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
© 2020 Vandenack Weaver LLC
For more information, Contact Us

Supreme Court Issues Ruling on Insider Trading Case

In its first insider trading decision in nearly two decades, the United States Supreme Court upheld the insider trading conviction of Bassam Salman and reaffirmed the three-decade-old personal benefit standard applied to insider trading violations under federal securities laws. Salman was convicted of securities fraud, after making over $1 million by trading on a tip from his brother-in-law, who was an investment banker with Citigroup at the time.

To prevail in an insider trading case, the Securities and Exchange Commission (“SEC”) must establish that the person who gave the tip, the “tipper”, received a personal benefit in exchange for giving non-public information to the tippee. The Supreme Court ruled that the personal benefit test is satisfied if the tipper gifts the confidential non-public information to a relative or friend. This result is different from the Second Circuit case, United States v. Newman, which stated that the personal benefit test requires an insider to receive something of a pecuniary and valuable nature in exchange for the information. The Supreme Court noted in Salman v. United States that the Newman outcome is inconsistent with the requirements of the personal benefit test and clarified the test is satisfied even in the absence of a tipper’s receipt of a pecuniary benefit.

Notably, the Supreme Court did not address several pressing issues with insider trading. While the Supreme Court stated the personal benefit test is not necessarily satisfied when a tipper discloses information to anyone, it did not specify how close a relationship is required between a tipper and tippee, outside the context of relatives or friends. Similarly, the Supreme Court did not address the constitutionality of aggressive enforcement tactics, including the SEC’s use of the “rocket docket”. The “rocket docket” requires cases to be decided within 300 days of filing, and consequently leaves little time to prepare for a hearing. It is unclear whether the Supreme Court intends to address these concerns in the near future.

© 2016 Vandenack Weaver LLC
For more information, Contact Us

SEC Updates Rules for Capital Raises Through Regulation D

Over the past couple of years, the Securities and Exchange Commission (“SEC”) has evolved how companies can raise capital, while simultaneously maintaining adequate protection for investors. For example, starting in May of 2016, companies were provided the option of raising capital through the newly created Regulation Crowdfunding, but the SEC was not finished modernizing the laws for exempt securities issuance. On October 26, 2016, the SEC finalized rules amending Regulation D, which contains exemptions from securities registration.

 

Many non-public companies, at all stages, rely on Regulation D for capital raises. Depending upon the unique circumstances of the company, the company may have utilized registration exemptions under rule 504, 505, or 506 of Regulation D. However, exemption under rule 505 became disfavored compared to rule 504 and 506 because of the additional, and oftentimes onerous, regulatory requirements. Recognizing this trend, the SEC finalized rules that increased the amount a company can raise under rule 504 to $5,000,000 dollars, up from $1,000,000, in a 12-month period. This means that the same amount of capital can be raised under rule 504 as was possible under rule 505, allowing the SEC to repeal rule 505.

 

For most companies relying on Regulation D to raise capital, the factors used before the rule change will likely continue to be the predominate factors when determining whether to use rule 504, often referred to as the “seed capital” exemption, or rule 506 exemption. For example, an entrepreneur in the first few years of business that requires additional capital to get a product, currently in research and development, to the market, will likely look to rule 504, which limits the total money raised, but is more navigable for new companies. Moving forward, as the SEC undergoes a change of leadership, starting when SEC Chairwoman Mary Jo White steps down in early 2017, these rules may continue to evolve and any company looking to utilize a Regulation D exemption should consult with legal counsel. For more information on the current changes under SEC Regulation D, please visit the following SEC website: https://www.sec.gov/news/pressrelease/2016-226.html

© 2016 Vandenack Weaver LLC
For more information, Contact Us

SEC Amends Form 10-K to Make Annual Reports User Friendly

The Securities and Exchange Commission (“SEC”) recently issued an interim rule that amends the Form 10-K; a form certain publicly traded companies annually file to give a complete review of the company’s business and its overall financial condition. The rule allows the registrant to include an optional summary page of the information that the form requires. Each item in the summary must include a hyperlink to a more detailed explanation in the filing.

The amendment is pursuant to the Fixing America’s Surface Transportation Act (“FAST Act”), which was signed into law in December 2015. The FAST Act requires the SEC to take various steps to simplify and modernize certain disclosure requirements. The amendment is effective as of June 1, 2016.

© 2016 Vandenack Williams LLC
For more information, Contact Us

SEC Order Permits Companies to Use In-Line Structured Data Filings

A recent order from the Securities and Exchange Commission (“SEC”) permits companies to file financial statements with the SEC in a new format. Companies may now use Inline XBRL, which embeds structured data in the filing. The format uses machine readable tags and designed for better quality data and lower filing costs.

The SEC’s decision is part of its effort to improve the access and transparency of disclosures. The agency is hopeful the new filing capability will increase the use of XBRL data by investors and other market participants and lower errors in financial statements. Companies may use the new format on a voluntary basis through March 2020.

© 2016 Vandenack Williams LLC
For more information, Contact Us

SEC Announces Priorities for 2016; Protecting the Retail Investor From Retirement Advisors

The Securities and Exchange Commission (SEC) announced their priorities for 2016 and examining retirement plan advisors remains a focal point. In June of 2015, the SEC, through their Office of Compliance Inspections and Examinations (OCIE), launched the Retirement-Targeted Industry Reviews and Examinations initiative (ReTIRE). Since that time, OCIE has conducted over 160 examinations of retirement advisors and brokers, with over 115 on the advisors. The purpose, generally, is to protect retail investors and their retirement accounts.

With a priority on protecting retail investors, OCIE is examining SEC registered advisors to ensure they are taking adequate steps to follow their fiduciary obligation towards their client’s best interests. This often means the advisor’s fee is scrutinized, with practices such as reverse churning being the target. Reverse churning, in sum, is a practice of advisors putting investors into accounts that pay a fixed fee to the advisor, but usually fail to perform in a manner to justify that fee. For 2016, the review is expanding and will now include the practice, disclosures, and sales strategies for exchange traded funds (ETF). Two other new priorities include examining the sale of variable annuities and undisclosed public pension advisor gifts and entertainment.

The effort by OCIE is not to be confused with the Department of Labor (DOL) examination on retirement advisors, which is running concurrently. The DOL examinations under the Employee Retirement Income Security Act, however, is similarly focused on protecting the retail investor. Comments by those at the SEC and DOL suggest that the focus on protecting the retail investor through these investigations are likely to continue for some time.

© 2016 Vandenack Williams LLC
For more information, Contact Us