‘Smart Money’ Says 2nd Circuit Won’t Halt SEC Regulation Best Interest

The U.S. District Court for the Southern District of New York several weeks ago dismissed a consolidated lawsuit seeking to derail implementation of the U.S. Securities and Exchange Commission (SEC) Regulation Best Interest (Reg BI) rulemaking package.

Important to note, the case was dismissed due to the Court’s self-declared lack of subject matter jurisdiction, and the ruling notes that motions had already been filed by the parties in the appropriate appellate court. In this case, because the Attorney General of New York is leading the litigation, this means the 2nd U.S. Circuit Court of Appeals will have to decide whether to hear the case and what to do about it. 

Claims in the consolidated lawsuit, which includes as plaintiffs both private fiduciary advisers as well as a group of prominent State Attorneys General, suggest Reg BI fails to meet the clear demands established by Congress in the Dodd–Frank Act.

Nancy Hendrickson, partner and co-chair of the financial services practice group at Kaufman Dolowich & Voluck, has been following the lawsuit closely, given her role representing clients in connection with SEC investigations, disciplinary actions and enforcement proceedings. Discussing potential outcomes with PLANADVISER, Hendrickson says she was not surprised that the District Court ruled in the way it did, but she was struck by the Court’s very brief and direct rejection of the lawsuit.

“The Securities and Exchange Act has a provision in it which it is stated that an aggrieved party that wants to challenge an agency action or order needs to file it in the circuit court of appeals for whatever circuit they reside in,” Hendrickson says. “What was surprising to see was that the District Court read the letters and motions from each parties’ counsel and said flat out, ‘We don’t even need briefs on this jurisdictional issue. We are going to dismiss the case outright in a three page summary decision.’ I don’t think either side was expecting that rapid outcome.”

Now that the case is to be reviewed by the 2nd Circuit, Hendrickson says, this changes the process in a significant way relative to what would have occurred in the District Court.

“With the matter before the 2nd Circuit, this means it is a very different review procedure—essentially it’s no longer a full blown lawsuit at this point,” she explains. “The process in the 2nd Circuit will be much more expedited than a full trial. In the trial court, you would see the creation of a much fuller record and then have the trial, and then the judge renders a decision. Here, the Circuit Court is simply going to use the record that was created in the rulemaking process. There won’t be much more information generated or used.”

As it stands currently, the record before the 2nd Circuit includes some 2,900 exhibits, but more than 2,600 of the exhibits are public comment letters. There are also transcripts of roundtable meetings and similar types of documents.

“That’s the record the plaintiffs are going to have to use in order to build their case,” Hendrickson explains. “The next step in the process is that plaintiffs have to file a brief, and then the SEC will have 90 days or so to respond. Then there could be one more reply from plaintiffs, and then we’ll have the oral arguments. That’s it.”

In her view, right now the “smart money” is on the SEC prevailing—meaning that Reg BI will take effect according to the original timeline.

“If firms are waiting to see how this plays out in the courts, they are likely wasting precious time they could be using to put new processes and procedures in place,” Hendrickson says. “The important compliance date of June 30, 2020, will be here before we know it.”

Bigger Than the DOL Fiduciary Rule?

To the extent advisory firms got a head start with Reg BI compliance based on their earlier efforts to comply with the now-defunct Department of Labor (DOL) fiduciary rule expansion, they can take some comfort that they are in a decent position to get into compliance with Reg BI fairly expeditiously. However, as Hendrickson warns, there is still a lot of practical uncertainty associated with the Regulation Best Interest package, especially with the mandated customer relationship summary form, or “Form CRS.” Another great unknown is what the states are going to do to strengthen their own standards for advisers and broker/dealers—particularly if this lawsuit is not successful.

“We have already seen several states enact their own conflict of interest standards, and I think it is likely that others will follow suit,” Hendrickson says. “And then FINRA is probably going to do something soon to readdress its own suitability standards. The point is that this is not a great time to be standing still.”

In a sense, Hendrickson sees Reg BI as being a bigger deal than the DOL fiduciary rule, mainly because it applies to all accounts, not just retirement accounts.

“There are so many action items and potential issues in here that I think a lot of people are overlooking at this stage,” she warns. “For example, how does the rule about providing the Form CRS function in the context of an adviser leaving one firm and trying to reach out to former clients and convince them to move from Firm A to Firm B? Does he have to give a Form CRS when he decides to pitch the new firm? And how does this increase the due diligence duties of firms that are hiring and onboarding advisers from other firms? Will they have to go client by client and make all these individualized determinations of what is really in a client’s best interest in terms of which firm they should work with?”

Seeking Regulatory Clarity

During Drinker Biddle & Reath’s latest “Inside the Beltway” webcast, Bradford Campbell, a partner in the firm’s employee benefits and executive compensation group, and James Lundy, a partner and member of the firm’s SEC and regulatory enforcement team, noted that, despite Reg BI’s heft, there is not a lot of clarity at this stage. They agreed with Hendrickson’s suggestion that many advisers feel frustrated that the SEC hasn’t really given the clear compliance roadmap that they would like to have at this stage. And like Hendrickson, they feel Reg BI stands comparatively little chance of being tossed by the 2nd Circuit.

“One of the main arguments the states are making is that Reg BI hasn’t followed the Dodd-Frank Act’s suggestion that the SEC consider a uniform fiduciary rule,” Campbell explains. “I think there are good counter arguments here for the SEC, namely that Dodd-Frankly also expressly provided authority to do something other than a uniform fiduciary standard.”

Campbell says it is interesting to read the states’ argument about why they believe they have standing to sue to block Reg BI. Their position in essence is that Reg BI would reduce the future tax revenues they would collect from investment accounts, due to the excessive fees that will allegedly be charged in the absence of a true fiduciary standard.

“On the standing issue alone, this is a novel and aggressive argument for standing, so it will be interesting to see the outcome there,” Campbell says. “On the rest of the lawsuit, I think these are more political points being made by the states than they are real legal maneuvers expected to succeed. This is more than anything evidence of the significant policy split that exists between the Federal Government and some states. It’s really a sign of a fiduciary collision course to come.”

Lundy notes that, generally speaking, when a regulator is challenged in court, it is typically private industry groups directing the effort.

“This situation is somewhat unique because it is the states leading the charge against Reg BI,” Lundy says. “In my view, recalling how the SEC’s so-called Merrill Lynch rule was overturned more than a decade ago, I think they have taken effective precautions to make sure this rule will not be overturned by a court. My bet is that the challenge won’t be successful, but it’s not set in stone.”

Like Hendrickson, Campbell and Lundy agree that firms must get moving now to prepare for Reg BI’s implementation date of June 30, 2020.

“We simply have to go full steam ahead on compliance because there is not any other practical option,” Campbell concludes.