On February 21, 2020 the Massachusetts Securities Division issued regulations imposing a fiduciary duty standard on broker-dealers and agents when dealing with retail customers and prospective customers. 950 Code of Massachusetts Regulations ("C.M.R.") § 12.207; https://www.sec.state.ma.us/sct/sctfiduciaryconductstandard/fiduciaryrule-adoption.htm. The regulations became effective on March 6, 2020, and the Division has stated it will commence enforcement as of September 1, 2020. 950 C.M.R. § 12.207(6); February 21, 2020 Adopting Release, page 1 (https://www.sec.state.ma.us/sct/sctfiduciaryconductstandard/fiduciaryrule-adoption.htm). These regulations are an attempt to one-up the Securities and Exchange Commission's Regulation Best Interest ("Regulation BI"), which will be effective as of June 30, 2020. The New Jersey Bureau of Securities and the Nevada Securities Division have been working on similar regulations. It is expected the Massachusetts regulations, and the New Jersey and Nevada regulations if and when they are issued and become effective, will be challenged in court, most prominently on federal preemption grounds.
The Massachusetts regulations hold broker-dealers and agents to a fiduciary standard of utmost care and loyalty to customers when they make recommendations with respect to securities and when providing investment advice. Failure to adhere to the fiduciary standard will now be deemed "unethical or dishonest conduct or practices," for which the Division can invoke a full panoply of remedies. Massachusetts Uniform Securities Act ("MUSA"), Mass. Gen. Laws ch. 110A, § 204(a)(2)(G). Investment advisers and investment adviser representatives were already subject to a fiduciary duty standard under state and federal law, and these regulations do not apply to them.
Duty of care. The regulation defines the duty of care as follows: "The duty of care requires a broker-dealer or agent to use the care, skill, prudence, and diligence that a person acting in a like capacity and familiar with such matters would use, taking into consideration all of the relevant facts and circumstances." It goes on to list relevant facts and circumstances as to which "a broker-dealer or agent shall make reasonable inquiry." 950 C.M.R. § 12.207(2)(a).
Duty of loyalty. The duty of loyalty requires that all recommendations and investment advice be made "without regard to the financial or any other interest of any party other than the customer." 950 C.M.R. § 12.207(2)(b)(3). The Adopting Release (at page 6) clarifies that the latter requirement means that recommendations and investment advice must be rendered "with only the customer's interests in mind," i.e., "a broker-dealer or agent may not factor its own compensation, any of its other interests, or any interest of any other party, into the decision-making process behind the recommendation or investment advice." This provision differs significantly from Regulation BI. The Massachusetts regulation creates a presumption that any recommendation "made in connection with any sales contest" (that term is not defined) constitutes a breach of the duty of loyalty. 950 C.M.R. § 12.207(2)(d).
The duty of loyalty also requires disclosure of all material conflicts of interest as well as "reasonably practicable efforts" to avoid, eliminate, or mitigate all conflicts of interest (without the "material" qualification). 950 C.M.R. § 12.207(2)(b)(1) and (2). "In no case will disclosing a conflict of interest, without more, satisfy a broker-dealer's or agent's duty of loyalty." Adopting Release at page 6; see also 950 C.M.R. § 12.207(2)(c).
Episodic versus ongoing duty. The fiduciary duty standard applies when providing investment advice or recommending an investment strategy or securities transaction (so-called episodic application). It is only deemed to be ongoing when exercising discretion in a customer's account, or when there is a contractual fiduciary duty or contractual obligation to monitor a customer's account on a regular or periodic basis. 950 C.M.R. § 12.207(1).
Exclusions. The Adopting Release (at page 2) states the regulations do not apply to advice on commodities or insurance products, and the Division has subsequently clarified that they do not apply to variable annuities. The regulations also do not apply to fiduciaries acting for employee benefit plans or for participants in or beneficiaries of such plans, who are governed by the Employee Retirement Income Security Act ("ERISA"). 950 C.M.R. § 12.207(4). Investment advice and recommendations concerning government/municipal securities are excluded from the duty of loyalty but not from the duty of care. 950 C.M.R. § 12.207(2)(e). The suitability rule continues to apply where the fiduciary conduct standard does not apply. 950 C.M.R. § 12.204(1)(a)(4).
Geographic reach. The Division declined to limit the regulation's definition of the term "customer" to Massachusetts residents, stating that "[t]he Massachusetts Uniform Securities Act is clear as to the scope and applicability of the Final Regulations and does not need further clarification." Subsection 414(f) of MUSA delineates the parameters of the geographic reach of application of the antifraud provision of that act (Section 102): it "applies when any act instrumental in effecting prohibited conduct is done in the commonwealth, whether or not either party is then present in the commonwealth." So, if one party to a transaction allegedly involving prohibited conduct is in Massachusetts and another party is elsewhere, the transaction could be subject to two (or conceivably more) inconsistent state regulatory regimes (not to mention the overarching regulatory scheme presented by Regulation BI). "Generally speaking, the Commerce Clause protects against inconsistent legislation arising from the projection of one state regulatory regime into the jurisdiction of another State." Healy v. Beer Institute, Inc., 491 U.S. 324, 336-37 (1989); see also Pike v. Bruce Church, Inc., 397 U.S. 137 (1970); Consolidated Cigar Corp. v. Reilly, 218 F.3d 30, 55-57 (2000), aff'd in part, rev'd in part on other grounds sub nom. Lorillard Tobacco Co. v. Reilly, 533 U.S. 525 (2001) (regulation that reached content of advertisements in national magazines sold in Massachusetts as well as advertising on the internet if viewed from a device in Massachusetts found to impose unconstitutional burden on interstate commerce).
Registered broker-dealer entities and individuals consent to personal jurisdiction in Massachusetts as a condition of registration. MUSA § 202(a). The Securities Division exercises personal jurisdiction over nonregistered entities and individuals ancillary to its power to pursue those who violate the Securities Act: those who engage in prohibited conduct are deemed to have appointed the Secretary of the Commonwealth as agent for acceptance of process in any noncriminal proceeding "which grows out of that conduct." MUSA § 414(h). Exercise of such jurisdiction is of course subject to the "minimum contacts" strictures of the Due Process Clause of the United States Constitution.
Preemption. In that the SEC has already moved to occupy this field with its Regulation BI, which is inconsistent with the Massachusetts regulations in certain respects, legal challenges to the Massachusetts regulations based on federal preemption seem inevitable. In particular several of the commenters on the proposed Massachusetts regulation argued that it would be preempted by the National Securities Markets Improvement Act of 1996. The SEC has, thus far at least, essentially taken an agnostic position as to the merits of such challenges, on the basis such judgments would be premature. The release accompanying Regulation BI states, "Whether Regulation Best Interest would have a preemptive effect on any state law would be determined in future judicial proceedings and would depend on the language and operation of the particular state law at issue." Regulation Best Interest: The Broker-Dealer Standard of Conduct, 84 Fed. Reg. 33318, 33435 n.1163 (July 12, 2019). The Commission's lone Democrat member bemoaned its failure to "say unequivocally that today's release sets a federal floor, not a ceiling, for investor protection," predicting "extensive and expensive litigation over the scope of the rule--and its effects on nascent state regulation."
Adding further uncertainty and complication are the petitions for review of Regulation BI filed by seven states (not including Massachusetts) and the District of Columbia and two private parties, which are currently pending in the Second Circuit Court of Appeals.
The Massachusetts regulations were issued after two notice-and-comment rounds, one commencing in June 2019 and the other in December 2019, which elicited numerous comment letters. A hearing on the proposed regulations was conducted in January.
To learn more about the issues raised by this client bulletin, please contact John R. Snyder at jsnyder@potomaclaw.com
Note: This bulletin is for general use and should not be construed to provide legal advice as to particular factual situations.
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