Written By: Phil Feigin

Has the time come to license investors?

Regulators are often called upon to draw regulatory lines. In my experience as a former regulator (some would argue I never left, though it’s been almost 16 years), when called upon to fashion a regulatory scheme, it was a lot easier to flat out prohibit something than to decide how many of something would be allowed and how many would not.

Bright line numeric standards have their advantages. They are clear for all to see, both the regulators and the regulated, but they will all but certainly be set arbitrarily. In an environment where documented justification is required for any regulatory decision, it is all but impossible to find empirical evidence to support a conclusion that 15 is legal but 16 isn’t. It is a fool’s errand to argue the rationale why 15 is lawful but 16 is not. The only response possible is “because we had to draw the line somewhere.”

The “debate” to date against altering the standards in the 1982 definition of “accredited investor” has, in my view, been lacking in discussion of principles and empirical evidence. Consumer groups and state securities regulators have supported raising the standards, if for no other reason than inflation since 1982. Industry representatives, particularly those who have gone all in on the prospects of public solicitation and crowdfunding, have advocated for keeping the numbers where they are (or doing away with them altogether) with all the independence and credibility of a brewery lobbying to lower the legal drinking age. And what of those who would be directly impacted by new and higher standards? There has been no hue and cry, no outrage, no speeches about denial of rights, no taking to the financial streets with placards demanding to be among the “privileged” with access to private placements.

The problem with the whole “raise the standards” argument is that it begs the question, “Were they correct in the first place?” I agree wholeheartedly with those who question whether a net worth of $1 million (excluding principal residence) or two years of $200,000 in annual income (or $300,000 jointly with spouse) was what the Supreme Court had in mind in ruling way back when that private offerings could only be made to “sophisticated investors.” I might be willing to buy that having a million bucks in assets or making $200,000 per might mean a guy has the wherewithal to hire a professional to review an investment opportunity, but it says nothing about his financial sophistication to judge for himself. Far too often these days, that $1 million in assets is totally 401(k) money, built up over a 30 year career, with no pension in sight. It is not just running around money, and losing $50,000 or $100,000 of it is not something an older investor can easily make up once retired or even close to it.

It doesn’t take long as a regulator dealing with victimized investors before you find yourself internally struggling against developing a cynical perspective. You begin to wonder, even if jokingly, whether we’re going about it the wrong way. Instead of registering brokers and regulating issuers, we ought to be licensing investors. Make them take a test before they can invest, and impose continuing education requirements on them to maintain their investor’s license, and presumably, their acumen.

In a crude, indirect way, we sort of do that already, but we make the industry impose the test. Brokers and investments advisers are only allowed to recommend “suitable” investments to their clients. They are required to analyze the client’s financial sophistication, conditions and expectations before recommending investments to them. On the private placement promoter side, the “accredited investor” standards are an even cruder means of sorting those who should and should not be allowed to invest in investments deemed systemically riskier than others. Anyone who has ever fielded investor complaints wonders about the efficacy of the suitability and accredited investor standards, how they are applied, and how often they are ignored.

Assuming we are not going to develop a regulatory regime to license investors, both regulators and industry need another bright line means of identifying “accredited investors.” Whatever they come up with, it must this time be a meaningful indicator of true investment sophistication and the ability truly to withstand a total loss of investment. Advocates for the current “accredited investor standard” (or for no standard at all) have waved the banners of small business being the engine of the economy and job creation, humming God Bless America, but there are there any reliable statistics to support the premise that making it easier to offer private placements creates jobs? At the same time, detractors make the argument that easier private placements mean an increase in floundering businesses and frauds that sap capital from the real economy and cost jobs. Intuitively, both are right, but neither can truly prove it.

Here are my thoughts on revising the accredited investor standards:

  • the SEC should get rid of the income test—the accredited investor definition is the only place in federal securities law of which I am aware that includes an income test, and for good reason—ditch it;
  • keep the $1 million in assets test but 401(k) and IRA assets should be excluded unless the investment is made through or with the advice of a registered/licensed/family office investment adviser or broker-dealer,
  • even then, such an investment should be limited to no more than, say, 10% of total investment assets; and
  • people who already have at least, say, 25% of their total investment assets in brokerage accounts or alternative investments that are not held in 401(k) accounts or IRAs would be “accredited” on that basis alone.

These standards would provide for at least a modicum of investor sophistication (or at least potential liability for the people making recommendations) and protection against devastation. If 401(k) and IRA funds are eliminated from consideration, it probably wouldn’t be necessary to adjust the $1 million standard for inflation.

I do not envy the SEC’s task. No matter what they come up with, some people on one side of the line or the other will be unhappy. That’s what happens when you draw lines.


Fiduciary Duty for Broker-Dealers and Agents

Written By: Phil Feigin

Could the states impose fiduciary duty on their own?

For more years than I care to remember, consumer groups, state securities regulators and investment advisers large and small have warned of the confusion wrought on investors by the differences between the duties owed them by investment advisers and broker-dealers. IAs are fiduciaries and thus have duties of care and loyalty to their clients, while broker-dealers (absent discretionary authority) are generally not held to a fiduciary standard, subject instead to the lesser suitability standard, i.e., the requirement that they recommend only investments that are “suitable” to their customers. With the array of euphemistic titles brokerage firms bestow on their agents, calling them anything but salesmen, and the blizzard of commercials in the media in which they declare themselves to be in the investor’s corner, it is easy to make the case as to confusion.

I, for one, tend to downplay the confusion factor. I am sure many investors are at least confused as to the duties they are owed by their financial providers. At the same time, I doubt any consumer who visits a Volkswagen dealer is going to be confused by the fact they are likely to be shown Volkswagens to the exclusion of all other brands. But I digress.

The confusion argument has compelled a great deal of dialogue over the last many years, and led to the SEC’s Congressionally mandated assignment in Dodd-Frank to study and consider adopting a uniform fiduciary standard for broker-dealers and investment advisers. For me, that would be like drafting a uniform standard for real estate salesmen and attorneys, but again, I digress.

Ever since, the same consumer groups, state securities regulators and investment advisers large and small have been exhorting the SEC to adopt such a uniform standard, meaning some form of fiduciary duty. Notwithstanding Capital Gains, fiduciary duty is traditionally a matter of state law. The concept is a rarity in federal securities law. The preemption that has befallen state securities law of late often leaves the states with no choice but to urge the SEC or Congress to do something as opposed to doing it themselves.

Under the National Securities Market Improvement Act (“NSMIA”) back in 1996, the states were preempted from imposing any broker-dealer regulatory requirements that departed from federal standards:

No law, rule, regulation, or order, or other administrative action of any State or political subdivision thereof shall establish capital, custody, margin, financial responsibility, making and keeping records, bonding, or financial or operational reporting requirements for brokers, dealers, municipal securities dealers, government securities brokers, or government securities dealers that differ from, or are in addition to, the requirements in those areas established under this chapter….

In my view, the thrust of the provision was to prohibit state securities regulators from imposing books and records, forms and similar requirements on broker-dealers and their agents that were different than those required under federal law. My question is “would this (or some other) language also preempt a state from amending the private liability section of the state securities law to provide a private remedy for any investor whose broker-dealer or agent fails to act as a fiduciary to that investor?” I don’t believe anyone can say at this point.

How can anyone know? The only way to test the premise would be for a state to enact such a provision and wait to see if a broker-dealer successfully defended arguing the imposition of fiduciary duty is preempted in NSMIA. Scrutinizing the language, I can conjure up only two potential bases for preemption of such a state imposition of private liability for failing to act as a fiduciary under the provision. The first is under the term “financial responsibility,” although I believe that would be a reach as this phrase is meant to refer more to requiring a brokerage firm to have adequate capital, custody and the customer protection rule under the Securities Exchange Act of 1934. The second possibility would be a “penumbra” to the provision argument, i.e., it is not actually stated in the law expressly, but a court would rule preemption to be found in the “general intent” of the language.

Rather than waiting for and continually urging the SEC to suffer the laboring oar in the controversy, one or more states could propose and enact legislation that would create private civil liability on their securities brokerage licensees and registrants for failure to provide fiduciary services. This would not be a “law, rule, [or] regulation” constituting any sort of procedural snag in the licensing or registration process, as requiring separate state-required forms, reports, testing and filings might present. It would merely be grounds for private civil liability, a matter of prescribing the rights and liabilities between contractual parties.

Rather than continuing to harp on the beleaguered SEC to do something, perhaps a state itself committed to the cause could stand up for what it believes in and serve in that federalism-hallowed role as laboratory for new ideas. Let a state give such a private remedy a try. It would certainly get everyone’s attention.