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Act Could Impose Investment Advisor Fiduciary Standard on Broker-Dealers and Put an End to Mandatory Customer Arbitration

On July 21, 2010, President Obama signed into law the controversial and much anticipated Dodd-Frank Wall Street Reform and Consumer Protection Act (Act). The Act constitutes the most sweeping revision of the laws governing the financial services industry since legislation that was enacted during the 1930s in response to the Great Depression. The Act addresses a number of key areas which will impact the business of broker-dealers, both now and in the future.

One of the most striking aspects of the Act is the extent to which Congress left its provisions open to interpretation by regulators. While a few of the Act’s provisions become effective immediately, most will first require rulemaking by various federal financial regulatory agencies, and particularly by the Securities and Exchange Commission (SEC).

Under the Act, the SEC has the power to promulgate rules in a number of areas which could affect both the relationships of broker-dealers and their customers, and the resolution of disputes arising out of those relationships. Broker-dealers will need to be aware of this potential and seek to have appropriate input throughout the rulemaking process. Some of the more significant sections of the Act which affect broker-dealers are described below.

Fiduciary Duty (§913)

Early versions of the legislation made broker-dealers subject to the same fiduciary standards as investment advisors under the Investment Advisers Act of 1940. As the result of legislative compromise, the Act does not mandate the imposition of a fiduciary rule on broker-dealers. Instead, the Act requires the SEC to conduct a study to evaluate existing standards of care and conduct by broker-dealers and investment advisors who provide advice to customers. The study must be completed within six months of the enactment of the legislation, during which time the SEC also must seek public comment. Depending on the findings, the SEC has discretionary authority to promulgate rules for broker-dealers who provide personalized investment advice to retail and other customers — including the same fiduciary standard of care applicable to investment advisors under the 1940 Act.

Mandatory Arbitration (§921)

Since the Supreme Court’s 1987 decision in Shearson/American Express v. McMahon, 482 U.S. 220 (1987) (McMahon), brokerage firm customer agreements have included mandatory arbitration provisions requiring all customer-broker disputes to be arbitrated in the arbitration forums provided by industry sponsored self-regulatory organizations, principally the Financial Industry Regulatory Authority (FINRA). This method of dispute resolution has come under increasing criticism from consumer advocates and the claimants’ bar in recent years. In response, the Act authorizes the SEC to promulgate rules that prohibit or restrict firms from using agreements which include mandatory predispute arbitration provisions if the SEC determines that doing so is in the public interest and in the best interest of investors. When the McMahon decision was before the Supreme Court 23 years ago, the SEC submitted an amicus brief in support of the industry position that mandatory arbitration was appropriate. In the present climate of increased concern over consumer protection, the SEC quite possibly could conclude otherwise, which could subject firms to the vagaries of jury trials in at least some cases.

Accredited Investor Definition (§413)

Until now, the threshold for a natural person to be deemed an “accredited investor” under the Securities Act of 1933 was $1 million in net worth, which included the investor’s primary residence. However, effective upon enactment (unlike the other provisions discussed above), the Act revises that definition so that the principal residence is excluded from the calculation. Because the primary residence is frequently one of the principal assets — if not the principal asset — constituting an individual investor’s net worth, this could be very important in a case in which investor suitability is an issue. The SEC may, after review, make other adjustments or modifications to the definition “for the protection of investors, in the public interest, and in light of the economy.” Additionally, the SEC must review the definition of “accredited investor” at four-year intervals after the date of the Act’s enactment.

Disclosures and Studies (§§917, 919B, 956)

The Act authorizes the SEC to make rules regarding the disclosures that a broker must make in connection with the sale of investment products and services, including rules affecting costs, risks, compensation arrangements, broker conflicts of interest, and limitations on the range of products being offered by the broker. The SEC is also directed to conduct a number of studies that could eventually result in rulemaking and/or legislation, including studies to find ways to improve the financial literacy of customers, how costs and conflicts of interest are communicated, and customer access to registration information concerning brokers and investment advisors.

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These are just of few of the many provisions of the Act that will directly or indirectly affect the way broker-dealers and their parents and subsidiaries conduct business. Other provisions, for instance, address potential causes of action and penalties. Without a doubt, the Act is a game-changing event that will have far-reaching implications for broker-dealers.