Preamble to SEC best interest proposal may open back door for class actions

The Securities and Exchange Commission’s proposed Regulation Best Interest, designed to rein in broker-dealers’ conflicts to retail investors, does not include specific language that would make it easier for investors to bring class-action lawsuits for breach of contract.

But the lengthy preamble to the actual regulation includes what one prominent securities attorney calls “a more prescriptive approach” to mitigating or eliminating conflicts that tracks closely with language in the Labor Department’s fiduciary rule.

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Language in the preamble “could be relied on by a court” if brokers don’t apply specific recommendations to avoid conflicts, writes Kent Mason, a partner with Davis & Harmon, in a comment letter to the SEC.

The Labor Department’s fiduciary rule, which was vacated by the U.S. Court of Appeals for the Fifth Circuit in March, included a so-called private right of action that gave investors in IRAs the ability to bring class-action lawsuits against investment providers and broker-dealers.

In several lawsuits brought against the Labor Department’s rule, courts were split over whether Labor actually created a new private right of action, which only Congress can do, or if the rule merely expanded an existing private right of action created by the Employee Retirement Income Security Act. The 5th Circuit ultimately ruled Labor did create a new private right of action, which in part justified its decision to vacate the controversial rule.

While the Obama-era Labor Department made no bones over its intention for the private right of action provision to enforce the fiduciary rule, the SEC “very appropriately” is not trying to create a private right of action with Reg BI, writes Mason.

Language in the regulation itself applies a principles-based approach to addressing, disclosing, mitigating, and eliminating conflicts, with which Mason agrees. His lobbying clients have included Vanguard, TIAA, Voya, the American Benefits Council, and LPL Financial, according to opensecrets.org.

But in the preamble, regulators get specific. Broker-dealers “generally should consider” a list of practices to assure they are in compliance with Reg BI, the preamble says.

Levelizing compensation of proprietary products, eliminating compensation incentives among comparable product lines, implementing new supervisory procedures for rollovers, and avoiding sales contests and bonuses based on the accumulation of assets under management are among the practices that made the list.

The preamble language borrows from Labor’s fiduciary rule “in strongly pushing broker-dealers toward a regime where any differential in representative pay must be based on a neutral factor test,” says Mason.

While the SEC is not mandating restrictions on compensation in the preamble, firms may be compelled to do so in order to comply with Reg BI.

Doing so could lead to broker-dealers choosing to mitigate risk by eliminating services to small account holders and restricting access to some products, like variable annuities—two negative consequences of Labor’s fiduciary rule, argues Mason.

“The practices described as possibly in need of elimination seem almost arbitrary,” writes Mason. “What is concerning about incentives based on assets under management? Isn’t that simply an incentive to advise well and grow customer assets and recruit additional customers based on such good results?”

Mason claims the SEC fails to give guidance on which conflicts can be mitigated, and which must be eliminated. “A set of prescriptive rules without a logical framework underlying them is very hard to comply with,” he says.

Agreement from one Commissioner

“Regulating critical issues in the preamble is not consistent with a sound regulatory structure,” Mason says in his comment letter.

At least one SEC Commissioner is in agreement.

In a recent address to attendees at a National Association of Plan Advisors forum, Commissioner Hester Peirce, a Republican first nominated by President Obama and later by President Trump, referenced Mason’s comment letter and the risk of applying perceived regulatory prescriptions outside the actual language of a regulation.

“Obligations should be imposed through the rule text, not through language in the rulemaking release,” said Commissioner Peirce. “Especially in an area like this in which investors and registered representatives need to know what the rules are, a lengthy rulemaking release that supplements the rule text can breed confusion.”

Mason is suggesting the SEC eliminate all of the prescriptive examples in the preamble to the Reg BI proposal, and replace them with a statement of principles in line with those laid out in the actual rule.

“The DOL introduced a demonstrably counterproductive approach based on rigid mechanical rules that were not workable,” says Mason. “We urge the Commission to reject that approach and apply a principles-based approach that is much more workable and is espoused specifically in parts of the preamble.”

He is also requesting the SEC clarify that broker-dealers can disclaim liability for the new rules in client contracts, so as to avoid the unintended creation of a new private right of action.

“Any broker’s customer contract should be permitted to contain disclaimers stating that the new Commission rules are not part of the broker’s contractual obligation,” writes Mason.