By Amanda Maine, J.D.
In an opinion issued on Friday evening, a Second Circuit panel held that the Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest and that the SEC’s action was not arbitrary and capricious under the Administrative Procedure Act. The court’s decision comes just days before the rule’s June 30 compliance date (XY Planning Network, LLC v. SEC, June 26, 2020, Park, M.).
Regulation Best Interest. The Commission approved Regulation Best Interest (Reg BI) in June 2019 by a vote of three-to-one. Reg BI imposes a “best interest obligation” on broker-dealers, requiring them to act in the best interest of a retail customer at the time a recommendation is made. The best interest obligation is distinguished from the fiduciary duty imposed on investment advisers by the Investment Advisers Act. While the Commission did consider a uniform fiduciary standard for both broker-dealers and investment advisers, it ultimately rejected it, explaining in the adopting release that a one-size-fits-all approach would risk reducing investor choice.
Two groups consisting of an investment adviser interest group, XY Planning Network LLC (XYPN) and its member firm Ford Financial Solutions; and a group of states and the District of Columbia, challenged the legality of Reg BI, arguing that Section 913 of the Dodd-Frank Act requires the SEC to adopt a rule holding broker-dealers and investment advisers to the same fiduciary standard. The SEC asserted that the language of Dodd-Frank grants broad permissive rulemaking authority to implement Section 913, including Regulation Best Interest. A Second Circuit panel heard oral arguments on June 2.
Standing. The appellate panel first dispensed with standing arguments, finding that the state petitioners lacked standing to challenge Reg BI. The state petitioners had argued that Reg BI would diminish their tax revenues from investment income by allowing broker-dealers to provide conflicted advice to customers, which would be prohibited under a uniform fiduciary standard. The court was not convinced, finding that the state petitioners had not shown a direct link between Reg BI and their tax revenues and describing their argument as “too attenuated and speculative” to support standing.
However, the court found that XYPN and Ford Financial Solutions did establish Article III standing. Ford Financial had argued that Regulation Best Interest would create a significant risk that clients would not be able to differentiate Ford Financial’s fiduciary duty from the lower duty that broker-dealers owe their clients, harming Ford Financial’s ability to attract customers. By identifying an impairment to a specific business practice, Ford had made a concrete showing that it is likely to suffer financial injury, which is enough to show competitor standing, according to the court.
Legality of Reg BI under Dodd-Frank. The court then turned to the heart of the matter: whether the Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest. At focus was the language in Section 913(f) stating that the SEC “may commence a rulemaking…to address the legal or regulatory standard of care” for broker-dealers. Dodd-Frank Section 913(g) states that the SEC “may promulgate rules to provide that, with respect to [broker-dealers], when providing personalized investment advice about securities to a retail customer…the standard of conduct for such [broker- dealers]…shall be the same as the standard of conduct applicable to an investment adviser.”
XYPN and Ford Financial had argued that Section 913(g) of the Dodd-Frank Act requires the SEC to adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers. The court pointed to what it called the key language in each of the provisions: the use of the word “may.” According to the court, this language gives the SEC broad permissive rulemaking authority, including the authority to promulgate Regulation Best Interest. Rather than narrowing the scope of Section 913(f) as the petitioners argued, Section 913(g) simply provides a separate grant of rulemaking authority. Congress gave the SEC the authority to promulgate rules under either section or even to make no rule at all, the court declared.
The court also pointed to the discretionary language in Section 913(f) that allows the SEC to act “as necessary and appropriate in the public interest” to address the legal standards of care. This language further demonstrates that that Congress delegated broad, discretionary authority encompassing the promulgation of Reg BI, according to the court. Finally, the court dismissed the petitioners’ argument that Section 913(f) is a procedural authorization and only Section 913(g) provides substantive content for any such rulemaking. This approach would render meaningless the substantive portions of Section 913(f) that follow the broad grant of rulemaking authority, according to the court.
“Although 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 court stated.
Not arbitrary and capricious. Finally, the court rejected the petitioners’ contention that Regulation Best Interest is arbitrary and capricious. They first argued that Reg BI is based on an incorrect interpretation of the “solely incidental” and “special compensation” prongs of the broker-dealer exemption from the Investment Advisers Act. The court stated that the petitioners had failed to explain how the SEC’s interpretation of the broker-dealer exemption made Reg BI “arbitrary, capricious, or otherwise not in accordance with law.”
The petitioners had also argued that the rule is arbitrary and capricious because the SEC did not address evidence that consumers are not meaningfully able to differentiate between the broker-dealer and investment adviser standards. The court pointed out that the SEC had considered evidence of consumer confusion and found the benefits of decreased costs and consumer choice favored adopting a best interest obligation for broker-dealers. The court observed that the SEC considered several thousand comment letters and rejected proposed alternatives in concluding that the best interest standard will best achieve its goals. This decision, said the court, was not arbitrary and capricious.
“Petitioners’ preference for a uniform fiduciary standard instead of a best-interest obligation is a policy quarrel dressed up as an APA claim,” the court remarked.
Having found that the Dodd-Frank Act authorized the SEC to promulgate Regulation Best Interest and that it was not arbitrary and capricious, the court denied the petition for review.
Dissent on standing. Judge Sullivan, concurring in part and dissenting in part, agreed with the court’s reasoning on rejecting the petitioners’ challenge on the merits and the states’ lack of standing, but stated that he would have dismissed both petitions in their entirety because, in his view, the investment advisers also lacked standing to challenge Reg BI. According to Judge Sullivan, the impairment of a marketing tactic based on a competitor’s characterization of a government regulation does not rise to the level of a legally cognizable injury-in-fact for standing purposes. Ford Financial had not demonstrated a “concrete, particularized, and actual or imminent injury,” and thus lacked standing to challenge Reg BI, he advised.
Clayton reaction. In a tweet posted to the SEC’s Twitter account on Friday night, Chairman Jay Clayton stated: “We welcome today’s decision by the Second Circuit upholding Regulation Best Interest. As of next Tuesday, whether they choose to work with a broker-dealer or an investment adviser, Main Street investors will be entitled to recommendations and advice in their best interest—the financial professional cannot put its interests ahead of the investor.”
The case is No. 19-2886-(ag)L.