W. Scott Simon
Ninety years ago last week–Oct. 29, 1929, known as Black Tuesday–marked the official beginning of the Great Depression, according to most historians. America didn’t emerge completely from that worldwide disaster until the build-up began for World War II.
In an effort to repair some of the excesses in the country’s financial markets that helped lead to the Great Depression, Congress passed the Securities Exchange Act of 1934 (’34 Act) and the Investment Advisers Act of 1940 (’40 Act), both of which were signed into law by President Franklin Roosevelt. The ‘34 Act also created the U.S. Securities and Exchange Commission, the agency of the U.S. government with primary responsibility for enforcing federal securities laws.
The ’34 Act governs the activities of brokers and dealers as well as their registered representatives, which are subject to the suitability standard of conduct. This standard gives brokers and dealers a great deal of leeway in the way they choose to conduct securities trading with their customers; in effect, brokers and dealers need only make recommendations to their customers that are not unsuitable for them.
Companies raise capital by selling their stock in the primary market; this activity in “original issues” is regulated by the Securities Act of 1933. The ’34 Act, in contrast, governs the trading of these securities (stocks, bonds, and so on) in secondary financial markets. In those markets, trading often takes place between persons unrelated to the original issuing company, typically through brokers (conducting trading of securities for their customers as their agent) or dealers (conducting trading of securities for their own accounts as a principal in order to, for example, add to their inventory of stocks), or even both.
The ’40 Act governs the activities of registered investment advisors and their investment advisor representatives which are subject to the “best interest” fiduciary standard of conduct (compare that with the “sole interest” fiduciary standard of conduct required by the Employee Retirement Income Security Act of 1974).
The Fiduciary Wars: Once Again, With Feeling
The Fiduciary Wars that have raged over the past decade and a half have been fought on the turf of the ’40 Act. After all, it’s there that the activities and the regulation of RIAs and brokers and dealers meet head on. The ’40 Act, as noted, governs RIAs, but Congress recognized almost 80 years ago that brokers and dealers, in providing their transactional buy/sell services involving securities trading, might occasionally and inadvertently provide investment advice to their customers. But as long as that advice was “solely incidental” to the regular business of a brokers and dealers (as a broker/dealer) and the broker/dealer received no “special compensation,” then the broker/dealer wouldn’t be required to register as an RIA because it wouldn’t be deemed to be rendering ongoing investment advice. This is the narrow exemption for the inadvertent advice rendered by broker/dealers that was carved out of the ’40 Act. Congress, either then or today, clearly didn’t intend for such advice to include, say, comprehensive financial plans.
The XY Planning Network, LLC, et al., v. SEC, et al., Lawsuit
What’s revealing about the second of the lawsuits filed in September against the SEC and its chairman that seeks to overturn Reg BI–XY Planning Network, LLC (a consortium of RIAs), and one of its member firms, Ford Financial Solutions, LLC (an RIA)–is its discussion of the seemingly careless way in which the SEC defied the clear will of Congress. (I covered the first lawsuit filed by the attorney generals of seven states plus the District of Columbia in last month’s column.)
In response to the 2007-09 meltdown in financial markets, in 2010 Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (known as Dodd- Frank). Among other things, Dodd-Frank sought to level the regulatory playing field between broker/dealers and RIAs as a result of the brokerage industry encroaching on RIA turf. For years, broker/dealers have been increasingly providing full-fledged (not solely incidental) investment advice to their customers–clearly forbidden by the ‘40 Act–and, to add insult to injury, have failed in such situations to register as an RIA.
In section 913 of Dodd-Frank, the SEC was charged by Congress with correcting the mistake it has allowed to fester for so long: ensuring that broker/dealers play by the same regulatory rules required of RIAs.
Section 913(g)(1) authorized the SEC to “promulgate rules to provide that, with respect to a broker or dealer, when providing personalized investment advice about securities to a retail customer…the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an [RIA].”
Section 913(g)(2) further authorized the SEC to “promulgate rules to provide that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers…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.” It further states that “[s]uch rules shall provide that such standard of conduct shall be no less stringent than the standard applicable to [RIAs] when providing personalized investment advice about securities.”
In Reg BI, the SEC explicitly rejected the directive of Congress in section 913(g)(1) that the standard of conduct required of broker/dealers “shall be that same as” that required of RIAs under the ’40 Act.
The SEC also defied the will of Congress–as well as going against the recommendations made by its own professional staff–by refusing to ensure in Reg BI that broker/dealers “act in the best interest of the customer without regard to” a broker’s/dealer’s interests. Instead, the SEC inexplicably requires only that broker/dealers “act in the best interest of the retail customer at the time the recommendation is made without placing the financial or other interest of the broker/dealer…ahead of the interest of the retail customer.” The problem with that “standard” is that broker/dealers are allowed to consider their own interests in providing investment recommendations and advice.
This means that broker/dealers can continue to follow their business model in which conflicts of interests harmful to their customers are still allowed–while at the same time allowing them to market themselves as trusted advisers that act in their clients’ best interests. In choosing to follow this course of action, which directly contradicts the standard authorized in Section 913(g), where the interests of investors are the only relevant consideration, the SEC negated a crucial goal of Dodd-Frank–leveling the regulatory playing field between broker/dealers and RIAs–while not only doing nothing to reduce investor confusion but, in fact, actually increasing it.
Further, the SEC failed to obey the mandate of Congress that the standard of conduct required of broker/dealers “shall be no less stringent” than that required of RIAs under the ’40 Act.
In a nutshell, the SEC changed the narrow exemption for inadvertent investment advice given by broker/dealers that the ’40 Act commonsensically allows by enlarging it into a wide-open land rush (and completely upsetting the regulatory playing field, not leveling it) that will now allow broker/dealers to provide 1) full-blown (or even half-blown, for that matter) financial planning advice, 2) without having to follow a fiduciary standard for that advice nor its implementation, and 3) without requiring broker/dealers to register as RIAs.
The XY Planning Network lawsuit concludes quite properly that far from coming up with a harmonized standard of conduct applicable equally to both broker/dealers and RIAs, the SEC, through Reg BI, created a double standard when delivering investment advice. This, of course, is directly opposite to the fundamental, underlying goal of Congress as set forth in Dodd-Frank.
The SEC’s mission “is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.”
The problem is that Reg BI, as promulgated by the SEC, does not protect investors. Instead, it actively allows broker/dealers to engage in activities that are now even more harmful to investors. For example, I cannot think of a single study over the last decade that hasn’t found that investors are confused as heck by, say, what the term “fiduciary” means; what broker/dealers and RIAs are; the differing standards of conduct they are required to follow and the sharp differences in the services they provide; and by the way in which broker/dealers are compensated by investors and third parties. Reg BI tends to worsen these problems. Does anyone with knowledge of these issues really think, for example, that the SEC’s Disclosure Obligation is an improvement in making it clearer to retail investors the nature and amount of the fees they are charged?
And how are investors not confused even more by the SEC’s sly use of the term “Best Interest” in the very title of the Regulation and the “best interest” fiduciary standard of conduct required of RIAs under the ’40 Act? This simply makes investors think that when dealing with a broker/dealer, they are dealing with a fiduciary, which is patently misleading.
Instead of trimming the sails of the brokerage industry as it should have done years ago, the SEC not only stood by and allowed this encroachment, it actively promoted it not once (in 2005 via Release No. IA-2376/“Certain Broker-Dealers Deemed Not To Be Investment Advisers”–known as the Merrill Lynch Rule–which was vacated by the U.S. Court of Appeals for the District of Columbia Circuit in 2007), not twice (in 2007 re- proposing a loosened “solely incidental” interpretation for broker/dealers in Release No. IA-2652/“Interpretive Rule Under The Advisers Act Affecting Broker-Dealers”), but three times–now in 2019 with promulgation of Reg BI and Release No. IA-5249.
A number of commentators have expressed confidence that, when all is said and done, Reg BI will remain standing, unscathed by the two lawsuits filed in September (and perhaps others to follow). Are they looking at the same lawsuits that I am? Holy smokes: A first-year law student could pick out the yawning contradictions found in Reg BI and show how they have explicitly frustrated the will of Congress.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.