Tuning Out Harmony: The Second Circuit Upholds Regulation Best Interest

Financial Services Law

Last year, a group of state attorneys general (AGs) filed suit against the Securities and Exchange Commission (SEC), challenging the agency’s Regulation BI (Best Interest), enacted in June 2019. Regulation Best Interest established 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. The AGs maintained that Regulation Best Interest did not go far enough, especially given the provisions in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act that allowed the SEC to promulgate rules to harmonize the standard of care for broker-dealers with the exacting fiduciary duty standard applicable to investment advisers. On June 26, 2020, the United States Court of Appeals for the Second Circuit decided the petitions for review filed by the AGs—as well as an investment adviser interest group and one of its members—by holding that the states lacked standing to challenge the regulation and, in any event, based upon the standing possessed by one of the petitioners, declared the regulation to be valid.

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. Until then, broker-dealers needed to assess an investor’s “suitability” for a specific investment, but not whether the investment was in their “best interest,” which is a more invasive and complex determination based on the totality of the investor’s financial circumstances.1

Pursuant to the rule, broker-dealers are required to disclose “material facts,” including the capacity in which the broker is acting (e.g., primary dealer, underwriter, designated market maker), 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 or eliminate) conflicts of interest.

But the AGs of California, Connecticut, Delaware, the District of Columbia, Maine, New Mexico, New York and Oregon argued that the “best interest” rule failed to adopt the fiduciary standard applicable to investment advisers and thereby continues the dichotomy of standards applicable to broker-dealers and investment advisers. The states argued that the absence of a uniform standard of conduct for both investment advisers and broker-dealers causes confusion among retail customers with regard to what standard they can expect from the person giving them investment advice.

According to the AGs, the SEC’s failure to harmonize the standards applicable to broker-dealers and investment advisers damages their respective states due to, among other things, 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. The Second Circuit held that these allegations were insufficient to confer Article III standing on the states to challenge Regulation Best Interest because the states did not establish a “direct link” between the regulation and their tax revenues. The court found that the states’ theory of standing “rests too heavily on ‘conclusory statements and speculative economic data.’”

Nonetheless, the Second Circuit did reach the merits of the challenge when it found that petitioner Ford Financial Solutions LLC had standing to bring the challenge.

The court found that Regulation Best Interest was lawfully promulgated pursuant to Section 913(f) of Dodd-Frank. Specifically, the court held that Section 913(f) provided a “broad grant of permissive rulemaking” that “encompasses the best-interest rule adopted by the SEC.” The Second Circuit also found that Section 913(g), which encouraged the SEC to harmonize the standards applicable to broker-dealers and investment advisers, constituted a “separate” grant of rulemaking authority and did not limit the broad scope of Section 913(f).

Finally, the court found that Regulation Best Interest is not arbitrary and capricious. The Second Circuit held that the SEC “considered several thousand comments, explicitly rejected proposed alternatives, and concluded that the best-interest obligation ‘will best achieve the [SEC’s] important goals of enhancing retail investor protection and decision making, while preserving, to the extent possible, retail investor access (in terms of choice and cost) to differing types of investment services.’” The court dispatched the petitioners’ preference for a uniform fiduciary standard as a “policy quarrel dressed up as an APA claim.” It focused on the difference in the advice provided by investment advisers compared with that of broker-dealers (comparing advice that is ongoing with advice that occurs at the time of a recommendation). The court also found that the SEC balanced the benefits of a uniform standard of care against the significant compliance cost for broker-dealers that would translate into higher costs for retail customers. The court held that the SEC gave adequate reasons for electing to forgo harmony in favor of consumer choice and affordability, thereby precluding a finding that the regulation is arbitrary and capricious.

To read the decision in XY Planning Network, LLC, et al. v. SEC Commission, click here.

Why it matters

The Second Circuit has provided certainty, for now, with respect to the standard of conduct expected from broker-dealers, thereby eliminating any reluctance to adopt protocols implemented to comply with Regulation Best Interest. The Second Circuit did not opine about the wisdom of the policy of separate standards of conduct applicable to broker-dealers and investment advisers. We think this might be because broker-dealers and investment advisers are often not the same party, and therefore a heightened standard of care applicable to each is appropriate. 

However, the court found that the SEC sufficiently considered the cost to the retail consumer engendered by uniform standards. Thus, the SEC easily satisfied the highly deferential arbitrary and capricious standard applied to its rulemaking. Finally, the states will not be a factor with respect to any legal challenge regarding the lack of harmony of standards unless they can convince the Supreme Court that they have standing to challenge Regulation Best Interest.

It is important to remember that Regulation BI only applies to recommended securities by a broker-dealer. Much of the trading by retail investors through discount brokers and even some of the large brokers are characterized as “unsolicited” and are not specifically recommended. Furthermore, investment research broadly published by a firm, including recommended stocks, price targets, etc. are also not recommendations for purposes of Regulation BI. Regulation BI will expand the disclosures required for broker-dealer sales teams on new issues or follow-on offerings, and for wealth management teams in making explicit recommendations to clients in situations where the broker does not already have discretion to make trades.

1 Also as a result of Dodd-Frank, in June 2019, the SEC promulgated reforms to the Investment Advisers Act of 1940 in the form of “Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” Advisers Act Release 5248, available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf, which requires investment advisers to act with a fiduciary duty toward the client when advising them on the purchase of securities. An investment adviser must “at all times, serve the best interest of its client and not subordinate its client’s interest to its own.”



pursuant to New York DR 2-101(f)

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