There has been a lot of discussion over the last year on the different standards for broker-dealers and investment advisers. Under current regulatory requirements, broker-dealers do not have a fiduciary duty to their clients. Broker-dealers must abide by the anti-fraud provisions of the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) and must follow rules instituted by exchanges they are members of and the rules of the Financial Industry Regulatory Authority (“FINRA”). Investment advisers are largely governed by the Investment Advisers Act of 1940 (“Investment Advisers Act”), rules promulgated under the Investment Advisers Act, and state laws. Pursuant to the Investment Advisers Act, investment advisers have a fiduciary duty to their clients. Having a fiduciary duty to clients means that by regulation investment advisers are held to a higher standard than the standard that applies to broker-dealers. A study conducted by the U.S. Securities and Exchange Commission (“SEC”) in 2011 found that the average investor did not understand the difference between a broker-dealer and an investment adviser.
A new rule that took effect Monday, July 9th for broker-dealers looks similar to a fiduciary standard. Ron Rhodes, professor of law, Certified Financial Planner (“CFP”) and a scholar on the subject, recently explained that FINRA Rule 2111 imposes a duty of care on broker-dealers but falls short of imposing a duty of loyalty. The FINRA Rule creates a new suitability standard for broker-dealers: recommendations should be made in the “best interests” of their clients. In order for recommendations to be in the best interest of clients a broker-dealer or associated person needs to reasonably gather information from the client before then making a recommendation that fits the investor’s circumstances. Broker-dealers have a due diligence obligation to conduct reasonable basis suitability, customer-specific suitability, and quantitative suitability.
The “best interest” suitability standard is similar to an investment adviser’s fiduciary duties. “The suitability requirement that a broker-dealer make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests.” Investment advisers in their fiduciary duty must act in the best interest of their client and disclose any conflicts of interest that may be present. According to Rhodes, one major difference is that investment advisers acting in their fiduciary duty must select or recommend the best product while broker-dealers must select a product that meets the suitability requirements.
Following the approval of the rule by the SEC in 2010, FINRA issued Regulatory Notice 11-25 to offer guidance on the rule. Earlier this year FINRA came out with Regulatory Notice 12-25 that further clarified the rule. According to FINRA, the new rule “imposes broader obligations on firms and associated persons regarding recommendations of investment strategies involving a security or securities.” FINRA Rule 2111 “would cover a recommended investment strategy involving a security or securities regardless of whether the recommendation results in a securities transaction or even mentions a specific security or securities.”
Rhodes believes that the biggest change for broker-dealers is the indication by FINRA that broker-dealers must document and support their investment strategies. As a result of FINRA Rule 2111, broker-dealers should document why they chose the strategy and why other strategies were rejected. Rhodes believes imposing this requirement to broker-dealer reps is effectively requiring service more akin to the ongoing monitoring and supervision/application of an investment strategy that provided by investment advisers.
FINRA Rule 2111 also broadens the investment traits that broker-dealers and associated persons must attempt to collect from clients before making a recommendation. Prior to the new rule, broker-dealers were required to gather information on other investments, financial situation and needs, tax status, and investment objectives. The additional traits included in FINRA Rule 2111 are customer’s age, investment experience, time horizon, liquidity needs and risk tolerance. Broker-dealers and investment advisers should make it a practice to obtain these traits in any due diligence investigation of a client prior to making recommendations. Furthermore, FINRA Rule 2111 broadens what is considered an investment strategy to include recommendations to “hold” a security or securities. The recommendation to hold must be an explicit one. An implicit recommendation to hold, for example by being silent, would not apply to FINRA Rule 2111.
Many broker-dealers are speculating that this new rule and the FINRA Regulatory Notices are signs that they will soon be held to the same fiduciary standard as their investment adviser counterparts. To keep up to date on any new rules or regulations, stay connected with RIA Compliance Consultants.
Posted by Bryan Hill
Labels: Due Diligence, Fiduciary, FINRA, SEC
