On June 26, 2020, the U.S. Court of Appeals for the Second Circuit issued its ruling on the challenge to the legality of the Regulation Best Interest final rule (Reg BI), promulgated by the U.S. Securities and Exchange Commission (SEC) under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. As reported on June 2, 2020, the Second Circuit entertained oral argument. It issued its ruling late in the day on June 26, just prior to Reg BI’s June 30, 2020, implementation date two business days later.
The Second Circuit’s ruling had three holdings: (1) the individual investment adviser petitioner had standing to bring the petition to review, but the state petitioners did not; (2) section 913(f) of the Dodd-Frank Act authorized the SEC to promulgate Reg BI; and (3) Reg BI is not arbitrary and capricious under the Administrative Procedure Act (APA). We focus the analysis herein on the latter two holdings.
Ironically, the Second Circuit ruling involves an interpretation of the word “may.” The SEC Division of Enforcement has regularly taken the position that this general term lacks specificity for appropriate investment adviser disclosure language. Yet, instead of attacking this term, the SEC successfully argued that the use of the term “may” by Congress in the Dodd-Frank Act allowed the SEC the flexibility to promulgate Reg BI without being restricted to a uniform fiduciary standard.
Specifically, this holding explains that:
The Dodd-Frank Act authorizes the SEC to promulgate Regulation Best Interest. Congress stated that the SEC “may commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers … to address the legal or regulatory standards of care for” broker-dealers. Dodd-Frank Act § 913(f) (emphasis added).
This broad grant of permissive rulemaking authority encompasses the best-interest rule adopted by the SEC. Contrary to Petitioners’ argument, Section 913(g) does not narrow the scope of Section 913(f) but rather provides a separate grant of rulemaking authority.
The key language in each of the provisions at issue is “may,” which is permissive and reflects Congress’s grant of discretionary rulemaking authority to the SEC. See id. § 913(f) (“The Commission may commence a rulemaking …”); id. § 913(g)(1) (“the Commission may promulgate rules …”); id. § 913(g)(2) (“The Commission may promulgate rules …”). Congress gave the SEC the authority to promulgate rules under any of these sections — or to make no rule at all. With Regulation Best Interest, the SEC chose to proceed under section 913(f), not sections 913(g)(1) or (g)(2). (See XP Planning Network, LLC. et. al. v. United States Securities and Exchange Commission et. al.) p. 19.)
Regarding the Petitioners’ argument that Reg BI violated the ABA as arbitrary and capricious in this holding, the Second Circuit challenged this position by describing this claim as a preference for a uniform standard policy argument “dressed up as an APA claim.” Continuing, this holding described that the SEC “carefully considered and rejected a fiduciary rule.” Further, this holding disagreed with the Petitioners’ claim that Reg BI is arbitrary and capricious because it is based on an incorrect interpretation of the “solely incidental” and “special compensation” prongs of the broker-dealer exemption form the Investment Advisers Act of 1940.
The appellate court credited the SEC with issuing an interpretive release on “solely incidental” as it relates to this exemption. Interestingly, this interpretive release was included as part of the final package of rules and releases, but not the proposals. The Second Circuit, however, points out that Petitioners did not challenge the “solely incidental” interpretive release. Petitioners’ second argument in support of its arbitrary and capricious position points to consumer confusion, but this also is denied. The Second Circuit noted that the SEC considered the evidence of consumer confusion, but found the benefits of decreased costs and consumer choice, as evaluated by the SEC, to favor the adoption of Reg BI.
With the SEC’s success before the Second Circuit and the June 30, 2020, Reg BI implementation date for the brokerage industry, it appears that Reg BI is here to stay.