Fiduciary Advisory Firms Sue to Block SEC’s Reg BI

The U.S. Securities and Exchange Commission faces a second lawsuit seeking to derail its implementation of the Regulation Best Interest rulemaking package.

The new lawsuit, filed in the U.S. District Court for the Southern District of New York, includes as plaintiffs two advisory firms, XY Planning Network and Ford Financial Solutions. Similar to another lawsuit filed just this week by eight state attorneys general, the second challenge suggests the SEC’s Regulation Best Interest package fails to meet the directions and demands set out by Congress in the Dodd-Frank Act.

“One of the gaps that the Dodd-Frank Act sought to close concerned the standard of conduct applicable when individuals receive recommendations and advice on how to invest their money in markets,” the lawsuit states. “Investment advisers have traditionally been subject to a fiduciary standard, while brokers and dealers have not. Over time, the line between advisers and broker-dealers had blurred, with an increasing number of broker-dealers performing many of the same services as investment advisers, without having to satisfy the same regulatory requirements in doing so.”

According to the advisory firms filing suit, at first, the SEC heeded Congress’s mandate. Its staff studied the problem and prepared a report recommending the adoption of a universal standard of conduct, known as the “without regard to” standard.

“But last year, 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 complaint alleges. “Under the SEC’s so-called ‘best interest’ rule … a broker/dealer is permitted to take into account its own personal interests in providing recommendations and advice to investors on how to invest their life savings. This new rule means that broker/dealers may maintain harmful conflicts of interests while being able to market themselves as trusted advisers acting in their client’s best interests.”

The lawsuit suggests the rule thus circumvents a key goal of Dodd-Frank—leveling the playing field—and increases investor confusion.

In seeking to state an actionable claim, the lawsuit points out that one plaintiff is a network of registered investment advisers, while the other plaintiff is a member of that network and itself a registered investment adviser (RIA). They are said to be injured by the “best interest” rule because it causes them a competitive disadvantage with respect to broker/dealers, makes it more difficult to differentiate their fiduciary standard of conduct from the lower standard of conduct now applicable to broker/dealers, and reduces the incentive for broker/dealers to register as an investment adviser and thus join the network as a member.

The plaintiffs seek a declaration that the “best interest” rule exceeds the SEC’s statutory authority and is arbitrary, capricious, or otherwise not in accordance with law, in violation of the Administrative Procedure Act. They ask this Court to vacate and set aside the rule.

The text of the lawsuit offers background information about the differences between the advisory and brokerage professions. According to the plaintiffs, because the standard of conduct for broker/dealers has been lower than the standard for investment advisers—allowing broker-dealers to pursue their own financial gain when making recommendations to investors—brokers have a powerful incentive to avoid registering as investment advisers and being treated as such for regulatory purposes.

“This means that the traditional line between broker/dealers and investment advisers has broken down in practice, benefiting brokers to the detriment of investors and investment advisers,” the lawsuit suggests. “Among other things, the regulatory disparity between investment advisers and broker/dealers, and the increasingly blurry functional line between them, has undermined the ‘essential purpose’ of a key Depression-era statute, the Investment Advisers Act of 1940: ‘to protect the public from the frauds and misrepresentations of unscrupulous tipsters and touts and to safeguard the honest investment adviser against the stigma of the activities of these individuals.’”

According to the complaint, the SEC’s staff conducted the study required by Dodd-Frank and published its report in January 2011 after receiving over 3,500 comment letters. Both the study and the comments demonstrated that there was substantial “confusion by retail investors regarding the roles, titles, and legal obligations of investment advisers and broker-dealers,” the lawsuit states.

Consistent with Congress’s grant of authority in Dodd-Frank, the report recommended that the SEC “engage in rulemaking specifying a uniform fiduciary standard of conduct that is no less stringent than currently applied to investment advisers under Advisers Act Sections 206(1) and (2) that would apply to broker/dealers and investment advisers when they provide personalized investment advice about securities to retail customers. … The report further recommended, as contemplated by subsection (g)(1), that ‘the standard of conduct for all brokers, dealers, and investment advisers, when providing personalized investment advice about securities to retail customer, 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.’ … Seven years later, in 2018, the SEC proposed a rule rejecting the approach recommended by the study in favor of preserving the regulatory gap that Congress intended to close.”

The full text of the complaint is available here.