LawFlash

Update on State Fiduciary Duty Regulations

June 19, 2019

As Massachusetts steps up to the plate, New Jersey extends comment period and announces public hearing.

Just as the comment period on New Jersey’s fiduciary rule proposal came to a close, Massachusetts Secretary of State William Galvin announced on June 14, 2019 a preliminary solicitation of public comments (Solicitation) on a regulation that would apply a “fiduciary” duty to broker-dealers and advisers in Massachusetts (Regulation).[1] The Solicitation states that the fiduciary standard is needed to protect Massachusetts investors, in spite of the fact that the US Securities and Exchange Commission (SEC) recently adopted Regulation Best Interest,[2] because the SEC:

  • failed to adopt a standard for broker-dealers “no less stringent than” the fiduciary duty that apples to investment adviser under the Investment Advisers Act in accordance with the authorization under Section 913 of the Dodd-Frank Act;
  • did not define “best interest;”
  • did not prohibit “broader-based” sales contests other than those related to specific products and product types; and
  • would permit many conflicts to be addressed through disclosure.

The Regulation is substantially similar to New Jersey’s, but includes some important differences that we highlight below. The comment period ends on July 26, 2019.

Meanwhile, New Jersey announced that it will hold a public hearing on July 17 and is reopening the comment period until July 18.

Summary of Massachusetts Proposal

The Regulation, if finalized in its preliminary form, and unless federal preemption applies, would require broker-dealers, “advisers,” and their representatives and agents to comply with certain fiduciary duties when providing recommendations to “customers” and “clients” regarding:

  • Purchases, sales, or exchanges of any security;
  • Investment strategies;
  • Opening accounts; or
  • Transferring assets.

Additionally, the fiduciary duties would apply with respect to discretionary authority over a customer’s or client’s account or a “contractual” fiduciary duty. According to the Solicitation, IRA rollover recommendations would also be in scope. Failure to adhere to the fiduciary standard would be considered a “dishonest or unethical business practice” under the proposal.

Violations of the standard may expose entities or persons covered by the Regulation to liability under Section 204 of the Massachusetts Uniform Securities Act (G.L. c. 110A, § 204), which permits the Massachusetts Securities Division (Division) to:

impose an administrative fine or censure or deny, suspend, or revoke any registration or take any other appropriate action if he finds (1) that the order is in the public interest and (2) that the applicant or registrant or, in the case of a broker-dealer or investment adviser, any partner, officer, or director, any person occupying a similar status or performing similar functions, or any person directly or indirectly controlling the broker-dealer or investment adviser:

(G) has engaged in any unethical or dishonest conduct or practices in the securities, commodities or insurance business….

Emphasis added.

When Will the Regulation Be Effective?

The Solicitation and Regulation do not indicate an effective date. Unless an effective date is provided, the Regulation could become effective immediately upon publication of a final regulation in the Massachusetts Register.

Observation: Immediate applicability would leave broker-dealers and investment advisers without time to implement all necessary changes needed to comply with the regulation, including amendments to current client or customer agreements and disclosures or operational changes to supervision and surveillance to facilitate compliance with the fiduciary standards.

Who Would Be Treated as a Fiduciary Under the Regulation?

The fiduciary duty would apply to broker-dealers, “advisers,” and agents. The proposal defines “adviser” to include both Massachusetts registered investment advisers and persons excluded from state registration, including, presumably, federally registered investment advisers. This definition also includes a rebuttable presumption that the term “adviser” includes not only investment advisers and investment adviser representatives, but also other persons who charge fees for rendering investment advice based on assets under management or portfolio performance.

Observation: The precise contours of the scope of the Regulation (if finalized) will likely be defined over time, as cases are pursued by the Division. Historically, the Division has advanced an expansive view of the scope of its jurisdiction, though courts have not found its jurisdiction to be unlimited.[3] The definition of “adviser” appears to pull into scope entities other than registered investment advisers and broker-dealers, including federally registered investment advisers. However, there are questions regarding the Division’s authority over entities other than state-registered broker-dealers and investment advisers, including federal preemption concerns discussed in more detail below.

Who Is a “Customer” or “Client?”

The Regulation does not specifically define “customers” and “clients” to whom the fiduciary duty is owed, but does provide a carve-out for certain institutional investors, including

  • banks, savings and loan associations, insurance companies, and registered investment companies;
  • state registered broker-dealers;
  • state or federally registered investment advisers;
  • Internal Revenue Code Section 501(c)(3) organizations with securities portfolios of more than $25 million;
  • certain investing entities whose only investors are accredited investors with invested minimums of $50,000 and that ceased accepting new beneficial owners as of February 3, 2012, and meet other requirements; and
  • investing entities whose only investors are financial institutions and institutional buyers.

The Regulation also carves out advice provided by an ERISA plan fiduciary.

Observation:The Regulation’s carve-outs are similar to carve-out provided in the US Department of Labor’s (DOL) vacated fiduciary rule and New Jersey’s proposal, but, in contrast to New Jersey’s proposal, does not exclude any natural persons (regardless of sophistication or wealth).

When Would the Fiduciary Duty Apply?

The Regulation states that the fiduciary duty would apply to standalone recommendations made by a broker-dealer, agent, or adviser, and would extend through the execution of the recommendation. But the fiduciary duties would be ongoing if the broker-dealer, agent, or adviser:

  • makes ongoing recommendations or provides investment advice, in any capacity, to a customer or client; or
  • receives ongoing compensation in connection with the recommendation or advice.

Observation:When the Massachusetts ongoing fiduciary duty would apply is again similar to the New Jersey proposal, but would be broader as it is also triggered on “ongoing recommendations” and “ongoing compensation.” As broker-dealers are not currently required to provide ongoing advice or monitoring under federal law (except where agreed-upon with the customer), many broker-dealers providing services in Massachusetts would need to develop new compliance and supervisory standards and procedures to comply with this requirement in Massachusetts.

What Fiduciary Duties Would Apply?

The Massachusetts fiduciary duty consists of a duty of care and a duty of loyalty.

  • Duty of care. Must use the “care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use taking into consideration all the facts and circumstances.” The duty of care would require consideration of risks, cost, and conflicts related to the recommendation, as well as the customer’s or client’s investment objectives, financial situation, and needs, and any other relevant information.
  • Duty of loyalty. Must “avoid conflicts of interest” and “make recommendations…without regard to the financial or any other interest” of any party other than the customer or client.

There is no presumption that disclosure of a conflict satisfies the duty of loyalty. Moreover, there is a presumption of a breach of the duty of loyalty for offering or receiving compensation for a recommendation or advice is not the “best of the reasonably available options.” The proposed regulation specifies that disclosure of the conflict alone will not satisfy the duty of loyalty. And transaction-based compensation is not presumed a breach so long as it is the “best of the reasonably available remuneration option” and is reasonable and the duty of care is satisfied.

Observation: The Regulation mirrors the “prudence” and “without regard to” phrasing of the duties of care and loyalty that many found ambiguous and problematic to operationalize in connection with the DOL’s vacated fiduciary rule. Like New Jersey’s proposal, the Regulation does not provide additional guidance on what the “best of the reasonably available options” means. The lack of clear guidance leaves a fair amount of uncertainty as to the steps broker-dealers, agents, and advisers would need to take to satisfy and substantiate these fiduciary duties.

Are There Arguments that Federal Law Could Preempt the Massachusetts Regulation?

Yes, there are arguments that the National Securities Markets Improvement Act (NSMIA) preempts aspects of the Regulation 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 antifraud prohibitions), and holds that the states cannot impose additional or different books and records requirements on broker-dealers. Other preemption arguments may include that the SEC’s Regulation Best Interest preempts the field for state fiduciary regulations.

Observations: The proposal appears to anticipate potential preemption challenges by stating that nothing in the proposal establishes any requirements of making and keeping records, bonding, or financial or operation reporting for any broker-dealer or agent that differs or is in addition to current federal requirements established under 15 USC § 78o(i). This is similar to the approach taken by New Jersey.

Next Steps

We encourage firms that may be affected by the Regulation to provide comments to the Office of the Secretary of the Commonwealth. 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
Timothy P. Burke
Richard A. Goldman
Jason S. Pinney
T. Peter R. Pound

Matthew T. Bohenek

New York
Jennifer L. Klass
Eric Perelman

Philadelphia
Timothy W. Levin
Christine M. Lombardo

Washington, DC
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] The proposal is available here.

[3] See, e.g., Galvin v. The Gillette Co., No. 05‐1453, 2005 WL 1155253, at *3 (Mass. Super. Ct. Apr. 28, 2005) (While “[t]he discretionary powers granted to the Secretary by sec. 407(a) [of MUSA] are exceptionally broad” he “is not invested with the powers of a knight‐errant” and “to the extent the powers he seeks to exercise are specifically constrained by the legislation he cites as their source, he ought not be free to pursue them.”).