Journal of Financial Planning: December 2014
Arthur B. Laby, J.D., is professor of law at Rutgers University and the former assistant general counsel at the Securities and Exchange Commission. He serves as a director of the Certified Financial Planner Board of Standards. The views in this article are his own and do not necessarily reflect those of CFP Board or its staff.
The question of whether to impose a fiduciary duty on brokers who give advice to retail customers has bedeviled Congress and the Securities and Exchange Commission for years. As the book closes on 2014, one might complain that another year has passed with no resolution on a uniform fiduciary standard. Four years after the passage of Dodd-Frank, the SEC appears no closer to a verdict now than in the immediate aftermath of the law’s passage. As readers of the Journal will recall, Dodd-Frank section 913 gave the SEC authority to impose a fiduciary duty on brokers, but the law did not require the SEC to do so; the only requirement was for the SEC to study the issue. The SEC staff completed its study in January 2011, recommending that the Commission adopt a uniform fiduciary standard, but the Commission has not yet acted.
Grumbling about a lack of progress, however, detracts one from appreciating how the debate over a uniform fiduciary duty has advanced over the past 15 years. Although occasionally a crisis can precipitate change overnight, the most nettlesome issues crossing politics, finance, and law are seldom resolved by a single stroke of a pen. Instead, courts, regulators, and industry groups inch slowly, sometimes painfully so, toward resolution of the issues that vex us most. And often, only when change is already upon us does one witness a formal declaration of what is essentially a fait accompli. Fixed commissions on Wall Street, for example, disappeared long before the SEC’s “May Day” mandate that officially ushered in negotiated rates. The line separating commercial and investment banking blurred long before the passage of Gramm-Leach-Bliley, which officially eliminated the separation. And so it is with a uniform fiduciary standard. The SEC may well impose a fiduciary duty on brokers who give advice. By that time, however, industry practice may be out in front of the regulators, and reform will be little more than a rubber stamp of the status quo.
The Roots of the Controversy
To put the issue’s progress into perspective, history is a helpful guide. It was 1999 when the SEC first proposed a rule, sometimes called the Merrill Lynch rule, which addressed the thorny problem that brokers and advisers often perform similar functions but are regulated under different laws and standards—the suitability standard for brokers, and the fiduciary standard for advisers. Much has changed since 1999. In that year, Wall Street was preparing for the Y2K problem, President Bill Clinton was cited for contempt of court for making false statements in a sexual harassment lawsuit, and we were still in a pre-9/11 world. Although 15 years might seem like a long time to deliberate over this issue, the proper treatment of broker-dealers and investment advisers can be traced much farther back in time, to before the birth of the SEC itself. The debate regarding fiduciary accountability pre-dates the existence of registered investment advisers. It began as a controversy over the roles of brokers versus dealers.
One reason the uniform fiduciary issue is challenging is because the merged title of broker-dealer obscures the difference in the roles and responsibilities of brokers and dealers. The role of a securities dealer is a decidedly non-fiduciary role. Unlike a broker, who transacts securities for a customer, a dealer transacts as a principal with a customer. Placing a “sole interest” fiduciary standard on a dealer would arguably rule out a transaction between a dealer and a customer because the transaction benefits the dealer as well as the customer. Even if the standard were a “best interest” standard as opposed to a “sole interest” standard, the problem remains because the interests of the dealer and the customer are adverse. It is hard to see how a dealer can advise a customer in the customer’s “best interest” when the same dealer is on the other side of the transaction about which the dealer is advising. Since both sides want to buy low and sell high, the conflict is unmistakable.
This fundamental contradiction in the dealer’s role was hotly debated in the years leading up to and immediately following the passage of the first federal securities laws in 1933 and 1934. In fact, an early draft of the Securities Exchange Act would have prohibited a broker from acting as a dealer or underwriter. The prohibition was championed by John T. Flynn, a member of the Senate Banking Committee staff. Flynn lamented the inherent conflict of interest when a person acts as another’s agent and then enters the market and trades for his own account.
Just as in Dodd-Frank some 75 years later, Congress, unsure of what to do, directed the SEC to study the issue. And just as in 2010, the legislative battle on Capitol Hill moved to the SEC. An early draft of the 1936 report recommended partial segregation of the broker and dealer roles, prohibiting broker-dealers from underwriting securities. The Commission, however, rejected this proposal and opted for nothing more than additional study. Subsequently, Flynn chided the SEC for its “watery timidity” and upbraided firms acting in a dual role as “one of the most sordid and outrageous chapters in the history of American finance.”
In the end, Flynn did not prevail and the controversial provision was struck from the final bill. When Franklin D. Roosevelt signed the Securities Exchange Act into law in 1934, firms were permitted to act as both broker and dealer. Six years later, when the Investment Advisers Act was passed, broker-dealer firms were exempted as long as their advice was solely incidental to brokerage and they did not receive special compensation for providing advice.
Over the years, the Commission has tried to strike a balance with regard to the dealer’s conflicting roles through application of the “shingle theory.” Under the “shingle theory,” a broker-dealer implicitly represents, by “hanging out a shingle,” that it will conduct its business in a fair, equitable, and professional manner. Under this approach, the SEC did not prohibit dealers from profiting from their customers, but dealers could not purchase or sell securities substantially below or above market prices—the price had to be fair and reasonable. Obtaining a reasonable price for a customer, however, is not the same as acting in a customer’s best interest.
In the 1970s and 1980s, as technology made trade execution a commodity, brokers’ advisory role became more prominent. At the same time, brokers increasingly marketed themselves as “financial advisers” or “wealth advisers” and regulators did not object to the characterization. Moreover, many brokers sought to charge asset-based fees as opposed to commissions. An asset-based fee, however, might be deemed special compensation for advice, which would vitiate the broker exclusion from the Advisers Act. As a result, brokers sought an exemptive rule from the SEC, which would permit them to charge special compensation for advice and continue to be excluded from the Advisers Act. In 2005, the SEC passed a rule doing just that but, after being sued by the Financial Planning Association, the courts struck it down as beyond the SEC’s authority. While the SEC was considering what to do next, the financial crisis of 2008 overtook events.
The Regulatory Pivot
When Washington regulators turned to this issue after the crest of the financial crisis, the terms of the debate shifted and the proposed solution was a marked transformation from earlier proposals. In 2009, the U.S. Treasury Department issued a white paper on financial reform. According to the white paper, brokers and advisers were often identical from an investor’s point of view. In many cases, both hold themselves out as advisers, both provide investment advice, and both charge an asset-based fee. Instead of recommending that brokers be permitted to charge an asset-based fee and still be treated as brokers under the law, however, Treasury recommended legislation to require that broker-dealers providing advice “have the same fiduciary obligations” as advisers.
Treasury’s recommendation was an elemental change in policy. Whereas the SEC’s approach was exemptive and permissive for brokers providing advice, Treasury’s approach was regulatory and restrictive, potentially placing new requirements on the firms. The SEC focused on compensation and on whether brokers might inadvertently become subject to the Advisers Act, and voted to exempt many brokers from being regulated as advisers. Treasury, from a broader vantage point, and mindful of developments in the market for financial services, aimed to restrict brokers’ activities, or to impose additional duties on them. The SEC, through its ill-fated rule, limited the number of brokers who would be subject to the Advisers Act and to a fiduciary duty; by contrast, Treasury sought to expand the number of brokers subject to a fiduciary obligation.
This turn of events seemed to signal a welcome improvement to those who favor a uniform fiduciary standard. To see why this pivot has been so important, look at relevant developments post Dodd-Frank. FINRA, the self-regulatory organization for broker-dealers, has edged closer to imposing a fiduciary duty on brokers. In an FAQ on suitability, FINRA explained what it means for a broker to act in a customer’s “best interest” (the fiduciary standard), but stopped short of imposing a best interest standard. In a Report on Conflicts of Interest, FINRA stated that “effective practices” by firms include adoption of a “best interests of the customer standard” to address conflicts.
Similarly, SIFMA, the broker-dealer trade association, has advocated a uniform fiduciary standard to apply to brokers and advisers. SIFMA advocates a “business model neutral” fiduciary standard. Consequently, there would be details to work out to reconcile SIFMA’s approach with the Dodd-Frank requirement that a fiduciary standard be “no less stringent” than that required by the Advisers Act. Although the SEC has not indicated whether it will propose a fiduciary rule, in its January 2011 study, the SEC staff recommended that the Commission move forward. Finally, the Department of Labor appears close to re-proposing its rule, which would more broadly define investment advisers to IRA accounts and employee retirement plans as fiduciaries. Thus, with the SEC staff, FINRA, and SIFMA advocating a fiduciary duty for brokers, and with the DOL likely moving forward soon, a fiduciary duty for brokers may be a fait accompli by the time the SEC gets around to adopting it.
Next Steps
Movement toward a uniform fiduciary standard has been indisputable but the biggest challenges lie ahead. The primary goal is no longer seeking agreement that a fiduciary standard is desirable; that has largely occurred, although dissenters still exist. The more pressing challenge is to establish the parameters of the obligation.
Dodd-Frank gave the SEC authority to require a standard of conduct for a broker that is “the same as the standard of conduct applicable to an investment adviser.” The SEC, however, could propose a fiduciary standard for brokers consistent with an Advisers Act “best interest” approach but then weaken it through a series of exceptions and exemptions. The risk for the SEC is that the farther it walks back from the Advisers Act standard suggested in Dodd-Frank, the more vulnerable it becomes to the same criticisms of “watery timidity” that it endured 80 years ago on similar questions.
This is not a comfortable spot for any regulator. With careful deliberation, however, and with good faith participation by investors, financial firms, and industry groups through the notice and comment process, the SEC has the regulatory judgment and technical expertise to successfully resolve this issue once and for all—already made easier by market developments out of its control.