Showdown in 2nd Circuit over Reg BI

The smart money is betting the SEC will prevail in the challenge to its new rules scheduled to take effect June 30

A showdown is looming next month in a federal appeals court in New York on the enforceability of the Securities and Exchange Commission’s new Regulation Best Interest, which is scheduled to go into effect on June 30. The raging coronavirus pandemic is unlikely to deter implementation of the new rules, which the SEC has reaffirmed will take effect next month, or the adjudication of the dispute, which will be argued the week of June 1 by teleconference before the 2nd Circuit Court of Appeals.

Regulation Best Interest was implemented by the SEC under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and has four components: (1) the disclosure obligation; (2) the care obligation; (3) the conflict of interest obligation; and (4) the compliance obligation. Broker-dealers must furnish retail customers with a Form CRS relationship summary; investment advisers must give their customers similar information in their Form ADV 3. The new regulations are designed to enhance protections and preserve choice for retail investors, eliminate conflicts of interest, and clarify compensation arrangements.

The plaintiffs in the court challenge are seven states (New York, California, Connecticut, Oregon, New Mexico, Delaware and Maine), as well as a network of investment advisers who claim that their business will be harmed by the watering down of financial services provided by broker-dealers, who are subject to a lesser regulatory regime.

The trial court, in the Southern District of New York, spontaneously dismissed the case on the grounds that original jurisdiction for such challenges under the federal securities laws is in the federal courts of appeals. Now that the case is in the 2nd Circuit, the smart money is betting that the SEC will prevail.

The plaintiffs argue that Dodd-Frank was motivated by confusion among investors about the different roles, compensation and legal duties required of registered investment advisers, who traditionally give investment advice in exchange for advisory fees, and registered representatives, who execute trades for commissions. The plaintiffs seek one uniform legal standard for registered investment advisers and broker-dealers, and argue that most retail customers cannot distinguish between receiving investment advice for money and a recommendation to buy or sell a security.

Eponymous bill sponsors Christopher Dodd and Barney Frank have filed an amicus brief in the 2nd Circuit arguing that they intended the SEC to promulgate a uniform fiduciary standard. Indeed, the statute does expressly empower the SEC to promulgate a uniform standard.

For its part, the SEC, along with several securities industry amicus briefs, points to the deference Congress gave the commission in Dodd-Frank. The act gives the SEC 14 factors to consider in preparing its report, the last of which is a broad catch-all: “any other consideration that the Commission considers necessary and appropriate in determining whether to conduct a rule-making under subsection (f).” This language suggests that Congress was giving the SEC a wide-ranging menu of considerations for it to consider in its rule-making. In addition, the act says the commission “may” promulgate a uniform fiduciary standard, further suggesting that the standard is discretionary with the SEC.

Most legal analysts believe the SEC has the better argument here. The commission’s decision-making process, while not ideal, was hardly irrational. The regulation of broker-dealers is obviously within the SEC’s statutory mandate, thereby distinguishing Reg BI from the Department of Labor’s ill-fated effort to carve out a fairly Byzantine fiduciary standard for individual retirement accounts, which was struck down by the 5th Circuit in 2018. Plus, the SEC has listened to the securities industry’s argument that many retail investors have smaller nest eggs, and benefit from using a pay-as-you-go commission model. Paying an annual management fee may not always benefit buy-and-hold customers with modest accounts.

In short, broker-dealers who were hoping for a last-minute reprieve from the new SEC regulations are well-advised to start ramping up for compliance with Regulation BI, get their form CRS in order, ensure that their brokers do not portray themselves as “financial advisers,” and start preparing compliance materials.

Barry Temkin is a partner at Mound Cotton Wollan & Greengrass and an adjunct professor at Fordham University School of Law, where he teaches broker-dealer regulation.