K. Susan Grafton
Washington, D.C. +1 202 261 3399
New York +1 212 698 3611
Massachusetts’ Secretary of the Commonwealth, William F. Galvin, caused the Securities Division to issue, on November 29, 2019, a revised proposed uniform standard of conduct for broker-dealers, investment advisers, and their agents (collectively, Covered Persons) when making recommendations to retail customers or clients (collectively, Retail Investors) with respect to securities (Proposal).1 This development has the potential for significant commercial implications for not only broker-dealers and investment advisers, but also for mutual fund complexes and other investment product manufacturers. The Proposal follows an earlier proposal (Initial Proposal) issued the day after the Securities and Exchange Commission issued its Regulation Best Interest (Regulation BI) under the Securities Exchange Act of 1934.2
A public hearing is scheduled for January 7, 2020,3 and comments on the Proposal are due by such date.
If adopted, the Proposal would:
Regulation Best Interest
The SEC adopted Regulation BI on June 5, 2019, as part of a package of rules, amendments and interpretations under the 1934 Act. Among other things, Regulation BI sets forth a new standard of conduct applicable to broker-dealers when providing recommendations to retail customers regarding any securities transaction or investment strategy involving securities. Through its adoption of Regulation BI, the SEC strengthened the duties owed by broker-dealers to retail customers. Citing the benefits of preserving the broker-dealer business model, the SEC elected to impose a “best interest” standard of conduct on broker-dealers,4 rather than a uniform standard of conduct for broker-dealers and investment advisers, as Congress permitted in Section 913 of the Dodd-Frank Act. A uniform standard of conduct would have subjected broker-dealers as well as investment advisers to a fiduciary duty with respect to Retail Investors.5 As a result, Regulation BI has drawn criticism, with some believing that the federal standard does not go far enough.6 For example, Secretary Galvin has voiced his disappointment that Regulation BI did not adopt the uniform standard of conduct authorized by Section 913 of the Dodd-Frank Act, and a number of states in addition to Massachusetts have taken steps to impose a fiduciary obligation on broker-dealers and their agents.7 However, many have supported Regulation BI for preserving the broker-dealer business model and investor choice.8
Overview of Regulations Proposed in Massachusetts to Date
The Initial Proposal, which was published by the Massachusetts Securities Division on June 14, 2019,9 would have imposed a uniform fiduciary duty on Covered Persons when providing investment advice to Retail Investors. Specifically, under the Initial Proposal, any recommendations made or advice provided by a Covered Person would need to be in the best interest of the Covered Person’s client or customer without regard to the interests of the Covered Person.
The Massachusetts Securities Division, after an initial round of public comments, issued proposed revisions to the Initial Proposal on November 29, 2019. The revised Proposal, if adopted, would impose a strict fiduciary duty pursuant to which Covered Persons cannot rely only on disclosure and consent to cure conflicts of interest. For broker-dealers, which historically have not been subject to a fiduciary duty, this represents a significant departure from past obligations, as well as from their new obligations under Regulation BI.
Below is a brief summary of key differences between the Initial Proposal and the revised Proposal and highlights of additional considerations introduced by the Massachusetts Securities Division through the Proposal. Specifically:
Notwithstanding the potential issues with the Proposal identified above, Secretary Galvin’s view is that, the Proposal sets forth a uniform standard of conduct that: is clearly defined; addresses the most problematic areas in the industry; places affirmative duties to mitigate conflicts of interest; and protects investors who are confused about the differing duties between types of financial firms.15
Application to Investment Advisers and Broker-Dealers; Interpretive Questions
Revised Proposal and SEC-Registered Investment Advisers
It is possible that the Proposal could be read to impact SEC-registered investment advisers and their investment adviser representatives. However, modifications to the Initial Proposal arguably indicate that the Proposal is not intended to apply to SEC-registered investment advisers and their investment adviser representatives. Under the Initial Proposal, the term “adviser” was specifically defined as:
any person ... who receives any consideration from another person primarily for advising the other person as to the value of securities or their purchase and sale, whether through the issuance of analyses or reports or otherwise. It is a rebuttable presumption that such term includes all investment advisers and investment adviser representatives, as well as other persons who charge fees based on assets under management or portfolio performance for rendering investment advice.
Under this standard, it could be argued that the Initial Proposal was intended to capture SEC-registered investment advisers and their investment adviser representatives. However, this definition was removed from the Proposal and replaced with references to the definitions of “investment adviser”16 and “investment adviser representative”17 under the Massachusetts regulations. Because these existing definitions expressly carve out federal covered advisers from the definitions under the applicable Massachusetts regulations (and, therefore, the Proposal), the Proposal could be read, based on the plain meaning of its text, that it is not applicable to SEC-registered investment advisers and their investment adviser representatives.
The financial services industry generally has opposed state-level proposals for regulation governing the standard of conduct owed by broker-dealers and investment advisers to their respective customers and clients. Instead, industry participants typically have viewed the SEC or other federal regulators as the regulatory agencies best positioned to impose such standards. In seeking to minimize the potential impact or likelihood of adoption of any state-level regulations in this area, some industry observers have pointed to NSMIA as preempting states from regulating broker-dealers and investment advisers, except as permitted by Section 15(i) of the 1934 Act and Section 203A(b)(1) of the Advisers Act.18 However, state regulators have argued that this interpretation goes too far and would essentially neuter all state-level oversight.19 The SEC received comments during the drafting of Regulation BI requesting the SEC to explicitly mention NSMIA and the preemptive effect that Regulation BI would have on state laws, but the agency declined to include any such references in the final draft.20
The resolution of whether Regulation BI – or any other SEC action in this area – is sufficient to preempt the adoption of state-level fiduciary standards owed by broker-dealers and investment advisers to their respective customers and clients is uncertain at this time, and likely will be decided only after protracted litigation.21
A question arises as to whether or not any principal transactions would be permissible under the Proposal, given its: focus on loyalty, admonition to “avoid conflicts”; and insistence on a “without regard to” standard. Almost all fixed income obligations are traded on a principal basis, as are foreign currency transactions. Similarly, a firm usually acts in a principal capacity when it acts as an underwriter in an offering, or is part of an underwriting syndicate.
The Proposal also raises the question of whether a Covered Person that acts as a dealer (i.e., by both buying and selling the same security in its own account) would violate the Proposal. Similarly, if a broker-dealer acts as an underwriter or selling group member and sells offered securities as principal to retail customers, there is a question as to whether that would that violate the Proposal’s duty of loyalty. Congress in the Dodd-Frank Act and the SEC in Regulation BI, explicitly preserved the ability of broker-dealers to act as underwriters and dealers and to effect transaction on a principal basis. While the Request for Comment to the Proposal states that: “[t]hese [principal] transactions are not prohibited under the Proposal, but they do present conflicts of interest that must be addressed and managed according to the Proposal,”22 this creates uncertainty as to how Covered Persons could engage in those activities with Retail Investors and not violate the Proposal.23
The Proposal strongly signals Massachusetts’ willingness to take the lead on state initiatives to impose a fiduciary duty on both broker-dealers and investment advisers providing investment recommendations or advice to Retail Investors. Although there are expected to be a number of judicial challenges to any final regulations that are adopted, it is important for industry participants to evaluate the potential impact of state fiduciary initiatives on their operations and supervisory and compliance policies and procedures.
1) Solicitation of Comments on Proposed Fiduciary Conduct Standard for Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives.
2) SEC Final Rule, Regulation Best Interest: The Broker-Dealer Standard of Conduct (Regulation BI Release). For additional information regarding the final rulemaking package that includes Regulation BI, please refer to Dechert OnPoint, SEC Adopts Enhanced Standard of Conduct for Broker-Dealers and Clarifies Fiduciary Duties of Investment Advisers.
3) The hearing will be held at 9:30 a.m. on Tuesday, January 7, 2020 at John W. McCormack Building, One Ashburton Place, Ashburton Cafe Conference Room, Plaza Level, Boston, Massachusetts.
4) See footnote 2 (“Regulation Best Interest enhances the broker-dealer standard of conduct beyond existing suitability obligations, and aligns the standard of conduct with retail customers’ reasonable expectations by requiring broker-dealers, among other things, to: act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker-dealer ahead of the interests of the retail customer; and address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest, and in instances where we have determined that disclosure is insufficient to reasonably address the conflict, to mitigate or, in certain instances, eliminate the conflict.”).
5) Section 913(g) of the Dodd Frank Act authorized the SEC to harmonize the standards of conduct for broker-dealers and investment advisers, provided that such standard requires broker-dealers to act in their customers’ best interests “without regard to” the broker’s own financial interests.
6) While some consumer advocates have lauded the states willing to take a tougher stance, these observers do not take into account that a patchwork of regulations that differ among states and with applicable federal standards may: lead to additional investor confusion; undermine federal securities law; and result in less investor choice and fewer investment options in certain states.
7) For example, Nevada has already passed such a law and New Jersey has a proposed rule under consideration. Some interest groups have stated their belief that these state laws are preempted by Regulation BI because of the National Securities Markets Improvement Act (NSMIA). So far, the SEC has declined to address whether the state initiatives are preempted by NSMIA. But it is likely that the fate of many of these laws will be decided through extensive judicial proceedings.
8) See e.g., The Evolving Market for Retail Investment Services and Forward-Looking Regulation – Adding Clarity and Investor Protection while Ensuring Access and Choice, speech by Chairman Jay Clayton (May 2, 2018) (Chairman Clayton stating that “[a] principal focus of mine is working to ensure that both [the investment advisory and retail brokerage business models] remain available. I firmly believe we can preserve this choice, increase access to investment advice, lower costs, and, importantly, enhance investor protection”); see also Keynote Address: ALI CLE 2018 Conference on Life Insurance Company Products, Speech by Dalia Blass (Nov. 8, 2018) (“[J]ust as investors can benefit from a variety of financial services, they can also benefit from a variety of investment options. For one investor, a mutual fund may check all the boxes; for another, an insurance product may work better. That is why, as my staff and I continue our work, I believe it is important for us to keep in mind past experiences and focus on those policy options that help preserve choice for investors”).
9) Preliminary Solicitation of Public Comments: Fiduciary Conduct Standard for Broker-Dealers, Agents, Investment Advisers, and Investment Adviser Representatives.
10) Subject to the potential interpretive issue identified in the “Application to Investment Advisers and Broker-Dealers; Interpretive Questions – Revised Proposal and SEC-Registered Investment Advisers” section below, the Proposal’s requirements should be viewed as applying only to Massachusetts-registered investment advisers (i.e., not to SEC-registered investment advisers).
11) Under the Proposal a Covered Person would violate Section 207 by failing to act in accordance with its required fiduciary duty in any way during any period where the Covered Person: (i) has or exercises investment discretion over a Retail Investor’s account (except in certain limited circumstances); (ii) has a contractual fiduciary duty; (iii) has a contractual obligation to monitor a Retail Investor’s account on a regular or periodic basis; (iii) receives ongoing compensation or charges ongoing fees for advising a Retail Investor; or (iv) otherwise engages in conduct that results in a customer or client having a “reasonable expectation” that the Covered Person will monitor the Retail Investor’s account on a regular or periodic basis. However, neither “regular” nor “periodic” is defined in the Proposal.
12) This is in contrast to Regulation BI which requires firms to eliminate “sales contests, sales quotas, bonuses and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.” See Regulation BI Release.
13) As proposed, disclosure or mitigation of conflicts of interest, without more, would not be viewed as de facto compliance with the duty of loyalty.
14) See Regulation BI Release, 84 FR at 33318.
15) See supra footnote 1.
16) M.G.L. c. 110A, section 401(m) (defining “investment adviser” as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities ... . [but excluding any] “federal covered adviser”).
17) Section 401(n) (defining “investment adviser representative” to exclude persons employed by or associated with “a federal covered adviser, subject to the limitations of section 203A of the Investment Advisers Act of 1940”). For purposes of sections 401(m) and 401(n), the term “federal covered adviser” is defined as “a person who is registered with the Securities and Exchange Commission under section 203 of the Investment Advisers Act of 1940. ''Federal covered adviser'' shall not include any person who is excluded from the definition of ''investment adviser'' pursuant to clauses (A) to (G), inclusive, of paragraph (1) of subsection (m).” See section 401(o).
18) Section 15(i)(1) of the 1934 Act, added as a result of NSMIA, states that: “No law, rule, regulation, or order, or other administrative action of any State or political subdivision thereof shall establish capital, custody, margin, financial responsibility, making and keeping records, bonding, or financial or operational reporting requirements for brokers, dealers, municipal securities dealers, government securities brokers, or government securities dealers that differ from, or are in addition to, the requirements in those areas established under” the 1934 Act. (emphasis added). Similarly, Section 203A(b)(1) of the Advisers Act, added as a result of NSMIA, states that “No law of any state or political subdivision thereof requiring the registration, licensing, or qualification as an investment adviser or supervised person of an investment adviser shall apply to any person (A) that is registered under section  as an investment adviser, or that is a supervised person of such person, except that a State may license, register or otherwise qualify an investment adviser representative that has a place of business located within that State; or (B) that is not registered under [Section 203] because that person is excepted from the definition of an investment adviser under section [202(a)(11)].”
19) See Supplemental Comment Letter Re: Regulation Best Interest (File No. S7-07-18), Form CRS Relationship Summary, Amendments to Form ADV, Required Disclosures, and Restrictions on the Use of Certain Names or Titles (File No. S7-08-18), and Standards of Conduct for Investment Advisers (File No. S7-09-18), North American Securities Administrators Association, Inc. (Apr. 25, 2019); see also Mark Schoeff Jr., State regulators urge SEC not to try to block state fiduciary laws, Investment News.
20) See Federal Preemption of State Regulation under NSMIA: Regulation Best Interest (SEC Release No. 34-83062; File No. S7-07-18); and Form CRS Customer Relationship Summary (SEC Release No. 34-83063; IA-4888; File No. S7-08-18).
21) Indeed, as part of the Small Business Impact Statement released in connection with the Proposal, the Massachusetts Securities Division acknowledged that “[i]t is possible that newly-formed broker-dealers and existing broker-dealers who do not currently conduct business in Massachusetts may decide not to conduct business in Massachusetts if they determine that being held to a fiduciary standard will be too costly or subject them to too much regulatory risk. However, any potential deterrent effect on new business formation is substantially outweighed by (1) the cost to investors of conflicted advice, and (2) the ample and varied sources of financial advice already available to Massachusetts investors.” Initial Small Business Impact Statement Pursuant to M.G.L. c. 30A §§ 2 and 5 Massachusetts Securities Division Proposed Amendments to 950 CMR 12.200 (Dec. 13, 2019).
22) The Commonwealth of Massachusetts William Francis Galvin, Secretary of the Commonwealth Securities Division, Request for Comment, December 13, 2019 Section D.v.
23) This view is supported by the statement in the Request for Comment that:On a case by case basis, the Division may deem it a breach of the duty of loyalty to effect a principal transaction when an agency transaction would have been cheaper for the customer, to recommend an affiliated or proprietary product when a third-party product would be expected to be better for the customer or client, or to limit products offered in a way that disadvantages some or all of a firm’s customers or clients.
The authors would like to thank Christopher Dotson for his contributions to this OnPoint.