The SEC recommends broker-dealer fiduciary duties

Cite this Article
Larry Ribstein, The SEC recommends broker-dealer fiduciary duties, Truth on the Market (January 24, 2011),

The SEC staff,  acting under Dodd-Frank §913(g), has decided to recommend a “uniform fiduciary standard” for broker-dealers and investment advisors who provide investment advice to retail customers. The recommended rules would provide that

the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), 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.

The staff recommendations “were guided by an effort to * * * recommend a harmonized regulatory regime for investment advisers and broker-dealers when providing the same or substantially similar services, to better protect retail investors. ”

The “uniform standard” will, among other things, “obligate both investment advisers and broker-dealers to eliminate or disclose conflicts of interest;” “consider specifying uniform standards for the duty of care owed to retail investors, through rulemaking and/or interpretive guidance;” and “engage in rulemaking and/or issue interpretive guidance to explain what it means to provide “personalized investment advice about securities.”

The staff will also consider how to harmonize regulation of investment advisers and broker-dealers regarding such issues as advertising, use of finders and solicitors, supervision, licensing and registration of firms.  

The staff study is misguided in two ways:  First, it’s not evidence-based. Second, it fundamentally misplaces the role of fiduciary duties.

Commissioners Casey and Paredes issued a statement emphasizing the first problem.  They begin by noting that “the views expressed in the Study are those of the Staff of the Commission and not necessarily those of the Commission as a whole or of individual Commissioners.” They then note that

the Study’s pervasive shortcoming is that it fails to adequately justify its recommendation that the Commission embark on fundamentally changing the regulatory regime for broker-dealers and investment advisers providing personalized investment advice to retail investors. * * * The Study also does not adequately recognize the risk that its recommendations could adversely impact investors.

This risk exists because ” the Study does not identify whether retail investors are systematically being harmed or disadvantaged under one regulatory regime as compared to the other.” Thus, the study fails to fulfill Dodd-Frank’s mandate to evaluate the “effectiveness of existing legal or regulatory standards of care” applicable to broker-dealers and investment advisers.

In particular, Commissioners Casey and Paredes say the Study “may not only fail to resolve investor confusion but ” may in fact create new sources of confusion” and

unduly discounts the risk that, as a result of the regulatory burdens imposed by the recommendations on financial professionals, investors may have fewer broker-dealers and investment advisers to choose from, may have access to fewer products and services, and may have to pay more for the services and advice they do receive. Any such results are not in the best interests of investors; nor do they serve to protect them.

The Commissioners specifically suggest further work analyzing risk- and investor- adjusted returns under the two regulatory regimes; “differences in the quality of advice or types of product recommendations as a function of the regulatory regimes;” “investor perceptions of the cost/benefit tradeoffs of each regulatory regime;” and investors’ ability to bring claims against professionals under each regulatory regime.

The Commission should take these recommendations seriously if it wants to avoid further troubles with the DC Circuit.

My own criticism of the SEC’s recommendations focuses on the second point noted above — the confusion inherent in imposing fiduciary duties on securities professionals. In my recent paper, Fencing Fiduciary Duties, I note (footnotes omitted) that the relevant Dodd-Frank provision

does not appear to impose a fiduciary duty.  The provision refers to the “best interest” standard under Section 206 of the Investment Advisers Act of 1940, and its main function appears to be to align the duties of brokers-dealers with those of investment advisers. Although the Section 206 duty has been held to be a fiduciary duty, this characterization is questionable.  It traces back to SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963). which held that an advisor’s “scalping,” or purchasing shares before recommending them and then selling on the rise in market price, “operates as a fraud or deceit upon any client.”  While the Court referred to investment advisers as fiduciaries, its holding was based on an interpretation of the common law of fraud, and amounts only to a duty to disclose the material fact of an advisor’s self-interest rather than a fiduciary duty of unselfishness.  This is consistent with this paper’s analysis of the non-fiduciary nature of the duty of professionals and advisors.

Fiduciary duties are even less appropriate for brokers and dealers than they are for professionals and advisors.  Customers generally do not delegate fiduciary-type open-ended power that would justify fiduciary-type selflessness consistent with this article’s analysis. Rather, brokers, dealers and advisors take no action regarding the customer’s property without instructions.  Nor should customers expect unselfish conduct from people who are selling securities for a commission or profit. Thus, application of fiduciary duties to brokers, dealers and advisors would not be consistent with customers’ expectations and create a potential for confusion similar to that in the mutual fund situation discussed above. As Arthur Laby has recognized,

[w]hen acting as a dealer, the firm seeks to buy low and sell high–precisely what the customer seeks. It is hard to see how any dealer can act in the “best interest” of his customer when trading with her. [citing Arthur B. Laby, Reforming The Regulation Of Broker-Dealers And Investment Advisers, 65 BUS. LAW. 395, 425 (2010)].* * *

The legislative history of the Securities Exchange Act of 1934 indicates that existing law does not impose a fiduciary duty on brokers and dealers. Laby shows that plans to prohibit a broker from acting as a dealer or underwriter ultimately were squelched in favor of recognizing the “shingle theory,” which imposes a [non-fiduciary] duty to buy and sell at reasonable prices. * * *

A broker-dealer fiduciary duty also would be inconsistent with Dodd-Frank’s legislative history.  Treasury initially recommended a broker-dealer and investment adviser duty to “act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” This is clearly a fiduciary standard of unselfishness, consistent with this article’s characterization. The change from the initial proposal to the final version represents a clear rejection of the fiduciary approach.

The SEC should go no further than spelling out the disclosure duties that are appropriate to advisors, dealers and brokers.  It should not confuse the duties of securities professionals by applying the fiduciary label to non-fiduciary relationships.  This would help investors buy only the level of service and commitment to their interest that is appropriate to the relationship they are contracting for.  Investors would not have to pay a higher price for securities professionals’ unselfishness when they are also planning to exercise their own judgment and control.  They would still get enough disclosure to prudently use the services they are buying, while having the flexibility to contract for a higher level of protection when they want it.

In other words, the SEC need not, and should not, impose “fiduciary duties” on broker-dealers, and such duties are not required by Dodd-Frank.

See also my Senate testimony on fiduciary duties of investment bankers; my article, Federal Misgovernance of Mutual Funds discussing the debacle culiminating in the Supreme Court’s Jones v. Harris when Congress tried to impose a fiduciary duty concerning compensation of mutual fund advisors, and my post from last August on brokers as fiduciaries.