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:
- Limit the ability of Covered Persons to make recommendations to Massachusetts Retail Investors until after the Covered Persons have made “all reasonably practicable efforts” to avoid conflicts of interest, eliminate conflicts that cannot be avoided, and mitigate conflicts that cannot be avoided or eliminated.
- Require that Covered Persons provide recommendations and advice “without regard” to the interests of any person other than the Retail Investor – a standard that was called for under the Department of Labor’s now vacated Fiduciary Rule Best Interest Contract Exemption, and which created considerable implementation, interpretative and operational challenges.
- Cover commodity and insurance products as well as securities.
- Mandate that covered recommendations may not be made “in connection with any sales contest, implied or express quota requirement, or other special incentive program.”
- Impact not only broker-dealers, and Massachusetts registered investment advisers, but potentially also federally registered investment advisers and their agents operating in Massachusetts, depending on the resolution of certain interpretive issues.
- Raise significant interpretative questions, including how principal transactions with Covered Persons may be effected by or on behalf of Retail Investors.
- Increase the prospect of a state-by-state approach to financial services regulation, which could result in an uneven patchwork of laws that may be duplicative of, different than, and possibly in conflict with, federal standards, including Regulation BI.
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:
- The Proposal is intended to reach an investment adviser’s10 or a broker-dealer’s relationship with a Retail Investor. “Retail Investor” does not include, among other entities, certain regulated institutions such as banks, registered investment advisers, trust companies, insurance companies and “qualified institutional buyers” under Rule 144A under the Securities Act of 1933.
- The Proposal would require that a Covered Person exercise the “utmost” care in carrying out its duties of care and loyalty to Retail Investors. The “utmost” care standard has no analogue under the federal securities laws, including the Investment Advisers Act of 1940, or the Employee Retirement Income Security Act of 1974.
- Under the Proposal, a Covered Person would violate its fiduciary duty by failing to act in accordance with its duty: (i) when providing investment advice or recommending an investment strategy, the opening of or transferring of assets to any type of account, or the purchase, sale, or exchange of any security, commodity, or insurance product; and (ii) at any time during which certain arrangements between the Covered Person and its Retail Investor are in effect.11
- A Covered Person’s fiduciary duty under the Proposal also would apply when the Covered Person receives ongoing compensation or charges ongoing fees for: (i) advising Retail Investors either directly or “through publications or writings” as to certain investment-related matters; or (ii) providing such services “as an integral component of other financially related services.” However, the Proposal does not provide guidance as to what would constitute a “writing” or what services would be viewed as an “integral component.” These interpretive issues represent a potentially significant oversight that could lead to questions regarding whether a Covered Person is deemed to be engaged in “unethical or dishonest conduct or practices” in violation of the Proposal. If adopted, it is possible that the Massachusetts Securities Division could take an expansive view of how to interpret these provisions.
- Somewhat consistent with Regulation BI, the use of certain terms in titles, credentials or professional designations by a Covered Person would be viewed as resulting in a Retail Investor having a “reasonable expectation” that the Covered Person will monitor the Retail Investor’s account on a regular or periodic basis. However, the terms included in the Proposal – though provided as illustrative examples and not an exhaustive list – are more expansive than those included in Regulation BI and would include, for example, planners, consultants and managers. Because most financial professionals – and many professionals who are not financial professionals – use some combination of these terms, it would be difficult for them to fall outside the application of the Proposal.
- Consistent with, but broader than, Regulation BI, the Proposal indicates that a Covered Person will be presumed to have violated its duty of loyalty if the Covered Person makes a covered recommendation “in connection with any sales contest, implied or express quota requirement, or other special incentive program.”12 The Proposal also states that a Covered Person’s duty of loyalty requires the Covered Person to disclose all material conflicts of interest in addition to otherwise making “all reasonably practicable efforts” to: avoid conflicts; eliminate conflicts that cannot be avoided; and mitigate conflicts that cannot be avoided or eliminated.13 These two requirements could pose significant operational challenges. Moreover, because certain conflicts are inherent in a wide range of traditional brokerage activities (e.g., transaction-based compensation, principal trading, sales of proprietary or affiliate products, and sales of underwritten offerings), it is not clear that broker-dealers could avoid these conflicts unless they eliminate these product and services offerings to Retail Investors located in Massachusetts.
- The Proposal retains the Initial Proposal’s requirement that recommendations must be made “without regard to the financial or any other interest of any party other than the customer or client.” By contrast, in adopting Regulation BI, the SEC explained that it used “without placing the financial or other interest … ahead of the interest of the retail customer” instead of “without regard to” to avoid making the standard of conduct overly broad.14
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.