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SEC Study Mandated by Dodd-Frank Recommends Uniform Federal Fiduciary Standard for Brokers and Advisers; Divided Commission Sends Study to Congress

By Jim Hamilton

Based on its review of the broker-dealer and investment adviser industries pursuant to a study mandated by Dodd-Frank Section 913, the SEC staff recommended the adoption of a uniform federal fiduciary standard for brokers and advisers that would be no less stringent than the standard currently applied to investment advisers under Advisers Act Sections 206(1) and (2). The new standard would apply expressly and uniformly to both brokers and investment advisers when providing personalized investment advice about securities to retail customers. In the staff?s view, the uniform standard should be designed to increase investor protection and decrease investor confusion in the most practicable, least burdensome way for investors, brokers and investment advisers. More specifically, the study said that the standard should provide that the broker or adviser must act in the best interest of the customer without regard to the financial or other interest of the broker or investment adviser providing the advice.

In a separate statement, Commissioners Kathleen Casey and Troy Paredes opposing sending the staff study to Congress as drafted because it does not fulfill the mandate of Section 913 to evaluate the effectiveness of existing legal or regulatory standards of care applicable to brokers and investment advisers. In their view, 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.

In the study, the staff noted that Section 913 explicitly provides that the receipt of commission-based compensation, or other standard compensation, for the sale of securities does not, in and of itself, violate the uniform fiduciary standard of conduct applied to a broker-dealer. Section 913 also provides that the uniform fiduciary standard does not necessarily require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice. Indeed, during the House-Senate conference on Dodd-Frank that hammered out the compromise Section 913, House Financial Services Chair Barney Frank said that Congress did not envision a uniform fiduciary standard containing a continuing duty to retail investors.

In a comment letter to the SEC, SIFMA urged the SEC to define the scope of the term ``personalized investment advice?? as used in Dodd-Frank but left undefined by the legislation. If the term is interpreted too broadly, cautioned SIFMA, retail customers could be cut off from investment opportunities even if they are making the investment decision without a specific recommendation. In order to simultaneously protect retail customers and provide them access and choice, SIFMA recommended that the term ?personalized investment advice? be defined to mean and apply only to investment recommendations provided to address the objectives of a specific retail customer after taking into account the customer?s specific circumstances.

The SEC staff urged the Commission to define ``personalized investment advice?? to encompass the making of a recommendation, as developed under applicable broker-dealer regulation, and to not include impersonal investment advice as developed under the Advisers Act. Beyond that, the staff believes that the term also could include any other actions or communications that would be considered investment advice about securities under the Advisers Act (such as comparisons of securities or asset allocation strategies), except for impersonal investment advice as developed under the Advisers Act.

Either in the rulemaking or separate guidance, the SEC staff study urged the Commission to identify specific examples of potentially relevant and common material conflicts of interest in order to facilitate a smooth transition to the new standard by brokers and consistent interpretations by brokers and investment advisers. In the staff?s view, the existing guidance and precedent under the Advisers Act regarding fiduciary duty, as developed primarily through SEC interpretations under the antifraud provisions of the Advisers Act, and through case law and numerous enforcement actions will continue to apply.

A uniform standard of conduct will obligate both investment advisers and brokers to eliminate or disclose conflicts of interest. Thus, the study urges the Commission to prohibit certain conflicts and facilitate the provision of uniform and simple disclosures to retail investors about the terms of their relationships with brokers and investment advisers, including any material conflicts of interest. The Commission should consider which disclosures might be provided most effectively in a general relationship guide akin to the new Form ADV Part 2A that advisers deliver at the time of entry into the retail customer relationship, and in more specific disclosures at the time of providing investment advice.

The staff said that the Commission also should consider the utility and feasibility of a summary relationship disclosure document containing key information on a firm?s services, fees, and conflicts and the scope of its services. It may be appropriate to adopt rules prohibiting certain conflicts, to require firms to mitigate conflicts through specific action, or to impose specific disclosure and consent requirements.

Further, in the interest of harmonization, the Commission should consider whether to modify the Advisers Act books and records requirements, including by adding a general requirement to retain all communications and agreements, including electronic information and communications and agreements, related to an adviser?s ?business as such,? consistent with the standard applicable to brokers.

While Section 913(g) of Dodd-Frank does not require the standard of care to include the principal trading restrictions of Section 206(3) of the Advisers Act, the SEC staff urged the Commission to address through interpretive guidance and/or rulemaking how broker-dealers should fulfill the uniform fiduciary standard when engaging in principal trading. In its comment letter to the SEC, SIFMA said that Congress did not include these restrictions because it would have inappropriately deprived retail customers of the benefits of access to broker inventories of a range of securities. Thus, SIFMA urged the SEC not to apply the trade-by-trade disclosure and consent requirements of Section 206(3) to principal transactions that are subject to the uniform standard of care where the broker or investment adviser does not have discretionary authority regarding the customer account.

Full post as published by Jim Hamilton's World of Securities Regulation on January 24, 2011 (boomark / email).