As the standard-of-care saga continues, nobody can predict exactly how each new regulator will define "best interest" or whether they will opt instead to use the term "fiduciary." What seems certain, though, is that any new rule will be challenged in court.
We saw this with the Department of Labor's 2016 fiduciary rule and again with New York's Regulation 187, which imposes a new standard of care on annuity and life insurance distribution, and now we are seeing it with the Securities and Exchange Commission's Regulation Best Interest.
On Tuesday, the states of New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon, and the District of Columbia filed suit in the Southern District of New York asking that Regulation Best Interest be vacated for having exceeded the SEC's statutory jurisdiction and for being arbitrary and capricious.
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The states' primary argument is that the line between broker-dealers and investment advisers has become blurred, leaving investors "confused and at increased risk of being harmed as a result of the different level of protection they receive based on the different accounts they have." And the SEC was expressly given authority in 2010 under Section 913(g) of Dodd-Frank to impose a uniform fiduciary standard on both broker-dealers and investment advisers, if, after performing a study, it determined imposing such a standard was appropriate. The states appear to argue that by not imposing a uniform fiduciary standard, the SEC violated its statutory mandate.
The states argue that not only was the SEC given authority, but early drafts of Dodd-Frank contained language that would have required the SEC to impose a fiduciary standard on broker-dealers. The states then note that in 2011, the required study was completed, and SEC staff recommended that the commission "exercise its rulemaking authority under Dodd Frank Act Section 913(g), which permits the Commission to promulgate rules to provide that: 'the standard of conduct for all brokers, dealers, and investment advisers … shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice."
The states then note that in promulgating Regulation Best Interest, the SEC did not use the powers given to it under Section 913(g) of Dodd-Frank. They briefly note that the SEC instead used powers given to it under Section 913(f) which authorized rulemaking to address the "regulatory standards of care … for providing personalized investment advice" to retail investors.
The states then go on to argue that Regulation Best Interest does not mandate the standards that the SEC would have been required to mandate if the SEC had relied on Section 913(g). They argue that a coherent reading of Section 913 as a whole should have led the SEC to impose a standard where brokers were required to act "without regard to their own interests" rather than one in which brokers are required "to put the customer's interest ahead of their own."
While the lawsuit was just filed, and it is too early to make predictions on the merits, it highlights a few key themes that have come up each time a regulator has issued a new standard-of-care regulation. First, with federal rules, plaintiffs will likely always be able to find a favorable jurisdiction. DOL's fiduciary rule was challenged in Republican-leaning Texas, the SEC's rule is being challenged in Democrat-leaning New York.
Second, legislators need to provide clearer guidance to regulators. Section 913 of Dodd-Frank has language that arguably (or seems to) (1) prohibits the SEC from banning commissions, (2) gives it authority to impose a standard of care requiring brokers to act "without regard to" their own interests, and (3) gives the SEC authority to craft a different standard of care instead. It is easy to see where there would be litigation when Congress includes contradictory goals within a single section of a statute.
Finally, the case should be exciting to watch because it may influence the DOL's anticipated fiduciary proposal, which is expected later this fall.
Kevin L. Walsh and David N. Levine are principals at Groom Law Group.