Conduct of Business Regulation: A Survey and Comparative Analysis

Although recent regulation and scholarship has focused on the financial stability and solvency of financial institutions, the business conduct of these institutions remains an issue of abiding regulatory concern. In a my chapter “Conduct of Business Regulation,” which is in the forthcoming Oxford Handbook of Financial Regulation, I provide a survey and comparative analysis of conduct of business (COB) regulation in the US, the EU, and Australia. COB regulation governs financial intermediaries’ conduct toward their clients; that is, toward the actors—whether individuals or institutions—with whom financial intermediaries transact in providing financial products and services. While the expression “conduct of business regulation” is not widely employed in the US, it is commonly used by international financial regulatory bodies and by financial regulators in many jurisdictions, including the Member States of the EU. In the US, COB regulation encompasses the regulation of broker-dealers and investment advisors under state and federal law; in the EU, the regulation of investment firms under MiFID I and the proposed MiFID II/ MiFIR regime; and in Australia, the regulation of financial services licensees and individual advisors under federal law. Generally speaking, these various financial intermediaries are in the business of providing securities-related services, including advice and recommendations.

The various regimes adopt remarkably similar regulatory strategies. Modal strategies include anti-fraud rules, and duties ofa care, loyalty, fair-dealing and best-execution—and variants of these duties. Other core regulatory strategies include registration or licensing requirements and mechanisms to enforce the duties imposed. Sources of these strategies include legal instruments such as statutes and the rules and regulations of agencies, as well as judicial and other adjudicative opinions interpreting and applying these instruments. In some jurisdictions, including the US, the UK and Australia, COB regulation coexists with the general law, or private law (namely, laws of general application, including contract law, property law, tort law, and equity). In these jurisdictions, therefore, regard must be had to both regulatory and general law developments, often giving rise to difficult questions concerning inconsistencies and conflicts, including whether COB regulation potentially supersedes otherwise unyielding general law.

The Distinctive US Experience

Despite the similarities among regimes, the US experience with COB regulation is distinctive in important respects. The US applies a bifurcated structure to regulate investment advisers and broker-dealers. The former are in the business of providing advice, or issuing reports or analyses; the latter primarily perform securities-related functions, including executing client trades and providing generalized or client-specific research and may give advice incidental to the conduct of their business. Both types of financial intermediary must register with the SEC, and some financial intermediaries are dual-registered.

While subject to distinct regimes, investment advisers and broker-dealers face broadly similar regulatory strategies in most respects. Both are subject to anti-fraud rules. Both owe duties of best execution as well as duties imposing standards of care, loyalty and good faith. Nevertheless, important rule differences exist, which the chapter discusses.

Perhaps the most commonly cited difference between the regulation of investment advisers and broker-dealers concerns the fiduciary status of investment advisers. That status arises from the Supreme Court’s interpretation of Section 206 of the Adviser’s Act, an anti-fraud provision, in SEC v. Capital Gains Research Bureau. In contrast, broker-dealers may be fiduciaries on an ad hoc basis, where the facts and circumstances justify such a result. Despite the distinction, and the attention it has garnered, investment advisors and broker-dealers adopt broadly similar approaches to conflicts of interest. This stems from the weak fiduciary status of investment advisors: according to the Supreme Court, they must either eliminate or disclose material conflicts of interest (and their business interests will usually dictate they take the latter approach). Broker-dealers must also disclose conflicts of interest, a duty stemming from anti-fraud provisions of federal securities laws. Importantly, the disclosure duty for broker-dealers applies even in the absence of any fiduciary relationship, and even where their recommendations are suitable. Accordingly, with some exceptions, both types of financial intermediary must disclose conflicts of interest—investment advisers to discharge their fiduciary duties, and broker-dealers to avoid violating anti-fraud rules.

Although both investment advisers and broker-dealers take disclosure-based approaches toward conflicts of interest, their disclosure practices differ. The extent, form, and timing of required disclosures differ, with investment advisers tending to disclose conflicts more often and in greater detail than broker-dealers. Accordingly, the different fiduciary characterization of investment advisers results in different disclosure practices, not necessarily in a stricter standard of loyalty.

Other distinctions between investment advisers and broker-dealers concern forms of remuneration and intensity of regulatory oversight. Broker-dealers face greater remuneration-based risks, but also face more compliance examinations and enforcement actions than investment advisers. They also face oversight by an industry regulator (FINRA), in addition to the SEC, while investment advisers are subject to SEC oversight only.

One further potential US distinction concerns the complexity of its regulation. The US approach involves multiple layers of rules, sources of law, and regulators. The product is a complex and often esoteric regulatory system. For example, determining the rules applicable to broker-dealers may require resort to federal and state statutes, the rules and regulations of federal and state public regulators, rules and interpretations of self-regulators, and formal and informal pronouncements of regulators. Such regulation coexists with federal and state general law. Enforcement is undertaken by federal and state regulators, by self-regulators and even by federal and state criminal prosecutors. Multiple private actions may also be underway. The framework may thus give rise to simultaneous, uncoordinated proceedings. Contributing to this complexity is the US preference for piecemeal, incremental reform, rather than coherent, wholesale reinvention.

International Comparisons

International comparisons are also made in the chapter. Several stand out. To begin, the EU and Australia have undertaken wholesale reforms of COB regulation, whereas the US remains tied to a regulatory structure adopted in the mid-1930s, changes to which have been incremental and piecemeal. The differing approaches to reform may reflect the more adversarial and contested nature of the politics of financial regulatory reform in the US.

Clients protections also differ somewhat. The EU adopts a three-fold categorization of clients, according to their knowledge and experience; clients may be eligible counterparties, professional clients, or retail clients. The regime provides each with differing levels of protection, except in the area of conflicts of interest, where all categories receive equal protection. Eligible counterparties are not owed duties concerning suitability, appropriateness, best execution, order handling and inducements. Professional clients are owed a somewhat diluted suitability duty. In contrast, US COB regulation does not categorize clients in the same way, but does prevent some clients from investing in certain securities and relaxes the suitability obligation owed to institutional clients.

The recently-reformed Australian regime provides unique client protections. It imposes a heightened suitability duty, one requiring that advice be both in the “best interests” of a client and “appropriate” for it. In addition to requiring financial intermediaries to “manage” conflicts of interest, it imposes a “conflict priority duty.” This duty requires an advice provider to prioritize the interests of a client where she knows, or reasonably ought to know, that the client’s interests conflicts with her own. Like the US, the EU regime accepts the potential desirability of financial intermediaries providing third party benefits, such as soft dollar commissions, whereas Australia bans financial intermediaries from accepting certain types of remuneration considered to materially sway their ability to give financial advice to retail investors.

While international comparisons of enforcement and effectiveness are difficult to make, it is evident that the US maintains a level of enforcement staff exceeding that of most other countries, even taking account of market size. Private enforcement through the class action device provides significantly greater deterrent force in the US than elsewhere.

The chapter also discusses financial-crisis related COB reforms, including those in the MiFID II/ MiFIR regime. In doing so, it questions the practical effect of imposing a uniform standard for investment advisers and broker-dealers.

The chapter concludes by observing that US COB regulation is characterized by complexity, piecemeal reform, and a blunt distinction between financial intermediaries that is not adopted in comparable jurisdictions. Unlike other jurisdictions, particularly the EU and Australia, the US has also shown resistance to addressing remuneration-based risks, especially commission risks facing broker-dealers. Whether the US regime ultimately produces weaker deterrence of wrongdoing, however, is difficult to tell. It may in fact be more tailored to subtle differences in financial intermediaries, products and markets than other regimes. If that were so, however, it would be more the result of good fortune than of careful design.

The chapter is available here.