The uniform standard of fiduciary duty called for by the Securities and Exchange Commission staff last week is likely to throw a wrench in the wirehouse business model.
Indeed, if the principles of the 1940 Investment Advisers Act, which currently governs the duties of registered investment advisers, become the core of such a standard, broker-dealers will be stymied.
“If you transposed the act onto our brokerage operations, there are a number of things that we wouldn't be able to do,” said James Wiggins, a spokesman for Morgan Stanley.
The sale of initial public offerings to a firm's clients would be one such forbidden activity.
Morgan Stanley was the largest underwriter of initial public offerings last year, and the ability to buy into IPOs is a major draw for many of its brokerage customers. Under current adviser rules, however, the firm's role as a dealer would preclude its brokers from offering IPOs to their customers.
“Our clients want them, but under certain definitions of fiduciary duty, we couldn't provide access to them,” Mr. Wiggins said.
In theory, a fiduciary standard could affect a broad range of dealer activities, including underwriting, market making and sales of proprietary investment products. Although commission-based compensation schemes in the brokerage industry arguably violate the fiduciary duty articulated in the Advisers Act, last year's Dodd-Frank legislation specifically said that charging a commission and selling proprietary products aren't necessarily violations of fiduciary duty.
Because of Wall Street's political clout, compliance experts doubt that brokers would come under the "40 Act umbrella, despite the SEC staff's recommendation that a standard “no less stringent” than the current adviser standard be adopted.
“Most people don't expect the standard will be the same as in the Advisers Act,” said Amy Lynch, founder and president of FrontLine Compliance LLC, which provides compliance consulting services for broker-dealers and investment advisers. “The language is going to be watered down.”
With the two SEC commissioners disagreeing with the report's conclusions, the language could be watered down considerably.
“It's all going to be hashed out at the commissioner level,” said Nancy Lininger, founder of The Consortium, a compliance consultant.
One new obligation that a uniform standard would require of broker-dealers is clearer and more comprehensive disclosure. That would include more information about fees in the investment relationship and all current and potential conflicts of interest at the outset of the relationship.
These disclosures likely would be along the lines of the current Form ADV documentation required of financial advisers, including Part 2, which provides a plain-English narrative description of the adviser's business, fees charged, products and services offered, and potential conflicts that the adviser may have.
For broker-dealers, whose disclosures typically are lengthy, dense and incomprehensible to the average investor, this would be a significant new obligation. Additional documentation around investment recommendations and executed transactions could also increase the disclosure burden significantly.
Other aspects of broker-dealer operations also could be affected.
The SEC report recommended that commissioners address the issue of principal trading, which could affect the market-making activities of broker-dealers. The bond market, which is almost entirely dealer-driven, could be especially affected.
“Under certain definitions, we couldn't be a market maker,” Mr. Wiggins said.
Investors with high concentrations of stock, such as corporate executives with large holdings of restricted company shares, also could present a problem. A fiduciary acting in the best interests of such a customer would counsel diversification, and under some interpretations of fiduciary duty, a broker might be unable to maintain such an account.
Along with the implementation of a uniform fiduciary standard, the SEC staff recommended harmonizing the regulation of brokers — currently overseen by the Financial Industry Regulatory Authority Inc. — and advisers — currently regulated by the SEC or state securities regulators — in order to “provide retail investors the same or substantially similar protections.”
If harmonization were to occur, the more stringent elements of each regulatory scheme might apply to both.
In the area of advertising, for example, broker-dealers could be required to stop using celebrity spokespeople in TV commercials, as well as fictional investors who entrust their life savings to brokers. Investment advisers are not allowed to use such campaigns.
A fiduciary standard would change the way broker-dealers conduct their business but is unlikely to force a wholesale restructuring of their operations.
With all the changes in the industry, the 1940 Advisers Act probably won't serve as the foundation of the new standard, said Ira Hammerman, general counsel of the Securities Industry and Financial Markets Association.
“It was written in a different time for a different world,” he said. “Over the last 25 years, there's been a convergence in business models, and now regulators are catching up to where businesses have been in the last few decades.”
E-mail Andrew Osterland at [email protected].
