States Sue the SEC to Stop Reg BI…My Initial Thoughts

As I fly home this morning* from the great State of New York, I have read the 38 page complaint filed by eight states against the SEC regarding Reg BI. People have been asking me for my initial impressions…so here they are in no particular order. 

1- The Attorneys General bringing the lawsuit are from New York, California, Connecticut, Delaware, District of Columbia, Maine, New Mexico, and Oregon.

2- The case has been filed in federal court in the Southern District of New York.

3- Could we see more cases filed in different courts? Maybe. Probably. Those fighting Reg BI could follow the game plan instituted by those who fought the DOL Fiduciary Rule and engage in what’s called “forum shopping” which means not putting all your hope in one court so multiple cases are filed in different courts the litigant believes may be friendly. The courts are almost always in different appellate circuits, again with an eye to the idea that the circuit may be friendly as well. It’s like buying multiple tickets to a raffle. Except there are rules against a single litigant filing the same claim in more than one court, so like minded parties get together and plan their strategy with some testing certain theories in one court and other theories in another court. 

4- Why do states even get a say in fighting a federal regulation published by a federal agency? The legal term for this is called “standing.” The simplest explanation is that the states have to show they may be harmed if Reg BI stays on the books. The following justification for standing is given in the lawsuit: “Among the harms they will suffer, Plaintiffs will lose 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; Plaintiffs will bear a greater financial burden to assist retirees and others whose savings are insufficient to meet their needs due to conflicted investment advice; and the regulation will harm Plaintiffs’ strong quasi- sovereign interest in protecting the economic well-being of their residents.”

5- The primary allegation by the states is that the Dodd-Frank statute authorized, and a subsequent study recommended, that broker-dealers and RIAs be subject to a uniform standard and that the standard be a fiduciary standard. It is undisputed the SEC declined to take this approach with Reg BI.

6- The states also take issue with Reg BI’s rejection of an overly prescriptive approach of a fiduciary standard and its alternative adoption of a best interest standard that largely pushes the work of creating a compliance and enforcement framework down to the individual firms: “In addition, although the Final Rule requires firm-level efforts to develop, maintain and enforce compliance policies to address potential conflicts of interests, these requirements provide no assurance that harmful conflicts will not taint broker-dealer advice. Instead, the Final Rule defers to firms to develop these policies, which will be judged against the vague and undefined “best interest” standard, amid a broader regime that permits almost all conflict of interest obligations to be satisfied through disclosure. 84 Fed. Reg. at 33,385, 33,491 (to be codified at 17 C.F.R. § 240.15l-1(a)(2)(iii)).”

7- An underlying aspect of the case is a complicated legal argument that Section 913 of Dodd-Frank required the SEC to act in a certain way (creating a uniform fiduciary standard) as opposed to whether they had discretion to act in the way that they did (not creating a uniform fiduciary standard). Fighting over the rules of rule making was also at the center of the strategy against the DOL Fiduciary Rule. It’s esoteric and complicated but will end up being the key to the final outcome. I don’t believe from what I’m reading the court will have to decide whether a fiduciary standard or best interest standard is better, although there will be a lot of ink spilled on that point. Instead the court will have to decide whether the SEC properly followed the rules of rule making in declining to adopt a uniform fiduciary standard. It’s nuanced but it’s an important nuance.

8- Finally, what do the states want? They want Reg BI “vacated” which essentially means stricken from the Federal Register as if never published, just like what the 5th Circuit did to the DOL Fiduciary Rule. They also want the SEC stopped from applying or enforcing Reg BI in anyway. 

So to all those in the industry who in good faith try and adhere to the rules, whatever they may be…this storyline is starting to feel familiar again. We’re going to have to walk and chew gum and therefore (1) do the hard work of getting ready for the effective date of Reg BI next year, (2) carefully monitor the outcome of this lawsuit and maybe more to come, (3) we are also supposed to see DOL Fiduciary Rule 3.0 proposed before the end of the year too, so the industry will also need to carefully analyze that proposed rule and submit detailed comment letters probably by late spring, and (4) don’t forget, actually provide the best service you can to your clients. 

Buckle up, the next 9 to 12 months are going to be interesting. 

*It is hard to believe 18 years have passed since 9/11/2001. In the desire that we never forget that day or the days that followed, I hope today can be one filled with acts of kindness and empathy for both others and yourselves.