“Only government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless.” --Milton Friedman
On July 10, 2009, the Obama administration released the Investor Protection Act of 2009. The proposal was introduced by Rep. Paul Kanjorski (D-PA) on October 1, 2009. The proposal would amend both the Investment Advisers Act of 1940 and the Securities Exchange Act of 1934 to authorize the Securities and Exchange Commission (SEC) to issue rules that require broker-dealers and investment advisers to be held to a fiduciary standard when providing investment advice to retail customers.
Currently, investment advisers and broker-dealers are subject to different standards of care and regulatory regimes. Pursuant to the anti-fraud provisions of the Investment Advisers Act and most State laws, investment advisers owe a common law fiduciary standard of care to their customers. A fiduciary standard is an obligation to act in the best interest of the client; meaning, an investment advisers must hold the client’s interests above their own. This standard is enforced by the SEC and the States. Broker-dealers are subject to general anti-fraud limitations under the Securities Exchange Act of 1934, as well as a “suitability” standard and other conduct standards prescribed by the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization. Under suitability requirements, a broker-dealer must have an "adequate and reasonable basis" for any recommendation that it makes. In other words, broker-dealers must act according to what is “suitable” for the client based on the client's financial situation and objectives. The suitability standard is enforced by FINRA. However, as the capital markets have evolved, institutions and individuals have come to perform both services and register under both Acts.
While increasing the standard of conduct for broker-dealers that provide investment advice to retail customers may be prudent, legislation attempting to do so must be well thought out and carefully crafted to ensure that it does not cause harm to an economy experiencing record deficits with fragile capital markets.
ISSUES OF CONCERN
Creates Uncertainty In the Marketplace: The current standards for investment advisers and broker-dealers are well established and interpreted under case law. All participants in this market know the current standards and have a general understanding of what to expect if litigation becomes necessary. The new harmonized standard would be subject to additional legal interpretation for broker-dealers, unnecessarily creating uncertainty for market participants at a time when certainty is needed the most. Also, the Kanjorski proposal would provide the SEC with the authority to expand the application of the new standard of care beyond broker-dealers and investment advisers who give advice to retail customers. (The proposal defines a retail customer as individuals or legal representatives who receive “personalized investment advice from a broker, dealer, or investment adviser; and…use such advice primarily for personal, family, or household purposes.”) However, the proposal provides that the new standard of conduct would apply to broker, dealers and investment advisers in providing advice to retail customers “and such other customers” as the SEC may provide. For example, a broker who is not providing personal investment advice but is merely executing an order on behalf of a customer may be subject to the new standard of care if the SEC deems it so. Such an expansion of the fiduciary standard to broker-dealers that provide impersonal investment advice like providing proprietary products and services could have a damaging impact on an otherwise successful business model.
Lacks Proper Oversight: The proposal would “harmonize” the standard of care without harmonizing the oversight and enforcement of the new fiduciary standard. Currently, almost all broker-dealers are examined by the SEC or FINRA every two years while less than 10 percent of investment advisers are examined by the SEC on a yearly basis. Absent proper oversight and enforcement to ensure that participants comply with the new duties, the proposal would be ineffective. For example, Bernard Madoff had a fiduciary obligation to his client, but he violated all of its tenets.
Creates A Windfall for Trial Lawyers: Arbitration is used to resolve disputes among industry members, their employees, and individual investors. Rather than bearing the massive expenses associated with litigation, arbitration provides a less expensive way for all parties involved to resolve controversies. Cases involving investors are resolved by a neutral panel of three arbitrators. Arbitration awards are to be paid within 30 days of the date of the award, unless a party seeks judicial review.
Rep. Maxine Waters (D-CA) is expected to offer an amendment during markup in the Financial Services Committee that would permit private securities class actions based on “scheme liability”—overturning the Supreme Court’s decision in Stoneridge v. Scientific-Atlanta (2008). The amendment would create a new private cause of action against any company and individual who did not violate the securities laws but rather, without knowing they were doing so, allegedly provided “substantial assistance” to another business or someone else who violated those laws. It is an invitation for lawyers to impose liability under a theory of guilt by association.
Increases Costs for Investors: As investment firms begin to factor in the risk of litigation, the associated costs would be passed on to customers, making investment transactions more expensive.
Increases Costs for Taxpayers: The proposal would authorize more taxpayer funds to be appropriated to the SEC for the next six fiscal years. The proposal would increase the SEC’s budget by an additional $89 million for FY 2010 and an additional $56 million for 2011. For FY 2014, the bill allocates $2 billion, and for FY 2015, the bill allocates $2.25 billion. These allocations are in addition to “any other funds authorized to be appropriated to the Commission.”