The past few years have seen much focus on how key federal agencies – the Department of Labor and the Securities and Exchange Commission – define rules on protecting investors (especially retirement plan participants) from certain practices of broker-dealers and sales representatives. And after these years of headlines, proposals, litigation and regulations, we are left with (i) no changes to the DOL fiduciary standards and (ii) changes to SEC rules that are considered to emphasize disclosure over enhanced standards of conduct.
In light of this (limited) movement from these federal agencies, we are seeing increased activity on the state level. Most notably:
• New York State has issued final regulations, effective August 1, 2019, requiring that insurance “producers” (which term includes brokers and agents) selling annuities must take steps to ensure that the transaction is in the “best interest” of the consumer.
• Massachusetts is circulating, for preliminary comment, a regulation to apply a fiduciary conduct standard on broker-dealers, agents, investment advisers, and investment adviser representatives when dealing with their customers and clients. As noted on the Massachusetts web site, “The fiduciary obligation under the conduct standard applies to the provision of recommendations, advice, and to the selection of account types. Therefore, the conduct standard will apply to recommendations to open IRA roll-over accounts, as well as recommendations to open accounts involving asset-based or transaction-based remuneration.”
• New Jersey has issued a proposed rule to specify that broker-dealers, agents, investment advisers and investment adviser representatives owe a fiduciary duty to their customers.
• Nevada has adopted a new law imposing a fiduciary duty on broker-dealers, sales representatives and investment advisers and has since followed up with new proposed regulations implementing this law and specifying that broker-dealers, agents, investment advisers and investment adviser representatives owe a fiduciary duty to their customers.
• Other states have attempted to act or taken more narrow actions. Maryland’s proposed legislation was rejected in committee and Connecticut has enacted a new law applicable only to plans covering Connecticut governmental employees.
This state activity is notable for a number of reasons. Several of these states (Massachusetts and New York) have specifically identified shortcomings in federal regulations as a rationale for state action; such blunt finger-pointing is unusual in the dry world of financial regulation.
Also, these state efforts have (and will continue) to generate fierce opposition from the financial industry, including litigation (New York) and threats to stop selling financial products in the state (Nevada). Indeed, it is not clear if the financial services industry is more concerned over meaningful changes on a federal level (which might emerge from a Democratic-led Congress) or the patchwork of state rules that are emerging in light of the (modest) rules currently coming from the SEC and the DOL.
The Preemption Battles Ahead
However, perhaps the most interesting –and possibly significant — battle over these state initiatives is likely to occur under the arcane rules governing federal “preemption” of state law. Under the U.S. Constitution, federal law takes precedence over any conflicting state law. So, if the federal government chooses to preempt state law in an area, it has the power to do so.
So, the question that will face these –and other–state initiatives is whether federal laws (particularly ERISA and federal securities law) are the exclusive authority to set standards for these activities and, thereby preclude state action?
In assessing the preemption battles ahead there are a few key points to note:
• As noted, under the U.S. Constitution, federal law takes precedence over any conflicting state law. So, if the federal government chooses to preempt state law in an area, it has the power to do so. Also, in some situations, the federal courts will find state action preempted even when there is no explicit provision claiming federal preemption. This can occur if state action is considered too inconsistent with a set of federal rules or the state action has too great an impact on an area controlled by federal law.
• These state fiduciary initiatives impact two areas with very different preemption regimes: ERISA plans and federal securities laws; this will make the preemption claims even trickier to follow.
• Section 514 of ERISA specifically states that ERISA “shall supersede any and all State laws insofar as they may now or hereafter relate to any employee benefit plan.” Although that seems pretty definitive, there is still plenty of room for ambiguity — ERISA’s preemption provision specifies that it does not preempt state law regulating insurance, banking, or securities. And, indeed, the New York law is focused on annuity sales, under the state’s authority to regulate the sales of insurance.
Also, in applying ERISA preemption, there is further room for conflicting perspectives in determining whether a state law “relates to” an employee benefit plan. This becomes relevant when a state law is not aimed at ERISA plans—but impacts ERISA plans as part of a broader scope. For example, a state law seeking data on health claims was considered preempted because of its impact on ERISA plans (even though the law was not aimed at ERISA plans and impacted both ERISA and non-ERISA plans).
• The issue of preemption under federal securities law may prove to be especially complex. State securities regulators have historically retained parallel authority to regulate broker-dealer firms and registered representatives in their state. However, federal law does specifically preempt state law regarding the “making and keeping of records” and “financial or operational reporting requirements.” Securities Exchange Act of 1934, Section 15(i). So, look for industry to challenge state initiatives as requiring new recordkeeping or reporting obligations.
It should be noted that the issue of preemption was specifically raised with the SEC as it was developing the new “best interest” rules finalized in June. See letters to the SEC from Securities Industry and Financial Markets Association (arguing that state rules should be preempted) and from North American Securities Administrators Association (arguing that state rules should not be preempted). And, in response to this issue, the SEC …punted. In adopting Regulation BI the SEC specifically stated that:
Back to the Courts
These state rules have been opposed by the financial industry and such opposition is likely to continue. These firms find the current regulatory environment very profitable and have opposed all efforts to impose stricter limits on their business models. Accordingly, we can anticipate such opposition will continue as states seek to fill the gap left by federal regulators. And, such opposition will likely manifest itself in the form of lawsuits—especially lawsuits claiming federal preemption. Stay tuned.