The Second Circuit Upholds Regulation Best Interest

On June 26, 2020 the U.S. Court of Appeals for the 2nd District ruled that the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) authorizes the Securities and Exchange Commission’s (“SEC”) Regulation Best Interest rule and that the rule is not arbitrary and capricious. Specifically, the Court held that Section 913(f) of the Dodd-Frank Act grants the Securities and Exchange Commission (SEC) confers broad rulemaking authority which includes the Best Interest rule adopted by the SEC.

Background on the Regulation Best Interest Rule

Under federal law, both investment advisers and broker-dealers offer financial services to retail customers. However, only the former owe a fiduciary duty to their clients; broker-dealers do not. To reduce retail investor confusion in the marketplace regarding the investment advisory services and brokerage services, the SEC promulgated the Regulation Best Interest rule. Thus, the point of the Regulation Best Interest rule was to establish a “best interest” standard of conduct applicable to broker-dealers when making a recommendation of a securities transaction to a retail customer. A retail customer is a “natural person, or the legal representative of such a natural person, who: (A) receives a recommendation of any securities transaction or investment strategy involving securities from a broker, dealer, or a natural person who is an assigned person of a broker or dealer; and (B) uses the recommendation primarily for personal, family or household purposes.” However, the rule does not define “best interest.” Rather, it delineates four component obligations a broker-dealer must follow, in addition to prioritizing the interests of the retail customer above any interests of the broker-dealer or associated persons thereof. Those four obligations include:

  • The Disclosure Obligation,
  • The Care Obligation
  • The Conflict of Interest Obligation, and
  • The Compliance Obligation.

Issues in XY Planning Network, LLC., v. U.S. Securities and Exchange Commission

Petitioners in this case, including an organization of investment advisers, seven states, and the District of Columbia brought forth an action challenging the lawfulness of Regulation Best Interest. They argued that the Dodd-Frank Act requires the SEC to adopt a rule holding broker-dealers to the same fiduciary standard as investment advisers.

However, the Second Circuit held that the key language in Section 913(f) of the Dodd-Frank Act, which is permissive, reflects Congress’s intent to confer discretionary rulemaking authority to the SEC. The pertinent language states:

“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.”

Petitioners argued that Section 913(g) narrows this discretionary authority under Section 913(f). Unlike the broad authority under 913(f), Section 913(g) is specific in that it authorizes the SEC to establish a fiduciary duty for broker dealers. Thus, Petitioners reasoned that 913(f) was a procedural authorization to commence rulemaking only and that 913(g) provided the substantive content for any such rulemaking. The Second Circuit disagreed and found this interpretation at odds with the plain meaning of the regulation in which 913(f) and 913(g) are two separate and freestanding grants or rulemaking authority that are not interdependent provisions that limit one another.

The Second Circuit also rejected Petitioners’ argument that Regulation Best Interest is arbitrary and capricious. Rather, the court highlighted the fact that the SEC considered thousands of comments and input before rejecting the extension of the fiduciary duty to broker-dealers. The Petitioners further alleged that Regulation Best Interest is arbitrary and capricious because the SEC failed to adequately address the significant evidence that consumers are not meaningfully able to differentiate between the standards of conduct owed by broker-dealers and investment advisers. But once again, the Court showed deference to the SEC’s determination that while a uniform standard of care may reduce retail investor confusion, this benefit could not overcome the burden that would result with respect to significant compliance costs for broker-dealers that would ultimately cause retail customers to experience an increase in the cost of obtaining investment advice and lead to a potential exit of broker-dealers from the market.

This is an important decision in that the Second Circuit has explicitly ruled that that Regulation Best Interest is the standard of conduct expected from broker-dealers. And, moreover, the court rejected the argument that Congress required the SEC to harmonize the investment adviser and broker-dealer regulatory models. Going forward, Regulation Best Interest will open the door to disclosures required for various broker-dealers when they are making explicit recommendations to clients in scenarios where the broker does not already have discretion to make trades. Given this important circuit decision, firms should heed the three-page Appendix the SEC issued on April 7, 2020 to implement plans with respect to Regulation Best Interest. The compliance date for Regulation Best Interest began in June 30, 2020.

VW Contributor: Skylar Young
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2nd Circuit Ruling that Dodd-Frank Whistleblower Retaliation Claims are Arbitrable under Employment Agreements filed for US Supreme Court Review

Date: December 31, 2019

On December 16, 2019 Petitioner Erin Daly filed a petition for writ of certiorari to have the United States Supreme Court review the 2nd Circuit ruling of Daly v. Citigroup Inc., 939 F.3d 415 (2nd Cir. 2019), which held that arbitration clauses were valid for whistleblower retaliation complaints under the Dodd-Frank Act.

The facts of the case pertain to the Plaintiff working in the Private Bank Division of Citigroup.  The Plaintiff allegedly complained to internal bank attorneys and human resources employees that her supervisor repeatedly demanded of her to disclose material non-public information to the supervisor’s favored clients, and was subsequently fired when she reported her complaint.  The Plaintiff then filed a complaint in the Southern District of New York alleging several claims under the whistleblower retaliation clauses of the Dodd-Frank and Sarbanes-Oxley Acts.  Citigroup responded by filing a motion to dismiss the Plaintiff’s Sarbane-Oxley Act claims and compel arbitration for the Dodd-Frank Act claims.  Citigroup argued the Plaintiff’s signed employment agreement contained an arbitration clause, and all of the claims, except the claims under the Sarbanes-Oxley Act were subject to mandatory arbitration.  In regard to the Sarbanes-Oxley Act claim, Citigroup argued for dismissal based on the fact the Plaintiff had not exhausted all of her administrative remedies.  The district court granted both of Citigroup’s motions.

On September 19, 2019, the 2nd Circuit affirmed the district court’s ruling and joined the 3rd Circuit in holding that Dodd-Frank whistleblower retaliation complaints are arbitrable (See Khazin v. TD Ameritrade Holding Corp., 773 F.3d 488 (3d Cir. 2014)).  The 2nd Circuit justified its decision in noting that unlike the Sarbanes-Oxley Act, which explicitly contains an anti-arbitration provision, the Dodd-Frank Act contains no language, signaling Congress’s intent to not preclude whistleblower retaliation complaints under the Dodd-Frank Act from being precluded.  Thus, the Plaintiff, in signing the employment agreement with the arbitration provision, was bound to arbitration for her Dodd-Frank Act whistleblower retaliation claims.

While there is no guarantee that the Supreme Court will grant certiorari and review the case, this is an important case to follow as the 2nd Circuit is now the second federal appellate court decision to conclude that mandatory arbitration clauses in employment agreements are enforceable with respect to whistleblower retaliation claims under the Dodd-Frank Act.

VW Contributor: Ryan Coufal
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