We circulate this statement as law professors specializing in the field of securities regulation who are concerned that the Securities and Exchange Commission (the “Commission”) has moved in a new direction that is both contrary to its past practice and harmful to the interests of investors. In Release No. IA-5248 (“Commission Interpretation Regarding Standard of Conduct for Investment Advisers”) (June 5, 2019) (“Release 5248”), the Commission has turned its back on its history and reinterpreted the case law in a surprising manner that reverses what it said only a year ago. This month, in its very first sentence discussing the “Duty of Loyalty” owed by an investment adviser to its clients, Release 5248 states:

“The duty of loyalty requires that an adviser not subordinate its clients’ interests to its own.”

Last year, the Commission declared in proposing its new standard that the law “requires an investment adviser to put its client’s interests first.”[1] That had been the Commission’s time-honored position (and the investment adviser industry has agreed and repeatedly emphasized that duty in its communications to clients). To state only that you cannot subordinate the client’s interests to your own represents a very weak substitute that may allow the investment adviser to still give considerable weight to its own interests.

Even more surprising, Release 5248 relies upon SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) (“Capital Gains”), to support its new position that the duties of an investment adviser, as a fiduciary under the Investment Advisers Act, largely require only that the investment adviser make full disclosure of any conflicts to which it is subject. To understand how bizarre this re-interpretation is, we need only consider the facts of Capital Gains. It was a “scalping” case in which the defendants repeatedly purchased a stock and then recommended it to their many clients, profiting when the stock went up. The lower courts had dismissed the Commission’s enforcement action against these defendants because no loss to investors was shown. An intent to injure investors was necessary, they said. But the Supreme Court disagreed, finding that the term “fiduciary” had to be interpreted not under common law standards, but under broader equitable principles. Reviewing the legislative history of the Investment Advisers Act, it cited the following canon as a guide to its interpretation:

“[An investment adviser] should continuously occupy an impartial and disinterested position, as free as humanly possible from the subtle influence of prejudice, conscious or unconscious, or any act, which subjects his position to challenge in this respect.[2]

In the next paragraph, the court added that:

“[The adviser] should not ‘directly or indirectly engage in any activity which may jeopardize [his] ability to render unbiased investment advice’.”[3]

In short, the investment adviser must seek to avoid conflicts of interest, not merely disclose them.

Now, consider again what the Commission has just said in Release 5248: do not subordinate your client’s interests to your own. It can be argued in a scalping case that the client has suffered no injury and thus its interests were not subordinated (indeed that was precisely the argument that won in the lower courts before the Supreme Court reversed them). Perhaps under the Commission’s new formulation, the investment adviser might make some boilerplate disclosure (“From time to time, we will recommend securities in which we have a proprietary position”). Does that really tell the investor that he is being used to advance the adviser’s agenda? Should the investor be deemed to have consented to a conflict simply because he reads this boilerplate prose? Why is consent inferred from silence?

Although Capital Gains insists that fiduciaries have “an affirmative duty of utmost good faith and full and fair disclosure of all material facts, as well as an affirmative obligation to employ reasonable care to avoid misleading clients,”[4] Release 5248 largely downsizes these requirements to an obligation to disclose all material facts about conflicts.

Sadly, this is ironic, because the Congressional goal in the Dodd-Frank Act was to achieve a near parity in the duties of brokers and investment advisers.[5] Parity can be achieved by leveling up or leveling down. Historically, investment advisers were subject to a fiduciary duty, whereas, in the case of brokers, their duty depended on state law. In adopting Regulation Best Interest, the Commission has taken an ambiguous position that may raise the standard for brokers marginally (there is much debate on this point). But it has done so by lowering the standard for investment advisers. We fear this more than offsets any possible improvement in the new standard for brokers.

Worse yet, the Commission’s ambiguous interpretation of the broker’s fiduciary duty in Regulation Best Interest may be read to preempt state laws and rules that do clearly impose a higher fiduciary duty. At least 23 states specify such a fiduciary rule for brokers (and Massachusetts is currently adopting such a rule). All these rules are now at risk because of the Commission’s new standard. In the past, when the only standard was specified by FINRA, there was no possibility of preemption because FINRA is treated legally as a private body. But now that the SEC has offered its own standard, there is grave uncertainty, and brokers may be insulated from the claims of their clients for breach of fiduciary duty.

We hope that there will come a day (and soon) when the Commission will revisit these mistakes.

ENDNOTES

[1] The proposing release said that the law “requires an investment adviser to put its client’s interests first.” See “Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers,” Release No. IA-4889 (April 18, 2018). We are unaware of any new circumstances or forces (other than possibly industry pressure) that could justify this fundamental a reversal. The idea that the client’s interest must be put first is simply a shorthand version of Justice (then Judge) Cardozo’s famous statement in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928) that: “A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”

[2] 375 U.S. at 188.

[3] Id. at 189.

[4] Id. at 194.

[5] Section 211(g) of the Investment Advisers Act (15 U.S.C. § 80b-11(g)) instructed the Commission that it “may promulgate rules to provide that the standards of conduct for all brokers, dealers and investment advisers…shall be to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer or investment adviser providing the advice.” Section 211(g) then added that “such standard of conduct shall be no less stringent than the standard applicable to investment advisers under Section 206(1) and (2) of this Act when providing personalized investment advice about securities,…”