State AGs to SEC: Your "Best" is Not Good Enough

Financial Services Law

Led by New York Attorney General Letitia James, a group of eight state AGs filed suit against the Securities and Exchange Commission (SEC), challenging the agency’s recently enacted Regulation BI (Best Interest).

This final rule attempts to establish a heightened standard of conduct for broker-dealers when making recommendations to retail customers by requiring, among other things, that the broker-dealer act in the “best interest” of the retail customer. However, several states have filed suit alleging that the new standard of conduct for broker-dealers is not in harmony with the fiduciary standard governing investment advisers, does not define “best interest,” and allows broker-dealers to consider their own financial interests when giving investment advice to a retail customer.

What happened

By a vote of 3 to 1 in June 2019, the SEC adopted a rulemaking package concerning a new broker-dealer standard of conduct.

According to the SEC, the new standard of conduct “substantially enhance[d]” the prior obligations, requiring broker-dealers to act in the best interest of a retail customer when making a recommendation to him or her related to any securities transaction or investment strategy involving securities.

Pursuant to the rule, broker-dealers are required to disclose “material facts,” including the capacity in which the broker is acting, fees, the type and scope of services provided, conflicts, limitations on services and products, and whether the broker-dealer provides monitoring services.

The broker-dealer must consider the potential risks, rewards and costs associated with a recommendation in light of the retail customer’s investment profile and make a recommendation in the retail customer’s best interest. Also required are written policies and protocols reasonably designed to identify (and, at a minimum, disclose) conflicts of interest.

But the AGs of California, Connecticut, Delaware, the District of Columbia, Maine, New Mexico, New York and Oregon have commenced a lawsuit in the Southern District of New York alleging that the “best interest” rule fails to adopt the fiduciary standard applicable to investment advisers and thereby continues the dichotomy of standards applicable to broker-dealers and investment advisers. According to the complaint, the absence of a uniform standard of conduct causes confusion among retail customers with regard to what standard they can expect from the person giving them investment advice.

The AGs assert that the “best interest” rule “undermines critical consumer protections for retail investors, increases confusion about the standards of conduct that apply when investors receive recommendations and advice from broker-dealers or investment advisers, makes it easier for brokers to market themselves as trusted advisers (while nonetheless permitting them to engage in harmful conflicts of interest that siphon investors’ hard-earned savings) and contradicts Congress’s express direction.”

During the drafting of Dodd-Frank, lawmakers considered the disparity between the standards of conduct for broker-dealers and investment advisers and enacted Section 913(b) of the statute in response, the AGs allege. That provision directed the SEC to conduct a study to evaluate the regulatory regime and prepare a report. Further, Section 913(g) of Dodd-Frank authorized the agency to harmonize the standards of conduct for broker-dealers and investment advisers, the AGs allege.

The SEC conducted its study, reviewing more than 3,500 comments before publishing a report in January 2011 that determined “retail customers do not understand and are confused by … the standards of care applicable to investment advisers and broker-dealers when providing personalized investment advice and recommendations about securities.”

However, according to the AGs’ complaint, seven years later, when the agency issued a Notice of Proposed Rulemaking regarding the standard of conduct for broker-dealers, the notice departed from the Section 913 study recommendations in “several significant respects.” The complaint alleges that the SEC “established a new and largely undefined ‘best interest obligation’” that did “not require that the broker or dealer act ‘without regard to’ his or her own financial interests as is mandated under Section 913(g)(2).” Additionally, the complaint alleges that the SEC failed to meet the standard set by Dodd-Frank, disregarded its own study findings and improperly based its authority on Section 913(f) of Dodd-Frank.

According to the AGs, these failures amount to violations of the Administrative Procedure Act (APA) that will damage their respective states. The complaint alleges that the damage to the plaintiff states includes lost revenue from the taxable portions of distributions from their residents’ investment and retirement accounts that are worth less because of expensive conflicts of interest in investment advice, a greater financial burden to assist retirees and others whose savings are insufficient to meet their needs due to conflicted investment advice, and harm to their quasi-sovereign interest in protecting the economic well-being of their residents.

The AGs request that the court declare that the “best interest” rule violates the APA or, in the alternative, is arbitrary, capricious or an abuse of discretion. The lawsuit asks the court to vacate the rule and permanently enjoin implementation.

To read the complaint in New York v. U.S. Securities & Exchange Commission, click here.

Why it matters

The AGs’ action is a direct attack on the adequacy of the SEC’s rulemaking regarding compliance with Dodd-Frank’s mandate to harmonize standards of conduct for those who provide investment advice to retail customers. The lawsuit renders uncertain whether the SEC’s new “best interest” rule will remain enforceable as the industry standard for broker-dealers. Accordingly, the lawsuit, brought ostensibly to eradicate confusion among retail customers regarding the standard of conduct to expect from the person providing investment advice, may actually create confusion with respect to how broker-dealers design protocols to comply with the new rule. Stay tuned.



pursuant to New York DR 2-101(f)

© 2023 Manatt, Phelps & Phillips, LLP.

All rights reserved