Seven States Sue SEC on Concern Broker Rule Is Weak

Seven states asked a federal court on Monday to invalidate a regulation that requires stockbrokers to disclose more about conflicts of interest that could influence their financial advice, claiming that the rule is weak.

Source: WSJ | Published on September 11, 2019

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The lawsuit, filed in Manhattan federal court by the states’ Democratic attorneys general, illustrates how a rule intended to protect mom-and-pop investors has become a political lightning rod for the Securities and Exchange Commission. The states and consumer advocates generally insist the rule is too weak to help clients, while the SEC says it improves investor protections while preserving the broker-dealer industry’s business model.

The plaintiffs argue the SEC exceeded its authority to craft the rule by taking an approach that deviates from a model authorized by the 2010 Dodd-Frank financial overhaul law.

The statute said brokers could be required to follow the same standard of conduct that constrains investment advisers. Investment advisers must continually monitor their clients’ best interest, while the brokers’ duty is tied only to specific recommendations.

The SEC wound up not requiring brokers to follow the stricter standard, although regulators say the rules for brokers and advisers are now closer than they have ever been. While brokers and advisers are governed by two different standards, the industries have significant overlap and many households are confused by the difference between them. Most Wall Street firms offer both account types.

Brokers are paid through sales commissions, which may vary by product, while investment advisers earn a fixed percentage fee levied on the value of a client’s assets.

The SEC passed its rule, known as Regulation Best Interest, in June, with the commission’s lone Democratic member voting against it. Supported by the financial industry, the rule relies largely on disclosures to investors and will preserve brokers’ commission-based sales model.

The states say the SEC relied on flawed economic analysis to justify its approach, which is aimed at giving investors more information about brokers’ complex pay incentives. The states say the rule was thus “arbitrary and capricious,” a claim that businesses often use when they challenge federal regulations.

“With this rule, the SEC is choosing Wall Street over Main Street,” New York Attorney General Letitia James said in a statement. “Instead of adopting the investor protections of Dodd-Frank, this watered-down rule puts brokers first.’’

The lawsuit on Monday was filed by New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon and the District of Columbia. The complaint says they have standing to bring the lawsuit because the SEC’s rule won’t protect their residents from biased investment advice. Brokers are generally subject to both federal and state regulation.

An SEC spokeswoman declined to comment.

SEC Chairman Jay Clayton said in a speech Monday that the regulators struck the right balance with their rule, which says that brokers can’t put their own financial interests ahead of their clients’ needs and goals. Mr. Clayton is a political independent who was appointed by President Trump.

“This comprehensive package brings the standards of conduct and required disclosures of financial professionals in line with what a reasonable investor would expect,” Mr. Clayton told the Economic Club of New York.

The states’ legal challenge echoes a fight over a similar rule imposed by the U.S. Labor Department during the Obama administration. That rule imposed a stricter standard of care, known as a “fiduciary duty,” on stockbrokers handling retirement accounts. In that case, business groups, including the main lobbying outfit for broker-dealers, successfully petitioned an appeals court in 2018 to overturn the regulation.

Tom Quaadman, an executive vice president at the U.S. Chamber of Commerce, said the business group was considering how to oppose the states’ lawsuit. The chamber says the SEC’s regulation should preempt any rules passed by local officials that would impose stricter, state-specific standards on the industry.

“Unfortunately, this lawsuit is wrong on the law,” Mr. Quaadman said.

Groups that advocate for retail investors say the SEC’s rule won’t rein in many harmful conflicts of interest.

“Whether we have to wait for a new administration to do this, or it can be achieved through a lawsuit, we believe the answer is for this rule to be scrapped and for the SEC to produce a strong, uniform fiduciary standard of care that covers both brokers and advisers,” said Barbara Roper, director of investor protection at the Consumer Federation of America.