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Sustainable Investing

The SEC Should Try Enforcing the Investment Advisers Act of 1940

The Securities and Exchange Commission favors the interests of broker/dealers over those of investors, says Scott Simon. Here's how.

According its website, the U.S. Securities and Exchange Commission has a three-part mission: protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. Many believe, however, that the SEC places undue emphasis on protecting the interests of broker/dealers and, by extension, the registered representatives they employ to the detriment of investors. This, they maintain, is due to the SEC's belief that broker/dealers are crucial in facilitating capital formation in our country's financial markets.

The view that the SEC favors the interests of broker/dealers over those of investors happens to be one that I share. The source from which that favoritism springs is the failure of the SEC to enforce the limited broker/dealer exclusion found in the Investment Advisers Act of 1940 ('40 Act).

Section 202(a)(11) of the '40 Act defines a Registered Investment Adviser (and, by extension, its investment adviser representatives--collectively, RIAs) as any person or firm that (1) for compensation, (2) is engaged in the business of (3) providing advice to others or issuing reports or analyses regarding securities. An entity must meet all three of these conditions to be considered an "investment adviser."

An entity that appears to meet all three conditions of the definition of an investment adviser can still avoid being subject to the '40 Act if it qualifies for an exclusion from the definition.

One such exclusion is a broker or dealer. The SEC defines a broker/dealer as "any person engaged in the business of effecting transactions in securities for the account of others," while an RIA is defined as an entity that "receives compensation for providing advice about securities as part of a regular business."

Broker/dealers registered with the SEC under the Securities and Exchange Act of 1934 ('34 Act) are excluded from the requirements of the '40 Act (a broker/dealer won't be classified as an RIA subject to the '40 Act's fiduciary standard) if the advice the broker/dealer gives is: (i) solely incidental to the conduct of their business as broker or dealer, and (ii) they do not receive any special compensation for providing investment advice. The SEC notes: "In general, a [broker/dealer] whose performance of advisory services is ‘solely incidental’ to the conduct of its business as a [broker/dealer] [i.e., effecting transactions in securities] and that receives no ‘special compensation’ is exempted from the definition of investment adviser."

According to the SEC, investment advice is "solely incidental" to broker/dealer services when the advice is "in connection with and reasonably related to the brokerage services provided." If the advice is not solely incidental, a broker/dealer will be subject to the '40 Act regardless of the form of compensation it may receive. To avoid receiving special compensation, a broker/dealer generally must receive only commissions, markups and markdowns.

In cases of a hybrid registrant (a broker/dealer receiving a fee based on a percentage of assets, compensating it for both investment advisory and broker/dealer services), the SEC maintains that a broker/dealer receives special compensation.

In sum, then, a broker/dealer can render investment advice only if it's incidental to--that is, a minor part of--the broker/dealer's sale of securities. If it's not incidental advice then, by (legal) definition, it has to be fiduciary advice, which thereby subjects the broker/dealer advice-giver to the fiduciary standards of the '40 Act.

So much for the law. And yet, many commentators continue to state incorrectly that broker/dealers provide investment advice. These commentators--even including some regulators who really should know better--don't seem to understand that broker/dealers cannot legally provide advice--particularly ongoing advice--unless it's "incidental” to their business as a broker/dealer.

They tell stories such as this: Many small investors like to work with broker/dealers and, in cases where they purchase mutual funds, are charged upfront commissions by broker/dealers that typically range from 2.00% to 4.75%. For each year that follows, they are also charged a fee typically ranging from 0.25% to 1.00% for the broker/dealer's ongoing investment advice.

This kind of story often appears in the media--like fingernails dragging across a chalk board to me--but it is flat out wrong. The ongoing fee described in these stories is what's known as a 12b-1 fee, which has nothing whatever to do with investment advice. In fact, the SEC defines a 12b-1 fee as: "So-called '12b-1 fees' are fees paid by a mutual fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses... Distribution fees include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature."

In short, 12b-1 fees are simply ongoing (trailing) commissions that broker/dealers receive for the products they have sold to, say, their small investor customers. They have nothing to do with being compensated for rendering investment advice--ongoing or otherwise--to their customers. When any fee is received in exchange for investment advice, a broker/dealer recipient would legally be transformed into an RIA. Broker/dealers do not--because they legally cannot--provide substantive investment advice. If they do, they are required to register as an RIA and submit to the fiduciary standard of the '40 Act.

A 12b-1 fee--whether it's an annual 0.25%, 1.00% or somewhere in between--is charged to a broker/dealer's customer on an annually recurring basis even if the customer never lays eyes on the broker/dealer again. The only way a broker/dealer’s customer can avoid that charge is to sell the mutual fund. Of course, an investor no longer satisfied with an RIA with which it works can fire the RIA without dumping the mutual fund.

It is therefore wholly false for these stories to say that making broker/dealers submit to a fiduciary standard will mean that their customers will not receive valuable personalized investment advice in, say, the next market downturn. Broker/dealers are legally permitted to render advice only in connection with "effecting transactions in securities," but not for ongoing investment advice.

That's why I suggest in the most humble way that the SEC thoroughly enforce the bright line between broker/dealers and RIAs--that is, the limited broker/dealer exclusion--found in the '40 Act. The SEC's strict enforcement of this would go a long way in helping all understand that broker/dealers are engaged in (nonfiduciary) sales (which have value in the right context) while RIAs are engaged in providing (fiduciary) advice. This will help clear up the great mischief allowed by the SEC prior to, and especially subsequent to, 2007 when it lost the Merrill Lynch case in the U.S. Court of Appeals for the District of Columbia Circuit.

And yet, remarkably, the SEC still insists in Regulation Best Interest on trying yet again to enlarge the scope of the broker/dealer exclusion in the definition of an investment adviser in the '40 Act. That effort alone shows that the SEC favors the interests of broker/dealers over those of investors, which is directly contrary to its core mission.

Access Scott's previous articles here. W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. For more information, visit Prudent Investor Advisors, or email The views expressed in this article do not necessarily reflect the views of Morningstar.

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