The SEC Calls for Uniform Fiduciary Duties

This section of my Web site will explain: (1) What the courts have held broker’s “fiduciary duties” to encompass and (2) The main findings of the SEC and it recommendations to Congress.

What Does a Broker’s Fiduciary Duty Mean?

During the market meltdown of the late 2000s, many customers were upset and confused that their brokers had not called them with advice on how to weather the financial storms. They didn’t receive advice on whether to hold tight, to sell rapidly dropping securities or to buy something else. The market’s collapse was met with broker silence. When those customers consulted attorneys and were told that, in most instances, a broker’s duties end after the transactions take place, they asked, “How can that be? He said he was my ‘investment advisor.'”

Courts and arbitrators draw a distinction between stock brokers who earn commissions on transactions (whether such brokers are called Financial Advisers, Wealth Managers, Managing Directors, Vice Presidents or similar names) and financial professionals who actually manage a customer’s portfolio from the outset and thereafter and, instead of receiving commissions on trades, are compensated periodically by a percentage of the assets they are managing. Most accounts fall in the first category where the broker is required to recommend suitable investments and to tell the customer material information about the investment, so that the customer, and not the broker, is making the ultimate investment decision. Such a broker’s duties to the customer usually end at point-of-sale. They do not have to call the customer again, although they do.

In Leib v. Merrill Lynch, Pierce, Fenner & Smith – a frequently cited 1978 Michigan federal court decision concerning broker fiduciary duties – it was held that when a broker usurps control over a non-discretionary account (the typical customer account, where the customer must give his or her approval before each trade), “the broker owes his customer the same fiduciary duties as he would have had the account been discretionary from the moment of its creation.” The Leib court listed four fiduciary duties that are often used as benchmarks by customer attorneys and defense attorneys in securities arbitration cases:

1. Manage the account in a manner directly comporting with the needs and objectives of the customer as stated in the authorization papers or as apparent from the customer’s investment and trading history.

2. Keep informed regarding the changes in the market which affect his customer’s

interests and act responsively to protect those interests.

3. Keep his customer informed as to each completed transaction.

4. Explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged.

In United States v. Frank Skelly and Craig Gross, the influential New York Federal Second Circuit Court of Appeals in 2006 recognized that while “there is no general fiduciary duty inherent in an ordinary broker/customer relationship …. a relationship of trust and confidence does exist with respect to those matters that have been entrusted to the broker.” Most commonly, said this federal appeals court, such a relationship exists in situations where a broker has discretionary authority over the customer’s account. In the 2002 Second Circuit Court of Appeals case of De Kwiatkowski v. Bear Stearns & Co, the court drew a distinction between a broker’s obligation when he recommends an investment and any obligation thereafter. The obligation of a broker, said the federal court, depends on his decision to extend his legal obligation beyond that which he would otherwise be responsible for. When the broker assumes that greater responsibility, he has become the customer’s fiduciary, with the litany of responsibilities that continue as long as that special relationship exists.

The SEC’s 2011 Study on Investment Advisers and Broker-Dealers

In a Nutshell – There should be a uniform fiduciary standard for investment advisers and broker-dealers when providing personalized investment advice about securities to retail customers:

The uniform fiduciary standard of conduct for all brokers, dealers and investment advisers when providing personalized investment advice about securities to retail customers shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment adviser, providing the advice that is no less stringent than the existing fiduciary standard of investment advisers under Investment Advisers Act.

The SEC found that there is confusion by many investors about the distinction between investment advisers and broker and the duties they owe.

· Investment Advisers – The fiduciary duty of investment advisers includes a duty of loyalty and a duty of care (including a duty of suitability), with the duty of loyalty requiring investment advisers to act in the best interests of clients and to avoid or disclose conflicts.

· Brokerage Firms and Brokers – The standard of conduct for broker-dealers has been characterized as primarily to deal fairly with customers and to observe high standards of commercial honor and just and equitable principles of trade. They also are subject to a number of specific obligations, including a duty of suitability and requirements to disclose certain conflicts.

· What the SEC Found – The SEC found that in practice, the required disclosures of conflicts by brokerage firms have been more limited than with investment advisers and apply at different points in the customer relationship. It also found that these differences in the standards of conduct are significant and are not well understood by retail customers.

Guidance for Brokers Under the Uniform Fiduciary Standard

In its Study, the SEC stated that, “The existing guidance and precedent under the Advisers Act regarding fiduciary duty, as developed primarily through Commission interpretive pronouncements under the antifraud provisions of the Advisers Act, and through case law and numerous enforcement actions, will continue to apply to investment advisers and be extended to broker-dealers, as applicable, under the uniform fiduciary standard.” In other words, what had not been precedent before for brokers will be precedent now.

What follows is a summary of critical questions asked and answered by the SEC: (1) What should a broker’s duty of loyalty entail? (2) What should a broker’s duty be for “principal transactions” as contrasted to the trading of securities on a stock exchange or NASDAQ? (3) What should be a broker’s duty of care? (4) What does it mean for a broker to provide personalized investment advice about securities? Since these subjects will be raised in most customer securities arbitrations, the SEC’s interpretations and recommendations should play an important role in such cases.

What Should a Broker’s Duty of Loyalty Entail?

The Investment Advisers Act of 1940 prohibits an adviser from putting its interests ahead of its clients. By incorporating Advisers Act Section 206(1) and 206(2), a uniform fiduciary standard would require an investment adviser or brokerage firm to eliminate or provide full and fair disclosure about its material conflicts of interest. Mindful of court decisions on the subject of a broker’s fiduciary duties under various circumstances, the Dodd-Frank Act provides that the uniform fiduciary standard shall not require broker-dealers to have a continuing duty of care or loyalty to a retail customer after providing personalized investment advice.

What kind of disclosure is required of investment advisers that would not be required of brokerage firms? Investment advisers must provide clients and prospective clients with a current firm brochure before or at the time an adviser enters into an advisory contract with the client. The firm brochure (Part 2A of Form ADV) contains information about the investment adviser’s services, certain conflicts of interest, its range of fees, methods of analysis, investment strategies and their risk of loss, review of accounts, client referrals and other compensation and the adviser’s disciplinary and financial information.

The SEC found that brokerage firms are not subject to a comparable requirement for a general disclosure of conflicts at the time the customer-broker relationship is established. Instead, reported the SEC, when recommending a security, brokers generally are required to disclose any material adverse facts or material conflicts of interest (i.e. any economic self-interest) so that customers may evaluate their overlapping motivations. Broker-dealers also are required to make certain specific disclosures (i.e., whether they are acting as market makers for a recommended security, or if they have any other control, affiliation or interest in the security). “For the uniform fiduciary standard to be effective,” wrote the SEC in its Study, “investors need to understand any material conflicts of interest of their investment adviser or broker-dealer.”

Therefore, the SEC Staff recommended that the SEC consider developing a uniform approach to disclosure that would provide retail customers of both brokerage firms and investment advisers with relevant key pieces of information at the outset of the advisory or brokerage relationship and at appropriate times thereafter. “This presumably would include extending to broker-dealers a requirement of a general relationship disclosure document analogous to Form ADV Part 2 at or prior to account opening.” The Study recommended that the SEC explore the utility and feasibility of a summary disclosure document that would describe in clear, summary form, a firm’s services (including the extent to which its advice is limited in time or is continuous and ongoing), charges and conflicts of interest.

And what about the timing of customer disclosure? The SEC Staff believes customers would benefit from receiving information about the firm’s conflicts of interest, fees, scope of services and disciplinary information before or at the time of entering into a customer relationship, with annual updating disclosures thereafter In other words, disclosures at point-of- sale could be more effective about a product, about risks, about compensation or about any specific conflicts when personalized investment advice is given. Now, when a brokerage firm’s customer purchases an initial public offering (IPO) or a specific investment product or strategy, documents describing those securities or strategies are sent out after the purchase takes place.

What Should a Broker’s Duty be for Principal Trading (as Opposed to Exchange Trading)?

Why is there even a concern? Because of the risks of price manipulation or the placing of unwanted securities into client accounts (i.e., dumping). “Engaging in principal trading with customers or clients represents a clear conflict for any fiduciary,” said the SEC. The Advisers Act, Section 206(3), prohibits an adviser from engaging in a principal trade with an advisory client unless it makes discloses to the client in writing before completion of the transaction. By contrast, for brokerage firms, there is no specific requirement for written disclosure or explicit consent for each principal transaction.

Under the proposed uniform fiduciary standard, a brokerage firm would be required, at a minimum, to disclose its conflicts of interest related to principal transactions, including its capacity as principal. When engaging in principal transactions, brokerage firms would remain subject to obligations relating to suitability, best execution and fair and reasonable pricing and compensation. Lastly, the SEC Staff believes that requests for customer consent embedded in voluminous advisory agreements or other account opening agreements impede the provision of such consent.

What Should a Broker’s Duty of Care Entail?

Under the Investment Advisers Act, an investment adviser’s duty of care requires it to make a reasonable investigation to determine that it is not basing its recommendations on materially inaccurate or incomplete information. “The duty of care,” says the SEC, “also obligates investment advisers to seek best execution of clients’ securities transactions when they have the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts).” The SEC then stated that a brokerage firm has, at minimum, the following three obligations:

1. Suitability – To reasonably believe that its securities recommendations are suitable for its customer in light of the customer’s financial needs, objectives and circumstances and comply with specific disclosure, due diligence and suitability requirements for certain securities products.

2. Best Execution – To seek to execute customers’ trades at the most favorable terms reasonably available under the circumstances.

3. Charges – To charge only prices for securities and compensation for services that are fair and reasonable taking into consideration all relevant circumstances.

The Study recommended that the SEC should consider specifying uniform standards for the duty of care owed to retail customers. Minimum baseline professionalism standards could include specifying what basis a brokerage firm or investment adviser should have in making a recommendation to a retail customer.

What Does it Mean to Provide Personalized Investment Advice About Securities?

First of all, said the SEC in its Study, the determination of whether a communication rises to the level of investment advice depends on particular facts and circumstances and that in the securities industry the key word is “recommendation” and not “advice.” However, said the SEC, “communications that constitute a call to action or that reasonably could influence the customer to enter into a particular transaction or engage in a particular trading strategy are likely to be considered recommendations.” That is, the more individually tailored the communication is to a customer or a targeted group of customers, the more likely it will be viewed by courts, regulators and arbitrators to be a recommendation (and the obligations that flow from a recommendation).

What are some examples of communications that are generally viewed as constituting a recommendation? According to the SEC:

1. Customer specific communications to a targeted customer or targeted group of customers encouraging the particular customers to purchase a security or engage in a particular trading strategy.

2. Communications stating that customers should be invested in stocks from a particular sector and urging them to purchase one or more stocks from a list of buy recommendations.

3. Portfolio analysis tools that generate a specific list of buy or sell recommendations for a customer based on information the customer has inputted regarding his investment goals and other personalized information.

4. Technology that analyzes a customer’s financial or online activity and sends specific investment suggestions that the customer buy or sell a security.

5. In a discretionary account, securities that are bought, sold or exchanged are considered to be implicitly recommended.

On the other hand, what are examples of communications that, according to the SEC’s understanding of the term, would not constitute a recommendation?

1. General financial and investment information: (a) basic investment concepts such as risk and return, diversification, dollar cost averaging, compounded return and tax deferred investment; (b) historic differences in the return of asset classes (e.g., equities, bonds, or cash) based on standard market indices; (c) effects of inflation; (d) estimates of future retirement income needs; and, (e) assessment of a customer’s investment profile.

2. Descriptive information about an employer-sponsored retirement or benefit plan, participation in the plan, the benefits of plan participation and the investment options available under the plan.

3. Asset allocation models that: (a) are based on a generally accepted investment theory; (b) are accompanied by disclosures of all material facts and assumptions that may affect a reasonable investor’s assessment of the asset allocation model or any report generated by such model; and, (c) comply with applicable FINRA interpretive material allowing investment analysis tools.

4. Interactive investment materials that incorporate the above.

In its Study, the Staff of the SEC recommended that the SEC define the term “personalized investment advice about securities” to provide clarity to brokerage firms, investment advisers and retail investors. “Such a definition at a minimum should encompass the making of a recommendation as developed under applicable broker-dealer regulation, and should not include impersonal investment advice as developed under the Advisers Act.”


Parties and counsel in a securities arbitration should appreciate that the SEC Study is not recommending that the violation of a uniform definition of fiduciary duty should give rise to a cause of action that a customer can base a claim on. However, when such a definition is accepted by Congress, at the recommendation of the Securities and Exchange Commission, it will go a long way to set standards by which to judge the conduct at issue before the arbitrators.