For more than a decade, regulators have been wrestling with raising investment advice standards. That struggle won’t end when the Securities and Exchange Commission’s reform package is implemented in June.
Sometime between now and then, one or more states are likely to jump into the fray by promulgating their own final fiduciary duty regulations. At that point, uncertainty will once again cloud the advice landscape.
One thing is almost certain — the financial industry will challenge the state regulations in court. When that happens, it could set the stage for sorting out who is in charge of advice rules — the SEC or states — or how they will be able to combine their efforts.
Massachusetts and New Jersey are closing in on final rules that would require all financial advisers in those states to adhere to a fiduciary duty, a standard that now applies to investment advisers.
The SEC’s Regulation Best Interest — the centerpiece of the agency’s advice reform — is designed to raise the broker standard above the current requirement of suitability. Under the SEC rules, investment advisers would continue to be governed by fiduciary duty.
The states are moving ahead with their own rules because they assert that Regulation Best Interest does not go far enough to protect investors. Brokerages insist that Reg BI is tough enough and that allowing states to do their own thing would create a patchwork of regulations that would substantially increase compliance costs and limit the advice market.
In its rule-making package, the SEC did not say whether its regulations should preempt those of individual states.
Now that question is likely to be addressed in court, as Reg BI faces two lawsuits that have been filed by state attorneys general and by a network of investment advisers. If it withstands the legal challenge, Reg BI will be implemented June 30.
By that date, lawsuits against state rules could be underway.
One question that could arise: Does the National Securities Markets Improvement Act of 1996 make Reg BI the only advice standard in the land? Another possible question: Are state rules, and how they define a broker’s ongoing duty to a customer, in conflict with the SEC’s interpretation of the section of the Investment Advisers Act that exempts brokers from registering as advisers?
“There is no precedent for these issues,” said Anya Coverman, senior vice president of government affairs and general counsel at the Institute for Portfolio Alternatives. “It has never come to a head, and a legal challenge would certainly break new ground.”
In 2011, a federal appeals court addressed the so-called “solely incidental” prong of the Investment Advisers Act that allows brokers to provide some advice without becoming investment advisers. The case, Thomas v. Metropolitan Life Insurance Co., centered on a broker who allegedly failed to disclose incentives to sell proprietary products.
But the potential litigation over state advice rules would venture into new areas. Kevin Walsh, a principal at Groom Law Group, said lawsuits could center on whether state securities regulations must complement national law or can conflict with it.
“It’s a little bit different than the cases we’ve seen before in the securities setting,” Mr. Walsh said. “When this does get litigated, it will be a big deal; the states can’t adopt rules that require noncompliance with federal rules.”
No state rule has become final yet, and trade associations representing brokerages are being coy about their next steps. Everyone is anticipating lawsuits.
“We really need clarification that this SEC national rule is the only rule that folks need to focus on,” said Christopher A. Iacovella, chief executive of the American Securities Association. “We’ll discuss options. Everything’s on the table.”
The states were girding for a court battle from the moment they began drafting their rules, said Barbara Roper, director of investor protection at the Consumer Federation of America.
“That’s not just a likelihood, it’s an inevitability,” Ms. Roper said of lawsuits. “States knew they would face a legal challenge from the industry.”
The basis of that challenge was laid out in comment letters sent to Massachusetts Secretary of the Commonwealth William Galvin regarding his fiduciary proposal.
The Securities Industry and Financial Markets Association asserts that the Massachusetts rule would require brokers to keep additional books and records to prove that they are complying with the measure. Under NSMIA, states cannot promulgate rules that force brokers to add to their record keeping.
In a Jan. 6 comment letter, SIFMA Chief Executive Kenneth E. Bentsen Jr. argued that the Massachusetts rule would trigger an ongoing fiduciary duty in brokerage accounts. Under Reg BI, the broker standard of conduct applies only at the time of recommendation.
Mr. Bentsen also said that the Massachusetts rule’s requirement that brokers make recommendations “without regard to” their own or their firms’ financial interest are different from the duty of loyalty contained in Reg BI.
“Thus, any state regulations that impose new or different standard-of-conduct requirements on B-Ds, including those enumerated above, which would require new supervision obligations and compliance procedures, would in turn trigger new or different record-keeping obligations, which would in turn be subject to express federal preemption under NSMIA,” Mr. Bentsen wrote.
Mr. Galvin declined to comment on the regulation while Massachusetts is in the rule-making process.
The North American Securities Administrators Association, the group representing state regulators, defended the Massachusetts rule in its own comment letter.
“Through the rule proposal, [Massachusetts] is exercising its legitimate authority on behalf of the citizens of Massachusetts to regulate securities activities in the state,” Christopher Gerold, NASAA president and chief of the New Jersey Securities Bureau, wrote in a Jan. 7 letter. “As long as the rule proposal does not conflict with federal law — and it does not — it is merely another manifestation of the American system of governance.”
Mr. Gerold also declined to comment on the New Jersey rule while that state is in its rule-making process.
Michael Pieciak, Vermont commissioner of financial regulation and former NASAA president, said the Massachusetts regulation does not center on books and records but rather focuses on how brokers interact with their clients — an area in which there are no NSMIA restrictions on a state.
“States know they’re on firm footing when it comes to regulating conduct,” Mr. Pieciak said. “When you start taking away that ability, you’re handcuffing [state] regulators in a way that’s not good for the investing public. Each state should have the ability to protect their investors as they see fit.”
If brokers believe they need to keep more records to comply with the Massachusetts regulation, they are doing so voluntarily, Ms. Roper said. Arguing that it’s a mandate and that it should trigger preemption goes too far. “
That would be a great overreach, but it hasn’t been decided in court yet,” she said.
Ms. Roper was involved with the debate over NSMIA more than 20 years ago and said Congress always intended for states to maintain a wide latitude in regulating brokers. “Rule-making in this area clearly falls within the scope of state authority Congress sought to preserve,” she said.
Brokerages should be able to adjust to multiple advice standards — one from the SEC, and others from states — because California and Georgia already hold brokers to a fiduciary standard imposed by a couple of court cases, Mr. Pieciak said.
He also said the Massachusetts and New Jersey rules are “more similar than dissimilar” and that other states will likely follow their lead if they choose to craft their own standards. The compliance burden on firms would be manageable, Mr. Pieciak said.
But Robin Traxler, senior vice president for policy and deputy general counsel at the Financial Services Institute, said that if states go their own way on advice standards, it will sow chaos and raise compliance spending.
“If the states start to create their own standards, it makes it difficult for our members to understand what their compliance obligations are,” Ms. Traxler said. “It becomes very confusing for advisers and investors as well. It would only make doing business in those states more costly.”
Sometime over the next few months, the question of whether states can create their own standards is likely to be argued in a courtroom.
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