SecuritiesAdviser. What the uniform fiduciary standard means for broker-dealers

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1 SecuritiesAdviser News and analysis for the securities and commodities industry October 2013 What the uniform fiduciary standard means for broker-dealers Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), the SEC was given the authority to but is not required to adopt a uniform fiduciary standard of conduct for both broker-dealers (BDs) and registered investment advisers (RIAs) when providing financial advice to retail customers. If implemented, the standard must be no less stringent than that which is already applicable to investment advisers under the Investment Advisers Act of 1940 (Advisers Act). 1 The development of a uniform fiduciary standard is complicated by the fact that BDs and RIAs currently operate under vastly different business models, and heightens the responsibility of retail customers to be fully educated with regard to their investment strategies. In addition, a separate rule may need to be developed for individual retirement accounts (IRAs) and pension plans. Earlier this year, the SEC requested quantitative data and economic analysis from RIAs, BDs and industry groups to determine the following: 1. the benefits and costs of establishing such a standard; and 2. whether there should be broader harmonization between BD and RIA regulations, including record keeping, advertising, pay to play and other obligations that currently apply to them 2 ¹ See ² Ibid.

2 The Securities Industry and Financial Markets Association (SIFMA), which represents hundreds of securities firms, banks and asset managers, has long supported such a uniform fiduciary standard and recently submitted a letter in response to the SEC s request for information relating to it. SIFMA has also been a strong proponent of investor education to help individuals of all backgrounds increase their understanding of financial markets and make informed decisions about their personal finances. In this issue of SecuritiesAdviser, we will discuss the latest developments regarding the standard, SIFMA s response and results from its study of potential costs associated with complying with a uniform fiduciary standard, the Department of Labor s (DOL) proposal, and what BDs and RIAs should do to prepare. Background Currently, BDs and RIAs are subject to different regulatory regimes, although some of their services are similar. Many investors are unaware of the difference between BDs and RIAs or their legal implications. Before delving into the SEC s proposed fiduciary standards for BDs and RIAs, it is worth reviewing the differences between them and their respective regulatory frameworks. In basic terms, the BD business model is transaction-based and customers are charged a commission per event, while the RIA requires attention over time and charges clients a fee. Broker-dealers A BD is a person or company that buys and sells securities on behalf of its customers, for its own account or both, and receives a commission for each transaction. BDs are regulated by the SEC and must be members of the Financial Industry Regulatory Authority (FINRA), which is their governing body. BDs are held to standards set by FINRA, and must follow its suitability rule. Last year FINRA released Rule 2111, a revised version of the suitability rule, which became effective on July 9, The revised rule states that BDs must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer. 3 In addition to revising the suitability rule, FINRA also adopted new communications rules for dealing with clients. Rule 2210, which went into effect in February 2013, reclassified all BD communications into three new categories: correspondence, retail communications and institutional communications. FINRA has also surveyed its members regarding conflicts of interest and intends to issue a white paper on best practices by fall See 2 SecuiritesAdviser October 2013

3 RIAs An RIA is a person or company who receives compensation for providing investment advice to clients. The adviser s fee is generally not associated with the investments chosen. Investment advisers managing more than $110 million in assets must register with the SEC. Advisers managing less than $110 million are subject to securities regulations for the state in which they primarily operate. 4 Investment advisers are held to the fiduciary standard established by the Advisers Act, which requires them to act in the best interest of their clients. 5 A critical difference between BDs and RIAs is that under current regulations, BDs do not have a legal fiduciary duty to act in the best interest of their clients, but rather must adhere to the suitability rule. Some BDs contend that improved disclosures on investment products would be sufficient to satisfy their fiduciary duty to clients, and that broker-dealers are already being held to a higher standard in terms of oversight, enforcement and accountability. RIAs claim that establishing a new uniform rule would dilute the current, well-established standard. SEC s request for data In response to the SEC s request, SIFMA submitted a 25-page reply, which addressed several issues concerning the standard. 6 While SIFMA has long supported the need for a uniform fiduciary standard and broader harmonization of BD and RIA regulations as they relate to providing services to retail clients, it has argued against overlaying existing Advisers Act guidance on BDs because of the differences between BD and RIA business models. According to SIFMA and other industry groups, BDs should not be held to the same rules, guidance and legal precedents that apply to RIAs because of the differences in their respective business models. SIFMA has suggested that the SEC should instead apply to BDs the fiduciary duties outlined in Section 15(k) of the Securities Exchange Act of The Advisers Act requires continuous fiduciary duty to clients, while providing discretionary advice and avoiding conflict. SIFMA contends that a BD s fiduciary duty is not continuous, but rather is more transaction-oriented in nature. Further, the BD model does not seek to avoid conflicts, but tends to disclose and manage them. One of the unintended consequences of applying Advisers Act guidance to BDs would be an increase in legal and compliance costs for the BD, which would reduce access and affordability for retail clients. Furthermore, given conflict-of-interest provisions in the Advisers Act, BDs could be less motivated to develop new products, resulting in fewer investments options for investors. The SEC must take into account the differences in BDs and RIAs respective business structures when developing a uniform fiduciary standard. 4 See 5 See p SecuiritesAdviser October 2013

4 As part of its request for information, the SEC asked for potential costs that could result from various approaches to implementing a new fiduciary standard. In response, SIFMA collected data from 18 member firms, which, as of Dec. 31, 2012, collectively held $4.8 trillion in assets, representing 48 million retail client accounts. 7 SIFMA said their cost projections focused on two key areas where costs are expected to be significant: 1. Upfront disclosure documents: The disclosure document is similar to the relationship guide that advisers supply to clients on Form ADV Part 2A, which is generally given to clients upon opening a new account. Firms estimated that creating, maintaining and updating this document would cost an average of $2.8 million the first year and $631,000 each subsequent year. Respondents estimated that they would have to supply such documents to a combined total of 51 million customers New systems and procedures: Respondents estimated that developing, upgrading and maintaining new systems and procedures to comply with the new standard would cost approximately $5 million the first year and $2 million each subsequent year. 9 Given that the specifics of the SEC s proposed fiduciary standard are still unclear, SIFMA has indicated that it is very difficult to collect data. SIFMA also noted that not all costs and benefits can be reduced to a dollar amount. Nevertheless, they cautioned that cost estimates could increase substantially if the SEC does not implement the standard in a way that appropriately addresses the broker-dealer model. Prospective DOL fiduciary rulemaking Concurrent with the SEC s efforts to promulgate a uniform fiduciary standard, the DOL is seeking to revise its own fiduciary rules. In 2010, the DOL proposed expanding the definition of fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA). While the initial proposal was withdrawn, the DOL is expected to recast its rule in the next several months. A notice of proposed rulemaking on the DOL s spring 2013 regulatory agenda indicated that the rule may be recast as a conflict-of-interest rule. While the full details of the DOL s proposal are not yet known, the proposed rule would have widespread impact on many service providers who are not currently considered ERISA fiduciaries. 7 See p Ibid., p Ibid., p SecuiritesAdviser October 2013

5 According to SIFMA, the rule would result in nearly every BD that deals with IRAs or other retirement plans being considered a fiduciary, and thus subject to standards contained in ERISA and the Internal Revenue Code. Such standards would require compliance with prohibited transaction rules, which conflict with the BD commission-based model. Under the DOL s expected proposal, the receipt of commission would be a violation of fiduciary duty as expressed in Section 913 of the Dodd-Frank Act. SIFMA also noted that the DOL s proposal could limit access to important investment information for millions of investors. For example, any discussion regarding rolling over 401(k) assets into an IRA would be considered a fiduciary conversation; even such basic questions as the timing of when to take a distribution would give rise to fiduciary standards. Currently, overall IRA assets are approximately $5 trillion and are expected to reach $7.3 trillion by 2016; needless to say, the impact of the DOL s rulemaking would be vast. 10 It is important to note that the DOL is not acting under direction by Congress, as the Dodd-Frank Act specifically called for the SEC to review the issue of fiduciary duty. Although we think the DOL should allow the SEC to complete their review, both agencies are moving forward separately with their proposed fiduciary rulemaking. BDs should pay close attention to the DOL s new rules when they are released because they are expected to be much stricter for ERISA plans and IRAs. FINRA s best practices In an effort to identify problems and highlight best practices, FINRA is collecting data from 14 large firms on how they define and manage conflicts of interest with clients. The purpose of the study is to identify best practices, give feedback to the firms and encourage adoption. As part of the review, FINRA is particularly interested in conflicts of interest regarding internal and third-party compensation and the sale of proprietary products. 11 FINRA is expected to discuss its findings in a white paper scheduled to be released in fall Next steps for BDs and how we can help We encourage BDs to pay close attention to the DOL s new rules when they are released, because they will have significant impact on them with regard to their IRA and pension plan practices. Not only do we believe BDs should strongly consider the best practices FINRA is expected to outline in its upcoming white paper, we think the DOL should also pay careful attention to them, since FINRA is better equipped to make recommendations on fiduciary standards. Ultimately, we believe BDs should refer to FINRA s revised suitability rules for guidance and next steps. To the extent the DOL and the SEC establish their new respective rules, Grant Thornton LLP s dedicated Financial Services professionals have the experience to help you interpret the new rules and apply them to your business. 10 See external.cerulli.com/file.sv?f0000fa 11 See 5 SecuiritesAdviser October 2013

6 The following are some of our business advisory services: Perform audits of IRAs and pension plans for compliance with new DOL rules Review sales practices Review operations at branch offices Assist with development of new systems required to comply with new rules Review best practices and implement FINRA recommendations Review documentation to demonstrate that reasonable diligence was used when making investment recommendations Review staffing required to comply with new rules Review of compliance with the customer-specific and quantitative suitability rule documentation Assist in validation of customers financial markets education process Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information on the issues discussed, consult a Grant Thornton LLP client service partner or another qualified professional. About Grant Thornton LLP The people in the independent firms of Grant Thornton International Ltd provide personalized attention and the highest-quality service to public and private clients in more than 100 countries. Grant Thornton LLP is the U.S. member firm of Grant Thornton International Ltd, one of the six global audit, tax and advisory organizations. Grant Thornton International Ltd and its member firms are not a worldwide partnership, as each member firm is a separate and distinct legal entity. In the United States, visit Grant Thornton LLP at Contact information Nichole Jordan National Banking & Securities Sector Leader T E nichole.jordan@us.gt.com Jack Katz Global Leader; National Managing Partner, Financial Services T E jack.katz@us.gt.com Grant Thornton LLP All rights reserved U.S. member firm of Grant Thornton International Ltd 6 SecuiritesAdviser October 2013