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«THE FLAWED STATE OF BROKER-DEALER REGULATION AND THE CASE FOR AN AUTHENTIC FEDERAL FIDUCIARY STANDARD FOR BROKER-DEALERS Gary A. Varnavides∗ ∗ ...»

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Fordham Journal of Corporate &

Financial Law

Volume 16, Issue 1 2011 Article 5

BOOK 1

THE FLAWED STATE OF

BROKER-DEALER REGULATION AND

THE CASE FOR AN AUTHENTIC

FEDERAL FIDUCIARY STANDARD FOR

BROKER-DEALERS

Gary A. Varnavides∗

∗ Copyright c 2011 by the authors. Fordham Journal of Corporate & Financial Law is produced by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl

THE FLAWED STATE OF

BROKER-DEALER REGULATION AND

THE CASE FOR AN AUTHENTIC

FEDERAL FIDUCIARY STANDARD FOR

BROKER-DEALERS

Gary A. Varnavides Abstract

THE FLAWED STATE OF BROKER-DEALER REGULATION AND THE CASE FOR AN

AUTHENTIC FEDERAL FIDUCIARY STANDARD FOR BROKER-DEALERS

THE FLAWED STATE OF BROKER-DEALER

REGULATION AND THE CASE FOR AN

AUTHENTIC FEDERAL FIDUCIARY STANDARD

FOR BROKER-DEALERS

Gary A. Varnavides*

I. INTRODUCTION

The 2008 financial crisis revealed that the American financial industry’s regulatory scheme is broken and in desperate need of reform.

The modern American financial system operates under an antiquated regulatory structure developed in the 1930s and 1940s that is illequipped to deal with the intricacies and risks of modern finance.

Accordingly, reforming financial industry regulation is necessary to deal with the complexities of the 21st century financial services industry.

President Obama championed financial industry reform during his campaign and stressed the importance of passing legislation during his first year in office. The House of Representatives recently passed a comprehensive piece of legislation reforming the financial industry and the Senate will begin working on its version of the bill in early 2010. 1 Tucked into the extensive House bill is the Investor Protection Act of 2009 (“IPA”), which significantly changes the federal securities laws. 2 * J.D., 2010, Fordham University School of Law; B.A. 2007, Boston College. I would like to thank the editors and staff of the Fordham Journal of Corporate & Financial Law for all of their hard work throughout the year. A special thank you to my parents for their unwavering support and encouragement throughout law school.

1. Carle Hulse, House Approves Tougher Rules on Wall Street, N.Y. TIMES, Dec.

12, 2009, at A1.

2. Posting of Peter J. Henning to DealBook Blog, http://dealbook.blogs.nytimes.com/2009/12/15/what-the-sec-gains-from-the-financialbill/?scp=1&sq=investor%20protection%20act%20of%202009&st=cse (Dec. 15, 2009).

204 FORDHAM JOURNAL [Vol. XVI

OF CORPORATE & FINANCIALLAW

This Note addresses a critical section of the IPA: its proposal that broker-dealers be held to a new, higher standard of conduct towards customers modeled on the Investment Advisers Act of 1940 (the “‘40 Act”). Currently, broker-dealers are regulated under the Securities Exchange Act of 1934 (the “‘34 Act”) and sometimes held to a fiduciary standard of conduct towards customers, whereas investment advisers are regulated under the ‘40 Act and always held to a fiduciary standard.

This bifurcated regulatory scheme—the product of another era when broker-dealers and investment advisers were distinct entities—results in two different regulatory standards and enforcement mechanisms for broker-dealers and investment advisers. Today, however, broker-dealers and investment advisers offer virtually identical services to investors, resulting in considerable confusion for both investors and regulators.

Thus, the IPA seeks to harmonize the regulation of broker-dealers and investment advisers by holding both groups to a consistent standard of conduct.

Part II of this Note discusses the history of broker-dealer and investment adviser regulation, including the development of different legal duties and regulatory schemes for each group. Part III identifies and analyzes the different contexts in which broker-dealers and investment advisers are held to a fiduciary standard. Part IV examines the central problems within the current regulatory framework for brokerdealers and investment advisers. Part V analyzes the IPA and concludes that it is too vague and does far too little to protect broker-dealer customers. Part VI proposes an alternative to the IPA: the adoption of an authentic, federal fiduciary standard for broker-dealers that preserves a private right of action for investors. Finally, Part VII concludes that this Note’s proposal is a superior alternative to the IPA that would better regulate broker-dealers and offer better protection for broker-dealer customers.

–  –  –

SEC Commissioner Elisse Walter describes the current federal securities laws, enacted by Congress in the 1930s and 1940s, as a “badly worn patchwork quilt” in desperate need of reform. 3 Indeed, the

–  –  –





regulation of broker-dealers and investment advisers is “balkanized” and reflects antiquated notions about the functions of broker-dealers and investment advisers that are virtually obsolete. 4

A. THE ORIGINS OF BROKER-DEALER REGULATION: THE ‘34 ACT

The Securities Exchange Act of 1934 5 (the “‘34 Act”) and its implementing rules “comprise the most central regulatory apparatus for broker-dealers.” 6 Section 15(a) of the ‘34 Act requires broker-dealers engaged in interstate securities transactions to register with the Securities and Exchange Commission (the “SEC”). 7 The ‘34 Act gives the SEC broad authority to set rules regarding broker-dealers, including the ability to revoke or suspend broker-dealer registration if the brokerdealer violates federal law or engages in other misconduct. 8 An interesting and unique aspect of broker-dealer regulation is the SEC’s reliance on self-regulatory organizations (“SROs”) to regulate the broker-dealer industry. Although the SEC has the authority to establish rules for broker-dealers, it delegates most of this authority to SROs, with the primary SRO being the Financial Industry Regulatory Authority (“FINRA”). 9 Accordingly, FINRA and its predecessor, the National Association of Securities Dealers (the “NASD”), have been most responsible for establishing the applicable rules and standards for broker-dealers.

The ‘34 Act requires broker-dealers to become a member of at least one SRO. 10 Pursuant to this requirement, the NASD was founded in 1939 and charged with regulating broker-dealers. FINRA, the contemporary successor to the NASD, was created in July 2007 through the consolidation of the NASD and the enforcement arm of the New York

Ninth Annual Policy Conference: Regulating Broker-Dealers and Investment Advisers:

Demarcation or Harmonization? (May 5, 2009) (transcript available at http://www.sec.

gov/news/speech/2009/spch050509ebw.htm) [hereinafter Walter Speech].

4. See id.

5. 15 U.S.C. §§ 78a-78nn (2006).

6. ANGELA A. HUNG ET AL., INVESTOR AND INDUSTRY PERSPECTIVES ON

INVESTMENT ADVISERS AND BROKER-DEALERS 7 (RAND Corp. 2008), available at www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf.

7. See 15 U.S.C. §§ 78a-78nn.

8. See id.

9. See Stuart Kaswell et al., Broker Dealer Regulation—An Overview, Outline, 1673 PLI/CORP. 9, 17-20 (2008).

10. See 15 U.S.C. §§ 78a-78nn.

206 FORDHAM JOURNAL [Vol. XVI

OF CORPORATE & FINANCIAL LAW

Stock Exchange (“NYSE”). 11 Accordingly, all broker-dealers, barring certain narrow exceptions, are required to register with FINRA. 12 FINRA’s membership statistics demonstrate its considerable mandate: it oversees nearly 4,800 brokerage firms, approximately 171,000 branch offices, and roughly 644,000 registered securities representatives. 13 Under its broad authority from the SEC, the NASD (and now FINRA) developed a comprehensive set of rules regulating brokerdealers, its Rules of Conduct. 14 These rules govern virtually every aspect of broker-dealer regulation: registration requirements, supervision requirements, record-keeping requirements, and most importantly for this Note’s purposes, standards regarding broker-dealer duties to customers. 15 NASD Rule 2310 establishes the standard for a broker-dealer

making a recommendation regarding a security to a customer:

suitability. 16 Rule 2310 specifies that a broker-dealer making a recommendation to a retail customer must have grounds for believing that the recommendation is suitable for that customer based on the customer’s portfolio, financial situation, and needs. 17 Moreover, before making a recommendation, the broker-dealer must make reasonable

efforts to discover:

[T]he customer’s financial status;

[T]he customer’s tax status;

[T]he customer’s investment objectives;

[S]uch other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer.

Unlike investment advisers, broker-dealers “are not categorically bound—by statute, regulation, or precedent—to a per se rule imposing

11. About the Financial Industry Regulatory Authority, http://www.finra.org/AboutFINRA/ (last visited Dec. 19, 2009) [hereinafter About FINRA].

12. See 15 U.S.C. §§ 78a-78nn.

13. About FINRA, supra note 11.

14. See Kaswell et al., supra note 9, at **17-20.

15. See id.

16. See FINRA Manual, NASD Rule 2310 (eff. Aug. 20, 1996), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=3638.

17. See id.

18. Id.

2011] BROKER-DEALER REGULATION 207 fiduciary obligations toward clients.” 19 Instead, as discussed below, courts and arbitrators determine the applicable standard for a brokerdealer on a case-by-case basis depending on the circumstances of the broker-dealer’s relationship with the client.

B. THE ‘40 ACT AND INVESTMENT ADVISER REGULATION

The ‘40 Act “regulates the collection of financial professions that typically includes financial planners, money managers, and investment consultants.” 20 It defines “investment adviser as “any person who, for compensation, engages in the business of advising others” about investing in or selling securities, or who issues reports or analysis about securities for compensation. 21 The ‘40 Act has two aspects that distinguish it from the ‘34 Act and directly impact broker-dealer regulation.

1. Broker-Dealer Exception

The ‘40 Act regulates financial professionals who offer investment advice to customers for compensation. Thus, it would seem that brokerdealers, who regularly provide investment advice to their customers in connection with their broker-dealer business, are subject to the ‘40 Act.

The ‘40 Act, however, contains a broker-dealer exception: pursuant to Section 201, a broker-dealer providing investment advice to a customer is not subject to the ‘40 Act if the advice is “solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefore.” 22 The exception recognized that brokerdealers traditionally provided varying degrees of investment advice to their customers in support of their primary function as broker-dealers. 23 In recent years, the ‘40 Act’s broker-dealer exception has created widespread confusion amongst broker-dealers about whether their services were exempt under the ‘40 Act. This confusion stems from the widespread “migration of stockbrokers into the advisory arena.” 24 HUNG ET AL., supra note 6, at 10.

19.

See id.

20.

15 U.S.C. § 80b-2(a)(11) (2006).

21.

Id. (emphasis showing exception).

22.

See generally Curtlan R. McNeily & John P. Moriarty, Regulation of Financial 23.

Planners, 19 REG. FIN. PL. § 3:9, p. 6. (2009).

24. See Rachelle Younglai, Congress Told to Toughen up Broker Standards, 208 FORDHAM JOURNAL [Vol. XVI

OF CORPORATE & FINANCIAL LAW

Specifically, in the 1990s a growing number of broker-dealers began offering fee-based accounts to their customers. In a fee-based brokerage account, broker-dealers “provide customers a package of brokerage services—including execution, investment advice, custodial and recordkeeping services—for a fee based on the amounts of assets on account with the broker-dealer.” 25 Thus, the concern for broker-dealers is whether providing investment advice in the context of collecting a fee violates the broker-dealer exception’s “no special compensation” provision.

Over the last decade, the SEC has repeatedly, and unsuccessfully, tried to provide a clear interpretation of the ‘40 Act’s broker-dealer exception. In 1999, in response to the growing trend of broker-dealers offering fee-based accounts, the SEC proposed a rule entitled “Certain Broker-Dealers Deemed Not To Be Deemed Investment Advisers.” 26 After this rule sparked considerable debate and comment from brokerdealers, the SEC proposed a further clarification of the broker-dealer exception: any broker-dealer providing investment advice that is solely incidental to its brokerage services would be exempted from the ‘40 Act, regardless of whether it charges a wrap or fixed fee, or transaction-based commissions, mark-ups, and mark downs. 27 Thus, under the SEC’s proposed rule, a broker-dealer would still be exempt from the ‘40 Act, even if they received special compensation for their investment advice.



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