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ANALYSIS: SEC Broker Conduct Standard Survives in 2nd Circuit

June 29, 2020, 4:49 PM

The Second Circuit upheld Regulation Best Interest (Reg BI), the SEC’s conduct standard for broker-dealers and investment advisers. The 2–1 decision came down from the court just days before the regulation’s compliance date of June 30, 2020. According to the panel, "[a]lthough Regulation Best Interest may not be the policy that Petitioners would have preferred, it is what the SEC chose after a reasoned and lawful rulemaking process.”

The Challenges to Reg BI

A group of states and the District of Columbia, along with an investment adviser group and an individual adviser, sued the SEC, claiming that the Dodd-Frank Act required the SEC to adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers. The petitioners additionally claimed that the SEC failed to properly consider the rulemaking under the Administrative Procedure Act (APA), by, among other arguments, not adequately addressing evidence of consumer confusion caused by the different standards.

The panel unanimously rejected the claims by the state plaintiffs on standing grounds. While states may challenge federal regulations if they can show “a direct injury in the form of a loss of specific tax revenues,” in this case, the state group failed to show an actionable injury. According to the court, the states “failed to establish a direct link between Regulation Best Interest and their tax revenues.”

A majority of the panel did find, however, that the named investment adviser had sufficient standing to pursue the claims.

Failure of Substantive and Procedural Claims

The appeals panel rejected both the substantive claims that the SEC lacked the authority to adopt Reg BI, and procedural arguments that it failed to comply with an appropriate review under the APA.

Initially, the court found that Section 913(f) of the Dodd-Frank Act authorized the rulemaking. The court described the section of the statute as a “broad grant of permissive rulemaking authority” which “encompasses the best-interest rule adopted by the SEC.” The court held that the Commission acted under the permissive grant of authority in Section 913(f). The fact that the following section, Section 913(g), allowed the SEC to establish a uniform fiduciary standard, did not require the agency to do so.

The court also rejected the adviser’s APA argument based on a lack of consideration of investor confusion. According to the panel, the SEC considered thousands of comments and explicitly rejected proposed alternatives in the adopting release. The court described the procedural challenge as “a policy quarrel dressed up as an APA claim.”

Circuit Judge Richard Sullivan authored a dissenting opinion. He stated that he agreed with the majority’s analysis of Reg BI and its rejection of the challenges on the merits. He dissented because he would have dismissed all claims on standing grounds without reaching the merits.

Compliance with Reg BI is Now Due

With the dismissal of this most significant court challenge to Reg BI, broker-dealers and investment advisers must comply with the regulation (and its companion rules) by June 30. SEC Chairman Jay Clayton stated in April that the agency would not be delaying the rules’ June compliance date due to the Covid-19 pandemic or other reasons.

The SEC’s Office of Compliance Inspections and Examinations and the Division of Enforcement will likely take an initial light touch, looking for good faith efforts and substantial compliance measures. Chairman Clayton stated in his April remarks that the agency and its staff will take “firm-specific claims of unforeseen circumstances” and related operational constraints and resource needs into account in the examination process.

Firms must be ready, however, and must be prepared to demonstrate to the agency that they have acted reasonably and diligently to meet Reg BI’s demands.

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