State law fiduciary duties and SEC and blue sky laws – how they might work together.

The Department of Labor’s fiduciary rule feels like the train that will never come on a Friday afternoon.  Unfortunately, while more passengers gather on the platform, they aren’t all merely waiting for the 5:02 express to the suburbs; instead, more regulators on different levels are itching to weigh in with their own policies.  While some lawmakers, like Senator Jon Tester, a democrat from Montana, urged the Securities Exchange Commission (“SEC”) to consider working with the Department of Labor (“DOL”) so that investment advisors “don’t get ping-ponged back and forth between two rules,” its possible that a third rail of regulation could exist in the form of states changing their definitions of fiduciaries.

First, the Department of Labor’s rule, portions of which have gone into effect, addresses what information financial advisors can discuss and recommend to their clients, with a goal of keeping those advisors from recommending products the FA has an interest in but is not appropriate for the investor. In other words, it makes the FA put the client’s interests ahead of their own. Several months ago, we published an article on this blog on the different kinds of fiduciaries and how they relate to portions of ERISA. As we said in that blog post: a fiduciary is someone who is authorized by an agreement to act on behalf of another.  The term fiduciary is more than a label; it carries a certain set of obligations with it, including high duty of care to the investor. Thus, if one regulator calls only FAs discussing retirement accounts a fiduciary (along the lines of the DOL) and another regulator calls anyone discussing investments a fiduciary (along the lines of the SEC), then there could be two different but related sets of rules.
 

And while the SEC Commissioner may have testified recently that he is working to harmonize a rule with the DOL as a top priority for him, the SEC has been soliciting public comment on standards of conduct for financial advisors and broker-dealers.  Other SEC Commissioners have stated that they think the DOL’s rule is disruptive of the broker-client relationship.
 

When states get involved in expanding these definitions, the situation gets the curious and curiouser. In the Spring of 2017, Nevada’s legislature passed a law authorizing its regulators to expand the reach of the definition of fiduciaries.  Now, Nevada, California, Missouri, South Carolina and South Dakota all impose fiduciary duties on broker-dealers.  As of September of 2017, 14 states do not impose fiduciary standards on broker-dealers and 32 others have limited fiduciary standards. Given that, there could be a real need for the SEC to step in and create its own law, one that might trump state laws through the doctrine of preemption.
 

Its possible that this ping-ponging between different rules could be rectified in a similar manner to how state and federal securities laws work. While every state has its own securities regulations (called “Blue Sky Laws”) that are designed to protect state residents from fraudulent sales of securities, those laws give way to the federal ones concerning registration requirements. It’s actually not as confusing as it sounds: fraud has always been a concept that is defined by state law. And, there are other federal systems and codes that specifically incorporate or defer to state law on various issues; one example is the Bankruptcy Code’s provisions o  the definition of property rights.  Essentially, federal and state regulators carve out their own areas.  So to with regard to registration, the federal law sets out that “no state law, rule, regulation, order or other administrative action requiring or regarding the registration or qualification of securities or securities transaction may apply directly or indirectly to a covered security.” Other provisions prohibit states from interfering with communications (prospectus, proxy, reports). For securities not traded on national exchanges, the prohibition against regulating registration does not apply.
 

But, states do retain jurisdiction to investigate and bring enforcement actions based on unlawful conduct or deceit in connection with securities transactions, in other words, fraud. States also license brokers and FAs. To be clear, both states and the SEC have jurisdiction to investigate fraud, this kind of jurisdiction is called concomitant jurisdiction, meaning at the same time. Similarly, certain civil rights issues may raise concomitant jurisdiction between a state attorney general and the US Attorney General. This system of preemption, limitation and concomitant jurisdiction could harmonize the fiduciary rule.
 

Its possible for states to be limited in their roles in how they extend fiduciary duties and whom they wish to bring into that definition. State regulators and federal regulators aren’t waiting on the same train when it comes to sale of securities. They either all get on the same train concerning fraud in how the securities are sold, or they get on totally different trains when it comes to registration. This too could happen with state and federal laws with regard to fiduciaries, based on state licensing laws.  Hopefully, all of the players can work out a clear system before investors and advisors get left behind on the platform.