Court Quashes Lawsuit Challenging SEC’s Reg BI

Just days before the effective date of the Securities and Exchange Commission (SEC)’s Regulation Best Interest (Reg BI), a federal appellate court ruled that Section 913(f) of the Dodd-Frank Act authorizes Reg BI, and Reg BI is not arbitrary and capricious.

In October, the U.S. District Court for the Southern District of New York dismissed a consolidated lawsuit seeking to derail implementation of Reg BI. The 2nd U.S. Circuit Court of Appeals has denied review of that decision.

Important to note, the case was dismissed by the District Court because of the court’s self-declared lack of subject matter jurisdiction, and the ruling noted that motions had already been filed by the parties in the appropriate appellate court. In this case, because the Attorney General of New York was leading the litigation, the 2nd U.S. Circuit Court of Appeals had to decide whether to hear the case and what to do about it. Former Democratic legislators Christopher Dodd and Barney Frank had filed an amicus brief urging the 2nd Circuit to take up the case and arguing that that Reg BI violates Congress’ mandate in Dodd-Frank Section 913, which requires that any rule promulgated to address the inconsistent standards of care between investment advisers and broker/dealers (B/Ds) must harmonize those standards of care.

XY Planning Network co-founder Michael Kitces said he had filed a lawsuit against the SEC seeking to derail its Reg BI on behalf of the best interests of registered investment advisors (RIAs) and the protection of consumers.

Kitces, whose firm was the lead plaintiff in the case, said Reg BI permits B/Ds to put their interests ahead of clients in several ways. “First and most directly, it literally has no provision that requires B/Ds to mitigate their conflicts of interest,” Kitces told PLANADVISER. “Under Reg BI, brokers themselves have an obligation to mitigate conflicts of interest and act in the best interests of customers when making a recommendation, but brokerage firms themselves only have to disclose, but not mitigate, them.

“The second challenge to this, which is a bit more pernicious, is that the SEC blessed dual registrants, that is, allowing people who are an RIA and a B/D—the latter legally being a product salesperson—to switch hats anytime they want without clearly disclosing this to clients,” Kitces continued. “So a dual registrant may be giving advice to a client and then, without making it clear to the client because they continue to use the ‘financial adviser’ title, switch hats to being a B/D and then sell them products. The problem is the client doesn’t know when the adviser stopped being an adviser because [he] can say [he’s] an adviser throughout the whole process.”

XY Planning Network (XYPN), Ford Financial Solutions, a group of states and Washington, D.C., filed petitions for review under the Administrative Procedure Act (APA) claiming that Reg BI is unlawful under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

In its lawsuit, XYPN contended that Reg BI would injure investment advisers by making it more difficult for them to differentiate their standard of care from that of broker/dealers in advertising to attract customers. The owner of Ford Financial Solutions attested that Ford “currently attract[s] and retain[s] clients by, in part, highlighting [the] firm’s fiduciary duty to clients,” in contrast to the less stringent suitability standard governing B/Ds. Ford claims that under Reg BI, B/Ds will be able to advertise that they must act in their clients’ “best interests” just as Ford does, even though they will face “comparatively fewer regulatory obligations, lower compliance costs and less legal exposure.”

The state petitioners claimed that Reg BI will diminish their tax revenues from investment income by allowing B/Ds to provide conflicted investment advice to customers, which would be prohibited under a uniform fiduciary standard.

The appellate court concluded that Ford has standing to bring its petition based on the impairment of its current ability to attract customers by touting the fiduciary duties it owes its clients. “In other words, by enabling broker/dealers to advertise their new best-interest obligation, Regulation Best Interest will put Ford and other investment advisers at a competitive disadvantage compared to the status quo,” it says in its decision.

Because Ford identified an impairment to a specific business practice, it has made a “concrete showing that it is in fact likely to suffer financial injury” from Reg BI, the appellate court stated. However, it found the state petitioners lack Article III standing because their claim that Reg BI will cause a decline in state revenue is “entirely speculative.”

The appellate court found Section 913(f) of the Dodd-Frank Act grants the SEC broad rulemaking authority, and Reg BI falls within the discretion granted to the SEC by Congress. “Although Regulation Best Interest may not be the policy that petitioners would have preferred, it is what the SEC chose after a reasoned and lawful rulemaking process,” the 2nd Circuit wrote in its decision.

The appellate court noted that the SEC responded to comments submitted about its proposed rule in a 173-page Adopting Release explaining why it chose the best-interest standard. The original lawsuit alleged “the SEC broke from Dodd-Frank’s requirements—and the recommendations of its own staff—by proposing a rule adopting neither a universal standard nor a ‘without regard to’ standard.” The appellate court noted that the SEC, in its Adopting Release, considered and rejected a uniform fiduciary standard for investment advisers and B/Ds, explaining that “a ‘one size fits all’ approach would risk reducing investor choice” and that a uniform fiduciary standard “would [not] provide any greater investor protection (or, in any case, that any benefits would [not] justify the costs imposed on retail investors in terms of reduced access to services …).”

The 2nd Circuit noted that the Adopting Release also explicitly noted that the SEC was relying on Section 913(f)’s broad grant of rulemaking authority to promulgate Reg BI. “We thus hold that the SEC lawfully promulgated Regulation Best Interest pursuant to Congress’s permissive grant of rulemaking authority under Section 913(f) of the Dodd-Frank Act,” the decision says.

The petitioners contend that Reg BI is arbitrary and capricious because it relies on an incorrect interpretation of the broker/dealer exemption to the Investment Advisers Act (IAA), and the SEC did not adequately address evidence of consumer confusion. The 2nd Circuit rejected both arguments.

It notes that the SEC carefully considered and rejected a fiduciary rule based on its findings that the fiduciary duties owed by investment advisers are “not appropriately tailored to the structure and characteristics of the broker/dealer business model (i.e., transaction-specific recommendations and compensation).”

The petitioners claim that Reg BI is arbitrary and capricious because it is based on an incorrect interpretation of the “solely incidental” and “special compensation” prongs of the broker/dealer exemption from the IAA. The appellate court notes that the SEC issued an interpretative rule on the phrase “solely incidental” along with Reg BI, and the petitioners have not challenged that rule, nor do they argue that they are permitted to do so. The court also notes that the phrase “special compensation” is not even mentioned in Reg BI or the adopting release. It concluded that the petitioners fail to explain how the SEC’s interpretation of the B/D exemption to the IAA could make Reg BI arbitrary and capricious.

Regarding the argument that Reg BI is arbitrary and capricious because the SEC failed adequately to address the “significant evidence that consumers are not meaningfully able to differentiate between the standards of conduct owed by broker/dealers and investment advisers even with the assistance of disclosure forms,” the 2nd Circuit notes that the SEC considered evidence of consumer confusion and found that the benefits of decreased costs and consumer choice favored adopting the best-interest obligation.

In the Adopting Release, the SEC explicitly recognized that a uniform standard of care may “reduce retail investor confusion as it would ensure that investors are provided the same standard of care and loyalty regardless of what type of financial professional they engage.” But, the court said, the SEC weighed these benefits against the “significant compliance costs” for B/Ds that could cause “retail customers [to] experience an increase in the cost of obtaining investment advice” and lead to “the potential exit of broker/dealers from the market.”

“Thus, Regulation Best Interest was not arbitrary and capricious because the SEC gave ‘adequate reasons for its decision’ to prioritize consumer choice and affordability over the possibility of reducing consumer confusion, and it supported its findings with ‘substantial evidence,’” the appellate court concluded.