Appeals Court Upholds SEC Regulation Best Interest
Retail investors received a major win June 26, 2020 as the Second Circuit Court of Appeals upheld the SEC’s Regulation Best Interest, just days before the June 30, 2020 compliance date. Reg BI establishes a “best interest” standard of conduct for broker-dealers when making recommendations to retail customers, replacing the outdated “suitability” standard.
Almost immediately after the SEC adopted Reg BI, a suit was filed against the Commission to challenge the regulation. Seven states and the District of Columbia, an investment adviser group, and an individual advisor alleged that the SEC exceeded its authority under the Dodd-Frank Act and acted improperly under the Administrative Procedure Act by failing to address evidence of consumer confusion about the new standards.
The Court found that the state plaintiffs lacked standing to pursue their claims because they failed to show “a direct injury in the form of a loss of a specific tax revenue” linked to the regulation. Only the claim by the named investment advisor survived a standing challenge and was able to proceed through the Courts.
Furthermore, the Court upheld that the SEC was authorized to promulgate and adopt the rule under Section 913(f) of Dodd-Frank’s grant of broad rulemaking authority. Section 913(g)’s allowance for a uniform standard between broker-dealers and investment advisors in no way required the SEC to establish such a rule – as the Plaintiffs incorrectly claimed it did. Therefore, the standard in Regulation BI is permissible even though it is not identical to the standard for investment advisors. The goal was to raise the bar for broker-dealers and harmonize their standard with other industry professionals while recognizing that each financial professional operates differently.
Finally, the Court found that the SEC did not violate the APA based on the consideration of thousands of public comments and examining the views of interested investors in their final rule. SEC comment letters are a staple of communication between the Commissioners and the investment community they are tasked to serve. Regulation BI was met with the same level of public comment as the SEC typically elicits. The Commission members consult comments and examine rule-making measures with investor protection in mind.
Regulation BI holds broker-dealers to a higher standard that the industry has seen. Because broker-dealer status is tied to commission-based compensation, retail clients were left vulnerable to “suitable” recommendations that helped boost their broker-dealer’s income. Now, broker-dealers must only recommend investment options that are in the best interest of their client.
This regulation increases transparency, trust, and due diligence to protect retail investors more than ever. Main Street investors can now feel secure that the recommendations they receive are truly for their best benefit and that their interests are not taking a backseat to those of their financial professional.
Broker-dealers and investment advisors must now be ready to comply with the regulation by the original June 30 compliance date. While the Commission confirmed that the compliance date due to the COVID-19 pandemic, it is expected that the Commission will be initially satisfied with good faith efforts and substantial compliance practices.