During the busy fall conference season for financial professionals, virtually every agenda includes coverage of issues associated with regulatory reform and the extension of the fiduciary standard to brokers and dealers who provide advice to retail investors.
One of the hot topics under discussion is how regulatory reform will affect financial advisers' ability to sell proprietary products. The language of Title IX of the Dodd-Frank Act provides the Securities and Exchange Commission considerable leeway in deciding how to use its authority to extend the fiduciary standard to brokers and dealers through rulemaking.
However, there are some important provisions that express congressional intent with regard to how advisers can offer proprietary products consistently with the legislation.
Congress recognized the potential conflicts of interest associated with recommending proprietary products but noted in the act that “the sale of only proprietary or other limited range of products by a broker or dealer shall not, in and of itself, be considered a violation of the [fiduciary] standard.”
A key phrase in the quoted passage is “in and of itself.” This is apparently intended to mean that, so long as other guidance and requirements of the act are met, proprietary products can be recommended to clients.
At least four other provisions in Title IX of the act seem to provide required constraints on advising retail investors to buy proprietary products. The most general calls upon the SEC to assure that in the rules it promulgates, “the standard of conduct for [brokers or dealers] ... shall be the same as the standard of conduct applicable to an investment adviser under Section 211 of the Investment Advisers Act of 1940.”
In turn, Section 211 of the Advisers Act obliges those giving personalized investment advice to, among other things, “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.” This is consistent with the cardinal rule of the fiduciary standard.
A second provision calls upon the SEC to “examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest and compensation schemes for brokers, dealers, and investment advisers that the commission deems contrary to the public interest and the protection of investors.”
Where the SEC goes with rules on this subject is particularly hard to project, but if the commission intends to be consistent with the well-established fiduciary duty of loyalty as it is applied under the Employee Retirement Income Security Act of 1974, the operative principle is that advisers and their employers shouldn't be permitted to make more money by recommending proprietary products than comparable non-proprietary products.
The third provision involves an implied duty of due care when recommending any product, proprietary or not. The act states: “Nothing in this section shall require a broker or dealer or registered representative to have a continuing duty of care or loyalty to the customer after providing personalized investment advice about securities.”
Although this provision opens up a can of worms, it does suggest that a professional who gives advice does owe the client the duties of due care and loyalty at the time that advice is rendered to buy a product.
Due care is a fiduciary obligation to act with the skill, prudence, diligence and good judgment of a professional. It goes beyond the suitability standard that applies to traditional brokerage transactions.
The fourth provision is specific to proprietary products: “Where a broker or dealer sells only proprietary or other limited range of products, as determined by the commission, the commission may by rule require that such broker or dealer provide notice to each retail customer and obtain the consent or acknowledgment of the customer.” Congressional intent seems clear here; the fiduciary duty should apply in the provision of advice to retail investors, especially when inherent conflicts exist.
From a practical perspective, it appears that advisers will be able to recommend proprietary products when providing advice to retail investors if they follow sound fiduciary processes. Specifically, advisers should apply the same due-diligence process both to proprietary and non-proprietary products; avoid the inherent conflicts associated with non-level-compensation arrangements that provide incentives to recommend one product over another, and provide written disclosure with informed client consent when the advice offered includes a proprietary product recommendation.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
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