Eight States Sue the SEC in an Effort to Overturn Reg BI

A number of state attorneys general have filed a lawsuit against the SEC, seeking to overturn the SEC’s recently adopted Regulation Best Interest or “Reg BI.” This not unexpected move comes in the wake of simmering discontent which has built up against Reg BI ever since its adoption on June 5th. In a nutshell, consumer advocate groups, state regulators and some high-ranking SEC officials all oppose Reg BI on the grounds that it doesn’t go far enough in imposing a more rigorous standard of conduct on broker-dealer firms. This lawsuit, filed in New York federal district court, ramps-up this disagreement considerably.

Reg BI, which this blog has discussed in some detail recently, is part of a comprehensive package of new rules and interpretations released by the SEC on June 5th. Specifically, the long-awaited Reg BI replaces the prevailing “suitability” standard of conduct applicable to broker-dealers and their registered representatives with a new “best interest obligation.” While under suitability, broker-dealers were only required to ensure that that their recommendations were “suitable” in light of a customer’s investment objectives and risk tolerance, the new best interest obligation requires that a broker-dealer always act in a customer’s “best interest.” Additionally, under Reg BI, the broker-dealer cannot place its interests ahead of a customer’s interests.

However, as noted, many observers feel that this new best interests standard is a much too timid response by the SEC. These observers had hoped for the SEC to implement a unitary fiduciary standard for all persons making investment recommendations—be they broker-dealers or investment advisers. Advocates of the unitary fiduciary standard point to the increased blurring of distinctions between brokers and advisers in recent years, especially the prevalence of dually-registered firms and the ubiquitous use of the term “financial advisor,” which, they say, sows enormous confusion with consumers. The lawsuit, filed by the states of New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon, and the District of Columbia, gives voice to these advocates.

The lawsuit argues that in enacting Reg BI the SEC contradicted Congress’ express direction in the 2010 Dodd-Frank Act to implement a unitary fiduciary standard. Specifically, the lawsuit points to Section 913(g) of the Dodd-Frank Act, which the States’ assert “make[s] clear that any rules promulgated by the Commission regarding the standard of conduct for broker-dealers must be ‘the same as the standard of conduct applicable to an investment adviser’ under the Advisers Act.” Essentially, the lawsuit contends that any final rules implementing a revised standard of conduct for brokers must by definition be done in reliance on Section 913(g), which mandates a fiduciary standard. The SEC, on the other hand, explicitly relied on a different statutory provision—Section 913(f)—which arguably offers the SEC more flexibility in crafting a standard of conduct for brokers as it sees fit. It is on this rather technical legal distinction that the lawsuit will ultimately be decided.

Notably, Section 913(f) provides that “[t]he Commission may commence a rulemaking, as necessary . . . to address the legal or regulatory standards of care for brokers, dealers, investment advisers, [and] persons associated with [such firms] . . . .” Section 913(g), entitled “Authority to Establish a Fiduciary Duty for Brokers and Dealers,” on the other hand, amends existing law to read that the SEC “may” promulgate rules establishing a unitary fiduciary standard.

In this light, it is likely that the SEC will argue that its reliance on Section 913(f) was entirely proper in that it is that section which confers its rulemaking authority. Given its reliance on Section 913(f), the SEC will likely further contend that—through its use of the word “may”—Section 913(g) is of secondary importance, only conferring authority to create a unitary fiduciary standard if the SEC sees fit. Indeed, in adopting Reg BI, the SEC cited “the express and broad grant of rulemaking authority in Section 913(f)” versus the “overlapping, yet distinct, rulemaking power” in Section 913(g).

While a federal judge will ultimately decide this and other aspects of the lawsuit, it is clear that Reg BI is getting off to a rocky start. As noted, critics include SEC insiders (Commissioner Jackson and Investor Advocate Fleming) as well as numerous consumer groups and academics. However, even more problematic are the number of individual states that are already implementing their own state-specific standards of care for brokers. For example, Nevada, Massachusetts, and New Jersey have all begun the process of crafting fiduciary standards of care for brokers doing business in those states. We can reasonably expect to see more of this in the months ahead. The result, unfortunately, may be an even more confused playing field for brokers in the United States. We will, of course, keep a close eye on developments in this area, and chronicle as needed.

Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules.  Please visit our Investment Adviser Practice Group page for more information.

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