ALI-ABA Course of Study Investment Adviser Regulation March 4, 2011 New York, New York

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1 97 ALI-ABA Course of Study Investment Adviser Regulation March 4, 2011 New York, New York Reforming the Regulation of Broker-Dealers and Investment Advisers By Arthur B. Laby Rutgers University School of Law Camden, New Jersey This article was previously published in The Business Lawyer, Vol. 65, February American Bar Association. All Rights Reserved. It is reprinted here with permission.

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3 99 Reforming the Regulation of Broker-Dealers and Investment Advisers By Arthur B. Laby * A key component of financial regulatory reform is harmonizing the law governing brokerdealers and investment advisers. Historically, brokers charged commissions and were regulated under the Securities Exchange Act of Advisers charged asset-based fees and were subject to the Investment Advisers Act of 1940, which contains a special exclusion for brokers. In recent years, brokers have changed their compensation structure and many now market themselves as advisers, raising questions about whether they should be treated as such. The Obama Administration s 2009 white paper on regulatory reform and draft legislation call for a fiduciary duty to be imposed on brokers that provide advice. This Article explores the debate over regulating brokers and advisers, and makes four key claims. First, changes in brokers compensation and marketing methods vitiate application of the broker-dealer exclusion and should subject brokers to the Advisers Act. Second, changes in the nature of brokerage, spurred by changes in technology, make the broker-dealer exclusion unsustainable and Congress should repeal it. The third claim is that imposing fiduciary duties on brokers is incompatible with their historical roles as dealers and underwriters. To resolve this tension, this Article suggests a compromise that enhances brokers duties but does not hobble their ability to perform their traditional functions. Finally, regulating brokers as advisers would overburden the U.S. Securities and Exchange Commission. This Article offers alternatives to alleviate the strain. Table of Contents Introduction I. The Regulation of Broker-Dealers and Investment Advisers A. Historical Roles B. Regulatory Response The Securities Exchange Act The Investment Advisers Act The Broker-Dealer Exclusion * Associate Professor, Rutgers University School of Law Camden. I am grateful to Karen Barr, Mercer Bullard, Sharon Byrd, Hardy Callcott, Jennifer Choi, Shaswat Das, Deborah DeMott, Jim Draddy, James Fanto, Jill Fisch, Jay Feinman, Tamar Frankel, Jerome Landau, Robert Plaze, Steven Schwarcz, and Harwell Wells for comments on an earlier draft. Brian Cassidy and David Somers provided excellent research assistance pass-03_Laby-r01.indd 395

4 The Business Lawyer; Vol. 65, February 2010 C. Changes in Compensation Structure Competition and Two-Tier Pricing Migration to Fee-Based Pricing Application of the Advisers Act to Brokerage Accounts D. The Rise and Fall of Advisers Act Rule 202(a)(11) The SEC s Rule The Decision in Financial Planning Association v. SEC II. Application of the Broker-Dealer Exclusion A. Form and Substance in Broker-Dealer Regulation Marketing as an Adviser Asset-Based Fees B. The Relevance of the Broker-Dealer Exclusion The Historical Context of Brokerage Modernization III. Objections to Treating Brokers as Advisers A. The Contradiction in the Broker-Dealer s Role Dealing and Underwriting a. Dealers b. Underwriters Resolving the Fiduciary Tension for Broker-Dealers a. Dealers i. Disclosure ii. Limitations on Trading b. Underwriters i. Prioritizing the Broker s Duty ii. Use of a Qualified Independent Underwriter B. Resource Constraints Registration Thresholds Exemption from Registration a. Regulation Versus Registration b. Implementing an Exemptive Approach Conclusion INTRODUCTION Financial regulation in the United States is at a critical juncture. The current financial crisis 1 and the Bernard Madoff investment scandal 2 have ignited reform 1. For a discussion of the financial crisis, see Symposium, Modernizing the Financial Regulatory Structure, 5 N.Y.U. J.L. & BUS. 339 (2009). 2. See Diana B. Henriques, Madoff, Apologizing, Is Given 150 Years, N.Y. TIMES, June 30, 2009, at A1; Diana B. Henriques, Madoff Scheme Kept Rippling Outward, Crossing Borders, N.Y. TIMES, Dec. 20, 2008, at A1; Dave Kansas, Madoff Does Minneapolis, FORTUNE, Feb. 2, 2009, at pass-03_Laby-r01.indd 396

5 101 Reforming the Regulation of Broker-Dealers and Investment Advisers 397 efforts hotly debated in the corridors of Washington. 3 A key component of reform is revamping the regulation of broker-dealers and investment advisers. Brokerage and advisory firms now perform similar functions, but they are regulated differently under an antiquated system of securities laws. 4 The recent attempt of the U.S. Securities and Exchange Commission ( SEC or Commission ) to address the inconsistency was vacated by the courts, 5 creating an interregnum period during which final decisions to reshape the law will be made. Change is around the corner. In its 2009 white paper on regulatory reform, the Obama Administration called for regulatory harmonization and for a fiduciary duty to be imposed on brokers providing advice. 6 The U.S. House of Representatives has passed a bill that would require SEC rulemaking imposing a fiduciary duty on brokers; 7 draft legislation in the Senate addresses harmonization as well. 8 These proposals are highly charged and regulators, academics, and industry groups disagree sharply over how to construct this corner of the regulatory edifice. 9 Individuals and institutions in the United States generally invest through two types of registered securities intermediaries: broker-dealers, regulated under the 3. See Bill Swindell, House Panel Wrangles over SEC Structure, CONGRESS DAILY, Oct. 6, 2009, (subscription database). 4. See infra notes and accompanying text. 5. See infra Part I.D U.S. DEP T OF THE TREASURY, A NEW FOUNDATION: REBUILDING FINANCIAL SUPERVISION AND REGULATION 71 (2009), available at FinalReport_web.pdf [hereinafter TREASURY WHITE PAPER]. 7. Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Cong [hereinafter H.R. 4173]. 8. S. COMM. ON BANKING, HOUSING & URBAN AFFAIRS, 111TH CONG., RESTORING AMERICAN FINAN CIAL STABILITY ACT: CHAIRMAN S MARK TEXT (2009), available at FullBillTextofTheRestoringAmericanFinancialStabilityActof2009.pdf [hereinafter SENATE DRAFT LANGUAGE]. 9. See SEC Oversight: Current State and Agenda, Hearing Before the Subcomm. on Capital Markets, Insurance, and Government-Sponsored Enterprises of the H. Comm. on Financial Servs., 111th Cong. 13 ( July 14, 2009) (statement of Mary L. Schapiro, Chairman, U.S. Sec. & Exch. Comm n), available at [hereinafter Schapiro Statement] (stating that financial services providers that provide advice should be subject to equivalent regulation ); Elisse Walter, Comm r, U.S. Sec. & Exch. Comm n, Speech at the Mutual Fund Directors Forum Ninth Annual Policy Conference Regulating Broker-Dealers and Investment Advisers: Demarcation or Harmonization? (May 5, 2009) (transcript available at spch050509ebw.htm) [hereinafter Walter Speech] ( [E]very financial professional should be subject to a uniform standard of conduct. ). But see Luis A. Aguilar, Comm r, U.S. Sec. & Exch. Comm n, Speech at Investment Advisers Association Annual Conference: SEC s Oversight of the Adviser Industry Bolsters Investor Protection (May 7, 2009) (transcript available at spch050709laa.htm) [hereinafter Aguilar Speech] (rejecting harmonization and analyzing how brokers that provide advice should be treated). For commentary by academics and practicioners, see Tamar Frankel, Fiduciary Duties of Brokers-Advisors-Financial Planners and Money Managers 18 (Boston Univ. School of Law Working Paper No , 2009), available at cfm?abstract_id= ( Congress should amend the law to impose on [broker-dealers] all the duties imposed by the Advisers Act. ); John C. Coffee, Jr., Changes Needed Before Fed Is Given Regulatory Mission, N.Y.L.J., July 16, 2009, at 5; Thomas P. Lemke & Steven W. Stone, The Madoff Opportunity : Harmonizing the Overarching Standard of Care for Financial Professionals Who Give Investment Advice, WALL ST. LAW., June 2009, at 1, available at Opportunity_June2009.pdf; Michael Koffler, Six Degrees of Separation: Principles to Guide the Regulation of Broker-Dealers and Investment Advisers, 41 SEC. REG. & L. REP. (BNA) 776 (Apr. 27, 2009) pass-03_Laby-r01.indd 397