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As SEC's Reg BI looms, states chart their own fiduciary path

With dueling state and federal advisor rules taking shape, and an anticipated wave of lawsuits in response, it could be a busy year in the fight over standards of conduct for brokers and advisors.

Barring another protracted government shutdown, the SEC is expected to finalize Regulation Best Interest in the first half of this year, given that Chairman Jay Clayton has signaled it’s a top priority for the commission says George Michael Gerstein, an attorney with Stradley Ronon who co-chairs the firm's fiduciary governance practice.

Meanwhile, legislators and regulators at the state level are exploring whether to enact more stringent standards for advisors and brokers.

Earlier this year, Nevada proposed a regulation that would apply a fiduciary duty to advisors and brokers. The proposal also follows a law the state enacted in July 2017 that dramatically expanded the definition of financial planner to include brokers and other types of advisors in the wealth management sector.

If adopted, the regulation "would fundamentally change the legal obligations of broker-dealers and investment advisers doing business in Nevada," according to an analysis from law firm Eversheds Sutherland.

Among other things, Nevada's rule would subject brokers who don't qualify for an exemption to an explicit and ongoing fiduciary duty, triggering a requirement to make upfront disclosures about compensation and potentially creating new legal liabilities for breaching fiduciary responsibilities. Additionally, dually registered brokers and advisors would be presumed under the rule to be acting as an advisor, eliminating the chance of securing an exemption to the ongoing fiduciary duty.

The timing of Nevada's proposal is an open question. The state Securities Division is collecting comments on the regulation through March 1, and then plans to hold a public forum on the issue.

Through a spokeswoman, the Nevada secretary of state's office says it does not yet have a target date for adopting the final rules, but that it is monitoring "all rule-making in the area, including those promulgated by the Securities and Exchange Commission."

Nevada's proposal has sparked keen national interest, and the practical matter of reviewing all the feedback the state will receive and incorporating any changes to the rule could push a finalization date past when the SEC might complete its own rule.

"I do think most states, including Nevada, will probably wait for the SEC to come out with its final rulemaking," Gerstein says.

That's not a unanimous view, however.

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"I would not expect Nevada to wait on the SEC," says Barbara Roper, director of investor protection at the Consumer Federation of America. "They released their proposed rules well after the SEC released its proposal, and they deliberately took a different approach in some areas."

Roper, like other investor advocates, has been critical of the SEC's proposal for failing to elevate the standard of conduct for brokers to the fiduciary status that governs advisors. State initiatives in Nevada and elsewhere come as a response to the more cautious approach taken by federal authorities — both at the SEC and, previously, the Department of Labor, which abandoned its own fiduciary rule soon after President Trump took office.

New Jersey’s securities division is developing a uniform fiduciary standard at the direction of Gov. Phil Murphy, a Democrat. (Nevada's rule springs from a bill passed through the legislature.) Backers of the New Jersey proposal explicitly frame their efforts as a response to the absence of strong federal rules.

"It has been more than a decade since the financial crisis and more than eight years since the staff of the SEC recommended establishing a uniform fiduciary standard for investment advisers and broker-dealers," Christopher Gerold, chief of the New Jersey Bureau of Securities, writes in an email. "Yet the SEC has failed to act, and we will continue to work to fill the void left by the federal government," he adds, while declining to comment on a timetable for the proposal to advance.

New York's legislature, meanwhile, is working on a bill that would require non-fiduciaries to make blunt disclosures about their conflicts of interest. The office of Assemblyman Jeffrey Dinowitz, the Bronx Democrat who is sponsoring that legislation, tells Financial Planning that the bill passed out of committee last week Dinowitz is actively shopping for a sponsor in the state's upper chamber, he says.

Gerstein suggests that the SEC could slow the momentum of competing state proposals by incorporating into its rule some concrete examples fleshing out what advice in the "best interest" of clients actually means in practice.

After opposing the Labor Department’s more stringent fiduciary rule, prominent industry groups such as FSI have now thrown their support behind the SEC's proposal, and are warning against states going in their own direction and creating a tangled regulatory landscape that would pose serious compliance challenges for firms with a national footprint.

"We strongly encourage states to wait for the SEC to complete its rulemaking process and follow its lead," says Michelle Carroll Foster, FSI's vice president for state affairs. "State-specific standards would not only create a patchwork of rules across the country and increase confusion, but it would also impose additional compliance costs on financial advisors."

Further complicating matters is the potential for a wave of lawsuits on a variety of fronts, according to Gerstein. On one hand, a state fiduciary rule like Nevada's could face a legal challenge on whether it is preempted by federal rules such as the Employee Retirement Income Security Act, or ERISA. Other challenges could arise concerning whether state regulators exceeded their authority in drafting new rules for advisors and brokers.

On the other hand, Gerstein speculates that states could bring a case against the SEC arguing that Regulation Best Interest and the other parts of the rulemaking package don't go far enough to protect investors, just as states sued (unsuccessfully) to preserve the Labor Department’s fiduciary rule.

"I think there are going to be some jurisdictions that will be unhappy and challenge it," Gerstein says, though he suggests that could include just the "small minority" of states "that have already asserted themselves in this area."

In terms of state fiduciary proposals, observers look at efforts put forward by Nevada and New Jersey as a trial balloon that will be watched closely by other states that could follow suit.

"If the SEC finalizes its rule in its current form," Roper says, "and if one of the leading states survives the inevitable industry legal challenge, then I would definitely expect more states to follow this lead."

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