On July 10, 2009, the Treasury Department released the proposed Investor Protection Act of 2009 (the “Act”), which would, if enacted, implement portions of the financial reform proposals contained in the Administration’s recent White Paper. The Act enhances the regulatory powers of the Securities and Exchange Commission (“SEC”) in a number of areas, including authorizing the issuance of rules to: require broker-dealers and investment advisers to act solely in the best interest of retail (and potentially other) clients; prohibit sales practices, conflicts of interest and compensation schemes that the SEC deems to be contrary to investor interests; compel the provision of disclosure prior to the sale of interests in mutual funds; and limit or ban mandatory arbitration provisions in customer agreements. The Act also enhances the SEC’s enforcement powers by: expanding the scope of enforcement actions for aiding and abetting violations; increasing the SEC’s authority to ban persons from association with any SEC-regulated entities; and increasing the potential rewards for whistleblowers. This newsflash summarizes the main provisions of the Act.
The Act is the second piece of draft legislation released by the Administration to implement the White Paper. For further information on the White Paper, see the Davis Polk memorandum entitled “A New Foundation for Financial Regulation?” dated June 22, 2009. For further information on the initial legislative proposal implementing the White Paper, see the Davis Polk newsflash entitled “Consumer Financial Protection Agency Act of 2009” dated July 1, 2009.
New Conduct Standard for Securities Recommendations; SEC Authority to Prohibit Certain Sales Practices, Conflicts of Interests and Compensation Arrangements
Under current law, investment advisers are subject to fiduciary and anti-fraud obligations imposed by common law and the Investment Advisers Act of 1940 (the "Advisers Act"), although SEC rules and state law permit certain duties to be limited or eliminated with disclosure or consent. By contrast, broker-dealers are subject to general anti-fraud limitations under the Securities Exchange Act of 1934 (the “Exchange Act”) and SEC rules, as well as a “suitability” obligation and other conduct standards prescribed by the Financial Industry Regulatory Authority (“FINRA”) and other self-regulatory organizations. The Fact Sheet included in the Treasury Department’s press release announcing the Act states the Administration’s view that investors rely upon the investment recommendations of both broker-dealers and investment advisers in the same manner, and that the legal distinctions that result in different standards “are no longer meaningful.” The Act would authorize the SEC to adopt rules under the Exchange Act and the Advisers Act to provide that, when broker-dealers and investment advisers render investment advice about securities to retail customers or clients (and such other customers or clients as the SEC designates by rule), they are required “to act solely in the interest of the customer or client without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” The proposed standard could raise questions regarding the potential conflicts that arise in ordinary securities market activities, such as underwriting, trading as a principal, sales of proprietary products and cross-trading.
The Act also authorizes the SEC to facilitate the development of simple and clear disclosures to investors regarding the terms of their relationships with financial intermediaries and to examine and, where appropriate, prohibit financial intermediary “sales practices, conflicts of interest and compensation schemes” that it considers contrary to public and investor interests. However, there is no indication of which specific practices the Administration has in mind, nor is it clear whether the reference to “compensation schemes” is intended to include the compensation arrangements of individual industry professionals, as opposed to compensation arrangements between firms and customers and among intermediary firms.
The inclusion of these provisions in the Act may presage greater involvement by the SEC, in addition to FINRA, in directly regulating sales practices of broker-dealers.
Point of Sale Disclosures for Registered Funds
The Act would amend the Investment Company Act of 1940 (the “Investment Company Act”) to explicitly allow the SEC to issue rules requiring the delivery of documents, such as a concise summary prospectus or cost disclosure, prior to sales of registered fund interests. Industry groups have previously opposed this type of requirement.
In the White Paper, the Administration urges the SEC and the proposed Consumer Financial Protection Agency to conduct studies on whether the use of mandatory arbitration clauses should be eliminated or curtailed. The Act would give the SEC the power to prohibit or limit the use of mandatory arbitration provisions related to disputes with brokers, dealers, municipal securities dealers and investment advisers arising under the federal securities laws or self-regulatory organization rules if the SEC finds that such action is in the public interest and protects investors.
Enhancements to the SEC’s Enforcement Authority
Under the Act, the SEC would have the authority to seek remedies for aiding and abetting violations under the Securities Act of 1933 and the Investment Company Act, as it currently can for violations of the Exchange Act and the Advisers Act. In addition, the Act would extend the SEC’s aiding and abetting enforcement authority across all of the securities laws to include reckless conduct.
The Act would allow the SEC, in any action in which it levies sanctions in excess of $1,000,000, to compensate whistleblowers with up to 30% of the amount of the sanctions. Within these parameters, the amounts paid to whistleblowers under the Act would be within the sole discretion of the SEC and not subject to judicial review. This would greatly expand the SECís current authority under the Exchange Act, which caps such compensation at 10% of collected penalties, and restricts it to the insider trading context. The Act would also establish an Investor Protection Fund, intended to grow to a maximum of $100,000,000 through revenues from certain sanctions, to pay awards to whistleblowers and to fund investor education initiatives.
The Act also permits the SEC to impose a broader range of collateral bars under the Exchange Act and the Advisers Act, prohibiting offenders from associating with a broad range of SEC-regulated entities, rather than only those entities regulated under the particular statutory provisions under which the violation occurred.
The Act does not provide for a private right of action to enforce any of its provisions.
Creation of the Investor Advisory Committee
The Act would make permanent the SEC’s recently announced Investor Advisory Committee, which would consult with the SEC on a variety of matters, including regulatory priorities and issues regarding new products, trading strategies, fee structures and the effectiveness of disclosures. The SEC would not be bound to act upon the Investor Advisory Committee’s recommendations.
It is difficult to predict with any certainty the exact form of any final legislation. Davis Polk is monitoring developments with respect to the Investor Protection Act of 2009 and will issue additional newsflashes from time to time.