LawFlash

Nevada Proposes New Fiduciary Rules that Would Increase Broker-Dealer and Investment Adviser Obligations

February 08, 2019

This LawFlash outlines the key provisions in Nevada’s draft regulation and discusses, among other topics, when the regulation would be effective, when fiduciary duty would apply, and what conduct would be considered a fiduciary breach under the proposal. The comment period ends on March 1, 2019.

Nevada has issued proposed regulations[1] interpreting broker-dealers’ and investment advisers’ fiduciary duties under the amended Nevada financial planner statute (NRS 628).[2]

These regulations, if finalized as proposed, and unless federal preemption applies, would result in state-law fiduciary status—requiring a “best interest” standard—for broker-dealers that engage in many common brokerage activities, such as providing

  • investment recommendations;
  • financial plans; and
  • analyses and reports regarding securities to customers.

Key provisions of the draft regulation are summarized below.

When will the regulation be effective?

The proposed regulation does not have an effective date. Thus, unless an effective date is provided in the final regulation, the regulation could become effective immediately upon finalization.

Observation: Immediate applicability would leave broker-dealers and investment advisers without time to implement many changes needed to comply with the regulation, including amendments to current client agreements and disclosures, significant systems changes to develop the required “gains” disclosures (as discussed below), and operational changes to supervision and surveillance to facilitate compliance with the fiduciary standards.

Who would be treated as a fiduciary under these regulations?

Investment advisers (and professionals holding themselves out as such) are generally deemed to be fiduciaries under the regulations. Broker-dealers and representatives are also presumed to be acting as fiduciaries and have the burden of proving they are not. Dual-hatted broker-dealers and investment advisers would also be presumed to be acting as fiduciary investment advisers.

Activities that can result in fiduciary status for a broker-dealer include:

  • Providing “investment advice” – “Investment advice” is defined broadly to include not only recommendations to buy, hold, or sell a security, but also other services such as providing analyses and reports regarding a security, limited lists of securities, and advice regarding account types.
  • Using certain titles – Common titles that broker-dealers and their representatives use would result in fiduciary status, including advisor/adviser, financial planner/consultant, retirement consultant/planner. Significantly, exceptions that would not impose an ongoing fiduciary duty on broker-dealers or on broker-dealers that execute unsolicited, client-directed trades are not available to broker-dealers using the specified titles.
  • Managing client assets and performing discretionary trading. “Discretionary trading” excludes limited discretion as to time and price of a securities transaction that is client-directed and transactions executed to satisfy the client’s margin obligations.
  • Establishing a “fiduciary relationship” with a client. The regulations do not provide additional details on when or how a “fiduciary relationship” could be established.

Observations: The activities that can result in fiduciary status for broker-dealers are extremely broad and encompass many common brokerage practices. Moreover, the rebuttable presumption that broker-dealers are acting as fiduciaries places the burden on the broker-dealer to prove it is acting in a non-fiduciary capacity. As such, the regulations would pull many broker-dealers that provide services in Nevada into their scope.

When would the fiduciary duty apply?

Subject to limited exceptions, the Nevada fiduciary duty would apply to many aspects of client relationships with broker-dealers and investment advisers and their representatives, including when providing “investment advice,” maintaining client assets under management, disclosing fees and gains, acting in a fiduciary capacity, and through the completion of “any contract” or “term of engagement for services.”

In general, and in contrast to the Securities and Exchange Commission’s (SEC’s) Proposed Regulation Best Interest, the fiduciary duty for broker-dealers would be generally ongoing, unless the conditions of the regulation’s “Episodic Fiduciary Duty Exemption” are satisfied. Under this exemption, the broker-dealer’s fiduciary duty would end once advice is received by the client, the transaction is complete, and required fee and gain disclosures have been made. To be eligible for this exemption, the broker-dealer must meet a number of conditions, including (among other things) that

  1. the client solicited the investment advice;
  2. the client does not reasonably expect ongoing advice; and
  3. the broker-dealer does not use any of the titles listed above that result in fiduciary status.

Other exceptions are available for broker-dealers that are executing unsolicited trades and trades recommended by an investment adviser, subject to compliance with applicable laws, self-regulatory rules, and firm policies and procedures, so long as the broker-dealer does not use one of the specified titles, provide investment advice, or engage in certain other activities. The proposed regulation also provides an exception for clearing brokers.

Observations: We note that an ongoing fiduciary duty generally does not apply to broker-dealers under the federal securities laws, Financial Industry Regulatory Authority (FINRA) rules, other regulatory regimes to which broker-dealers are currently subject, the SEC’s proposed Regulation Best Interest, or the now vacated US Department of Labor (DOL) Fiduciary Rule. As such, many broker-dealers providing services subject to the Nevada regulation would likely need to develop bespoke compliance and supervision standards and procedures to be able to comply with the Nevada regulation.

What conduct would be considered a fiduciary breach?

The Nevada fiduciary duty requires, among other things, that the broker-dealer, investment adviser, and representative

  • perform reasonable “due diligence” on investment products and strategies;
  • recommend securities and investment strategies that are in the client’s “best interest”;
  • ·not put their own or other clients’ interests ahead of the client;
  • disclose that a recommended product is proprietary or that advice is based on a limited pool of products;
  • disclose material conflicts of interest;
  • receive no more than reasonable fees; and
  • ·not limit availability of securities to certain clients, unless based on the client’s investment goals or strategy, the firm’s limitations on quantity or type of investments that can be sold, or the security’s own sales limitations.

The regulations also clarify that selling a proprietary product and holding client positions in cash does not per se violate the fiduciary duty, so long as doing so does not otherwise violate law or self-regulatory organization rules, and the client is informed of all risks associated with the product or cash position.

Additionally, the receipt of transaction-based commissions is not a breach of fiduciary duty, so long as it is in the client’s best interest to be charged by transactions rather than other types of fees and the commission is reasonable.

Observations: The proposed Nevada regulations incorporate many familiar concepts from other recent rulemaking efforts in this space (i.e., the DOL’s Fiduciary Rule, SEC’s Regulation Best Interest, and the Certified Financial Planner Board’s standards), including “best interest” and “reasonable compensation.” However, the proposed regulations do not currently provide guidance on these standards, leaving ambiguity as to how they would be satisfied.

What disclosures must be provided at the time advice is given?

Under the Nevada statute, broker-dealers, investment advisers, and their representatives must disclose any “gains” resulting from a transaction at the time advice is given. The regulations would clarify that “gains” include, but are not limited to, the following:

  • Percentage of assets fee
  • Sales commissions
  • Mark ups and mark downs
  • Market maker commissions (Electronic Communication Network rebates or credits)
  • Transaction volume discounts
  • Management fees
  • Trailed or deferred fees or commissions
  • Front and back end loads
  • Service fees
  • Payment for order flow

If the actual amount of gain is not known at the time advice is given, the regulations would permit the broker-dealer, investment adviser, or representative to disclose the fact that the gain may be paid and the “manner of ascertaining that gain” to the client, and then to disclose the amount actually received within a reasonable time period.

The regulations further clarify that “gain” does not mean “profits” as a result of all business activities.

Observations: These regulations would appear to require disclosures beyond those currently required of broker-dealers and investment advisers, who generally are not required to disclose actual amounts of compensation received in connection with particular transactions at the point of sale.

It is also unclear whether the regulations permit disclosure using ranges or formulas, or whether dollar amounts are required. If the latter, the proposed regulations would permit significant operational challenges, particularly with respect to trailing commissions and other compensation that is paid as a percentage of assets over the time an investment is held.

Broker-dealers and investment advisers may wish to consider whether certain disclosures considered or developed in connection with meeting the DOL’s fiduciary rule could be helpful in developing disclosures that could potentially meet this regulation’s requirements.

Are there arguments that federal law could preempt the Nevada statute and regulations?

Yes, there are arguments that the National Securities Markets Improvement Act (NSMIA) preempt aspects of the Nevada statute and regulations as applied to federally registered broker-dealers and investment advisers. Importantly, NSMIA provides broad preemption for federally registered investment advisers (other than provisions relating to enforcement of anti-fraud prohibitions), and that the states cannot impose additional or different books and records requirements. Other preemption arguments may include that the SEC’s Regulation Best Interest could preempt the field for state fiduciary regulations.

There are also strong arguments that the Employee Retirement Income Security Act (ERISA) preempts Nevada’s fiduciary regulations with respect to services provided to ERISA plans, plan fiduciaries, and participants.

Observations: The proposed regulations anticipate potential preemption challenges, stating that the regulations should be read in harmony with NSMIA and the Securities Exchange Act. We anticipate that certain aspects of the regulation may be challenged on federal preemption grounds if the regulation is finalized as proposed.

Next Steps

We encourage firms that may be affected by the Nevada fiduciary law to comment on the proposed regulations. Morgan Lewis will continue to monitor developments in this area.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
David C. Boch
Jason S. Pinney
Richard A. Goldman
Matthew T. Bohenek

New York
Jennifer L. Klass
Eric Perelman

Philadelphia
Timothy W. Levin
Christine M. Lombardo

Washington, DC
Mary Dunbar
Lindsay B. Jackson
Daniel R. Kleinman
Steven W. Stone
Amy Natterson Kroll
John V. Ayanian
Michael B. Richman
Mark D. Fitterman
Monica L. Parry
Brian J. Baltz
Kyle D. Whitehead
Natalie R. Wengroff



[1] Read the draft regulations..

[2] Please see our previous client alert on the 2017 amendments to the Nevada financial planner statute.