THINKING BEFORE RULEMAKING: WHY THE SEC SHOULD THINK TWICE BEFORE IMPOSING A UNIFORM FIDUCIARY STANDARD ON BROKER-DEALERS AND INVESTMENT ADVISERS

Transcription

1 THINKING BEFORE RULEMAKING: WHY THE SEC SHOULD THINK TWICE BEFORE IMPOSING A UNIFORM FIDUCIARY STANDARD ON BROKER-DEALERS AND INVESTMENT ADVISERS Ross Jordan * I. INTRODUCTION The need for sound financial regulatory reform is as pressing as ever before. The recent financial crisis dealt a catastrophic blow to the 401ks and IRAs of millions of Americans. 1 The Bernard Madoff investment scandal, along with steep losses in retirement plans, left many retail investors questioning the competence and motives of their investment advice professionals. 2 As a result of the financial crisis and deteriorating investor confidence in financial service providers, Congress recently capitalized on the opportunistic political environment by passing the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). 3 Recognizing the inextricable link between the quality of investment advice provided to investors and investor confidence in the financial markets, 913 of the Dodd-Frank Act required the Securities and Exchange Commission (SEC) to issue a study examining existing standards of care for broker-dealers and investment advisers (Study). 4 The impetus behind 913 originated with regulators who were concerned that the increasing number of broker-dealers giving investment advice justified holding broker-dealers to the same fiduciary standard as investment advisers when providing investment advice. 5 More precisely, the central issue addressed in 913 is * J.D. Candidate (May 2012), Brandeis School of Law; B.A., Xavier University (2009). The author would like to thank his mom, dad, and girlfriend, Rebecca, for all their love and support. 1 See Craig Guillot, How the Financial Crisis Impacts Your Retirement, CNBC (Nov. 19, 2008), ( With the Dow Jones losing more than forty percent since its record high close a year ago and suffering an eightday loss of twenty-two percent in early October, investors have racked up more than $8 trillion of losses this year. ). 2 See Joshua Brockman, With Shaken Confidence, Investors Look to Future, NAT L PUB. RADIO (Dec. 24, 2008), 3 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010) (b)(1). 5 See Ronald D. Orol, SEC: Brokers Should Be Held to Fiduciary Standard, MARKETWATCH (May 6, 2010), 491

2 492 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 whether imposing a fiduciary standard on broker-dealers would ensure that investors are receiving appropriate and tailored investment advice from broker-dealers. 6 The Study, which was conducted by a cross-divisional task force (Staff) established by the SEC, was released less than six months after the passage of the Dodd-Frank Act. 7 Convinced that a fiduciary standard would provide more protection for investors, the Staff recommended that the SEC adopt a uniform fiduciary duty no less stringent than currently applied to investment advisers [Uniform Fiduciary Standard]. 8 The Uniform Fiduciary Standard would extend fiduciary obligations to broker-dealers when providing personalized investment advice. 9 Vested with rulemaking authority under 913, the SEC is now preparing to decide whether or not to adopt the Uniform Fiduciary Standard in whole or in part. 10 Should the SEC implement the Uniform Fiduciary Standard embraced by the Staff, little, if any, added benefit for investors will follow. Considering the strong ethical duties commonly associated with the fiduciary concept, 11 it is understandable why the notion of extending fiduciary obligations to broker-dealers has gained significant popularity. However, as with many things, the devil is in the details. Careful analysis of the Study s findings reveals faulty assumptions and questionable conclusions as to the purported benefits of holding broker-dealers to the Uniform Fiduciary Standard. Some of the Uniform Fiduciary Standard s shortcomings can be attributed to the Staff s Study, while others can be attributed to the fiduciary concept in general. On the one hand, the Staff s inability to describe in any detail the specific fiduciary obligations that would follow for broker-dealers under the Uniform Fiduciary Standard is understandable, as the history of ( I believe that broker-dealers and investment advisers providing the same services, especially to retail investors, should meet that same high fiduciary standard, Schapiro told participants at a Securities Industry and Financial Markets Association conference. ) Consistent with the Securities Exchange Act of 1934, customer will be used throughout this Note in relation to broker-dealers. See 15 U.S.C. 78a 78pp (2006). Consistent with the Investment Advisers Act of 1940, client will be used in relation to investment advisers. See 15 U.S.C. 80b-1 to 80b SEC STAFF, STUDY ON INVESTMENT ADVISERS AND BROKER-DEALERS ii (2011) [hereinafter SEC STAFF STUDY], available at Press Release, SEC, SEC Releases Staff Study Recommending a Uniform Fiduciary Standard of Conduct for Broker-Dealers and Investment Advisers (Jan. 22, 2011) [hereinafter SEC Press Release], available at 8 SEC STAFF STUDY, supra note 7, at at v. 10 Dodd-Frank Wall Street Reform and Consumer Protection Act 913(f). 11 See discussion infra Part III.B.

3 2012] THINKING BEFORE RULEMAKING 493 the fiduciary concept is somewhat convoluted. Moreover, the historically inconsistent and unclear articulation by financial regulators of an investment adviser s fiduciary duties of loyalty and care inevitably exacerbated the Staff s struggle to concretely define the Uniform Fiduciary Standard. 12 On the other hand, partially due to requirements in the Dodd- Frank Act, the Staff crafted the Uniform Fiduciary Standard such that, if adopted by the SEC, there is little chance that investors using brokerdealers will receive better investment advice or enjoy greater protection. Finally, the Study does not address how the SEC will be able to overcome potential budget shortages in order to properly enforce any fiduciary standard extended to broker-dealers. 13 This Note explores the debate over the proper role of the fiduciary concept in the regulation of investment advisers and broker-dealers. Within this discussion, special attention will be given to the Uniform Fiduciary Standard proposed by the Staff. On the surface, the fiduciary concept and the Staff s fiduciary standard appear to be consistent with investor protection. In practice, however, the Staff s fiduciary standard will fall well short of its laudable goals. Furthermore, implementation of the Uniform Fiduciary Standard may lead to adverse, unintended consequences for investors and for the overall financial services industry. Part II of this Note discusses the evolution of the broker-dealer and investment adviser industries, and the recent financial regulatory reform bill. Part III.A compares and contrasts the investment adviser industry and broker-dealer industry from a regulatory point of view, and explores the extent to which fiduciary notions currently apply to the two industries. Part III.B explains why so much confusion surrounds the understanding of the fiduciary concept. Part III.C reveals some of the issues associated with the fiduciary standard applied to investment advisers under the Advisers Act. Part III.D considers the Uniform Fiduciary Standard proposed by the Staff, and how the standard would affect the broker-dealer industry. Part IV begins by arguing that the SEC should conduct quantitative analysis comparing the two industries before adopting any fiduciary standard extending to broker-dealers. Part V then argues that if the SEC adopts a fiduciary standard for broker-dealers, it should be separate and distinct from the standard applied to advisers and should include a federal private right of action for investors See infra Part III.A.2. See SEC STAFF STUDY, supra note 7, at

4 494 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 II. HISTORY A. The Development of Rules and Regulations Governing Broker-Dealers and Investment Advisers The broker-dealer and investment adviser industries are regulated under different statutes. The Securities Exchange Act of 1934 (Exchange Act) regulates the business activities of broker-dealers. 14 On the other hand, investment advisers are regulated by the Investment Advisers Act of 1940 (Advisers Act). 15 Under the Advisers Act, an investment adviser is defined as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. 16 The Exchange Act defines a broker as any person engaged in the business of effecting transactions in securities for the account of others, 17 and a dealer as any person engaged in the business of buying and selling securities for such person s own account through a broker or otherwise. 18 Generally speaking, broker-dealers are excluded from the Advisers Act. 19 Broker-dealers and investment advisers can also be distinguished by their primary regulators. While the SEC establishes general rules targeting the deceptive and manipulative practices of broker-dealers, 20 the Financial Industry Regulatory Authority (FINRA), which is the self-regulatory organization for broker-dealers, proscribes and enforces specific rules applicable to the broker-dealer profession. 21 However, pursuant to the 14 See 15 U.S.C. 78a 78pp (2006). 15 See 15 U.S.C. 80b-1 to 80b b-2(a)(11) U.S.C. 78c(a)(4)(A) c(a)(5)(A) U.S.C. 80b-2(a)(11)(C). A broker-dealer giving investment advice enjoys immunity from the regulations under the Advisers Act if the advice is solely incidental to the brokerage services the broker-dealer provides and such broker-dealer does not receive special compensation for the advisory services. SEC STAFF STUDY, supra note 7, at 16. According to the Staff s Study, the solely incidental element... recogni[zes] that broker-dealers commonly give [some]... advice to their customers in the course of their regular business as broker-dealers and that it would be inappropriate to bring them within the scope of the [Advisers Act] merely because of this aspect of their business C.F.R b-3 (2011); see also Thomas Lee Hazen, Are Existing Stock Broker Standards Sufficient? Principles, Rules and Fiduciary Duties, 2010 COLUM. BUS. L. REV. 710, 734 (2010) ( [T]he SEC makes it clear that violation of its rules is not limited to violation of any specified SEC or selfregulatory organization rules, but rather covers all conduct that operates as a deceptive or manipulative device. ). 21 See Get to Know Us, FIN. INDUS. REGULATORY AUTH. 2 (2009), groups/corporate/@corp/@about/documents/corporate/p pdf (explaining that part of FINRA s

5 2012] THINKING BEFORE RULEMAKING 495 Exchange Act, the SEC has oversight authority over FINRA. 22 While the SEC acts more like a secondary regulator to the broker-dealer industry, the SEC serves as the primary regulator of investment advisers. 23 B. The Court s Role in Defining the Duties for Broker-Dealers and Investment Advisers Investment advisers are not explicitly labeled fiduciaries under the Advisers Act, 24 but they were officially recognized as fiduciaries by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc. 25 The Court stated that the Advisers Act reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship. 26 Based on the purpose and legislative intent of the Advisers Act, the Court held that the statute imposes fiduciary obligations on investment advisers. 27 Thus, since the Capital Gains decision, investment advisers have been subject to fiduciary obligations under the Advisers Act. As fiduciaries, investment advisers owe their clients a duty of care and loyalty. 28 Generally speaking, an adviser s duty of loyalty requires the adviser to disclose conflicts of interests, and to act in the client s best interest. 29 Moreover, an adviser s duty of care imposes certain obligations on the adviser that focus on the quality and appropriateness of the adviser s investment advice to the client. 30 The specific characteristics of the duty of care and loyalty, or lack thereof, are predominately decided by interpretive guidance provided by the SEC as well as some case law. 31 Even though broker-dealers are generally exempt from the fiduciary standard under the Advisers Act, 32 courts have consistently held that brokerduties are qualifying and licensing brokers, writing and enforcing rules and regulations for every brokerage firm and broker in the United States ). 22 Barbara Black, How to Improve Investor Protection After the Dodd-Frank Wall Street Reform and Consumer Protection Act, 13 U. PA. J. BUS. L. 59, 63 (2010). 23 See 15 U.S.C. 80b-1 to 80b-21 (2006). The Advisers Act refers to the SEC as the Commission. 15 U.S.C. 80b-2(a)(4). 24 See 80b-1 to 80b SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191 (1963). 26 (citations omitted). The Court went on to say that as fiduciaries, investment advisers have a duty of utmost good faith, and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading... clients. at SEC STAFF STUDY, supra note 7, at See id. 30 See, e.g., id. at 22, at See 15 U.S.C. 80b-2(a)(11)(C) (2006).

6 496 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 dealers, under some circumstances, owe a fiduciary duty to their customers. 33 Courts are generally in agreement that when a broker-dealer has discretion over a customer s account, certain fiduciary obligations will follow. 34 With exception to those cases where a broker-dealer has discretion over a customer s account, historically, fiduciary obligations of brokerdealers have varied considerably. Specifically, since broker-dealers are not subject to a federal fiduciary standard, relevant state fiduciary law will usually govern the application of fiduciary obligations for broker-dealers. 35 C. The Evolution of the Broker-Dealer Industry Leading to Investor Confusion over the Different Roles of Broker-Dealers and Investment Advisers Today s financial markets bear little resemblance to the small and relatively inactive markets that existed in the 1930s and 1940s when the Exchange Act and the Advisers Act were passed. 36 Along with the unprecedented growth in the financial markets over the last sixty years, the role of broker-dealers in the financial markets has changed considerably. 37 Traditionally, the main function of broker-dealers was the execution of securities transactions; however, this aspect of the broker-dealer business has become far less profitable on account of technological advances over the past decade and the deregulation of commissions for securities transactions. 38 Broker-dealers have adapted to this new environment by offering additional services to compensate for the loss in revenue. 39 For 33 See, e.g., ANGELA HUNG ET AL., INVESTOR AND INDUSTRY PERSPECTIVES ON INVESTMENT ADVISERS AND BROKER-DEALERS (2008). 34 ; see also SEC v. Zandford, 535 U.S. 813, 815, 823 (2002) (explaining that a broker-dealer owes a fiduciary duty to a customer when the broker-dealer has the discretion to execute security transactions without prior consent from the customer); Paine, Webber, Jackson & Curtis, Inc. v. Adams, 718 P.2d 508, 517 (Colo. 1986) ( [P]roof of practical control of a customer s account by a broker will establish that the broker owes fiduciary duties to the customer with regard to the broker s handling of the customer s account. ). 35 Arthur B. Laby, Fiduciary Obligations of Broker-Dealers and Investment Advisers, 55 VILL. L. REV. 701, (2010). 36 See, e.g., Tamar Frankel, Fiduciary Duties of Brokers-Advisers-Financial Planners and Money Managers 8, 10 (Boston Univ. Sch. of Law, Working Paper No , 2010), available at ssrn.com/sol3/papers.cfm?abstract_id= at See Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 BUS. LAW. 395, 405, (2010). 39 Frankel, supra note 36, at (discussing the expanded list of services offered by many broker-dealers); see also Laby, supra note 35, at 734 ( Today, advances in technology have reduced the time and cost to process trades. As a result, the advice component of brokerage business has eclipsed transaction execution in importance. ).

7 2012] THINKING BEFORE RULEMAKING 497 example, in addition to executing securities transactions, many brokerdealers today sell insurance, engage in derivative transactions, and most notably, offer free personalized investment advice. 40 As the broker-dealer industry has evolved, regulators and scholars have expressed concerns that the expansion of services offered by broker-dealers has made it extremely difficult for investors to distinguish them from investment advisers. 41 Many of these regulators and scholars fear that investors who are unable to distinguish between the two will wrongly assume that both industries are regulated under the same legal standards. 42 These concerns were validated by a 2008 SEC-commissioned research report, conducted by the RAND Corporation, which examined investors perceptions of the broker-dealer industry and the investment adviser industry. 43 In general, the RAND report indicated widespread confusion amongst investors as to the key distinctions between investment advisers and brokerdealers regarding their duties, the titles they use, the firms for which they work, [and] the services they offer. 44 Sixty-three percent of investors believed that broker-dealers providing advice about securities historically a service not offered by most broker-dealers was common to their profession. 45 Not only did the RAND report illustrate investors struggle to differentiate between broker-dealers and investment advisers, it also revealed investors misunderstandings as to the different legal standards applicable to broker-dealers and advisers. 46 For example, 42% of investors responded that all broker-dealers owed their customers a fiduciary duty. 47 A 2006 TD Ameritrade survey of 1000 U.S. investors found that a paltry 26% of investors were aware that only investment advisers, rather than 40 Frankel, supra note 36, at See, e.g., id. at 12 ( [Broker-dealers ] functions cannot be distinguished from those of advisers and financial planners. ); see also U.S. DEP T OF THE TREASURY, FINANCIAL REGULATION REFORM: A NEW FOUNDATION 71 (2009) [hereinafter A NEW FOUNDATION], available at initiatives/documents/finalreport_web.pdf ( Retail investors are often confused about the differences between investment advisers and broker-dealers. ). 42 Donald C. Langevoort, Brokers as Fiduciaries, 71 U. PITT. L. REV. 439, (2010). 43 HUNG ET AL., supra note 33, at 20 ( The interested-party interviews suggest that individual investors do not distinguish between investment advisers and broker-dealers. Marketplace changes that have resulted in investment advisers and broker-dealers offering similar services have added to investor confusion. ). RAND is a nonprofit research organization providing objective analysis and effective solutions that address the challenges facing the public and private sectors around the world. at ii. 44 at at See id. 47

8 498 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 investment advisers and broker-dealers, have fiduciary responsibilities to their clients. 48 D. The Political Response to Investor Confusion: The Treasury s Paper on Financial Regulatory Reform and the Dodd-Frank Act This blurring of the line between broker-dealers and investment advisers led to a strong political response in support of imposing fiduciary obligations on broker-dealers when providing investment advice to customers. 49 One of the first significant signs of this political support was the 2009 U.S. Department of Treasury s paper on financial regulatory reform. 50 The Treasury s paper, consistent with the RAND report and the TD Ameritrade survey, cited ample confusion among investors regarding the different regulations governing broker-dealers and investment advisers. 51 To address this confusion, the Treasury s paper recommended that the Commission [e]stablish a fiduciary duty for broker-dealers offering investment advice. 52 A little more than a year after the Treasury s paper was published, Congress passed the Dodd-Frank Act, the largest financial regulatory bill in generations. 53 Section 913 of the Dodd-Frank Act required the SEC to conduct a study of up-to-six-months in duration on the effectiveness of current legal or regulatory standards of care for investment advisers and broker-dealers when providing personalized investment advice and recommendations about securities to retail customers. 54 By amending the Exchange Act and the Advisers Act, 913 grants the SEC the power to promulgate rules defining and imposing fiduciary obligations on all broker-dealers when providing personalized investment advice about securities to retail customers TD AMERITRADE INST., INVESTOR PERCEPTION STUDY 2006, 1 (2006), available at 49 See Hazen, supra note 20, at ; Kristina A. Fausti, A Fiduciary Duty for All?, 12 DUQ. BUS. L.J. 183, (2010). 50 See Black, supra note 22, at A NEW FOUNDATION, supra note 41, at Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010) (b)(1) (g).

9 2012] THINKING BEFORE RULEMAKING 499 E. Recommendations Made by the Staff s Study Regarding Investment Advisers and Broker-Dealers On January 22, 2011, the Staff, fulfilling the mandate under 913 of the Dodd-Frank Act, released its Study on the regulation of broker-dealers and investment advisers. 56 In conducting its research, the Staff met with various interested parties, including FINRA, and reviewed more than 3,500 public comment letters. 57 The overarching recommendation made in the Study is that the SEC should adopt a uniform fiduciary standard for investment advisers and broker-dealers that is no less stringent than the standard under the Advisers Act. 58 Specifically, the Staff recommended the following: [T]he 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. 59 It is important to note that while the Staff s recommendations may carry substantial weight with the Commission, the SEC, under the Dodd-Frank Act, must formally adopt the Staff s recommendations before they become law. 60 F. Criticisms of the Staff s Study by Dissenting Commissioners Casey and Paredes The Study s recommendations to the Commission were not embraced by all of the Staff s members. 61 Commissioners Kathleen L. Casey and Troy A. Paredes believed the Study contained insufficient analytical and empirical evidence to substantiate many of its recommendations. 62 The two Commissioners argued that the Study emphasized the Uniform 56 SEC Press Release, supra note SEC STAFF STUDY, supra note 7, at ii. 58 at v vi. 59 at vi. 60 Dodd-Frank Wall Street Reform and Consumer Protection Act 913(f). 61 Kathleen L. Casey and Troy A. Paredes, Comm rs, Sec. & Exch. Comm n, Statement Regarding Study on Investment Advisers and Broker-Dealers (Jan. 21, 2011) (transcript available at 62

10 500 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 Fiduciary Standard as a means to resolve investor confusion over brokerdealers and investment advisers, but failed to identify the adverse consequences resulting from that confusion. 63 Another potential issue unresolved by the Study s research, according to Commissioners Casey and Paredes, is the potential cost burdens that could be imposed on brokerdealers, investment advisers, and investors following implementation of the Study s recommendations. 64 In light of these concerns, Commissioners Casey and Paredes advise that the SEC conduct additional research comparing investors overall success with broker-dealers and investment advisers before enacting any of the Study s recommendations. 65 III. ANALYSIS A. Comparing and Contrasting the Regulatory Framework of the Broker- Dealer and Investment Adviser Industries Members of the investment adviser and broker-dealer industries have long debated which industry is more effectively regulated. 66 Generally speaking, the practices of broker-dealers are regulated by a set of specific rules established by FINRA, while investment advisers are subject to a broader set of principles inherent in the fiduciary concept. 67 The brokerdealer industry will often criticize the principle-driven regulation of investment advisers as being vague. 68 Conversely, investment advisers argue that as fiduciaries to their clients under the Advisers Act, they are held to higher standards than broker-dealers when dealing with their clients Referring to investors confusion over broker-dealers and investment advisers, the Commissioners said: [T]he practical consequences resulting from that confusion for those very investors have not been sufficiently studied or documented. Moreover, the Study does not address the possibility that the Study s own recommendations will not resolve or eliminate investor confusion and may in fact create new sources of confusion. 64 ( [A]s 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. ). 65 Specifically, Commissioners Casey and Paredes recommend the SEC compare the two industries in four aspects: investor returns, quality of investment advice, investors ability to bring suits against broker-dealers or investment advisers, and the common characteristics of investors under each industry. 66 SEC STAFF STUDY, supra note 7, at See, e.g., Fausti, supra note 49, at See, e.g., SEC STAFF STUDY, supra note 7, at See Black, supra note 22, at 85 n.154.

11 2012] THINKING BEFORE RULEMAKING Important Rules for Broker-Dealers NASD rule 2310, 70 the suitability rule, is arguably the most significant rule pertaining to the conduct of broker-dealers. This rule requires broker-dealers, when giving investment recommendations to a customer, to have reasonable grounds for believing that the recommendation is suitable for such customer based on the broker-dealer s knowledge of other securities held by the customer, and the customer s financial situation and needs. 71 Before an investment recommendation is suitable, a broker-dealer must take reasonable efforts to obtain information concerning the customer s (a) financial status, (b) tax status, (c) investment objectives, and (d) any other information the broker-dealer believes is important in making the recommendation. 72 In addition to the suitability rule, broker-dealers have a duty to seek best execution when executing securities transactions for customers. 73 Under the duty to seek best execution, a broker-dealer must use reasonable diligence to find the best market to execute the order and find the most favorable terms for the customer. 74 One source of criticism targeted at the broker-dealer industry is the lack of disclosure requirements for broker-dealers. 75 Under certain circumstances, however, broker-dealers have a duty to make disclosures to their customers. For example, when a broker-dealer recommends a security to a customer and the broker-dealer was personally involved in the primary 70 FINRA was formerly named the National Association of Securities Dealers (NASD), and thus, rules promulgated before the establishment of FINRA are preceded by NASD. Rules established after FINRA, however, are preceded by FINRA. No other significance exists between the two different designations. See Regulation: FINRA Rules, FIN. INDUS. REGULATORY AUTH., Industry/Regulation/FINRARules/ (last visited Dec. 18, 2011). NASD CONDUCT R will be replaced with FINRA CONDUCT R beginning on July 9, See FINRA MANUAL: FINRA CONDUCT R (2010), available at &record_id=13390&element_id=9859&highlight=2111#r13390; FINRA MANUAL: NASD CONDUCT R (1996), available at &element_id=3638. In addition to clarifying some interpretive issues with NASD CONDUCT R. 2310, FINRA CONDUCT R expands the number of considerations a broker-dealer must take into account when making investment recommendations to customers. See FINRA MANUAL: FINRA CONDUCT R (2010). Specifically, under rule 2111, broker-dealers must consider customers investment experience, investment time horizon, liquidity needs, and risk tolerance before making investment recommendations. 71 FINRA MANUAL: NASD CONDUCT R. 2310, supra note FINRA MANUAL: NASD CONDUCT R (2011), available at display/display_main.html?rbid=2403& element_id= See id. Failure to seek best execution for a customer can result in the broker-dealer being subject to a disciplinary proceeding instituted by regulators. See Black, supra note 22, at See, e.g., Frankel, supra note 36, at 5 6.

12 502 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 or secondary distribution of the security, FINRA rule 2269 requires the broker-dealer to disclose the conflict of interest to the customer. 76 Moreover, under FINRA rule 2269, a broker-dealer engaging in principal trading with a customer must disclose his or her principal capacity following execution of the transaction. 77 Furthermore, if a broker-dealer recommends a speculative security, the broker-dealer must affirmatively disclose to the customer the speculative nature of it. 78 Additional disclosure obligations apply to broker-dealers under other circumstances Investment Advisers Fiduciary Duty of Loyalty and Care Compared to broker-dealers, an investment adviser s duty of loyalty under the Advisers Act s fiduciary standard imposes more stringent disclosure requirements. 80 Under the duty of loyalty, advisers are obligated to act in the client s best interest. 81 Despite widespread confusion and disagreement over the exact obligations incorporated in the meaning of 76 FINRA CONDUCT R states in relevant part: A member who is acting as a broker for a customer or for both such customer and some other person, or a member who is acting as a dealer and who receives or has promise of receiving a fee from a customer for advising such customer with respect to securities, shall, at or before the completion of any transaction for or with such customer in any security in the primary or secondary distribution of which such member is participating or is otherwise financially interested, give such customer written notification of the existence of such participation or interest. FINRA MANUAL: FINRA CONDUCT R (2009), available at display.html?rbid=2403&record%20id=11868&element_id=8664&highlight=2269#r Special NASD Notice to Members states in relevant part: When a registered representative recommends the purchase or sale of a stock to a customer, he or she must not only avoid affirmative misstatements, but must also disclose material adverse facts about which the salesperson is, or should be, aware. Particular care should be taken with respect to the accuracy and completeness of information concerning low-priced, speculative securities. In this connection, members should focus on the completeness of disclosure concerning securities issued by companies whose ability to operate as a going concern is subject to question or contingent on gaining additional financing. This includes disclosure of any conflicts of interest that could influence the salesperson s recommendation or the customer s decision to purchase or sell the security. Special NASD Notice to Members 96-32: Members Reminded to Use Best Practices When Dealing in Speculative Securities, 1996 NAT L ASS N OF SEC. DEALERS 233, 233 (May 9, 1996), available at 79 SEC STAFF STUDY, supra note 7, at Fausti, supra note 49, at ; Laby, supra note 35, at Laby, supra note 35, at 718.

13 2012] THINKING BEFORE RULEMAKING 503 acting in the client s best interest, 82 it is clear that an adviser s obligation to do so requires disclosure of all material conflicts. 83 For example, an adviser who engages in principal trading before obtaining the client s written consent breaches his or her duty of loyalty. 84 Conversely, since broker-dealers are not under a duty of loyalty, or obligated to act in the customer s best interest, they are free to sell securities from their own account without having to first obtain written consent from the customer. 85 The confusion surrounding the meaning of acting in the client s best interest, or the best interest standard, is due to the SEC s inconsistent interpretation of an adviser s duty of care under the Advisers Act. 86 As noted by Professor Barbara Black, following the holding in Capital Gains, the best interest standard was viewed as one part of an adviser s duty of loyalty to disclose conflicts of interest, as opposed to being part of an adviser s duty of care. 87 However, after a while, the SEC began referring to the best interest standard in the context of the quality of an adviser s investment advice, instead of an adviser s disclosure obligations. 88 Essentially, the Commission began describing the best interest standard as part of an adviser s duty of care to manage the client s portfolio in the best interest of the client rather than part of an adviser s duty of loyalty to disclose conflicts of interest. 89 Ever since the Commission started associating the best interest standard with the quality of an adviser s investment advice, the SEC and some in the 82 See discussion infra Part III.A.3; LEONARD I. ROTMAN, FIDUCIARY LAW (2005); Black, supra note 22, at 85 86; Melanie L. Fein, Brokers and Investment Advisers Standards of Conduct: Suitability vs. Fiduciary Duty (Aug. 31, 2010) (unpublished manuscript) (available at (describing the scope and source of the best interest duty as vague ). 83 Black, supra note 22, at 86 (explaining that following the decision in Capital Gains, courts interpreted the best interest standard as a part of an investment adviser s duty of loyalty to disclose conflicts of interest.); Laby, supra note 35, at 718 (explaining that disclosure of conflicts of interest has been a flash point for determining liability under the Advisers Act ). 84 Fein, supra note 82, at 31. Principal trading is a practice where an investment adviser or brokerdealer sells securities to, or buys securities from, a client or customer for purposes of the adviser s or broker-dealer s personal account. Id; see also discussion infra Part III.D See SEC STAFF STUDY, supra note 7, at See supra notes and accompanying text. 87 Black, supra note 22, at 86 ( Beginning with Capital Gains, courts viewed the best interests of the client standard as an aspect of the investment adviser s duty of loyalty to address conflicts of interests, rather than as an aspect of the adviser s duty of care addressing the quality of investment advice. ). 88 See id. ( Over time, the SEC came to express the investment adviser s fiduciary obligation more generally as a duty of loyalty that requires advisers to manage their clients portfolios in the best interest of clients. ). 89 See id.

14 504 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 investment advisory industry have argued that the best interest standard represents a higher standard of care than the suitability standard for brokerdealers. 90 What these advisers and the SEC are essentially saying is that investment recommendations that meet the suitability standard sometimes fail to meet the best interest standard. However, as Professor Black points out, this argument is one of semantics rather than substance. 91 First, the SEC has consistently said that the suitability standard and the duty to seek best execution apply equally to an investment adviser s duty of care. 92 If this is the case, as it is according to the SEC, then it would be nonsensical to enforce a lower standard of care (the suitability standard) if the best interest standard was actually higher. 93 Second, financial experts agree that in most situations there will be several suitable investments rather than one single best investment. 94 The only logical conclusion regarding the best interest standard is that it is part of an adviser s duty of loyalty, not duty of care. Furthermore, it is also clear that an adviser s duty of care incorporates the same obligations as a broker-dealer standard of care, requiring the adviser to give suitable investment advice and to seek best execution for clients security transactions. Nevertheless, because the Staff s Uniform Fiduciary Standard is modeled after the fiduciary standard under the Advisers Act, 95 adoption of the Staff s fiduciary standard by the SEC, absent further clarification by the Commission, will result in broker-dealers facing the same interpretational issues as advisers with respect to their fiduciary duty of loyalty and care. 3. The Significance of the Best Interest Standard and Its Confusion in the Staff s Uniform Fiduciary Standard If the SEC adopts the Uniform Fiduciary Standard, the best interest standard will apply to investment advisers and broker-dealers when giving 90 See id. at See id. at ; SEC STAFF STUDY, supra note 7, at Black, supra note 22, at Even the RAND report indicated that many investors questioned whether the best interest standard is really a higher standard of care than the suitability standard. See HUNG ET AL., supra note 33, at SEC STAFF STUDY, supra note 7, at 159 ( Application of the new standard is unlikely to result in any direct costs to investment advisers, especially in light of the fact that the recommended standard that would be applied to both broker-dealers and investment advisers would be consistent with standards already applicable to investment advisers under Advisers Act Section 206(1) and 206(2). ).

15 2012] THINKING BEFORE RULEMAKING 505 personalized investment advice. 96 Despite the Staff s endorsement of the best interest standard, the Staff s Study indirectly acknowledges the uncertainties surrounding its meaning. 97 In fact, the Staff, to a certain extent, also concedes that neither the duty of care nor the duty of loyalty, recommended by its own Study, is clear. 98 Rather than resolving these issues, the Staff suggests that the SEC, if it chooses to adopt the Uniform Fiduciary Standard, provide rulemaking and/or interpretive guidance on the best interest standard and the duty of care and loyalty. 99 On the one hand, the Staff supports extending fiduciary duties to broker-dealers; on the other hand, the Staff admits the need for more clarity regarding the duty of care and loyalty, and the relationship of the best interest standard to both. While the Staff s logic for extending fiduciary obligations to broker-dealers is questionable at best, the Staff s confusion is somewhat understandable given the legal community s struggle over the meaning of the fiduciary concept. 100 B. The Struggle to Understand the Fiduciary Concept To understand the issues associated with the fiduciary concept, and how those issues will hinder the effectiveness of the Staff s fiduciary standard, it is necessary to consider the evolution of the fiduciary concept. The fiduciary concept is commonly used to refer to a high ethical duty owed by one, the fiduciary, to another, the beneficiary. 101 Several examples of duties imposed on fiduciaries under the appropriate circumstances include honesty, loyalty, integrity, selflessness, and the utmost good faith. 102 Arguably, the most famous statement regarding the fiduciary concept came from Justice Cardozo in Meinhard v. Salmon: Many forms of conduct permissible in a workaday world for those acting at arm s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior at vi (stating that the standard of conduct under the Staff s fiduciary standard shall be to act in the best interest of the customer ). 97 at at 113, at , See discussion infra Part III.B. 101 See Black, supra note 22, at 75; Hazen, supra note 20, at ROTMAN, supra note 82, at Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928).

16 506 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 Judge Cardozo s interpretation of the fiduciary concept was only the beginning of an ongoing process to understand the fiduciary concept. Since Meinhard, judges, lawyers, and legal scholars have struggled to create a workable definition for the fiduciary concept. This struggle has been further complicated by the wide range of diverse legal relationships to which the fiduciary concept applies. 104 The popularity of the fiduciary concept in the legal field is in part due to its flexibility, which is the ability to apply the fiduciary concept to different relationships and situations. 105 However, this flexibility also presents challenges. 106 Professor Leonard Rotman describes one of those challenges as, [H]ow to preserve the necessary elasticity of the fiduciary concept to allow for its application to numerous and diverse scenarios while maintaining a sufficient level of certainty and predictability for juristic actors. 107 Professor Rotman suggests that overcoming this challenge maintaining the flexibility of the fiduciary concept while ensuring a level of predictability has been seriously compromised by the legal profession s gross misapplication of the fiduciary concept. 108 For example, Rotman argues that the fiduciary concept is frequently abused by judges who have no interest in the purpose of it, suggested by the scant space dedicated to the discussion or analysis of its principles. 109 Rotman believes the lack of judicial interest in the purpose of the fiduciary concept implies that some judges are more concerned with what the fiduciary concept might accomplish in a particular situation or how it may be used to evade difficulties inherent in bringing other claims than in ensuring doctrinally sound application of the fiduciary concept. 110 According to Rotman, one consequence of this judicial disinterest in the principles of the fiduciary concept has been the expanded use of the fiduciary concept without any 104 See ROTMAN, supra note 82, at 3; Black, supra note 22, at ROTMAN, supra note 82, at 37 ( [T]he flexibility of the [fiduciary] concept in its application and available relief and the onerous nature of fiduciary duties imposed upon wrongdoers have proven to be attractive to judges in numerous situations. ). 106 See id. at See id. at 5 6. Professor Rotman argues that the issues surrounding the fiduciary concept lie not with the concept itself, but with the legal profession s improper implementation of the concept. Thus, Rotman believes in reforming fiduciary law by fostering a principled approach to the fiduciary concept that is rooted in its foundational precepts. According to Rotman, if the fiduciary concept is properly reformed, the principles underlying the concept and the appellate process will ensure that judicial discretion in the application of the fiduciary concept is not abused. 109 at

17 2012] THINKING BEFORE RULEMAKING 507 regard to its doctrinal underpinnings, thus undermining the predictability of it. 111 Consistent with Professor Rotman s view, Professor Barbara Black argues that identifying the defining characteristics of the fiduciary concept is complicated by its application in multiple areas of the law. 112 Professor Black believes judges have contributed to the confusion of trying to ascertain the underlying principles of fiduciary relationships by using the fiduciary term as a conclusory label without providing sufficient analysis of the relevant factors in establishing a fiduciary relationship. 113 According to Professor Black, judges consciously favor rhetorical flourish over an in-depth analysis of the fiduciary concept because judges fear detailed analysis of the fiduciary concept would expose its weaknesses and jeopardize the relevance of the fiduciary concept in some areas of the law. 114 As Professors Black and Rotman emphasize, the fiduciary concept is inherently abstract. 115 Accordingly, the primary source of disagreement among critics and supporters of the fiduciary concept is not whether the fiduciary concept is easily definable, but whether the innate abstractness of the concept can be transformed into workable legal standards that can then be applied to legal relationships. 116 The application of fiduciary obligations for investment advisers nicely illustrates how difficult it is to create workable standards out of the fiduciary concept. C. Issues with the Fiduciary Concept as Applied to Investment Advisers As noted earlier, the Court in SEC v. Capital Gains established that embedded in the Advisers Act was the notion that investment advisers stand 111 See id. at Black, supra note 22, at ( The difficulty is exacerbated because judges frequently use the term as a conclusionary [sic] label whenever they find injury to a vulnerable party without much analysis of the factors deemed relevant in arriving at that conclusion. ). 114 at 78. To illustrate this point, Professor Black notes that if a literal application of the duty of loyalty, which mandates that the fiduciary put the beneficiaries interest ahead of fiduciary s interest, was imposed on investment advice providers, then all investment advice providers would be required to renounce all compensation paid to them by their clients. 115 Id; ROTMAN, supra note 82, at Compare Black, supra note 22, at 78 ( Because of its vague and amorphous quality, the fiduciary duty concept does not promote the development of clear and workable standards.... ), with ROTMAN, supra note 82, at 5 6 ( Although one may find it difficult to obtain a clear understanding of the fiduciary concept from much of the existing case law and commentaries on the topic, greater certainty can be achieved through an analysis of the fiduciary concept s history and purpose. ).

18 508 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 in a fiduciary relationship with their clients. 117 The Court s opinion, however, leaves more questions than answers as to the specific characteristics of investment advisers fiduciary obligations. 118 The extent of the Court s explanation of investment advisers fiduciary obligations is that they have an affirmative duty of utmost good faith, and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading [their] clients. 119 Moreover, the Advisers Act and other statutes under which investment advisers are deemed fiduciaries are either totally void of the word fiduciary, or say nothing as to the specifics of an adviser s fiduciary obligations. 120 However, through the use of enforcement actions, the SEC has established some specific standards of conduct that define certain aspects of an investment adviser s fiduciary obligations to clients. 121 Nevertheless, the intrinsically abstract nature of the fiduciary concept and the lack of statutory guidance detailing investment advisers fiduciary responsibilities explain why the evolution of fiduciary-based regulation of advisers has been primarily principle-driven Jones v. Harris Associates L.P: Questioning Investor Protection Under the Principle-Driven Fiduciary Standard for Investment Advisers The advantage of the predominately principle-driven fiduciary regulation of advisers, as opposed to the rule-based regulation of brokerdealers, is that it allows regulators, notably the SEC, to constantly adapt regulations to keep pace with the dynamic nature of the financial services industry. 123 In other words, the broad principles underlying the fiduciary 117 SEC v. Capital Gains, 375 U.S. 180, (1963). 118 See Black, supra note 22, at 66 (explaining that the question presented to the Court in Capital Gains did not provide the Court with the opportunity to delve into the concrete nature of the fiduciary duties owed by investment advisers to their clients); Fein, supra note 82, at 24 ( The nature of the fiduciary duty of an investment adviser, apart from the duty of disclosure, is unclear. ). 119 Capital Gains, 375 U.S. at Thomas P. Lemke & Steven W. Stone, The Madoff Opportunity : Harmonizing the Overarching Standard of Care for Financial Professionals Who Give Investment Advice, WALL STREET LAW., June 2009, at 1, 5, available at Opportunity_June2009.pdf. 121 Barry P. Barbash & Jai Massari, The Investment Advisers Act of 1940: Regulation by Accretion, 39 RUTGERS L.J. 627, (2008) See SEC STAFF STUDY, supra note 7, at , 122 n.554; see also Lemke & Stone, supra note 120, at 5 ( Because traditional fiduciary duty principles are embedded in, but not defined by, the Advisers Act, the SEC and its staff have expansive leeway to identify and define new fiduciary obligations for advisers in light of ever-evolving circumstances, and they do this fairly regularly. ).

19 2012] THINKING BEFORE RULEMAKING 509 concept make it such that advisers cannot bypass their responsibilities by simply moving from one bad business practice to another. However, as illustrated in the recent Supreme Court decision in Jones v. Harris Associates L.P., 124 the indeterminate nature of the principle-driven regulation of advisers is not always pro-investor. In Harris, shareholders of a mutual fund sued the fund s managing investment adviser. 125 The shareholders alleged that the adviser breached his fiduciary duty in violation of the Investment Company Act (Company Act), which imposes a fiduciary duty on mutual fund managers with respect to their compensation. 126 The Court acknowledged that the statute was vague and that it offered practically no guidance as to the meaning of the adviser s duty under the statute. 127 Finding the lower court s interpretation of the fiduciary duty under the statute to be in error, 128 the Court held that a breach of a fiduciary duty claim under the Company Act will succeed only when the adviser charges a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm s-length bargaining. 129 Thus, despite the stringent Jones v. Harris Assoc. L.P., 130 S. Ct (2010). at Section 36(b) of the Investment Company Act states in relevant part: [T]he investment adviser of a registered investment company shall be deemed to have a fiduciary duty with respect to the receipt of compensation for services, or of payments of a material nature, paid by such registered investment company.... An action may be brought under this subsection by the Commission, or by a security holder of such registered investment company on behalf of such company, against such investment adviser... for breach of fiduciary duty in respect of such compensation or payments paid by such registered investment company... to such investment adviser or person. With respect to any such action the following provisions shall apply: (1) It shall not be necessary to allege or prove that any defendant engaged in personal misconduct, and the plaintiff shall have the burden of proving a breach of fiduciary duty. (2) In any such action approval by the board of directors of such investment company of such compensation or payments... shall be given such consideration by the court as is deemed appropriate under all the circumstances. 15 U.S.C. 80a-35(b) (2006). 127 See Harris, 130 S. Ct. at 1426 (referring to the Company Act s reference to a fiduciary duty with respect to the receipt of compensation for services as hardly pellucid. ); see also Transcript of Oral Argument at 30, Harris, 130 S. Ct (No ) (regarding the last sentence of 36(b)(2) of the Investment Company Act, Justice Scalia sarcastically remarked, That s a wonderfully clear command, isn t it? ). 128 Harris, 130 S. Ct. at ( By focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred. ). 129 at 1425 (quoting Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 928 (2d Cir. 1982)).

20 510 UNIVERSITY OF LOUISVILLE LAW REVIEW [Vol. 50:491 obligations typically associated with the fiduciary concept, 130 based on the Court s opinion, an adviser satisfies the fiduciary duty imposed by the Company Act so long as the adviser s fee does not shock the conscience when compared to the fees charged by similar advisers Problems Raised by the SEC s Use of Enforcement Actions in Establishing Standards of Conduct for Investment Advisers The SEC has supplemented the principle-driven fiduciary standard under the Advisers Act with specific standards of conduct through enforcement actions targeted at investment advisers and advisory firms. 132 Specific standards of conduct provide advisers with a level of clarity as to the exact nature of their fiduciary obligations to clients in particular circumstances. 133 Two recent enforcement actions, Sage Advisory Services, L.L.C. 134 and Jamison, Eaton & Wood, Inc., 135 demonstrate the SEC s use of enforcement actions against advisers to establish standards of conduct. The enforcement actions against Sage and Jamison were brought under 206 of the Advisers Act the Act s anti-fraud provision in relation to the advisers fiduciary duty of care. 136 Specifically, both cases concern an adviser s duty to seek best execution. 137 As noted earlier, the duty to seek best execution in connection with clients securities transactions is a part of an investment adviser s duty of care. 138 Sage concerned an agreement between Sage Services L.L.C. and a broker, under which Sage paid the broker thirty cents per share to execute transactions for Sage s largest client. 139 According to the SEC s settlement 130 See Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928); ROTMAN, supra note 82, at 244 ( [F]iduciary duties require fiduciaries to act selflessly, with honesty, integrity, fidelity, and in the utmost good faith in the interests of their beneficiaries. ). 131 See Harris, 130 S. Ct. at Barbash & Massari, supra note 121, at 628. The SEC s Division of Enforcement is responsible for carrying out enforcement actions. For more information on the Division of Enforcement, see About Division of Enforcement, U.S. SEC. & EXCH. COMM N, (last visited Dec. 18, 2011). 133 See SEC STAFF STUDY, supra note 7, at 22, Sage Advisory Servs., L.L.C., Securities Act Release No. 7997, Exchange Act Release No. 44,600, Investment Advisers Act Release No. 1954, 2011 WL (July 27, 2001) [hereinafter Sage]. 135 Jamison, Eaton & Wood, Inc., Investment Advisers Act Release No. 2129, 2003 WL (May 15, 2003) [hereinafter Jamison, Eaton & Wood]. 136 at *1; Sage, supra note 134, at * Jamison, Eaton & Wood, supra note 135, at *1; Sage, supra note 134, at * See discussion supra Part III.A.2 (explaining that the SEC has said that the suitability standard and the duty to seek best execution apply equally to investment advisers). 139 Sage, supra note 134, at *2 3.