Fiduciary Duties of Broker Dealers & Investment Advisers

Dodd-Frank Wall Street Reform and Consumer Protection Act

In the wake of the 2008 financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was signed into law on July 21, 2010 to create broad financial regulatory reform concerning fiduciary duties of broker dealers and investment advisers.

Section 913 of Dodd-Frank mandated that the Securities and Exchange Commission conduct a study of the effectiveness of legal and regulatory standards of care for broker-dealers and investment advisers.  That study, released on January 21, 2011, recommends that the SEC establish a uniform fiduciary standard for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.  The full text of the SEC Study on Investment Advisers and Broker-Dealers is available here.

In addition to the changes recommended by the SEC study regarding the legal duties owed by broker-dealers and investment advisers, retail investors should also be aware of regulatory body rules that affect their broker-dealers and investment advisers.  The Financial Industry Regulatory Authority (“FINRA”) is a self-regulatory organization that oversees the financial investment industry and promulgates rules and regulations for broker-dealers and investment advisers.

This article is intended as a reference for retail investors to assist in understanding the changing landscape of fiduciary duties owed by broker-dealers and their investment advisers when dealing with retail investors.  The information contained herein is not legal advice.  If you have concerns regarding losses suffered as a consequence of your broker-dealer or investment adviser’s recommendations, please contact the securities attorneys at the White Law Group, LLC for a free consultation.

I.  The SEC Study on Investment Advisers and Broker-Dealers – What Duty are Investors Owed?

Section 913 of Title IX of Dodd-Frank required the SEC to conduct a study evaluating a number of concerns regarding the effectiveness of the regulatory scheme in place to protect investors in financial markets.  Specifically, the study was required to ascertain whether the existing legal or regulatory standards of care for providing personalized investment advice and recommendations about securities to retail customers were sufficient.  It also set out to determine whether there were any shortcomings in the legal or regulatory standards for protecting retail customers.

The most important aspect of the study was the recommendation that the SEC establish a uniform fiduciary standard for broker-dealers and investment advisers.  Specifically, this uniform fiduciary standard is intended to protect retail investors by holding broker-dealers and investment advisers to a consistent standard of care in order to eliminate consumer confusion.

For those unfamiliar with the concept of fiduciary duties, it may be helpful to think of a fiduciary like a trustee.  Essentially, a fiduciary relationship is one of trust.  Such a relationship “exists between two persons when one of them is under a duty to act or to give advice for the benefit of another upon matters within the scope of the relation.”  Restatement (Second) of Torts § 874 cmt. a (1979).  When a fiduciary relationship exists, the fiduciary has a heightened responsibility to care for the beneficiary for those matters that are within his area of expertise.

In other words, an investment adviser has heightened obligations to do more than merely execute customer orders and may be liable for damages arising from his failure to do so.

Broker-dealers also have obligations to its clients, including duties to make suitable investment recommendations.  Broker-dealers are also governed by regulatory rules of self-regulating organizations such as FINRA.

The intent of Dodd-Frank appears to be to impose similar standards on broker-dealers as currently exist for investment advisors.  The exact requirements of what this uniform standard of care will entail are undecided at this time.  However, it is clear that broker-dealers in the future will be held to no less stringent a standard than that owed by investment advisers.  The proposed standard in the study provides that:

“The standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such customers as the [SEC] may by rule provide), shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”

The study further explains that the duties owed by broker-dealers and investment advisers to their customers would be the duties of loyalty and care.

The duty of loyalty includes the concept that the broker, dealer or adviser must put the best interest of the customer ahead of his own financial interest in earning a commission off of the sale of the investment.  Frequently, high-risk investments offer greater commissions to the investment advisers and broker-dealers that sell them.  The enticement this commission offers may lead some advisers to inappropriately recommend products that are not, in fact, suitable for certain types of investors.  As the law exists today, investment advisers acting in this manner have violated their fiduciary duty of loyalty and care and may be liable for an investor’s losses.  The SEC study recommends that this duty be extended further to apply uniformly to broker-dealers.

The duty of care includes the responsibility of the investment adviser and the broker-dealer to properly investigate the product it is recommending.  “The Securities and Exchange Commission (SEC) and federal courts have long held that a [broker-dealer] that recommends a security is under a duty to conduct a reasonable investigation concerning that security and the issuer’s representations about it.”  FINRA Regulatory Notice 10-22, April 2010, available online here.

In other words, they have the responsibility to perform due diligence on the investment to ensure that it is a suitable investment for investors, generally, and for you personally.  Oftentimes, this due diligence can be time-consuming and costly and may not be performed thoroughly if at all.  “Small broker-dealers making private placements often conduct just a cursory due diligence examination consisting of little more than discussions with the issuer.

These broker-dealers lack the resources of a large investment banking firm and they are reluctant to incur the cost of outside service providers because the cost cannot typically be recovered if the placement is unsuccessful, as is often the case.”  Roger Wiegley, New Liability Exposure for Intermediaries in Private Placements, The Harvard Law School Forum on Corporate Governance and Financial Regulation, Aug. 21, 2011.

In such cases, it is the investor that will suffer harm because of the broker-dealer and investment adviser’s desire to cut costs.  Had the adviser researched the investment product, it may have discovered problems that would lead it not to recommend the product.  If those undiscovered problems cause the investment to suffer losses, the negligent adviser may be liable.

At The White Law Group, our FINRA arbitration attorneys have experience recognizing violations of these duties and can help investors that have been inappropriately or fraudulently sold investments that led to financial loss.  If you believe you have experienced such a loss as a result of this type of conduct, contact our securities attorneys today for a free consultation.

II.  Regulatory Changes – FINRA’s New Know-Your-Customer and Suitability Rules

In January, 2011 (the same month the SEC study was released), FINRA published Regulatory Notice 11-02, which set forth the new Know-Your Customer (Rule 2090) and Suitability (Rule 2111) rules for broker-dealers and investment advisers.  This Notice announced that the SEC had approved of the proposed new Rules for FINRA’s rulebook.  They are based on previously existing rules that may protect investors who have already invested and experienced losses as a result of their adviser’s conduct. (New FINRA Rule 2090 (Know Your Customer) is modeled after former NYSE Rule 405(1).  FINRA Rule 2111(Suitability) is modeled after former NASD Rule 2310.)

According to the Notice, “The know-your-customer and suitability obligations are critical to ensuring investor protection and promoting fair dealing with customers and ethical sales practices.”  The changes in the rules are intended to retain these core features of the rules they are based upon while strengthening, streamlining and clarifying them in order to further protect retail investors.

a.  FINRA’s Know Your Customer Rule

The new Know Your Customer rule (Rule 2090), states:

Every member [of FINRA] shall use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of each customer.

The key components of this rule are that the adviser use reasonable diligence in the account maintenance, and that the adviser know (and retain) the essential facts concerning the customer’s account.  Regulatory Notice 11-02 clarifies that essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”

The investment adviser and broker-dealer’s obligation under the Know Your Customer rule arises at the beginning of the customer-broker relationship.  It does not depend on whether the broker has made a recommendation.  The obligation then continues beyond the opening of the account and lasts throughout the life of the relationship with each customer.  The broker-dealer and investment adviser’s obligation includes, among other things, to service and supervise the customer’s accounts.  In other words, the adviser’s duty to conduct reasonable diligence exists in regard to both opening and maintaining customer accounts.

Under Rule 2090, broker-dealers and investment advisers have a duty to verify a customer’s “essential facts” at regular intervals that are calculated to prevent and detect any mishandling of the customer’s account that might result from the customer’s change of circumstances.  In other words, an adviser cannot simply gather facts about a customer when the customer creates his account and then ignore the customer for an extended period of time.  He must instead regularly confirm that the essential facts for that client are still the same.  Though there is no prescribed time frame for confirming “essential facts,” Rule 17a-3 of the Securities Exchange Act requires broker-dealers to attempt to update certain account information every 36 months.

b.  FINRA’s Suitability Rules

FINRA’s new suitability rules have been approved by the SEC and are set forth in Rule 2111.  Suitability refers to an investment adviser or broker-dealer’s obligation to only recommend investments for customers that are appropriate for that particular customer.

The new changes to the suitability rules include applying determinations to recommend investment strategies, and not only to recommendations relating to specific securities.

The rules implement a number of changes, including applying determinations to recommended investment strategies rather than only to recommendations for specific securities.  See, Anna T. Pinedo, Standard of Care for Broker-Dealers, Fiduciary Duty and Other Compliance Issues, Global Reference Guide:  Financial Services 2011, available at http://www.mofo.com/files/Uploads/Images/110300-Standard-of-Care-for-Broker-Dealers-Fiduciary-Duty-and-Other-Compliance-Issues.pdf

Rule 2111 states that a brokerage firm or associated person (i.e., an investment adviser) must “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”  See, FINRA Regulatory Notice 11-02.

The customer’s investment profile includes information that may determine whether a specific investment or investment strategy is suitable for an investor.  The investment profile may include, but is not limited to, the customer’s:

• Age;
• Other investments;
• Financial situation and needs;
• Tax status;
• Investment objectives;
• Investment experience;
• Investment time horizon;
• Liquidity needs;
• Risk tolerance; and
• Any other information the customer may disclose to the member or associated person in connection with such recommendation.

Importantly, the rule identifies three elements of suitability:  reasonable-basis suitability, customer specific suitability and quantitative suitability.

Reasonable-basis suitability requires a broker, based on his “reasonable diligence”, have a reasonable basis to believe that the recommendation is suitable for at least some investors.  Whether the broker-dealer or investment adviser’s investigation amounts to reasonable diligence depends on a number of case-specific factors, including the complexity of and risks associated with an investment.  The goal of the reasonable diligence is to provide the adviser with an understanding of the potential risks and rewards associated with the recommended investment or investment strategy.

Customer-specific suitability requires that a broker have a reasonable basis to believe that the recommendation is suitable for a particular customer based on that customer’s investment profile.

Quantitative suitability requires a broker who has actual or de facto (in fact) control over a customer account have a reasonable basis to believe that a series of recommended transactions, even if suitable when viewed individually, are not excessive and unsuitable for the customer when viewed all together.  See, FINRA Regulatory Notice 11-02; see also FINRA Rule 2111, Supplementary Material .05(c), available online here.

In other words, while any one in a series of transactions might be suitable for an investor, when a number of such transactions are made together, they may become unsuitable for that investor.  This quantitative suitability standard often applies in cases dealing with churning or excessive trading.

The result of the new suitability rules is a clear indication that broker-dealers and investment advisers must have a clear understanding of both their customers and the investments and/or investment strategies they are recommending to those customers.  A lack of such understanding is in and of itself a violation of the suitability rule.

III.  Conclusion

Largely as a result of the massive financial crisis of 2008, the financial services industry is seeing the largest effort since the Great Depression to reform the laws and regulations that govern financial service professionals.  Through the efforts of the SEC and self-regulatory organizations like FINRA, more comprehensive and clearer rules are being put into effect.

Of equal importance to the changes being made, the recommendations of the SEC have forced regulators to revisit the currently existing rules and regulations that govern broker-dealers and investment advisers.  There already exist numerous rules within the industry that protect retail investors from financial professionals’ misconduct.

The foregoing information has been provided by The White Law Group. If you believe that your financial professional has breached his or her’s fiduciary duty of care to you, please call the securities attorneys of The White Law Group for a free consultation at (888) 637-5510.

The White Law Group, LLC is a national securities fraud, securities arbitration, investor protection, and securities regulation/compliance law firm with offices in Chicago, Illinois and Franklin, Tennessee.

For more information on The White Law Group, visit https://whitesecuritieslaw.com.