This Client Alert updates our previous commentary regarding New Jersey’s efforts to establish a fiduciary duty applicable to all broker-dealers and investment advisers doing business in the state.
Following the adoption by the Securities and Exchange Commission (“SEC”) of Regulation Best Interest (“Reg BI”) on June 5, 2019, the New Jersey Bureau of Securities (the “Bureau”) agreed to hold a public hearing on July 17, 2019 regarding its previously proposed rule that would impose administratively a common law fiduciary duty upon broker-dealers and investment advisers in certain circumstances (the “Rule Proposal”). The hearing debated the necessity of a state law fiduciary standard in light of the fact that Reg BI has raised a broker’s standard of care above the suitability standard through its four component obligations: (i) full and fair disclosure obligation; (ii) duty of care obligation; (iii) conflict of interest obligation; and (iv) compliance obligation to establish, maintain and enforce policies and procedures.
As proposed, the Bureau’s regulation will take effect 90 days after the publication of a notice of adoption. Industry representatives argued that this period is insufficient for firms to implement comprehensive compliance plans. They urged the Bureau to provide at least a one year effective date for a new rule.
Industry advocates expressed four material concerns with the Proposed Rule:
The “Best Of The Reasonably Available Options” Standard is Impractical and Impossible to Quantify
Industry representatives focused their arguments on the lack of clarity surrounding the scope of the standard and the seemingly impossible to satisfy “best of the reasonably available options” language. They urged the Bureau to remove the presumption that a breach of fiduciary duty occurs if a recommended transaction is not the best of the reasonably available options. They claimed that the “best of the reasonably available options” standard is vague and leaves firms open to second guessing the recommendation.
National Association Of Insurance And Financial Advisors (“NAIFA’s”) Dennis Cuccinelli stressed that the wording is “so open-ended and subjective that any advisor can be found in violation.” Additionally, he urged that the Rule Proposal does not provide any guidance on how to determine whether the “best of the reasonably available options” standard has been satisfied. Some argued that this standard “best implicates a single solution, where many may be appropriate and reasonable for the investor.” Others also argued that it would be impossible to define “the best fee structure.”
The “Without Regard To The Financial Or Any Other Interest Of The Broker-Dealer” Language Mimics the Vacated DOL Fiduciary Rule
Jason Berkowitz of the Insured Retirement Institute (“IRI”) argued that the Rule Proposal incorporates “one of the most problematic elements of the now vacated Department of Labor (“DOL”) Fiduciary Rule – the requirement that firms make recommendations ‘“without regard to the financial or any other interest of the broker-dealer.”’ The SEC’s Issuing Release noted that there is a risk that the phrase can be inappropriately construed to require a broker-dealer to eliminate all of its conflicts when making a recommendation. The SEC believes that this position could ultimately harm retail investors by reducing their access to differing types of investment services and products and by increasing their costs.
In Reg BI, the SEC chose to formulate the best interest obligation as requiring that the broker-dealer act “without placing the financial or other interest of the broker-dealer ahead of the interest of the retail customer.” The SEC recognized that, although a broker-dealer will inevitably have some financial interest in a recommendation, the firm’s interests cannot be placed ahead of the customer’s interest.
An Ongoing Duty Would Adversely Impact Investor Choice For New Jersey Customers
SIFMA contended that the imposition of an ongoing fiduciary duty on brokerage services is not consistent with the SEC’s interpretation of the “solely incidental” prong of the broker-dealer exclusion from the definition of an investment adviser. As a practical matter, industry advocates claimed that this obligation would deprive investors of their ability to choose a transactional service (and fee) model. Under Reg BI, firms can provide their investors with a choice: “buy and hold” investors are able to choose transaction-based, episodic brokerage relationships, but those who wish to receive greater service and are willing to spend more can choose the advisory model. New Jersey’s current standard will take this choice away.
Reg BI Requires Full and Fair Disclosure
Reg BI’s Disclosure Obligation is similar to the disclosure standard for investment advisers under the Investment Advisers Act. It provides that full and fair disclosure that gives sufficient information to enable a retail investor to make an informed decision cures the conflict and satisfies the Disclosure Obligation. In contrast, the Bureau’s Rule Proposal simply states that there is no presumption that disclosing a conflict of interest in and of itself satisfies the duty of loyalty. The industry therefore urged that the final rule strike this provision and allow for disclosure of material conflicts of interest to satisfy the duty of loyalty.
Consumer advocates supported the Rule Proposal for the following reasons:
Consumer advocates responded that Reg BI’s Disclosure Obligation does not sufficiently protect investors from receiving potentially conflicted advice. These commentators cautioned that Reg BI could potentially allow brokers to mitigate their conflicts by merely disclosing the existence of a conflict to the investors. They referenced studies reporting that “disclosure is a completely ineffective way to inform investors.”
Former PIABA President Joseph Pfeiffer stressed the need for a fiduciary standard. He said that firms hold themselves out as fiduciaries in their marketing materials and asserted that investors believe that their brokers are fiduciaries and are placing the client’s interest ahead of the broker’s interests. Given this, he argued that firms should not shy away from upholding a fiduciary standard. Mr. Pfeiffer attributed this confusion among investors to the current rules, especially Reg BI, which he referred to as “just a slightly better suitability rule.”
Micah Hauptman of the Consumer Federation of America likewise noted in his testimony that “Reg BI is politics, rather than policy. It’s meant to seem like change but does not in any appreciable way [make change].” Mr. Hauptman also urged the State to take the broker dealer threats of a withdrawal from New Jersey with a grain of salt. He stressed that it is very doubtful that firms will leave the state. Even if some firms decided to leave the market, he contended that there are others that could provide high-quality advice, for a reasonable fee and in compliance with a fiduciary standard. Finally, the consumer advocates testified that senior investors whose life savings are at risk need protection more than ever. Loss of retirement savings costs the state economy valuable resources, necessitating the need for a heightened standard of care.
The Bureau is expecting to issue its final regulation in the fall. If the Rule Proposal is adopted as is, it may impose unworkable compliance obligations on firms operating in New Jersey. Specifically, the “best of the reasonably available options” and “without regard to the financial or any other interest of the broker-dealer” provisions impose frameworks that are ill-defined and not practical. The Rule Proposal’s disclosure provision reaches further than anything that the SEC has imposed on investment advisers.
We will continue to monitor the progress of the proposed fiduciary rule and provide updates on all further developments.
The authors would like to thank summer associate, Lada Bobrytska, for her assistance with the drafting of this alert.