain fiduciary principles currently applicable to investment advisers that commenters should assume would be extended to broker-dealers:
• Allocation of investment opportunities.  Firms would be required to disclose how it allocates investment opportunities among their customers and between customers and their own proprietary account (e.g., methods of allocating shares in IPOs)
• Aggregation of orders.  A firm may aggregate orders on behalf of two or more customers so long as the firm does not favor one customer over another.  It must make appropriate disclosures about its bundling practices.

The release goes on to identify several alternative approaches to the assumed “uniform fiduciary standard” and requests information about the relative costs and benefits of these alternatives  One alternative is an essentially “disclosure-only” approach  Another approach, proposed by SIFMA, would adopt a  standard of conduct that did not extend to broker-dealers the existing precedent on fiduciary duty under the Advisers Act.  The release also suggests other alternatives, including following models set by regulators in other countries. 

Finally, the SEC also requests information on potential areas for further regulatory harmonization of the obligations of broker-dealers and investment advisers. These include advertising and other communications to the public, supervision, licensing and registration of firms, licensing and continuing education requirements for associated persons, books and records, and the use of finders and solicitors.

To state the obvious: This request for data and information requests a lot of information, and there are many interested parties who are eager to win over the SEC to their point of view.  Hence, we can expect voluminous reports with quantitative and qualitative data and other economic analysis about the costs and benefits of the various formulations of standards of conduct.  It is unlikely that the SEC will be proposing a rule any time soon – if ever.  I personally am increasingly doubtful that the game is worth the candle.

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