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New regulations could make life tougher for dual registrants

The regulatory environment for dually registered advisors and brokers figures to get a lot more complicated in the coming months, as advisors who wear both hats will have to navigate a new federal regulation as well as an emerging patchwork of state rules.

The SEC's proposed Regulation Best Interest, expected to be finalized later this year, would preserve a two-tier system that applies different standards of conduct to brokers and advisors, including individuals who are registered as both, according to Clifford Kirsch, a partner with the law firm Eversheds Sutherland in New York.

"Regulation BI specifically anticipates dual registrants," Kirsch said at a recent conference in New York that was broadcast online.

"There's a part of the regulatory proposal that talks about when does Reg BI apply as opposed to the advisor's fiduciary duty, and Reg BI sort of acknowledges that if somebody's acting in a broker-dealer capacity, then Reg BI would apply," he said. "If they're acting in their advisory capacity then the advisor's fiduciary duty would apply."

But dual registrants will be required to offer upfront disclosures about how the different wings of their business operate, and regulators will expect them to be able to justify the decision to place a client in a brokerage or advisory account.

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A guard stands outside the headquarters of the U.S. Securities and Exchange Commission (SEC) in Washington DC May 27, 2004. Photographer: Chris Kleponis/ Bloomberg News.

Kirsch thinks that the SEC could issue the rule by September. Other industry watchers expect it could be earlier.

In some ways — and certainly to critics of the SEC's proposal — Reg BI would retain the status quo that holds advisors and brokers to different standards, with advisors bound by the fiduciary duty that is generally seen as more rigorous than the suitability standard that applies to brokers.

But even as dual registrants can technically operate under the suitability rules when acting as a broker, keeping the two sides of the practices distinct can be a major compliance headache, and some firms simply adhere to the fiduciary standard in all areas of the practice.

"The SEC has never taken the position that just because you're a dual registrant the Advisers Act applies to your brokerage business," says Jennifer Klass, a partner at the law firm Morgan Lewis & Bockius in New York. However, "where that line is, is sometimes murky"

Murkier still is the emerging set of proposals under consideration in several states. Following the collapse of the Department of Labor's fiduciary rule, a handful of states began considering their own rules to hold brokers to a higher standard of conduct, and that could upend compliance programs at dually registered firms with a presence in those states.

"If there's one theme in 2019 for dual registrants," Kirsch said at the conference, it's "the state activity here."

"The states are actively either enacting legislation, regulations, they're all in different stages," Kirsch said.

In general, state regulators seem to take a dimmer view than the SEC of the common practice at dual registrants known as hat switching, where an individual adheres to a fiduciary standard for a certain set of activities categorized in the advisory wing of the practice, but then defaults to the suitability standard when acting as a broker. A proposal in Nevada, the furthest along of all the state initiatives, would hold that dual registrants must adhere to the advisor's fiduciary duty in all activities not covered by a limited exemption.

In its Aug. 31 comment letter on the SEC's Regulation Best Interest, the North American Securities Administrators Association warned that the SEC's proposal failed to "provide specific instructions for firms walking this tightrope” could mean that “dually-registered firms will inevitably falter and fail to satisfy their legal duties."

At a minimum, NASAA said, the SEC should include guidance on how firms should navigate disclosures when switching from their role as a broker, with its attendant Reg BI rules, to an advisor operating as a fiduciary.

"Alternatively,” NASAA said “the commission could go a long way toward resolving the problems associated with dual registration by simply stating through guidance that firms with clients that maintain both advisory accounts and brokerage accounts must be treated as advisory clients in toto,".

The association added, parenthetically, that "this alternative is, in NASAA's view, the substantially preferable approach.

Whether or not the SEC incorporates that advice into its final proposal, states moving in their own direction are likely to take a harsher view of hat switching at dually registered firms.

"There are certain things that the SEC is more accepting of that state securities regulators are not," Kirsch said. "That's going to play out significantly the next couple of years."

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