The Fragmented Regulation of Investment Advice: A Call for Harmonization

Discussions about regulating investment advice have largely focused on whether to harmonize the laws governing two categories of individuals within the securities world—registered investment advisers and stockbrokers.  The discussion has overlooked insurance brokers who often times also provide investment advice.  Our article broadens the focus by arguing that harmonizing the regulation of investment advice necessarily requires reforms reaching beyond securities regulation and into insurance regulation as well.  We argue that consistent standards should govern the investment advice provided to retail investors.  Given the current regulatory fragmentation, this may only be accomplished by adopting a federal Investment Advice Act.

Today’s fragmented regulatory regime dates back to earlier eras.   When Congress structured the federal securities laws early in the last century, regulatory partitions between stockbrokers, investment advisers, and insurance brokers made sense.  These individuals provided different types of advice to investors.  Hence, different regulatory structures rightly governed them.

Yet much has changed since that time.  Stockbrokers and many insurance brokers have redesigned their business cards; many now self-identify primarily as financial advisers.  In addition to changing roles for stockbrokers and insurance brokers, financial product innovation has also further blurred these lines.  Securities and insurance products have hybridized and converged in unforeseen ways.  Investment products no longer clearly fall under any single regulatory regime and cannot be cleanly regulated.

In our article, The Fragmented Regulation of Investment Advice:  A Call for Harmonization, we chronicle the history of the statutes and regulations governing stockbrokers, investment advisers and insurance brokers.  Under the current system, a person giving investment advice may be governed by a different scheme if he or she is compensated in a particular manner or has a certain title.  Stockbrokers and investment advisers are regulated at both the federal and state levels, while insurance brokers are regulated solely by the states.  To showcase the issues inherent in the converging insurance and securities markets, we focus specifically on one investment product, equity-indexed annuities, following the pitched regulatory and legislative battles over the product.

We detail how the inefficiencies in the current system amplify investor confusion and gaps in regulation.  Equity-indexed annuities are complex products; however, they are often marketed to senior investors as riskless investments that will never lose money.  Investors are not told about high surrender penalties, illiquidity or other costs associated with the product.  Oftentimes, the sales person selling the product is not fully versed on the product because of its complexity.  The investors may not understand that, although they are purchasing the product from their stockbrokers, the investment may not be a security and therefore may not be supervised by the stockbrokers’ firms.

The current system has failed to remedy these issues.  After the Securities and Exchange Commission (the “SEC”) attempted to regulate equity-indexed annuities, Congress enacted legislation shifting the power to do so to the states.  Congress made it clear that it did not want the SEC regulating this product, notwithstanding that many investors purchase equity-indexed annuities from their stockbrokers (who are also often insurance brokers).

To address these issues, we suggest that a solution may be an Investment Advice Act—federal legislation governing the provision of investment advice to retail customers.  The Act would consolidate oversight of stockbrokers, investment advisers and insurance brokers to the extent they advise retail investors.  Under a more coherent regime, the duties owed to investors would vary depending on the level of services offered and not depend on what the person giving advice calls him or herself, the compensation he or she receives or the type of product ultimately sold to the investor.

We envision that a straightforward solution would apply to both securities and insurance professionals and involve three different tiers.  The first tier would permit a firm to offer execution only services and would impose minimal duties on the firm.  The next tier would allow a firm to expand the services offered to include advice about transactions and would impose duties in connection with those transactions.  Brokers offering transaction-based advice would be required to offer advice in the investor’s best interests but would not be required to assume any ongoing duties.  In the final tier, full-service firms would provide on-going management services, advice, and monitoring of the investments within the investor’s account.  The firm would owe the highest duties, offering advice in the investors’ best interest and continuing oversight.  Importantly, if a firm holds itself out as a full-service firm, all of its financial advisers would be held to duties of the highest tier to avoid investor confusion.

We believe that this type of legislation would reduce the inefficiencies inherent in the current patchwork system while respecting the need for different levels of services for investors.  Under the proposal, financial services firms would be able to offer varying levels of services at different costs with duties commensurate in scope with the services offered.  Ideally, this model will substantially reduce investor confusion, maintain adequate levels of investor protection and allow some freedom for firms to structure a business model that will work for them.

The preceding post comes to us from Christine Lazaro, Associate Professor of Clinical Legal Education and Director of the Securities Arbitration Clinic at St. John’s University School of Law, and Benjamin P. Edwards, Director of the Investor Advocacy Clinic and Adjunct Professor at Michigan State University. The post is based on their article entitled “The Fragmented Regulation of Investment Advice: A Call for Harmonization“, which is forthcoming in the Michigan Business & Entrepreneurial Law Review and available here.