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SEC Insights - June 2011


Impact of the Dodd-Frank Act on Broker-Dealers



On July 21, 2010, President Obama signed a 2,319-page Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”). The Act has significant implications for broker-dealers. However, because the Act delegates so much the rule-making to regulatory agencies, the overall impact of the Act cannot be determined; it will depend on how regulators, including (or “most prominently”) the Securities and Exchange Commission (“SEC”), will interpret (or “write”) the rules and put them into practice.

In this article, we will discuss the following possible significant impacts to broker-dealers: the potential shift from “suitability” standard to a “fiduciary duty” standard when broker-dealers provide advice and recommendations to retail customers, new disclosures to customers concerning conflicts of interest and the receipt of compensation, the SEC’s broad new powers to prohibit or restrict sales practices, conflicts of interest, and compensation schemes that the SEC deems contrary to the public interest, and the SEC’s new authority to alter the current system of mandatory arbitration by imposing conditions or limitations on its use.

The Act amends the Sarbanes-Oxley Act (“SOX”) to require auditors of all broker-dealers to register with the Public Company Accounting and Oversight Board (the “PCAOB”) and gives the PCAOB rulemaking power to require a program of inspection for those auditors. This eliminates the uncertainty that previously existed in which broker-dealers were required to be audited by PCAOB registrants, yet the PCAOB did not have the authority to regulate or inspect auditors of privately-held broker-dealers. The Dodd-Frank amendments do not set down a specific program of inspection of registered public accounting firms that provide audit reports for a broker or dealer, but delegates this rule-making to the PCAOB by providing the authority to mandate an inspection program (“may” versus “should”). In turn, rules adopted by the PCAOB for broker-dealer audits must be approved by the SEC. The Act gives the PCAOB the authority to differentiate among broker-dealer classes and exempt certain of these classes from inspection. Each broker or dealer shall pay the PCAOB an annual accounting support fee allocated to such broker or dealer.

Under the Act, the SEC is given the authority to issue rules that require investment advisers to take appropriate actions to safeguard their clients’ assets over which the advisor has custody, including verification by an independent public accountant. Increased custody requirements may also affect brokers that provide custody services to advisers and their customers. Further, in connection with the Act, the SEC is required within two years to pass those rules that are designed to increase the transparency of information that is available with respect to the lending or borrowing of securities.

The Act changes the Regulation D – Accredited Investor Net Worth Standards. The accredited investor definition, and in particular the net worth threshold, had not been modified since 1982. It previously required either income in each of the two most recent years in excess of $200,000 (or $300,000 for a couple) or a net worth of at least $1 million (either individually or jointly). Net worth included the value of primary residences, which generally have significantly increased since the early 1980’s. Since it is now not uncommon for middle class families to own homes worth $250,000 to $500,000, the pool of individuals qualifying as accredited investors has greatly increased over this time period.

The Act changes the rules significantly as the net worth calculation can no longer include the value of the investor’s primary residence. Net worth criteria is at least $1 million individually or jointly. This change was not subject to any notice period and was not phased in over time. As this change was immediately effective, it resulted in the pool of accredited investors being immediately reduced, and had the result of turning certain accredited investors into unaccredited investors overnight. The SEC is required to review the accredited investor criteria for all types of investors every four years and generally make any changes as it deems suitable.

The Act imposes a fiduciary duty upon broker-dealers when they conduct business with retail customers, replacing the previous suitability standard. The Act does not directly impose a fiduciary standard on broker-dealers, but rather directs the SEC to do so. The Act defines the fiduciary duty standard as acting 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. The more preventive fiduciary standard would require that anyone providing personalized investment advice to retail customers would need to act in the client’s best interests and therefore disclose any conflicts of interest. The fiduciary standard differs from the current suitability standard that requires that broker-dealers recommend products that are suitable for the customer in light of the customer’s investment objectives, risk tolerance, and other factors. Under the Act, the SEC will likely require that broker dealers provide new disclosures to customers concerning conflicts of interest and the receipt of compensation. For the uniform fiduciary standard to be effective, investors need to understand any material conflicts of interest of their investment advisor or broker dealer. It is believed that any other information about the scope of their relationships with their investment advisors or broker-dealers would be helpful to retail customers. Section 913(g) of the Act recognizes the importance of such disclosure, and directs the Commission to make possible the provision of simple and clear disclosures to investors regarding the terms of their relationships with broker-dealers and investment advisors, including any material conflicts of interest. Before the finalization and implementation of the above, the Act directs the SEC to conduct a study and consider industry comments. The purpose of the study is to evaluate how the implementation of the fiduciary standard would impact the retail broker-dealer customer.

In conclusion, the impact of the Dodd-Frank Act will continue to evolve over time as regulators study the requirements of the Act and determine the appropriate structure for implementation. The impact of the Dodd-Frank Act on broker-dealers will remain unclear until the SEC exercises its rulemaking authority.

A special thanks to article contributor John Schuyler.




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