Study on Investment Advisers and Broker-Dealers

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In “FINRA Supports Regulation to Quell Competition” we wrote:

While only 5% of the firms registered with the SEC as investment advisors are also registered as broker-dealers, FINRA firms employ 88% of the investment adviser representatives.

This comes from the January 2011 “Study on Investment Advisers and Broker-Dealers” As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act done by the Staff of the U.S. Securities and Exchange Commission. Here are some portions of that report:

Broker-dealers and investment advisers are regulated extensively, but the regulatory regimes differ, and broker-dealers and investment advisers are subject to different standards under federal law when providing investment advice about securities. Retail investors generally are not aware of these differences or their legal implications. Many investors are also confused by the different standards of care that apply to investment advisers and broker-dealers. That investor confusion has been a source of concern for regulators and Congress. …

Current State of the Investment Adviser and Broker-Dealer Industries

Investment Advisers: Over 11,000 investment advisers are registered with the Commission. As of September 30, 2010, Commission-registered advisers managed more than $38 trillion for more than 14 million clients. In addition, there are more than 275,000 state-registered investment adviser representatives and more than 15,000 state-registered investment advisers. Approximately 5% of Commission-registered investment advisers are also registered as broker-dealers, and 22% have a related person that is a broker-dealer. Additionally, approximately 88% of investment adviser representatives are also registered representatives of broker-dealers. A majority of Commission-registered investment advisers reported that over half of their assets under management related to the accounts of individual clients. Most investment advisers charge their clients fees based on the percentage of assets under management, while others may charge hourly or fixed rates.

Broker-Dealers: The Commission and FINRA oversee approximately 5,100 broker-dealers. As of the end of 2009, FINRA-registered broker-dealers held over 109 million retail and institutional accounts. Approximately 18% of FINRA-registered broker-dealers also are registered as investment advisers with the Commission or a state. Most broker-dealers receive transaction-based compensation.

Regulation of Investment Advisers and Broker-Dealers

The regulatory schemes for investment advisers and broker-dealers are designed to protect investors through different approaches. Investment advisers are fiduciaries to their clients, and the regulation under the Advisers Act generally is principles-based. The regulation of broker-dealers governs how broker-dealers operate, for the most part, through the Commission’s antifraud authority in the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”), specific Exchange Act rules, and SRO rules based on Exchange Act principles, including (among others) principles of fairness and transparency. Certain differences in the regulation of broker-dealers and advisers reflect differences, current and historical, in their functions, while others may reflect differences in the regulatory regime, particularly when investment advisers and broker-dealers are engaging in the same or substantially similar activity. The recommendations listed in the Study are designed to address gaps in the regulatory regime, as well as differences in approach that are no longer warranted, as they relate to providing personalized investment advice about securities to retail customers.

Investment Advisers: An investment adviser is a fiduciary whose duty is to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own. Included in the fiduciary standard are the duties of loyalty and care. An adviser that has a material conflict of interest must either eliminate that conflict or fully disclose to its clients all material facts relating to the conflict.

In addition, the Advisers Act expressly prohibits an adviser, acting as principal for its own account, from effecting any sale or purchase of any security for the account of a client, without disclosing certain information to the client in writing before the completion of the transaction and obtaining the client’s consent.

The states also regulate the activities of many investment advisers. Most smaller investment advisers are registered and regulated at the state level. Investment adviser representatives of state- and federally-registered advisers commonly are subject to state registration, licensing or qualification requirements.

Broker-Dealers: Broker-dealers that do business with the public generally must become members of FINRA. Under the antifraud provisions of the federal securities laws and SRO rules, including SRO rules relating to just and equitable principles of trade and high standards of commercial honor, broker-dealers are required to deal fairly with their customers. While broker-dealers are generally not subject to a fiduciary duty under the federal securities laws, courts have found broker-dealers to have a fiduciary duty under certain circumstances. Moreover, broker-dealers are subject to statutory, Commission and SRO requirements that are designed to promote business conduct that protects customers from abusive practices, including practices that may be unethical but may not necessarily be fraudulent. The federal securities laws and rules and SRO rules address broker-dealer conflicts in one of three ways: express prohibition; mitigation; or disclosure.

An important aspect of a broker-dealer’s duty of fair dealing is the suitability obligation, which generally requires a broker-dealer to make recommendations that are consistent with the interests of its customer. Broker-dealers also are required under certain circumstances, such as when making a recommendation, to disclose material conflicts of interest to their customers, in some cases at the time of the completion of the transaction. The federal securities laws and FINRA rules restrict broker-dealers from participating in certain transactions that may present particularly acute potential conflicts of interest. At the state level, broker-dealers and their agents must register with or be licensed by the states in which they conduct their business. …

Retail Investor Perceptions

Many retail investors and investor advocates submitted comments stating that retail investors do not understand the differences between investment advisers and broker-dealers or the standards of care applicable to broker-dealers and investment advisers. Many find the standards of care confusing, and are uncertain about the meaning of the various titles and designations used by investment advisers and broker-dealers. Many expect that both investment advisers and broker-dealers are obligated to act in the investors’ best interests.

Photo by Sherwood411 used here under Flickr Creative Commons.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.