Investor protection

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Fin Services Committee passes investor protection legislation

The House Financial Services Committee voted (41-28) on Nov. 4 to recommend the Investor Protection Act of 2009(Download H.R.3817) that has a variety of measures intended to improve investor protection and increase investor confidence. The bill contains two provisions of particular interest to retail investors.

First, the Act requires the SEC to establish a uniform "fiduciary duty" for broker, dealers and investment advisers providing personalized investment advice to retail customers. The proposed language does this in a somewhat convoluted manner. Section 103 amends the Securities Exchange Act and requires the SEC to promulgate rules that the standard of conduct for these brokers and dealers shall be the same as the standard of conduct for investment advisers. In turn, the Investment Advisers Act would be amended to require the SEC to promulgate rules to provide that the standards of conduct for all such brokers, dealers and investment advisers shall be "to act in the best interest of the customer" without regard to the financial or other interest of the advice provider.

The proposed legislation would also require the SEC to "harmonize," to the extent possible, enforcement and remedy regulations applicable to brokers, dealers and investment advisers. Second, section 201 of the proposed legislation gives the SEC the authority to prohibit or limit agreements that require customers of brokers, dealers, and investment advisers to arbitrate disputes "arising under the Federal securities laws or the rules of an SRO" if the SEC finds that it would be in the public interest and for the protection of investors. Notice that, under this language, agreements to arbitrate disputes arising under state law are not explicitly prohibited. Since many customers' disputes are negligence or breach of fiduciary duty claims arising under state law (since federal securities fraud requires scienter and federal courts do not recognize a private claim under SRO rules), adoption of this legislation may revive the complications that existed pre-McMahon, where federal claims could be brought in court while state claims arising under the same facts would go to arbitration.

The proposed legislation contains a number of other provisions of large and small import, including an increase in the agency's funding. It is reported in the press that a bipartisan amendment was added to the bill, to exempt permanently businesses valued at $75 million or less from the SOX 404(b) attestation requirement. The SEC had exempted these firms from the requirement, but the exemption is scheduled to expire in 2011.

Investor Protection Act draft

  • Protecting Investors and Righting Wrongs. The financial crisis exposed the perils of deregulation. The Investor Protection Act will right these wrongs by reforming the Securities and Exchange Commission (SEC) to strengthen its powers, better protect investors, and efficiently and effectively regulate our securities markets.
  • Comprehensive Securities Review and Reorganization. The failures to detect the Madoff and Stanford Financial frauds demonstrate deep deficiencies in our existing securities regulatory structure. An expeditious, independent, comprehensive study of the entire securities industry by a high caliber body will identify reforms and force the SEC and other entities to put in place further improvements designed to ensure superior investor protection.
  • Enhanced SEC Enforcement Powers and Funding. By doubling the authorized funding for the SEC over 5 years and providing dozens of new enforcement powers and regulatory authorities, the SEC will be able to enhance its enforcement programs and gain the tools needed to better protect investors and police today’s markets.
  • Fiduciary Duty. Every financial intermediary who provides advice will have a fiduciary duty toward their customers. Through a harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first.
  • Whistleblower Bounties. A whistleblower bounty program will create incentives to identify wrongdoing in our securities markets and reward individuals whose tips lead to successful enforcement actions. With a bounty program, we will effectively have more cops on the beat in our securities markets.
  • Ending Mandatory Arbitration. Because mandatory arbitration has limited the ability of defrauded investors to seek redress, the SEC will gain the power to bar these clauses in customer contracts.
  • Closing Loopholes and Fixing Faulty Laws. The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. The $65 billion Ponzi scheme also exposed faults in the Securities Investor Protection Act, the law that returns money to the customers of insolvent fraudulent broker-dealers. The Investor Protection Act closes these loopholes and fixes these shortcomings.

Advisors to $100 million could go under state regs

The House Financial Services Committee today unanimously approved a measure that would move oversight of investment advisory firms with less than $100 million in assets to state securities regulators.

Currently, advisory firms with less than $25 million are regulated by the states, while advisers with more assets are regulated by the Securities and Exchange Commission.

Committee chairman Barney Frank, D-Mass., offered the measure as an amendment to the proposed Investor Protection Act of 2009, which would raise standards for all financial advisers who provide personalized advice on securities to fiduciary standards. The amendment was approved on a voice vote with little debate.

Rep. Paul Kanjorski, D-Pa., chairman of the Capital Markets Subcommittee, had earlier said that an agreement had been reached to raise the threshold to $150 million in assets under management.

State securities regulators applauded the move.

"States have both the will and the ability to regulate," Texas Securities Commissioner Denise Crawford said in a statement. Ms. Crawford is president of the North American Securities Administrators Association Inc.

"Increasing the threshold to $100 million would reduce the SEC’s examination burden and allow the agency to focus on larger firms and other market issues," she said. "It’s clear that states have done a much better job at deploying their limited resources. States are ready to accept this increased responsibility.”

The committee also approved an amendment offered by Rep. Carolyn McCarthy, D-N.Y., which would authorize a study of whether investment advisers should be regulated under a self-regulatory organization.

Advisory groups have opposed coming under an SRO. They fear that the Financial Industry Regulatory Authority Inc. would be put in charge of the advisory industry.

Ms. McCarthy's amendment would require the SEC to report back to Congress in six months on whether an SRO is needed, taking into account the frequency of exams of advisory firms over the past five years. In fiscal 2009, the SEC has said it will examine about 9% of advisory firms, while Finra examines about 55% of the broker-dealer firms it regulates.

"Investment adviser firms are woefully under-examined," Ms. McCarthy said. “The study will bring insights on changes needed to protect investors," she said.

Davis Polk summary of legislation

"On July 10, 2009, the Treasury Department released the proposed Investor Protection Act of 2009 (the “Act”), which would, if enacted, implement portions of the financial reform proposals contained in the Administration’s recent White Paper. The Act enhances the regulatory powers of the Securities and Exchange Commission (“SEC”) in a number of areas, including authorizing the issuance of rules to: require broker-dealers and investment advisers to act solely in the best interest of retail (and potentially other) clients; prohibit sales practices, conflicts of interest and compensation schemes that the SEC deems to be contrary to investor interests; compel the provision of disclosure prior to the sale of interests in mutual funds; and limit or ban mandatory arbitration provisions in customer agreements. The Act also enhances the SEC’s enforcement powers by: expanding the scope of enforcement actions for aiding and abetting violations; increasing the SEC’s authority to ban persons from association with any SEC-regulated entities; and increasing the potential rewards for whistleblowers. This newsflash summarizes the main provisions of the Act.

The Act is the second piece of draft legislation released by the Administration to implement the White Paper. For further information on the White Paper, see the Davis Polk memorandum entitled “A New Foundation for Financial Regulation?” dated June 22, 2009. For further information on the initial legislative proposal implementing the White Paper, see the Davis Polk newsflash entitled “Consumer Financial Protection Agency Act of 2009” dated July 1, 2009.

New Conduct Standard for Securities Recommendations; SEC Authority to Prohibit Certain Sales Practices, Conflicts of Interests and Compensation Arrangements Under current law, investment advisers are subject to fiduciary and anti-fraud obligations imposed by common law and the Investment Advisers Act of 1940 (the "Advisers Act"), although SEC rules and state law permit certain duties to be limited or eliminated with disclosure or consent. By contrast, broker-dealers are subject to general anti-fraud limitations under the Securities Exchange Act of 1934 (the “Exchange Act”) and SEC rules, as well as a “suitability” obligation and other conduct standards prescribed by the Financial Industry Regulatory Authority (“FINRA”) and other self-regulatory organizations. The Fact Sheet included in the Treasury Department’s press release announcing the Act states the Administration’s view that investors rely upon the investment recommendations of both broker-dealers and investment advisers in the same manner, and that the legal distinctions that result in different standards “are no longer meaningful.” The Act would authorize the SEC to adopt rules under the Exchange Act and the Advisers Act to provide that, when broker-dealers and investment advisers render investment advice about securities to retail customers or clients (and such other customers or clients as the SEC designates by rule), they are required “to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” The proposed standard could raise questions regarding the potential conflicts that arise in ordinary securities market activities, such as underwriting, trading as a principal, sales of proprietary products and cross-trading.

The Act also authorizes the SEC to facilitate the development of simple and clear disclosures to investors regarding the terms of their relationships with financial intermediaries and to examine and, where appropriate, prohibit financial intermediary “sales practices, conflicts of interest and compensation schemes” that it considers contrary to public and investor interests. However, there is no indication of which specific practices the Administration has in mind, nor is it clear whether the reference to “compensation schemes” is intended to include the compensation arrangements of individual industry professionals, as opposed to compensation arrangements between firms and customers and among intermediary firms.

The inclusion of these provisions in the Act may presage greater involvement by the SEC, in addition to FINRA, in directly regulating sales practices of broker-dealers.

Point of Sale Disclosures for Registered Funds The Act would amend the Investment Company Act of 1940 (the “Investment Company Act”) to explicitly allow the SEC to issue rules requiring the delivery of documents, such as a concise summary prospectus or cost disclosure, prior to sales of registered fund interests. Industry groups have previously opposed this type of requirement.

Arbitration Provisions In the White Paper, the Administration urges the SEC and the proposed Consumer Financial Protection Agency to conduct studies on whether the use of mandatory arbitration clauses should be eliminated or curtailed. The Act would give the SEC the power to prohibit or limit the use of mandatory arbitration provisions related to disputes with brokers, dealers, municipal securities dealers and investment advisers arising under the federal securities laws or self-regulatory organization rules if the SEC finds that such action is in the public interest and protects investors.

Enhancements to the SEC’s Enforcement Authority Under the Act, the SEC would have the authority to seek remedies for aiding and abetting violations under the Securities Act of 1933 and the Investment Company Act, as it currently can for violations of the Exchange Act and the Advisers Act. In addition, the Act would extend the SEC’s aiding and abetting enforcement authority across all of the securities laws to include reckless conduct.

The Act would allow the SEC, in any action in which it levies sanctions in excess of $1,000,000, to compensate whistleblowers with up to 30% of the amount of the sanctions. Within these parameters, the amounts paid to whistleblowers under the Act would be within the sole discretion of the SEC and not subject to judicial review. This would greatly expand the SEC’s current authority under the Exchange Act, which caps such compensation at 10% of collected penalties, and restricts it to the insider trading context. The Act would also establish an Investor Protection Fund, intended to grow to a maximum of $100,000,000 through revenues from certain sanctions, to pay awards to whistleblowers and to fund investor education initiatives.

The Act also permits the SEC to impose a broader range of collateral bars under the Exchange Act and the Advisers Act, prohibiting offenders from associating with a broad range of SEC-regulated entities, rather than only those entities regulated under the particular statutory provisions under which the violation occurred.

The Act does not provide for a private right of action to enforce any of its provisions.

Creation of the Investor Advisory Committee The Act would make permanent the SEC’s recently announced Investor Advisory Committee, which would consult with the SEC on a variety of matters, including regulatory priorities and issues regarding new products, trading strategies, fee structures and the effectiveness of disclosures. The SEC would not be bound to act upon the Investor Advisory Committee’s recommendations.

It is difficult to predict with any certainty the exact form of any final legislation. Davis Polk is monitoring developments with respect to the Investor Protection Act of 2009 and will issue additional newsflashes from time to time.

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