The lawsuit brought against the Securities and Exchange Commission by Attorneys General from seven states and the District of Columbia may prove not to have standing in federal court, according to one attorney.

In their complaint, the Attorneys General are asking the U.S. District Court for the Southern District of New York to scrub Regulation Best Interest, the SEC's recently passed standard of care rule for broker-dealer recommendations to retail investors.

Their complaint alleges that the SEC acted outside the instructions of Congress established in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Harm to states and their residents

The states and the District of Columbia have standing to sue, according to the complaint, because of the harm they and their residents will suffer under Reg BI, which does not go far enough to alleviate consumer confusion over the different obligations of registered investment advisors and broker-dealers, or reduce brokers' from offering conflicted advice.

"Plaintiffs will lose revenue from the taxable portions of distributions from their residents' investment and retirement accounts that are worth less because of expensive conflicts of interest in investment advice," the states argue.

The complaint says $17 billion is lost annually to conflicted advice in IRAs alone, a figure used by the Obama administration's Council of Economic Advisers when it set out to promulgate the Labor Department's fiduciary rule.

The suing states—New York, California, Connecticut, Delaware, Maine, New Mexico, Oregon, and the District of Columbia—lose $3.6 billion annually to conflicted advice on securities recommendations in IRAs, the complaint alleges.

An "odd complaint"

But a favorable ruling for the States and the District of Columbia would remove Reg BI, and return broker-dealers to FINRA's suitability standard. Presumably, that would expose retail investors to more conflicted advice, and lead to further losses to the states' future coffers.

"It's an odd complaint," said Kevin Walsh, principal and a securities attorney with The Groom Law Group.

"If the states win, what do they get? They are asking the court to strike down Reg BI. That would not create a fiduciary standard for brokers. It would revert them back to the suitability standard, a lower threshold of conduct. There is a disconnect there," said Walsh.

Determining when a party has standing to sue

In Lujan v. Defenders of Wildlife, the Supreme Court created a three-part test to determine when a party has standing to sue in federal court.

The plaintiff must have suffered an "injury in fact," and there must be a "causal connection" between the injury and the alleged conduct, according to analysis from Cornell Law School.

The third part of the test: a favorable decision by the court will redress the injury.

"It's tough to see how the states really have an interest in seeing Reg BI struck down, or how that would be good for their citizens," said Walsh. "But at the end of the day, federal judges have some latitude."

The Southern District of New York is viewed as a favorable venue for consumer advocates.

The latest installment of the legal saga over the standard of care owed to retail investors by broker-dealers proves one thing.

"Any time a rule gets promulgated on the standard of care, someone will sue the regulator," said Walsh, referring to the legal battle over the Labor Department's fiduciary rule.

"This is a debate we've been having for 80 years," he added.

Instant Insights /

Do states have standing to sue SEC over Reg BI?

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