Amendments to Financial Reform Bill Raises Broker-Dealers’ Fiduciary Duty to Avoid Conflict of Interest in Investments

Senator Arlen Specter (D-Pa.) has introduced two amendments to the Senate’s financial reform bill (“Restoring American Financial Stability Act of 2010,”  S. 3217) which address several issues that contributed to the financial crisis of 2008. The first amendment, cosponsored by Senator Ted Kaufman (D-Del.), imposes a fiduciary duty on all registered broker-dealers, and their agents and employees, who provide investment advice regarding a purchase or sale of a security or a security-based swap. The fiduciary standard, in legal terms, requires one to act in the best interests of the investor and to disclose specific facts relating to a conflict of interest.

Unlike the House version of the bill, this amendment’s higher standard of care is not limited to only those broker-dealers that provide services to retail customers but includes all investors.

“Specter’s amendment also imposes criminal penalties for willful violations of the broker-dealer standard of care. The amendment permits the SEC to adopt rules and regulations to define the full scope and application of this duty, as well as to grant exceptions and adopt safe harbors, if necessary in the public interest and to protect investors.

Under current law, only the investment adviser owes his or her client a fiduciary duty. Broker-dealers, however, are held to a lesser standard of care and required only to recommend suitable investments to their clients and not to look out for their client’s best interests. Neither the current House nor Senate version of the bill on financial reform fully addresses the discrepancy in the standard of care between investment advisers and broker-dealers. The House version raised the standard solely for brokers who provided personalized services to retail customers - and would not apply to institutional investors, many of which include pension funds and mutual funds in which many American’s have their investments. The Senate Bill simply calls for a one year study by the SEC concerning the effectiveness of existing standards.

The amendment comes on the heels of a Judiciary Subcommittee hearing that Senator Specter chaired on Tuesday, May 4th titled, “Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?” During the hearing, John Coffee, a prominent securities professor at Columbia Law School, testified that, “a fundamental hole exists in the financial reform proposals now before Congress that this bill fills. Although no statute can eliminate all conflicts of interest, the proposed statute… would compel investment banks to address them more carefully and cautiously.”

Joined by Senators Jack Reed (D-R.I.) and Kaufman, Senator Specter has also introduced an amendment that would authorize defrauded investors to hold those who knowingly aid and abet securities fraud accountable in civil suits. Investors had that right until 1994 when the Supreme Court upended decades of settled law in ruling that aiders and abettors are not liable in civil suits. That ruling put the law at odds with federal criminal law, which makes it crime to aid and abet a crime, including securities fraud.

Conflicts of interest played a significant role in the 2008 financial crisis,” Specter said. “This is a common sense amendment which seeks to close a gaping loophole in federal law where brokers and dealers can avoid putting their clients’ interest first.”

“As we saw in the recent Goldman Sachs hearing, Congress needs to ensure that broker-dealers have a clear duty to act in the best interests of their clients,” said Sen. Kaufman. “By establishing a fiduciary duty obligation between brokers and customers, this amendment would help to end the conflicts of interest that permeate the financial industry and in doing so rebuild confidence among investors and restore the credibility to our capital markets.”

“The gatekeepers of our capital markets,” Specter said, “must be held accountable under the civil law, just as they are under criminal law, when they aid and abet securities fraud. Investors have paid a heavy price over the last decade for the law’s failure to do that.”

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