Seven US states and a fee-only financial planning platform are suing the US Securities and Exchange Commission for enacting an investment-advice rule that falls short of its statutory obligations and gives broker-dealers an unfair competitive advantage over investment advisors. All this comes in the aftermath of the defeat of the Department of Labour's Fiduciary Rule in the courts last year.

Early last year, the SEC proposed to overhaul the way in which it regulated broker-dealers and investment advisors. At the time, the Department of Labour’s Fiduciary Rule was still the law of the land and the SEC was under pressure to make its regulation resemble the DoL’s version and to close a long-denounced gap between the standards of conduct that apply to the 'suitability' of advice given by brokers and the 'fiduciary' advice of (registered) investment advisors.

The SEC's policy, then as now, was twofold: to oblige broker-dealers to act in the best interests of their clients when recommending products and strategies to them (thereby falling short of investment advisors' fiduciary obligations); and to oblige both broker-dealers and investment advisors to hand each client a new form at the beginning of the relationship that summarises services, fees, costs, conflicts of interest and the firm's disciplinary history.

XYPN's arguments

It is XYPN's belief that the SEC has exceeded its regulatory authority in the creation of Reg BI by permitting comprehensive financial planning services to be performed in connection with the sale of brokerage products without requiring the financial planner in question to register as an investment advisor and/or without fully subjecting such financial planning advice itself to a registered investment advisor's fiduciary duty.

Michael Kitces, a partner and the director of wealth management at the Pinnacle Advisory Group of Maryland and a co-founder of the XY Planning Network, argued at the time of the court decision against the DoL's Fiduciary Rule that the SEC was ignoring a part of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 that dictates that regulation for the financial advice that broker-dealers give clients should be no less onerous than regulation for the advice given by investment advisors.

He also thought that it was contravening the Investment Advisors Act 1940. On his blog a year ago he wrote: "[The Act] knowingly subjected broker-dealers to a lower standard than that of investment advisors specifically because brokers are not supposed to be in the business of advice (ongoing or episodic) in the first place, and were only permitted to provide advice to the extent that advice was/is 'solely incidental' to the sale of brokerage products and services. In other words, the problem is not that broker-dealers are giving advice without being subject to a fiduciary standard under FINRA regulation; the problem is that broker-dealers giving such advice are required to register as investment advisors, and if they did, they would already subject them to the fiduciary standard that applies to registered investment advisors, rendering the entire Regulation Best Interest proposal moot anyway!"

XYPN is therefore claiming that the SEC's creation of a 'best interest' rule for broker-dealers that is not actually a full fiduciary rule to act in the best interests of the client at all times is "anti-competitive to registered investment advisors who differentiate in the marketplace by their actual Best Interests commitment to consumers (and are actually held to such a standard)."

The Reg BI and Form CRS rules (the former is new rule 17 CFR 240.15l-1, made in accordance with the Exchange Act; the latter comes by way of amendments to rules 17 CFR 240.17a-3 and 17 CFR 240.17a-4) will become effective 60 days after their publication in the Federal Register and firms must be prepared to comply with them by 30 June 2020.

Enter seven attorneys-general

Seven US states – California, Connecticut, Delaware, Maine, New Mexico and Oregon – and the District of Columbia are suing the SEC on the same issue simultaneously. The application for declaratory and injunctive relief, lodged on 9 September (shortly before the XYPN lawsuit),  challenges the SEC's 'final' regulation. It says that the rule "undermines critical consumer protections for retail investors, increases confusion about the standards of conduct that apply when investors receive recommendations and advice from broker-dealers or investment advisers, makes it easier for brokers to market themselves as trusted advisors (while nonetheless permitting them to engage in harmful conflicts of interest that siphon investors’ hard-earned savings), and contradicts Congress’s express direction."

The SEC has long known that few retail investors are aware of the different standards that apply to broker-dealers and advisors; nor do they understand their legal implications. Maine, with the oldest population in the country, feels especially protective towards its citizens (HNW and otherwise) because it fears for the safety of their incomes in retirement.

In a section of the Dodd-Frank Act expressly entitled Authority to Establish a Fiduciary Duty for Brokers and Dealers, Congress authorised the SEC to promulgate rules that (a) make the standards of conduct that apply to broker-dealers and investment advisers the same and (b) call on all brokers, dealers and investment advisors, when providing personalised investment advice about securities to retail customers, to act in the best interest of customers without regard to their own interest. (Dodd-Frank Act ss913(g)(1), (g)(2), 124 Stat at 1828-29.)

Contrary to this delegation of authority, however — and despite the published recommendations of the SEC’s own expert staff — the states say that the rule neither equalises the standards nor requires broker-dealers to act in their customers’ best interests “without regard to” commercial advancement. They are therefore challenging the rule's validity.

They add in their submission: "The commission’s disregard for Congress’s directives in the Dodd-Frank Act will harm [the states] and their residents. [They] will lose revenue from the taxable portions of distributions from their residents’ investment and retirement accounts that are worth less because of expensive conflicts of interest in investment advice; [they] will bear a greater financial burden to assist retirees and others whose savings are insufficient to meet their needs due to conflicted investment advice; and the regulation will harm [their] strong quasi-sovereign interest in protecting the economic well-being of their residents."

The SEC's study

In the past, investment advisors provided advice in positions of trust and confidence and brokers provided arms-length sales recommendations. Both were regulated accordingly. Over time, brokers’ jobs blurred with advisors’ jobs, with brokers increasingly functioning as financial advisors without being regulated accordingly. A survey by the SEC in 2008 discovered the convergence of the two groups' activities for itself. This development has created confusion because investors rely on brokers’ recommendations as if those recommendations were trustworthy advice, when in fact they are often sales recommendations fraught with conflicts of interest.

As directed by the Dodd-Frank Act, the SEC conducted a study in 2011, reviewing more than 3,500 letters of comment, to evaluate the legal standards that applied to investment advisors and broker-dealers. It found that retail customers were indeed confused about the differing standards of care that the two groups had to observe and that this confusion was harmful to those investors. It therefore concluded that it should “exercise its rulemaking authority under Dodd-Frank Act s913(g), which permits the commission to promulgate rules to provide that the standard of conduct for all brokers, dealers and investment advisors [is] to act in the best interest of the customer without regard to [the brokers', dealers' or investment advisors'] financial or other interest." This is what the plaintiffs are accusing the SEC of not doing.

The eventual outcome of the litigation cannot be predicted, but the future for this issue as a whole is fairly clear. As Michael Kitces pointed out last year, in view of the growing pace of fiduciary regulation of financial advisors around the world (and indeed around the United States), some US federal fiduciary rule for advisors is likely to emerge sometime in the next few years, come what may.