In a very unusual lawsuit, attorneys general from seven states and the District of Columbia recently sued the SEC, and its chair, Jay Clayton, for declaratory and injunctive relief seeking to block the effectiveness of Regulation Best Interest (Regulation BI), the recently adopted standard of conduct applicable to broker-dealers doing business with retail customers. The plaintiffs in the case are the states of New York, California, Connecticut, Delaware, Maine, New Mexico, and Oregon, and the District of Columbia. The case was filed in federal court in the Southern District of New York. The attorneys general argue that the SEC was required to impose a higher standard, a fiduciary standard of behavior on broker-dealers doing business with retail investors. They also said that because Regulation BI does not impose fiduciary duties on broker-dealers, the SEC’s rule violates Congressional authority.

Best Interest vs. Fiduciary Duty

Regulation BI was finally approved in 2019, and unless barred by a court, will go into effect in 2020. Regulation BI imposes a standard of conduct on broker-dealers that is lower than a fiduciary standard. Presently, investment advisers are subject to the fiduciary standard, which is the highest duty an investment professional owes to its client. This means, in essence, the adviser must always put the clients’ interest ahead of the adviser, and any conflicts of interest must be prominently and conspicuously disclosed.

Regulation BI requires a broker-dealer working with retail investors to act in the best interests of the client. This is not a fiduciary standard but is a higher standard than suitability. Suitability is the current standard that applies to broker-dealers working with retail investors. Suitability only requires broker-dealers to recommend suitable investments to retail clients.

The States Argue Regulation BI Does not Go Far Enough and Violates Dodd Frank

The states and the District of Columbia argue that Regulation BI does not go far enough to police harmful conflicts of interest that broker-dealers have when providing investment advice to retail clients. The SEC chose not to impose a fiduciary duty on broker-dealers who work with retail clients. The SEC adopted Regulation BI with a new standard it called “best interest” obligation, which requires a broker-dealer to act in the best interest of a retail customer without placing his or her financial interest ahead of the retail customer. Regulation BI also imposes a disclosure obligation on broker-dealers to disclose the capacity in which the broker-dealer is acting.

The states and the District of Columbia contend that the SEC rule violates federal law because when Congress enacted Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd Frank), Congress authorized the SEC to do a study on standards of conflicts and then promote a rule that harmonizes the standards of conduct applicable to broker-dealers and advisers, and creates a standard for brokers, dealers and investment advisers providing personalized investment advice to retail customers; the rule should say these professionals must act in the best interest of customers without regard to their own personal interests. The SEC conducted the study but did not adopt a fiduciary standard for broker-dealers.

The states and the District of Columbia further argue that although Regulation BI does require the broker-dealer to place the financial interests of the retail customer above their own financial interest, it does not require that a broker-dealer act without regard to their own financial interest. The states argue the rule does not comply with Congressional statutory authority and should be enjoined.

The SEC’s Likely Response

The SEC has not filed an answer or moved to dismiss. The SEC will likely argue that the Section 913(f) of Dodd Frank does not require the SEC to adopt a fiduciary standard but merely requires the SEC to study the issue and adopt a rule of behavior after the study.

At this complaint stage, it is too early to tell whether a judge will block Regulation BI. It is likely that the SEC and Chair Clayton will vigorously defend this claim. It could take many years to resolve this claim. This case shows continuing hostility from some public officials toward the financial services and investment management industry.