In XY Planning Network, LLC, et al. v. SEC, et al., the United States Court of Appeals for the Second Circuit rejected a challenge to Regulation Best Interest brought by an organization of investment advisers, an individual investment adviser, seven states, and the District of Columbia. The Court denied the Petitioners’ petition, holding that: the individual investment adviser had standing but the states did not, that § 913(f) of the Dodd-Frank Act authorized the SEC’s promulgation of Regulation Best Interest, and that Regulation Best Interest is not arbitrary and capricious under the Administrative Procedures Act.
Historically, broker-dealers have owed only a “suitability” standard of care to their customers, less than the fiduciary standard for investment advisers. In 2019, the SEC adopted Regulation Best Interest, which imposes a “best-interest obligation” on broker-dealers, including a disclosure obligation, a care obligation, a conflict of interest obligation, and a compliance obligation. The Petitioners challenged Regulation BI, arguing that the Dodd-Frank Act required that the SEC adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers. The Second Circuit rejected this argument, holding that Regulation BI falls within the discretion granted to the SEC in the Act.
This ruling is important for at least two reasons. First, the opinion upholds the Security and Exchange Commission’s standard of conduct for broker-dealers providing investment services to retail customers Second, the Court provides guidance about standing under Article III of the Constitution for a petitioner to bring a petition for review under the Administrative Procedure Act.
Regulation Best Interest provides that broker-dealers owe their clients an aptly-named “best-interest obligation” in that they must “act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the [broker-dealer] . . . ahead of the interest of the retail customer.” See Regulation Best Interest, 17 C.F.R. 240.15l-1 (2019).
The Court found that the broker-dealer best-interest obligation was permissible under Dodd-Frank, relying on the “plain meaning” of the Dodd-Frank Act’s provision that provided SEC authorization to “address the legal or regulatory standards of care for brokers, dealers, [and] investment advisors…..” Section 913(f). Congress’s grant of authority, the Second Circuit held, was permissive, giving the SEC the authority to promulgate rules under the Dodd-Frank Act sections at issue (§§ 913(f) and 913(g)) or to choose not to make rules under those sections.
The case also addressed an important standing question. The Administrative Procedure Act provides a method for challenging SEC regulations. The Petitioners in XY Planning were an organization of investment advisers, an individual investment adviser, seven states, and the District of Columbia. The investment adviser petitioners argued that the Regulations Best Interest would make it difficult for them to attract customers. And the state petitioners argued that Regulation Best Interest would diminish their tax revenues from investment income because broker-dealers could provide conflicted investment advice to customers – something that would be prohibited under the fiduciary standard. Because the investment adviser petitioners could show that they currently highlight investment advisers’ fiduciary duty to clients, there was sufficient risk of damage for standing. It’s worth noting that the dissent, however, wrote that the investment advisers did not have standing because invalidating Regulation Best Interest would “leav[e] broker-dealers with even fewer obligations and a more pronounced competitive advantage over investment advisers.”
In contrast, the states did not have standing because there was no direct link between Regulation Best Interest and their tax revenues. The Court’s reasoning highlights the difficulty that states will have when challenging future SEC regulations. The implication of the Court’s ruling cast a wide net: think carefully about standing issues before challenging an SEC regulation.
Finally, the Court held that Regulation Best Interest was not arbitrary and capricious under the APA. Petitioners argued that the regulation relies on an incorrect interpretation of the broker-dealer exemption to the IAA and the SEC had failed to adequately address evidence of customer confusion. The Second Circuit rejected these arguments, finding that the SEC had “carefully considered a fiduciary rule based on its findings that the fiduciary duties owed by investment advisers are ‘not appropriately tailored to the structure and characteristics of the broker-dealer business model.'”
This decision was a big win for the SEC and a disappointing blow to investment advisers. Regulation Best Interest has survived a serious challenge in the Second Circuit, and it remains to be seen whether the Petitioners will seek and obtain further appellate review.