NAPA (June 10, 2019) – Regulatory Compliance

The ink is not yet dry on the SEC’s new investment advice package, but the prospects of a looming legal battle have already surfaced.

The SEC voted 3-1 on June 5 to put in place a new “best interest” standard of conduct for broker-dealers – the Regulation Best Interest – along with a new Form CRS Relationship Summary and two separate interpretations under the Investment Advisers Act.

But opponents of the rules didn’t wait for its release to raise concerns. “A number of consumer groups have certainly indicated that they are likely to challenge the guidance – whether one piece or all four pieces is yet to be determined,” notes David Levine, a Principal with the Groom Law Group. Levine observes that we’re still in the early stages, but adds that Commissioner Robert Jackson’s written statement in connection with Reg BI seems to follow that path as well.

In fact, nearly 24 hours before the SEC voted, the Public Investors Arbitration Bar Association (PIABA) and Consumer Federation of America (CFA) issued a strongly worded warning that the proposal will do more harm than good and that its true impact is being misrepresented by the SEC. The PIABA-CFA statement states, “While the Chairman’s plan is being pitched to the news media and Capitol Hill as improving protections for retail investors, the truth is that it is actually a step backwards: It will leave investors with fewer protections in important areas than they would have had if the Commission had not acted.”

“These regulations are a betrayal of the Mr. and Ms. 401(k) investors Chairman Clayton pledged to protect when he launched this rulemaking,” added Barbara Roper, director of investor protection at the CFA, an advocate of the 2015 Labor Department fiduciary proposal, and a harsh critic of the SEC’s efforts.

Rep. Maxine Waters (D-CA), Chairwoman of the House Financial Services Committee, was also quick to weigh on the SEC’s initiative, stating that, “The SEC’s final rule ignores the explicit will of Congress and fails to require all financial professionals to abide by a strong, uniform fiduciary standard of care when providing investors with investment advice.” Waters urged the SEC to rescind the rule, contending that it “could lower the standard that investment advisers currently abide by and mislead investors into thinking that brokers who comply with this new rule are putting their clients’ interests first.”

Spirit of Dodd-Frank?

The SEC’s rulemaking comes nearly a decade after the Dodd-Frank legislation authorized the commission to promulgate regulations addressing the standards of care for brokers, dealers and investment advisers when providing investment advice about securities to retail customers. Indeed, it’s been just over a year since the U.S. Court of Appeals for the Fifth Circuit vacated the DOL’s fiduciary rule, holding that the agency has essentially overstepped it rulemaking authority, the script has been flipped with the SEC’s rulemaking.

In his opening statement, Clayton stated the SEC’s recommendations reflect a “careful study of the DOL Fiduciary Rule, incorporating certain aspects of the rule that will enhance the broker-dealer standard of conduct in line with reasonable investor expectations, while avoiding other aspects of the rule that appear to have been primary drivers of the rule’s unintended consequences, such as the introduction of a best interest contract exemption and private right of action, and the uncertainty of whether, and if so to what extent, a commission-based fee model was compatible with the DOL Fiduciary Rule.”

Indeed, while the Labor Department’s recrafting of its fiduciary regulation was challenged by critics as going too far in its stated attempt to provide consumers, concerns expressed by critics of the SEC rules are that it doesn’t go far enough

Marcia Wagner, founder and Managing Director of The Wagner Law Group, agrees that Reg BI probably will be challenged. Wagner observes that counsel will likely be creative in so doing, noting, for example, that one of the challenges to the DOL fiduciary rule was that it violated the First Amendment to the Constitution.

“An argument may also be made that the SEC was arbitrary not to follow Dodd-Frank and Staff recommendation and provide for a uniform standard for advisers and broker dealers,” Wagner explained to NAPA Net. In addition, she notes that the SEC’s economic analysis may be challenged as insufficient.

One of the thrusts behind the SEC rulemaking was Section 913 of the Dodd-Frank Act, which calls for the Commission to conduct a study regarding gaps or deficiencies in the regulation of broker-dealers and investment advisers, as well as authorizing the creation of rules addressing this matter. In Section 913(f), Congress authorized the Commission to proceed with rulemaking to address the standards imposed on brokers and advisers for providing personalized advice, taking into consideration the findings of the staff study.

In contrast, Section 913(g), “Authority to Establish a Fiduciary Duty for Brokers and Dealers,” authorizes that rules be created providing “… that the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customers (and such other customers as the Commission may by rule provide), 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.”

This is where consumer groups may look in arguing that the SEC did not go far enough in meeting the principles outlined in the Dodd-Frank legislation, though where the courts may come down on the two provisions remains to be seen. As of now, no consumer or industry group has called for litigation, but it could be just a matter of time.

State Efforts and Preemption

In the meantime, while state regulators continue to push forward with efforts to strengthen the standards for investment professionals in their states, the SEC’s new guidance declines to stake a claim that Reg BI preempts state laws.

A client bulletin by The Wagner Law Group further explains that many had hoped the SEC would address the preemptive effect of Reg BI, particularly in light of actions taken by states such Nevada and New Jersey.

The SEC acknowledges that numerous commenters urged the Commission to coordinate with other regulators, including the DOL and state securities and insurance regulators, but it deferred the decision to the courts. “We note that the preemptive effect of Regulation Best Interest on any state law governing the relationship between regulated entities and their customers would be determined in future judicial proceedings based on the specific language and effect of that state law,” the SEC states in its explanation of Reg BI.

“Since the requirements of Reg BI are considered as too low by consumer groups and by some Democratic state leaders, I believe that more states will enact state fiduciary standards for investment and insurance advice,” notes ERISA attorney Fred Reish, partner with Drinker Biddle & Reath LLP. “There is a perception that Reg BI does not require adequate disclosure of product costs and advisor compensation and does not require that advisors only recommend low cost and high-quality investments and annuities.”

“Underneath it all, while we’re in the first inning of the discussion after the issuance of Reg BI, it certainly seems like there will be litigation – whether from the consumer advocate side addressing Reg BI or the industry side addressing state laws,” Levine adds.

For now, Reg BI and Form CRS will become effective 60 days after they are published in the Federal Register and they have a compliance date of June 30, 2020, but there’s sure to be plenty of debate before then. And, at some point in the next few months, the DOL will reenter the fray.