Congress is considering legislation that would require broker/dealer reps to adhere to the fiduciary standard. That could mean major changes in all areas of operation for firms and advisors
“Fiduciary” has quickly become the new buzz word in the investment industry, within the Obama Administration and on Capitol Hill; so much so, that the debate over whether a fiduciary standard should apply to all advice givers appears to have been skipped over and quickly replaced with a debate over what the standard should look like and how it should apply.
To act as a “fiduciary” is to serve under a legally defined standard of loyalty and due care to be exercised in the interest of your client. Despite opposition from industry groups such as the Financial Services Institute (FSI), the fiduciary standard will likely shape the conduct of all investment professionals who provide advice (whether it is called a fiduciary standard or not). As a result, many broker/dealer firms and registered reps are looking ahead and asking what this means for them.
No matter what changes come down the pike as a result of regulatory reform, the adoption of a fiduciary standard will mean fundamental changes in how the industry operates. Change will not occur over night, but firms and reps can be preparing for it as Congress and regulators are on a fast track to pass and implement reform. And embracing fiduciary principles now can put broker/dealers in a better position to adapt to the fast-changing landscape.
A New Frame of Mind
As currently envisioned, legislation seeking to align broker-dealer and investment advisor regulation would provide the SEC with an avenue for adopting and enforcing a fiduciary duty requiring investment professionals to act “solely in the interest of the customer or client” — without regard to the broker's or adviser's own interests, financial or otherwise. In addition, the SEC would have the authority to ban sales practices, conflicts of interest, and compensation schemes that interfere with the fiduciary duty. It would also establish rules for “simple and clear disclosures” related to the relationship between a professional and investor.
As a result of these changes, registered reps who give advice would need to adjust to a new frame of mind as their interactions with customers transform from a salesperson-customer association governed by transactional rules of conduct, such as the suitability standard, to an advisor-client relationship governed by a principles-based fiduciary standard. In practical terms, this means broker/dealers will have to change their approaches to training, disclosure, supervision, compliance and related regulatory requirements such as recordkeeping.
For starters, firms would be required to incorporate fiduciary concepts into their training in order to ensure that their registered reps fully appreciate the role of a fiduciary and how it affects investment advice and overall communications with investors. It would also affect compensation structures for reps who have traditionally received commissions and other financial incentives associated with product sales. For example, if broker/dealers were to adopt the fiduciary standard, it might mean an even greater shift towards fees and away from commissions.
The nature of products sold could also change. Through training, reps would need to become familiar with such product changes, as well as the complexity and costs of products and any potential conflicts of interest that could arise when they recommend specific products.
Advisors would also need to adjust their oral and written representations regarding the services and products they offer. Rules governing broker/dealer reps' disclosures would become aligned with current investment adviser disclosure requirements. This would mean clearly disclosing any unavoidable conflicts of interest as well as complying with any new regulations requiring straight-forward disclosures about the nature of the relationship between the investor and rep.
Broker/dealer firms also would have to update their supervisory procedures and compliance systems as appropriate and recognize that new recordkeeping requirements will play a key role in such updates. Firms and reps can expect new recordkeeping requirements to be aligned with existing investment adviser requirements. In other words, in addition to creating and maintaining account-record information, firms and reps would need to create and maintain records reflecting reps' interactions with investors as well as records evidencing that the rep has fulfilled his or her fiduciary obligations. What's more, because the fiduciary duty often extends beyond a transaction in a way that is different from traditional broker/dealer sales practice requirements, the nature of reps' and firms' reviews of customers' holdings in relation to their financial profile and how they document such reviews would also expand.
But maybe the most crucial area where rules could change for both broker/dealers and investment advisors is principal transactions. Any changes in requirements for how broker/dealer firms and reps engage in principal trades would have a major impact on large wirehouses with proprietary trading operations that sell out of their inventory to existing clients. If any new restrictions on principal transactions were adopted, these firms would need proper notice and time to alter their business operations.
Under current broker/dealer rules, reps can engage in principal transactions with investors without client consent and must only disclose their capacity in the transactions. However, investment advisors generally may only engage in principal transactions with both prior disclosure and client consent for each individual transaction. Some commentators, including the Securities Industry and Financial Markets Association (SIFMA), have observed that such trade-by-trade consent may be unnecessarily restrictive, while others have argued that any form of self-dealing should be banned because it represents an inherent conflict of interest and would undermine firms and reps' ability to uphold the fiduciary standard.
Prohibiting principal transactions outright may seem like the best course on the surface to remove broker/dealer self-interests; however, it is also a solution that would remove benefits for investors who, in some cases, get price advantages when buying from a broker/dealer's inventory. If such transactions are permitted, regulators would need to address how to “harmonize” current investment adviser and broker/dealer regulations. For example, receiving client consent on a transactional basis presents certain inefficiencies that could hamper market liquidity and adversely affect broker/dealers that hold securities in proprietary accounts.
As discussed above, a fiduciary standard alone cannot provide all of the protections necessary to safeguard investor interests and deter fraud. In the area of principal transactions, fiduciary obligations would be reinforced with other regulatory controls such as disclosure, fair pricing, and best execution rules. Indeed, both investment advisers and broker/dealers could be subject to tighter rules. At a minimum, simple and clear disclosures would be required so investors understand the nature of principal transactions, and as discussed above, firms and reps would need to create and maintain adequate records documenting these disclosures and any other interactions with investors.
Degrees of Change
Though many broker/dealers and reps stand to be affected by regulatory reforms that institute fiduciary and related obligations, it is important to recognize that not all firms and reps will experience changes in the same way depending on the services and products they provide. Also, as regulations change, the industry will react and evolve in new ways. In this case, given the increased focus on investment advice and interactions with retail investors, the adoption of a fiduciary standard of care for advice givers could result in a clearer division of responsibilities between reps who are investment service providers and reps who are investment product providers, which would make it somewhat easier to define and identify fiduciary obligations.
It is possible the SEC would adopt standards that provide scaled requirements based on services provided and investors served. For example, under current draft legislation, the existing broker exemption for “solely incidental” advice will remain in the Investment Adviser Act of 1940 and it will be up to the SEC to more clearly define what type of advice is “solely incidental” and whether fiduciary requirements will apply to such advice. In addition, most regulatory reform initiatives have focused on requirements for advice given to retail investors. Consequently, different regulations related to institutional investors could develop as well. Finally, as discussed earlier, those firms and reps that have already embraced a fiduciary-like relationship with their clients will be ahead of the curve. Once a fiduciary frame of mind has been adopted, they will be able to focus on improving their relationships with their clients as they adjust to any new regulatory requirements.
Kristina Fausti is director of Legal and Regulatory Affairs for Fi360, a consultant on fidcuariy issues. Before that she served as Special Counsel in the SEC's Division of Trading and Markets.