Investment Advisers
The Effects of Lowe on the Application of the Investment Advisers Act of 1940 to Impersonal Investment Advisory Publications
Lani M. Lee, 42(2): 507–51 (Feb. 1987)
This Article examines the 1985 Supreme Court decision in Lowe v. SEC, 472 U.S. 181 (1985), and the resulting expansion of the bona fide newspaper exclusion from the definition of investment adviser under the Investment Advisers Act of 1940. The Article also discusses potential problems in interpreting and applying the decision to impersonal investment advisory publications, First Amendment implications of the decision, and the SEC's recent legislative proposal designed to modify the result reached in Lowe.
An Insider's View of the Insider Trading and Securities Fraud Enforcement Act of 1988
Stuart J. Kaswell, 45(1): 145–80 (Nov. 1989)
This Article outlines the provisions of the recently enacted Insider Trading and Securities Fraud Enforcement Act of 1988. The Article discusses how the legislation alters the federal securities laws and imposes specific new statutory responsibilities on broker-dealers and investment advisers. It discusses changes to the law that permit the SEC to seek a civil penalty against a controlling person with respect to illegal insider trading committed by a controlled person. The Article also discusses aspects of the legislative process that produced this act.
Suitability in Securities Transactions
Lewis D. Lowenfels and Alan R. Bromberg, 54(4): 1557–97 (Aug. 1999)
This Article addresses the suitability doctrine under the federal securities laws—the duty on the part of the broker to recommend to a customer only those securities which are suitable to the investment objectives and peculiar needs of that particular customer. The suitability doctrine entails the matching of two elements: (i) the investment objectives, peculiar needs, and other investments of the particular customer with (ii) the characteristics of the security which is being recommended. All of the suitability rules of the various self-regulatory organizations—the NASD, the NYSE, the Chicago Board Options Exchange, and the Municipal Securities Rulemaking Board—are analyzed. Disciplinary actions under the suitability rules of these self-regulatory organizations are discussed. The SEC's role in the development of the suitability doctrine over the years is traced. Finally, private damage actions based upon the suitability doctrine under federal law, state law, and in arbitration proceedings are compared.
The Suitability Rule, Investor Diversification, and Using Spread to Measure Risk
Richard A. Booth, 54(4): 1599–1627 (Aug. 1999)
This Article reviews the state of the law regarding actions against broker-dealers based upon the NASD suitability rule and similar theories, summarizes the theory and practice of investor diversification, explains the motivations that may lead a broker to recommend excessively risky securities and investment strategies, and discusses the various methods that may be used to quantify or compare risk, focusing in particular on how the bid-ask spread may be used as a forward-looking surrogate for the direct measurement of risk.
On-Line Broker-Dealers: Conducting Compliance Reviews in Cyberspace
Joseph M. Furey and Beth D. Kiesewetter, 56(4): 1461 (Aug. 2001)
Business models for broker-dealers continue to evolve amid structural changes to our capital markets and continued technological enhancements. Regardless of what business model a broker-dealer ultimately selects for itself, developing or enhancing an on-line capability will be a necessity. Federal and state laws and regulations, as well as Self- Regulatory Organizations rules require broker-dealers to supervise their on-line trading systems and marketing activities. Scrutiny by state and federal securities regulatory authorities of on-line broker-dealers has increasingly focused on systems capacity issues and the disclosures made, or not made, by management with regard to the benefits and drawbacks of on-line trading. Broker-dealers that provide on-line trading capabilities to their customers should focus their attention on matters involving systems capacity, advertising and investor education, suitability, best execution, pricing of market data, relationships with internet portals, on-line discussion forums, customer privacy, electronic books and records, and day trading. In these circumstances, more on-line broker-dealers have conducted compliance reviews of their supervisory procedures and on-line trading systems to take into account new rules and other guidance provided by securities regulators. This Article examines issues broker-dealers should consider in developing and reviewing supervisory procedures and controls for market conduct and sales practices in an on-line environment.
Ethical Screening in Modern Financial Markets: The Conflicting Claims Underlying Socially Responsible Investment
Michael S. Knoll, 57(2): 681 (Feb. 2002)
In this Article, the author documents how socially responsible investment (SRI), the practice of making investment decisions using both social and financial criteria, has grown from a fringe movement practiced by a relatively small number of isolated investors into a major investment phenomenon that has become part of the financial mainstream. The author also documents how the SRI community sought to encourage that growth by convincing investors that they can make a difference in the world without financial sacrifice by screening their investments. That message, which is succinctly stated in the often-repeated slogan "doing well by doing good," embodies the two principal claims commonly made by SRI's modern adherents. These claims are that managing money according to ethical criteria can be as profitable and prudent as investing strictly for financial gain, and that SRI can directly change corporate behavior by drawing funds away from disapproved activities toward approved activities. This Article draws on modern financial theory and recent empirical research in order to evaluate these claims. It shows that, as a matter of finance theory, although either of the principal claims made by SRI's proponents might be true, the two claims cannot simultaneously both be true because each claim implies the falsity of the other. The author also surveys recent empirical work in finance in order to assess the validity of each claim. Based on this survey, the author concludes that screening is likely to entail no more than a minimal financial sacrifice for investors who do not substantially increase their costs by screening and do not narrow their universe of investments by so much as to substantially hamper diversification. On the other hand, the author concludes that there is little, if any, evidence that ethical screening has had a significant direct impact on targeted firms.
Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms
Henry T. C. Hu and Bernard Black, 61(3):1011–1070 (May 2006)
Most American publicly held corporations have a one-share, one-vote structure, in which voting power is proportional to economic ownership. This structure gives shareholders economic incentives to exercise their voting power well and helps to legitimate managers' exercise of authority over property the managers do not own. Berle-Means' "separation of ownership and control" suggests that shareholders face large collective action problems in overseeing managers. Even so, mechanisms rooted in the shareholder vote, including proxy fights and takeover bids, constrain managers from straying too far from the goal of shareholder wealth maximization.
In the past few years, the derivatives revolution, hedge fund growth, and other capital market developments have come to threaten this familiar pattern throughout the world. Both outside investors and corporate insiders can now readily decouple economic ownership of shares from voting rights to those shares. This decoupling—which we call "the new vote buying"—is often hidden from public view and is largely untouched by current law and regulation. Hedge funds, sophisticated and largely unfettered by legal rules or conflicts of interest, have been especially aggressive in decoupling. Sometimes they hold more votes than economic ownership, a pattern we call "empty voting." That is, they may have substantial voting power while having limited, zero, or even negative economic ownership. In the extreme situation of negative economic ownership, the empty voter has an incentive to vote in ways that reduce the company's share price. Sometimes hedge funds hold more economic ownership than votes, though often with "morphable" voting rights—the de facto ability to acquire the votes if needed. We call this "hidden (morphable) ownership" because under current disclosure rules, the economic ownership and (de facto) voting ownership are often not disclosed. Corporate insiders, too, can use new vote buying techniques.
This article analyzes the new vote buying and its corporate governance implications. We propose a taxonomy of the new vote buying that unpacks its functional elements. We discuss the implications of decoupling for control contests and other forms of shareholder oversight, and the circumstances in which decoupling could be beneficial or harmful to corporate governance. We also propose a near-term disclosure-based response and sketch longer-term regulatory possibilities. Our disclosure proposal would simplify and partially integrate five existing, inconsistent share-ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed; we briefly discuss possible strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies.
Reforming the Regulation of Broker-Dealers and Investment Advisers
Arthur B. Laby, 65(2): 395–440 (February 2010)
A key component of financial regulatory reform is harmonizing the law governing broker-dealers and investment advisers. Historically, brokers charged commissions and were regulated under the Securities Exchange Act of 1934. Advisers charged asset-based fees and were subject to the Investment Advisers Act of 1940, which contains a special exclusion for brokers. In recent years, brokers have changed their compensation structure and many now market themselves as advisers, raising questions about whether they should be treated as such. The Obama Administration's 2009 white paper on regulatory reform and draft legislation call for a fiduciary duty to be imposed on brokers that provide advice. This Article explores the debate over regulating brokers and advisers, and makes four key claims. First, changes in brokers' compensation and marketing methods vitiate application of the broker-dealer exclusion and should subject brokers to the Advisers Act. Second, changes in the nature of brokerage, spurred by changes in technology, make the broker-dealer exclusion unsustainable and Congress should repeal it. The third claim is that imposing fiduciary duties on brokers is incompatible with their historical roles as dealers and underwriters. To resolve this tension, this Article suggests a compromise that enhances brokers' duties but does not hobble their ability to perform their traditional functions. Finally, regulating brokers as advisers would overburden the U.S. Securities and Exchange Commission. This Article offers alternatives to alleviate the strain.
The Best of Both Worlds: A Fact-Based Analysis of the Legal Obligations of Investment Advisers and Broker-Dealers and a Framework for Enhanced Investor Protection
James S. Wrona, 68(1): 1 - 56 (November 2012)
A crucial debate on financial regulatory reform, affecting virtually every investor in the United States, is now taking place. The debate centers on the standards of care required of financial professionals when they provide investment advice. Two separate and markedly different regulatory regimes apply to these financial professionals: one for investment advisers and one for broker-dealers. This article discusses recent congressional initiatives related to advisers and broker-dealers, reviews existing obligations when advisers and broker-dealers provide advice to customers, and identifies regulatory gaps that need to be bridged. The level of regulatory oversight that both models receive also is explored. Finally, the article offers a framework to ensure robust investor protection and, as part of that framework, recommends that policymakers impose additional obligations on both broker-dealers and advisers to achieve truly universal standards of conduct that are in investors' best interests.
How Safe Are Institutional Assets in a Custodial Bank’s Insolvency?
Edward H. Klees,68(1): 103 - 136 (November 2012)
It is a widely held belief among institutional investors that custody accounts are protected against a bank's insolvency in the United States. This assumption undergirds trillions of dollars of assets held in custody in U.S. banks. However, despite the 2008 financial crisis, little if any attention has been paid to analyzing whether this belief is, indeed, valid. This article argues that while the FDIC, as receiver of almost all failed banks in the United States, will likely protect custodied assets to the extent permitted by law, clients bear several significant legal and operational risks that could limit recovery of their custodied assets. While investors can protect against some risks, others may be outside their control. The article outlines these risks and proposes ameliorative steps for institutional investors.
Soft Dollars, Hard Choices: Reconciling U.S. and EU Policies on Sell-Side Research
Paul G. Mahoney, 75(3): 2173-2200 (Summer 2020)
Investors use research provided by broker-dealers, also known as sell-side research, to help formulate trading ideas and strategies. Investors normally pay for sell-side research through brokerage commissions. Recent European Union regulations require some institutional investment managers to unbundle, or pay separately for, research and trade execution. Unbundling might subject a U.S. broker-dealer to regulation under the Investment Advisers Act of 1940, significantly affecting the broker’s business practices.