States’ Regulation of Broker Dealers

Posted in: Business Law

Recently, regulators in New Jersey have focused on the broker-dealer’s duties to possible investors, whom broker-dealers approach with proposed securities’ purchases, sales, and trades. The regulators’ proposal recognizes the advisory impact of the broker-dealers’ sales talk, especially when it is offered to retirees, who usually depend on their savings and have no other source of income. Many of these retirees have little understanding of the securities markets and may not comprehend that the possibility of getting richer by investing in riskier securities prices necessarily comes with the possibility of becoming poorer by falling prices.

This note focuses on the first step in the brokerage process of attracting potential clients for whom to buy and sell securities. For some people this first step involves a “sales talk”: “Trust me! This is the best investment opportunity that will not come around again for years. It is just for you.” Does this “sales talk” constitute advice as a matter of law? If this talk is advice, to what extent should brokers be classified as advisers, subject to fiduciary duties towards the potential securities investors, or sellers?

This topic was discussed in connection with the proposed rule of the Labor Department with respect to retirees’ pension accounts. The Labor Department’s rule was struck down by the US Court of Appeals for the Fifth Circuit, which held that the Department was not authorized to promulgate the rule. (The person who negotiated this rule has since left the Department.) Following this ruling, the Securities and Exchange Commission sought a public discussion of another proposed rule regulating broker-dealers and requiring their action in “the best interests” of investors. This rule was set out for public comment.

Then New Jersey proposed to pass a rule regulating the broker-dealers’ fiduciary duties to their customers. The hearing on that proposal was held on November 19, 2018. Many arguments for and against such a rule were presented before the New Jersey regulators. One issue raised was the nature of conflicting interests. The other issue was the desirability or lack of desirability of state involvement in this issue.

Charles Schwab Corporation expressed concern that the state’s regulation of brokers will create confusion. This paper focuses on the concern and suggests that brokers need not worry. Lawyers and physicians have practiced and flourished under state regulations for decades, and they have survived! They have managed to serve clients not only in the United States but all over the world. This note offers reasons for their success.

Abuses of entrusted power may offer short-term profits to the abusers. But long term it may lead to investors’ withdrawal from the financial markets and financial investments, resulting in the decimation of our financial system among others. The lower the investors’ self-protection is, the more power is entrusted to agents and experts, and the stricter the fiduciaries’ duty of loyalty should be. Fiduciary duties, therefore—not short-term profits or long-term profits—are the backbone of trust in the financial system. Without trust we can sit on our money and watch it carefully, but it will never feed the economy or us. As history has demonstrated time and again, when fiduciary duties are not followed, the financial system collapses.

What services do broker-dealers offer investors?

Broker-dealers (i) maintain custody of their clients’ securities and some of the cash as well; (ii) act as agents of their clients with respect to the clients’ securities’ trading; (iii) advise investors with respect to the desirability of trading in securities; and (iv) sometimes finance the clients’ purchases of securities, usually by backing the loans with the investors’ securities held in the brokers’ custody.

Brokers’ services as advisers, custodians, and agents, can be abused by: (i) failure to exercise their functions with proper expertise, and (ii) acting in dishonest conflict of interest. Therefore, fiduciary duties include a duty to exercise expertise (the “duty of care”) and a prohibition on acting dishonestly, in conflicts of interest (the “duty of loyalty”). Aduty of loyalty includes fully and fairly disclosing any conflicts of interest so that the client can either reject the broker’s recommendation or provide a written informed consent. The specifics and nature of the disclosure will vary with the sophistication of the client and the client’s ability to protect his or her interests.

Do brokers have fiduciary duties to their clients?

The answer involves an inquiry into three questions. First, what are fiduciary duties? Second, to what extent and under what circumstances are sales talk and other brokers’ services subject to fiduciary duties, and why? Third, how do fiduciary principles apply to broker-dealers? In fact, why do broker-dealers fight so hard and spend funds to avoid being classified as fiduciaries?

1. What are fiduciary duties?

Fiduciary duties play a significant social role, in part by encouraging socially desirable services, such as medical, legal, and trustee services. Because these services establish dependence by the service receivers and bestow power on the service givers, widespread abuse of such power would drive dependents to avoid these beneficial services, and thereby cause harm to our society. The law imposes on these service-givers duties to act expertly and honestly in order to encourage fiduciary services and strengthen trust in the service-givers. In fact, law can be viewed as encouraging resort to fiduciaries, with short-term limitations on fiduciaries. They may not abuse the trust that is necessary to induce people to seek their services.

Brokers have greater expertise than many, if not most, of their clients. They offer investment advice, whether paid for or free, on which most client-investors rely. To trade on behalf of their clients, brokers acquire possession of their clients’ securities and money. Like all agents and custodians, brokers must be trusted by their clients. Therefore, fiduciary law ensures that this trust is justified and enforced. Unless brokers are trusted, they will have no clients to serve, and dramatic losses in clients cause market runs and crashes.

Financial investments, sales, acquisition, and trading require expertise, which many investors lack. Therefore, investors must rely on experts to choose suitable investments, and on agents to trade for them in financial assets.

2a. When and why should fiduciary duties apply to brokers?

Brokers act in different capacities and offer different services, which should be subject to fiduciary duties. As custodians, they hold other peoples’ money, securities, or other financial assets. As agents, they act on behalf of investors, and can legally bind them to the broker’s activities or failures to act. As salespeople they offer advice about securities trading. In addition, as traders, brokers can and do affect our securities markets.

2b. Which brokers’ recommendations should trigger a fiduciary duty?

I believe that the duty should cover any recommendation, advice, or service relating to investments in any type of financial assets, including sale, purchase, lending, borrowing, depositing, and combining with other securities, and new securities.

2c. To whom should fiduciary duties be owed?

Fiduciary duties should be owed to direct and indirect recipients of the brokers’ fiduciary’s services. An investor who uses brokers’ services or the services of a related broker should be owed fiduciary duties by both. Further, transfer from one service provider to another should require the investor’s informed consent.

I trust that New Jersey would lead other states to solve a serious problem facing our financial system. American investors and the American financial system need the protection of fiduciary duties by whoever deals with other people’s investments and money or advises other people as a salesperson, whether paid or not paid for advice.

3. Why are brokers opposed to state regulation?

The last few years have demonstrated that brokers are opposed and would fight anywhere against any regulation as fiduciaries. The argument that state regulation will create confusion and havoc is simply another argument against regulation. The example of lawyers and physicians demonstrates the falsity of this argument. (That is, attorneys are subject to state attorney discipline, which is a form of self-regulation because the judiciary and/or state bar is itself comprised of attorneys.) In addition, corporate laws are established by states. Trust laws are established by states. Insurance companies are regulated by states. Massachusetts regulates small advisers while they are also regulated by federal law. The list is longer, but this should be sufficient as an example.


The regulation of broker-dealers as fiduciaries may take a few directions. One is for the broker-dealers to be paid a salary. Then the enormous pressure on them to trade will be reduced to avoid the violations such as the Wells Fargo example. They may then welcome the title that signifies trustworthiness. The other change is already rising by the investors. They need not know what a fiduciary is, but they concept of trust is already very familiar. Particularly today, the instability of the markets creates much anxiety for people, many of whom are dependent on their savings. For some, the promise of riches may be enticing, but for others the accompanying risk of loss may cause sleepless nights. The time has come for every investor to ask his or her broker: ARE YOU MY FIDUCIARY? If you are, PLEASE SIGN A STATEMENT TO THIS EFFECT AND THANK YOU. This problem may then fade away and be resolved.

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