On September 9, 2019, seven states and the District of Columbia sued the United States Securities and Exchange Commission to invalidate Regulation Best Interest: The Broker-Dealer Standard of Conduct (“Regulation BI”). The Attorneys General of California, New York, Connecticut, Delaware, the District of Columbia, Maine, New Mexico, and Oregon alleged in their complaint that Regulation BI:
undermines critical consumer protections for retail investors, increases confusion about the standards of conduct that apply when investors receive recommendations and advice from broker-dealers or investment advisers, makes it easier for brokers to market themselves as trusted advisers (while nonetheless permitting them to engage in harmful conflicts of interest that siphon investors’ hard-earned savings), and contradicts Congress’s express direction
Complaint, p. 1. The complaint, filed in the United States District Court for the Southern District of New York, alleges three claims for relief. First, the plaintiffs alleged that the SEC violated its authority under 5 U.S.C. § 706(2)(C) of the Administrative Procedures Act and that the Court may set aside the SEC’s action that is “in excess of statutory jurisdiction, authority, or limitations, or short of statutory right.” According to the plaintiffs, Regulation BI exceeded the SEC’s authority because the SEC expressly disclaimed reliance on the delegation of rulemaking authority in Dodd-Frank Act Section 913(g), which provides Congress’s controlling delegation of rulemaking authority to establish new rules regarding the standards of conduct that apply to broker-dealers providing personalized investment advice to retail customers. The second claim alleges that the SEC’s action violated section 913(g)(1) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) by establishing a broker-dealer standard of conduct that is not “the same as” the standard of conduct that is applicable to investment advisers under the section 211 of the Investment Advisers Act of 1940. The plaintiffs also alleged in their second claim that section 913(g)(2) of the Dodd-Frank Act requires that any regulation establishing a best interest obligation for broker-dealers must provide that the standard of conduct shall be to act in the best interest of the customer without regard to the financial or other interest of the broker-dealer. The third claim alleges the SEC’s adoption of Regulation BI may be set aside as “arbitrary, capricious, [or] an abuse of discretion” under 5 U.S.C. § 706(2)(A) of the Administrative Procedures Act.
The SEC issued Regulation BI on June 5, 2019. This much-anticipated rule takes effect on June 30, 2020. The stated purpose of Regulation BI is to establish a standard of conduct for broker-dealers and their associated persons when they make recommendations to retail customers for any securities transaction or investment strategy involving securities. According to the SEC’s 771-page release, the Regulation BI enhances the broker-dealer standard of conduct by requiring broker-dealers “to act in the best interest of the retail customer at the time the recommendation is made,” to refrain from “placing the financial interest of the broker-dealer ahead of the interests of the retail customer,” to “address conflicts of interest by establishing, maintaining, and enforcing policies and procedures reasonably designed to identify and fully and fairly disclose material facts about conflicts of interest,” and, in certain instances, to mitigate or eliminate conflicts.
The actual regulation takes up less than six pages, while the remainder of the 771 pages consists of the SEC’s attempt to explain why this new regulation, rather than the much broader fiduciary rule that it replaces, is in the best interest of retail investors. In fact, Regulation BI is in many ways a step backward. The new rule was universally opposed by investor advocates and falls far short of the protections investors deserve. The rule purports to require that brokers adhere to a “best interest” standard but does not actually require that they act in their customers’ best interests. The standard does not prevent brokers from placing their own interests first. It provides that brokers are not required to monitor customer accounts unless they agree “to provide the retail customer with specified account monitoring services.” Regulation BI permits broker-dealers to place their interests ahead of customers if they disclose the conflict.
The history of efforts to reform the standards applicable to broker-dealers has its origin in the financial crisis that began in September 2018. In July 2010, President Obama signed the Dodd-Frank financial reform law, which gave the SEC the authority to develop a uniform fiduciary standard for retail investment advice that was no less stringent than the standard applicable to investment advisers under the Investment Advisors Act of 1940. The same year, the United States Department of Labor released a rule designed to limit conflicts of interest for financial advisers who worked with customer retirement accounts. In January 2011, the SEC staff issued a report that recommended the SEC propose a uniform fiduciary rule. On April 14, 2016, the Department of Labor issued its final version of the fiduciary rule. Full compliance with the rule was to occur by January 1, 2018. In August 2017, the Labor Department proposed that compliance with the fiduciary rule be delayed for 18 months, until July 1, 2019. By that time, President Trump had been elected. The new administration stated its opposition to imposing a fiduciary standard on broker-dealers, and Department of Labor’s rule was shelved. Regulation BI is its replacement.
The SEC commissioners adopted Regulation BI by a vote of three to one, with Commissioner Robert L. Jackson, Jr. casting the sole dissenting vote. Commissioner Jackson issued a statement in which he wrote: “today’s rules retain a muddled standard that exposes millions of Americans to the costs of conflicted advice.” The Dodd-Frank law gave the SEC full authority to adopt a strong, pro-investor fiduciary standard that covered broker-dealers. Unfortunately, the SEC failed to do so.
The complaint contains an impressive summary of the deficiencies of Regulation BI.
© Andrew Whiteman 2019
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