The so-called Dodd-Frank 913 study fails to call for greater ethical mandates for broker-dealers and misses the critical issue of regulating market-makers and their duties to retail customers.
An important element of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was reform of the broker-dealer industry, the implementation of strong new fiduciary standards, and enhanced transparency for retail investors.
Since the adoption of Dodd-Frank, the Securities and Exchange Commission has sought to enact rules that make this legislative mission a reality.
Publicly, the SEC has represented that Dodd-Frank rules and studies have remained true to the central purpose of the legislation through protecting investors and encouraging issuance of strong fiduciary standards. The SEC has assured investors that the new rules of the game are fair, transparent, ethical, and founded upon good governance.
For example, in the broker-dealer space, Carlo V. di Florio, director of the SEC Office of Compliance, Inspections, and Examinations, explained in a speech entitled "The Role of Compliance and Ethics in Risk Management" that the Dodd-Frank mandated 913 broker-dealer study is emblematic of how ethics can shape the new securities legislation and fiduciary standards in general:
"The manner in which the federal securities laws are illuminated by ethical principles was well illustrated by the Study on Investment Advisers and Broker-Dealers that the Commission staff submitted to Congress earlier this year pursuant to Section 913 of the Dodd-Frank Act," Florio remarked.
However, contrary to Florio's statements, the 913 study fails to adequately address key underlying issues surrounding broker-dealer fiduciary standards. The study does not call for greater ethical mandates for broker-dealers and misses the critical issue of regulating market makers and their duties to retail customers.
The 913 Study
Section 913 of the Dodd-Frank Act required the SEC to conduct a study on the effectiveness of existing fiduciary standards regulating the conduct of broker-dealers and investment advisors that provide personalized advice to retail customers.
On Jan. 21, 2011, the SEC issued its published 913 Study on Investment Advisers and Broker-Dealers. Specifically, the SEC recommended adoption of a new "uniform" fiduciary standard that would apply to both broker-dealers and investment advisors. The proposed standard is intended to supplement existing fiduciary standards under the Investment Advisers Act of 1940 and would read as follows:
"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."
The 913 report explained that the components of this new fiduciary standard would include a duty of loyalty and a duty of care pursuant to the current standard under Section 206 of the Investment Advisers Act. Notably, the standard would not require a continuing duty of care or loyalty to a retail customer after personalized investment advice has been rendered.
To implement the report's recommendations, the document called for rulemaking, the identification of specific examples of material conflicts and consistent interpretations for broker-dealers and investment advisors.
The Proposed Uniform Fiduciary Standard
The 913 report does not provide guidance as to the most important element of the new standard: "the best interest of the customer." The proposed "best interest of the customer" is a highly subjective standard for broker-dealers and at the heart of the new uniform fiduciary standard.
Who is to decide what is in a retail investor's best interest?
Sophistication is clearly not universal for retail investors. The 913 report concedes that "retail customers do not understand the roles of broker-dealers and investment advisers." Therefore, it is unrealistic to conclude that all retail investors will understand what sort of trades and securities are most suitable for them. While broker-dealers are currently guided by case law suitability rules, it is unclear if the subjective "best interest" determination should fall within these suitability precedents or whether a greater standard should be established.
Rather than subjective suitability and best interest determinations, broker-dealer conduct should be regulated by bright-line, objective rules that make clear what interests of retail investors should be fundamentally protected. The study fails to elucidate any such standards, and as a result, makes the broker-dealer regulatory landscape even more confusing.
Disclosure of "Material" Conflicts and the Problem of Market-Making
The 913 study maintains that the duty of loyalty under the Advisers Act, incorporated into the Uniform Fiduciary Standard, would mandate "full and fair disclosure of all material conflicts of interest." Nonetheless, the 913 report states that this duty "is not continuing" and only "requires a firm to eliminate or disclose material conflicts of interest, it does not mandate the absolute elimination of any particular conflict." The document defers to the SEC rulemaking process in deciding what conflicts are "material" and require disclosure.
These recommendations fail to elucidate objective standards broker-dealers can apply in realistic transactions. Broker-dealer interests may undeniably conflict with retail customers when the dealer engages in proprietary trading. In these instances, what sort of information should broker-dealers disclose? Even when appropriate disclosure occurs, how will retail investors know the true nature of "material" conflicts when the SEC itself acknowledges that their education and knowledge is inadequate?
Perhaps most troubling is the absence of the market-maker issue in the 913 study. Market-makers are critical components of the financial system because they receive buy and sell offers for the asset inventory they hold. They buy and sell their own inventory for profit and often reject lower prices to receive a greater return.
As a result, retail investors purchasing securities priced by market-makers likely do not buy such assets at the best possible market price. Retail investors may be receiving overpriced securities from their own broker-dealers and other market-makers because of conflicts of interest in the current system.
Because of this situation, there should be rules governing the duties and appropriate disclosures from market-makers and broker-dealers. Particularly, market-makers should be compelled to disclose the price quotes they receive for their own inventory, bought and sold, that end up in the accounts of retail investors.
This should especially be an issue front and center for the SEC because of the role of market makers in the financial crisis. Market-maker banks and broker-dealers sold assets at levels higher than their true value to realize greater profits when it was known that such prices were inflated representations of market value. The 913 report suggests no solution or specific disclosure to this problem.
The SEC has proclaimed that the 913 study and the proposed uniform fiduciary standard are a major triumph for the agency and a win for governance and better business ethics. Yet, the standard suggests nothing new other than to propose an open-ended universal fiduciary standard that is overly ambiguous and dependent upon future SEC rulemaking.
Most troubling is that the report dodged the most critical issue of market-maker trading. Market-makers owe a greater duty to retail investors because they price the assets received from broker-dealers. Retail investors deserve investments that are priced fairly and in their best interest, not in the best interest of a market-maker bank.
In a free market, investors should, at the very least, be aware of all quotes received for market-maker inventory to evaluate (along with their broker-dealer) if the asset is a fair price and in their best interest. This would be a clear rule that would forward the key principles of Dodd-Frank: transparency, good governance, ethics, and better fiduciary standards.
The 913 rules will be issued later this year or in the early part of 2012. It remains to be seen what elements of the report will be implemented. However, based upon the language of the study itself, the SEC seems to be on the wrong track. The agency must be willing to take an aggressive stand on enhancing broker-dealer and investment advisor regulation when markets, investors, and the general public need them most.
Jordan D. Mamorsky is an attorney and Post Doctoral Research Fellow at Yale University. His research focuses on corporate governance and the ethical failures that contribute to financial crisis, securities fraud and breach of legal fiduciary duties.
1. See Dodd-Frank Section 913
2. See SEC Study On Investment Advisers and Broker-Dealers
3. Id. at VI.
4. Id. at 116
5. Id. at 113
6. Id. at 112