The Second Circuit is currently reviewing actions challenging the SEC’s Regulation Best Interest (Reg BI) rulemaking brought by seven states, the District of Columbia (state plaintiffs) and two investment advisers (adviser plaintiffs). The plaintiffs originally filed separately in the U.S. District Court for the Southern District of New York, but that court found that a U.S. Court of Appeals was the proper forum because the petition reviewed an agency action.
Briefs filed by both the state and adviser plaintiffs argue that the adoption of the regulations violated the Dodd-Frank Act grant of rulemaking authority, and that the agency arbitrarily disregarded evidence that retail investors did not understand the distinctions between the different investment professionals even after receiving disclosure documents. An amicus brief (congressional brief) filed by current and former members of Congress (including former Sen. Chris Dodd and Former Rep. Barney Frank) made a similar argument that the Dodd-Frank Act required the SEC to harmonize the standard of conduct between broker-dealers and investment advisers.
Despite the impressive list of authors of the congressional brief, including the namesakes of the authorizing legislation, and the compelling arguments made by the plaintiffs, the likelihood of success on the merits is slim. This is a textbook case for the application of Chevron deference, where courts refrain from substituting their judgment for that of the agencies charged with the execution of an ambiguous statute. While some federal courts (and Supreme Court justices) have taken shots at administrative deference, an agency rule that the financial industry and the business community strongly support makes a suspect test case for narrowing the Chevron doctrine.
Broker-dealers should expect that the Reg BI rulemaking package will become effective as scheduled in June 2020. The SEC’s Office of Compliance Inspections and Examinations (OCIE) announced that its 2020 broker-dealer examinations “will focus on issues relating to the preparation for and implementation of recent rulemaking.” It is no secret what new rulemaking OCIE is referencing. Some firms may hope that the state litigation could be that major snowstorm the night before term papers are due in school in terms of their Reg BI compliance preparation, but the word to the wise is to be ready and assume that school will be open bright and early in June 2020.
The Statutory Authorization Argument
The state plaintiffs, along with the advisory firms, argue in their briefs that under Section 913 of the Dodd Frank Act, the SEC could choose not to act, or they could adopt a broker conduct standard that is the same as the fiduciary threshold applicable to investment advisers. The Commission could not, however, according to the adviser plaintiffs, “create a new, different standard of conduct governing broker-dealers providing personalized investment advice.” As described by the plaintiffs, Reg BI creates “a complicated new regulatory scheme for broker-dealers with a variety of unique obligations, completely separate from the standards governing investment advisers,” and accordingly, falls outside the statutory grant of rulemaking authority.
This question will turn upon the court’s interpretation of two subsections of the Dodd-Frank Act. The first, Section 913(f), provides that “The Commission may commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers (and such other customers as the Commission may by rule provide), to address the legal or regulatory standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers for providing personalized investment advice about securities to such retail customers.” The second, Section 913(g), authorized the SEC to “promulgate rules to provide that, with respect to a broker or dealer, when providing personalized investment advice about securities to a retail customer (and such other customers as the Commission may by rule provide), the standard of conduct for such broker or dealer with respect to such customer shall be the same as the standard of conduct applicable to an investment adviser under section 211 of the Investment Advisers Act of 1940.”
According to the Commission, these are two distinct statutory grants of authority to act. Section 913(f), in the Commission’s view, is a general grant of authority that is both “express and broad.” This section, claims the Commission, does not require the adoption of the same standard applicable to investment advisers as set forth in Section 913(g). As stated by the SEC in the adopting release, “the availability of overlapping, yet distinct, rulemaking power under Section 913(g) does not negate the grant of authority under Section 913(f).”
The plaintiffs reject this position. According to the adviser plaintiff’s brief, if the SEC position was valid, “there would be no reason for Section 913(g) of the Act to exist.” If Section 913(f) did give the SEC general authority to regulate the standard of care more broadly, then the specific powers granted in Section 913(g) would be redundant, according to the advisers. In the brief filed by the state plaintiffs, these plaintiffs also rejected the Commission’s reliance on Section 913(f). According to the brief, Section 913(f) conferred general rulemaking authority on the SEC, in connection with the statutorily-mandated study under Section 913(b). The state plaintiffs added that “it is Section 913(g), and the provisions of the Advisers Act that it incorporated and reinforced, that provide the substantive standards for the Commission to follow in promulgating a rule.” When “read in context and with a view to its place in the overall statutory scheme,” the state plaintiffs concluded that the Dodd-Frank Act did not authorize the Reg BI rulemaking.
The congressional brief made a similar argument as the state plaintiffs. Section 913(f) provides the SEC with the authority to “commence a rulemaking.” The members of Congress argued, however, that Section 913(f) must be read in conjunction with Section 913(g). The latter section imposes specific limits on the SEC’s rulemaking authority, concluded the congressional brief, and according to the brief, effectively prohibits the adoption of the standard chosen by the SEC. According to the congressional brief, the rulemaking “violates Congress’ mandate in Section 913, which required that any rule promulgated to address the inconsistent standards of care between investment advisers and broker-dealers must harmonize those standards of care.”
The Arbitrary and Capricious Claim
The petitions also claimed that the regulatory action was an unreasonable response to the evidence presented to the SEC. Accordingly, the SEC failed to comply with the Administrative Procedure Act requirement to engage in reasoned rulemaking. The adviser plaintiffs claimed that the SEC “failed to reasonably account for the significant evidence that consumers are not meaningfully able to differentiate between the standards of conduct owed by broker-dealers and investment advisers even with the assistance of disclosure forms.” The adviser plaintiffs asserted that “specific evidence casts doubt on consumers’ ability to understand the differences between the standards of conduct, both before and after the disclosures required by rule.” Disclosure alone does not effectively solve the problem, concluded the advisers.
According to the state plaintiffs, the “ineffectual standard of conduct adopted in the Final Rule leaves investors vulnerable to the same harms that Congress, the 913 Study , and the Commission itself sought to remedy.” The state plaintiffs concluded that the rulemaking was arbitrary and capricious because the Commission conclusion that the rule enhanced investor protection “runs counter to the evidence before the agency.”
The Chevron Question
The action appears to present a textbook case for the court to give Chevron deference to the agency position. The SEC is the agency charged with interpreting the Exchange Act and the Dodd-Frank Act. The statutory provisions do appear to be ambiguous, as it is not clear whether Section 913(f) is a standalone grant of rulemaking authority or whether it must be read in tandem with Section 913(g). The adoption of Reg BI also does not appear unreasonable on its face, as the Commission produced nearly 800 pages of supporting arguments for their action. While it is not hard to disagree with the SEC action, it is difficult to argue that this was not reasoned rulemaking.
The plaintiffs and the congressional brief make compelling arguments that the SEC misread Section 913. I for one find it difficult to argue with the congressional brief’s assertion that “there was no reason for Congress to include a specific standard of care in Section 913(g) if Congress’ plan were to grant the SEC the power to promulgate any standard of care for broker-dealers under Section 913(f).” It is obviously irrelevant what I think, but this also appears to be a case where what the federal courts think is likely irrelevant. The question is not whether the SEC got it right. Rather, the question is whether the agency’s interpretation was a “permissible construction” of the statute. In this case, it is doubtful that an appellate panel will substitute its judgment for that of the SEC and find the rulemaking to be unreasonable.
Admittedly, judges and commentators have criticized the notion of Chevron deference recently. For example, when he was on the Tenth Circuit, then-Judge Gorsuch called Chevron deference “no less than a judge-made doctrine for the abdication of the judicial duty.” It is unlikely, however, that Chevron deference would fall over a rule that is widely supported by the financial services industry and the business community. For example, a senior official at the U.S. Chamber of Commerce stated that “ the benefits of Reg BI to the capital markets are abundantly clear, and there is little doubt that investors are better off today than they were before the rule was finalized and went into force.” Similarly, the Securities Industry and Financial Markets Association, the trade group representing broker-dealers, added that “it is undeniable that this rule will directly enhance investor protection and contribute to increased professionalism among financial service providers.”
Another test case will come, and the idea of judicial deference to administrative interpretations may well be relegated to history. In this case, however, the doctrine of Chevron deference will in all likelihood survive challenges to Reg BI.
The plaintiffs and others challenging Reg BI make compelling arguments that might well prevail on a level playing field. In this instance, though, it is likely that the Second Circuit, and then the U.S. Supreme Court, will grant a high degree of judicial deference to the SEC and uphold the rules. A decision in the case will likely come down near the June 2020 compliance date, and OCIE has announced that Reg BI preparedness will be a major point of emphasis in broker-dealer compliance examinations. Broker-dealers are advised to begin preparations for the new requirements as soon as possible. While the Commission will likely take a light touch with regard to initial enforcement of Reg BI compliance, OCIE will be looking for real progress by broker-dealers toward satisfying their new conduct standard obligations.