Brokers and investment advisers are the thread to different laws and regulations that bear greatly on their duties and responsibilities to clients.
Prior to 1940, broker-dealers were not generally considered fiduciaries when they provided investment advice.
Since the passing of the Investment Advisers Act of 1940 (“the Act”), Congress and federal regulatory agencies have tried to enact a uniform fiduciary standard for retail investment advice.
The Investment Advisers Act of 1940
The Investment Advisers Act of 1940 (“the Act”) regulates people who advise on investments. Its purpose is to imposes another level of responsibilities upon a specific subgroup of the stock market.
The Act differentiates between investment advisors and brokers:
- Investment advisers do not merely sell you stocks, but they also advise you based on your situation, goals, objective. These individuals must register with the SEC and adhere to additional rules. They also have a higher standard of care, known as a fiduciary duty.
- Brokers, on the other hand, are people you call up and say “buy me 100 shares of Disney today.” Basically, they are someone who just brokers the deal. They do not advise you on anything, and therefore, they are not regulated by the Act.
The key difference between investment advisers and brokers is that brokers typically charge one time fees per transaction. While investment advisors usually charge a percentage of the total amount you are investing.
Elements of the Investment Advisers Act
The Act contains a general antifraud provision, which the Supreme Court has interpreted as imposing a fiduciary duty on advisers.
The duty of Good Faith and Fair Disclosure:
The Act poses “an affirmative duty of utmost good faith, and full and fair disclosure of all substantial facts, as well as an affirmative obligation to employ reasonable care to avoid confusing clients” on investment advisers.
Standard of Care:
According to the Act, investment advisers are generally subject to the best interest of the client standard of care. This federal standard is uniformly adopted by federal and state courts for investment advisors.
The standard holds investment advisors to a duty of care and duty of loyalty and employs a “prudent person” standard.
Aligning Investment Needs With Recommendations:
The duty of care proposed by the Advisers Act works to align the customer’s investment and financial needs with the investment recommendations made by their advisors.
Conflicts of Interest:
Section 206 of the Act’s “broad proscription against any” fraudulent or deceitful practice upon clients and prospective clients, shows Congress intent was “to eliminate, or at least reveal all conflicts of interest which might incline an investment adviser — consciously or unconsciously — to provide advice which was not disinterested.”
Some advisers have shielded themselves from adviser regulation by taking advantage of an exclusion in the Advisers Act.
Under this exclusion, as long as a broker’s advice is “solely incidental” to brokerage services and other broker charges only commissions and not asset-based fees, the broker is excluded from Advisers Act regulation. However, courts have found broker-dealers to have a fiduciary duty under certain circumstances.
A fiduciary duty is likely imposed on broker-dealers when they betray the trust and confidence that comes with authority to trade on a customers behalf.
2010 Dodd-Frank Wall Street Reform Consumer Protection Act
After the Great Recession, the Dodd-Frank Act was put in place. It required the SEC to evaluate the standards of care for brokers and advisers and to adopt rules to address any regulatory gaps or overlaps identified by the study.
It also gave the SEC the authority to promulgate a uniform fiduciary standard for retail investment advice.
The uniform standard was enacted because the difference in regulation had lead some brokers to charge asset-based fees and market themselves as financial advisers, instead of stockbrokers, in order to avoid prosecution under the Act of 1940.
Department of Labor (“DOL”) Regulations on Retirement Accounts
In early 2016, the DOL promulgated labor regulations, which impose a fiduciary duty standard upon brokers that offer guidance with individual retirement accounts, 401(k) plans or other money saved for retirement. The DOL’s definition of a fiduciary demand that advisers act in the best interest of their clients, and to put their clients’ interest above their own.
It also requires advisers to have clients sign a best interest contract exemption (“BICE”).
It leaves no room for advisors to hide any potential conflict of interest and states that all fees and commissions must be clearly disclosed in dollar form to clients.
Previously, only advisors who were charging a fee for service (either hourly or as a percentage of account holdings) on retirement plans were considered fiduciaries. The fiduciary is a much higher level of accountability than the “suitability” standard previously required of a financial salesperson.
What is “Suitability?”
“Suitability” basically meant that as long as the investment recommendation met a client’s defined need and objective, it was deemed appropriate.
Now, financial professionals are legally obligated to set their client’s “best interest” first, rather than simply finding “suitable” investments.
Derivative Actions Claiming Breach of Fiduciary Duties
Derivative actions refer to claims brought by shareholders on behalf of the company.
These claims seek to compel a companies board of directors to take certain actions or seek damages from parties who profited at the company’s expense.
Typically, these claims involve self-dealing, lack of oversight, and breach of fiduciary duty.
Inadequate Consideration of Shareholders
These claims arise during acquisitions and mergers and usually seek an injunction to halt any deals because the shareholders allege they will be shortchanged in the deal.
Misrepresentations and Omissions
Generally, claims against corporate officers for material misrepresentations involve statements and claims made in public filings, like their prospectus.
However, claims of fraudulent misrepresentations can arise after virtually any public statement made by an executive officer.
A statement becomes public when it is published or communicated to a third-party.
Misrepresentations and Omissions Must Be “Material.”
A material misrepresentation is an act of intentionally concealing or fabricating a fact that, if known by other market participants, could have caused those market participants to alter their trade decisions.
If your misrepresentation or omission is likely to induce a “reasonable” person to give to a trade they otherwise would not have, or prevent them from making a trade they otherwise would have made, it may be considered “material.”