On June 9, 2019, six states and the District of Columbia filed a lawsuit against the U.S. Securities and Exchange Commission (SEC) over a final rule issued by the SEC. Although this isn’t the first time a state or group of states sued the SEC, it’s not a common occurrence either. What triggered this lawsuit is an issue that is of vital importance to virtually every investor in the United States—what is the duty owed to a customer by a broker-dealer, and how is that duty different from that owed by an investment adviser?
What is Fiduciary Duty? A Background
To put this debate into context, until the last few decades, the roles of brokers and advisers were separate. Brokers made recommendations of particular investments. In contrast, advisers worked with customers to evaluate their investment needs, plan for the future, and implement investment strategies. The law recognized brokers as salespeople, and required only that the recommendation be suitable based on the customer’s investment profile. In contrast, the law recognized that advisers are in a position of trust and confidence and, accordingly, bestowed upon them a fiduciary duty requiring that they always act in the customer’s best interest. So, for example, an adviser has a fiduciary duty to monitor a customer’s account, whereas a broker generally owes no such duty.
This legal distinction worked well for a while; that is, until the roles of brokers and advisers began to blur. The emergence of brokers calling themselves “financial advisers,” fee-based brokerage programs, and online advisory services has muddled the differences between brokers and advisers to the point that the vast majority of investors don’t know whether their financial professional is a broker or an adviser, and what duties align with each. (To make this point, if you have a financial professional, go to the “brokercheck” database at www.finra.org and type in the name of your professional to see the type of license he or she holds. The answer may surprise you.)
Congress Comes to the Rescue (Sort of)
In an attempt to address the differing standards of conduct for broker-dealers and investment advisers, Congress passed the Dodd-Frank Act in 2010, which, in part, mandated the SEC to conduct a study to evaluate “the effectiveness of existing legal or regulatory standards of care for brokers and … investment advisers,” and also provided the SEC with rulemaking authority to promulgate rules regarding those standards of conduct.
In addition, Congress in the Dodd-Frank Act provided specific language for the SEC to use in the new rule, including providing the standard of conduct for all brokers, dealers and investment advisers, “when providing personalized investment advice about securities to retail customers, to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”
In other words, Congress mandated the SEC to conduct a study, and then authorized the SEC to write rules based on the finding of the study. While Congress didn’t mandate that the SEC write the rules, it did include specific language to be used if the SEC chose to do so, language that includes, essentially, the same standard of care for both brokers and advisers.
The SEC Conducts the Study and Issues the Rule (Well, yes, but …)
The SEC conducted the study mandated by Dodd-Frank and published that study in January 2011. Not surprisingly, the study concluded that retail customers “do not understand and are confused by … the standards of care applicable to investment advisers and broker-dealers … ” and recommended that the SEC issue a rule providing the standard of conduct for all broker-dealers and investment advisers “shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”
Eight years later, on June 5, 2019, the SEC published the Final Rule, titled “Regulation Best Interest,” in which the SEC declines to “subject broker-dealers to a wholesale and complete application of the existing fiduciary standard under the Advisers Act.” Instead, Regulation Best Interest establishes a “best interest obligation,” requiring that a broker or dealer, “when making a recommendation of any securities transaction or investment strategy involving securities … to a retail customer, shall 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 or dealer] ahead of the interest of the retail customer.” (https://www.sec.gov/rules/final/2019/34-86031.pdf)
The devil is indeed in the details. Section 913 of Dodd-Frank and the SEC study set forth a traditional fiduciary duty—the broker-dealer shall act in the best interest of the customer without regard to the financial or other interest of the broker. In other words, brokers must put aside their own financial interests. Regulation Best Interest waters that standard down somewhat to “shall act in the best interest of the customer … without placing the financial or other interest of the [broker or dealer] ahead of the interest of the retail customer.” Brokers, therefore, need not put aside their financial interests; instead, they just need to make sure those interests are not put ahead of the customer’s interests.
The States Take Action
That distinction did not go unnoticed. Six states (New York, California, Connecticut, Delaware, Maine, and New Mexico) and the District of Columbia filed the lawsuit to vacate the rule in the U.S. District Court for the Southern District of New York, claiming in part that Regulation Best Interest fails to comply with Section 913 of Dodd-Frank and leaves investors in a more vulnerable position because the “best interest” language exacerbates investors’ mistaken belief that broker-dealers must put aside there own financial interests and actually do what is best for investors.
If you’re wondering how these states have “standing” to file the lawsuit, in other words, how have they suffered an “injury,” the states point to the loss of tax revenues from the taxable portions of distributions from investment accounts that have diminished in value as a result of conflicted advice caused by Regulation Best Interest. (The White House Council of Economic Advisers estimates that investors receiving conflicted advice earn approximately one percentage point lower each year, amounting to about $17 billion a year.)
What You Can Do
Be aware that titles such as “financial adviser,” “financial professional,” “investment professional,” and the like are meaningless when it comes to what duty is owed to you. If your financial adviser is an “investment adviser” or “investment adviser representative,” he or she owes a fiduciary duty to you and must always act in your best interest. If your financial adviser is a “broker-dealer agent” or “broker-dealer representative,” he or she generally does not owe you a fiduciary duty and is only required to make “suitable” investment recommendations (and is not required to monitor your account). Even under the new Regulation Best Interest, a broker may be allowed to recommend a higher-fee, lower-quality investment even when a higher-quality and lower-fee investment is available. Keep in mind, however, that some courts have imposed a fiduciary duty on broker dealers and agents under certain circumstances.
Always look your financial adviser up on FINRA’s BrokerCheck to see what licenses and disciplinary history he or she has, if any. The license will tell you what standard of care is owed to you as the customer.
If you have any concerns about your investments, please contact the Law Office of Scott Lane for a no-cost, no-obligation evaluation of your specific facts and circumstances. You may have a viable claim for recovery of your investment losses by filing an arbitration claim with FINRA.