Litigation Against the SEC’s Regulation Best Interest? Not Surprised

Contributor Scott Simon details two recent lawsuits filed against the SEC related to regulation best interest.

W. Scott Simon

 

I really thought that last month’s column would be my final one–at least for now–concerning Regulation Best Interest, or Reg BI, which was issued by the U.S. Securities and Exchange Commission on June 5.

That column concluded by calling for the demise, sooner rather than later, of Reg BI: “[I]n my view, some body with the appropriate standing should sue the SEC forthwith in order to jettison Reg BI for the great mistake it is. In 2007, the Merrill Lynch Rule was slapped down by a federal appeals court in Financial Planning Association v. SEC. The Court held that the SEC overstepped its bounds by attempting to negate a long-standing federal statute–the [Investment Advisers Act of 1940]–through its regulatory rule-making. My belief is that the SEC has committed even greater transgressions in the case of Reg BI.”

Well, guess what? Not one, but two, lawsuits were filed against the SEC and its chairman within five days of publication of the column (talk about waving a magic wand). The first suit was filed on Sept. 9 by attorneys general from New York, New Mexico, California, Oregon, Maine, Connecticut, and Delaware, plus the District of Columbia. The other suit was filed the following day by XY Planning Network, LLC, and one of its member firms, Ford Financial Solutions, LLC.

The issues discussed in the two lawsuits don’t appear to differ in any significant way. They do differ, however, in the harmful impacts that the feared Reg BI will have on public entities (namely, state governments), as described in the first suit, and on private entities (namely, Registered Investment Advisors), as described in the second suit.

In the first suit, the states contend that Reg BI will harm their sovereign, proprietary, economic, and quasi-sovereign interests. What this means, in short, is that the failure of Reg BI to set forth a fiduciary standard for broker/dealers has negative economic consequences, not only on investors but also on the litigating states. Let’s delve into this a bit.

First, each of the states has a strong interest in maintaining their status as an independent, self- governing entity within the federal framework of the United States. This sovereign interest is harmed, the states contend, when the SEC imposes a rule nationwide that causes injury to the economic well-being of their residents and negatively impacts their own tax coffers.

Second, the states argue that Reg BI will cause economic damage to their proprietary interest in tax revenue because it injures retail investors which, in turn, negatively impacts the states’ tax revenues and their economies. More particularly, as the suit explains: “…because distributions from tax-deferred retirement plans taken by retirees in excess of the specified New York State income tax deduction are taxable and provide revenue to New York State, losses in those plans means less tax revenue for New York State. Similarly, in the District of Columbia, distributions from tax-deferred retirement income such as a traditional IRA, a 401(k), or a private pension are fully taxable and any losses in those plans would directly impact tax revenue for those states. The other [states] are similarly harmed… Thus, [states] are injured by the loss of tax revenues from the taxable portions of the distributions from retirement and other retail investment accounts that have diminished value as a result of conflicted advice caused by [Reg BI].”

Third, “Reg BI will cause damage to the economic interests of the states because it will increase their financial burden in meeting the unmet needs of their retirees and other residents… Reduced retirement savings will injure [the states] both because they will shoulder an increased burden of providing public assistance to their residents, and because reduced retirement savings result in diminished economic activity.”

Fourth, Reg BI will cause damage to the states’ strong quasi-sovereign interest in protecting the economic well-being of their residents.

The states’ interests are related to the zero-sum nature of the relationship that exists between broker/dealers (plus their registered representatives) and their customers when following the nonfiduciary business model. A broker/dealer legally demands fealty from registered representatives, which can result in great financial expense to their customers. The more a broker/dealer demands from a nonfiduciary, and therefore from its customers, the less moola the customers (often unknowingly) must invest with a nonfiduciary under the business model followed by it. That model is, unfortunately, permitted (even encouraged) by Reg BI.

This obviously has a negative impact on the customers of nonfiduciaries. In their lawsuit, the states assert that there is a related, harmful zero-sum relationship injuriously impacting them as a result of the first suit. That is, when a customer has fewer assets than it would have otherwise as a result of the conflicts of interest allowed by Reg BI, a state will have less tax revenue to collect and therefore greater financial burdens because of the need to pick up that slack (indirectly) allowed by Reg BI.

Ultimately, the states fear that they will lose revenue from their residents’ taxable portions of distributions from the investment and retirement accounts that will be worthless because of the conflicts of interest inherent in the nonfiduciary business model that’s permitted by Reg BI. As a result, the states will bear a greater financial burden to assist retirees and others whose savings are insufficient due to conflicted investment advice. This leads to a related, harmful zero-sum relationship between those who benefit from Reg BI–broker/dealers and their registered representatives–and the states.

In the zero-sum relationship between broker/dealers (and their registered representatives), and their customers, the broker/dealers (directly) win. In the zero-sum relationship between broker/dealers (and their registered representatives) and the states, the broker/dealers (indirectly) win. That’s a pretty lousy system.

But the SEC has a history of unreasonably favoring the interests of broker/dealers at the expense of RIAs within America’s financial system. If Reg BI will eventually be vacated, the SEC should then begin vigorously enforcing the clear divide between fee-receiving fiduciary RIAs and commission-receiving nonfiduciary broker/dealers, as has always been required by the Investment Advisers Act of 1940.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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