In the wake of the demise of the Department of Labor's (DOL) fiduciary rule, New Jersey intends to proceed with a plan to impose its own fiduciary rule on brokerage and advisory professionals. Although the details of the proposed standard have yet to be announced, it is nonetheless expected that the proposed rule will create a standard of care well beyond the standard that is currently being proposed by the Securities and Exchange Commission (SEC).

On Sept. 17, 2018, New Jersey Governor Phil Murphy announced a plan for using the broad rulemaking authority of the New Jersey Bureau of Securities (the “Bureau”) in order to administratively create a uniform fiduciary standard applicable to both investment advisers and brokerage firms doing business in New Jersey. Governor Murphy said he was directing the Bureau to propose new rules establishing a uniform fiduciary standard in New Jersey because of his dissatisfaction with recent activity at the federal level, specifically the Trump Administration's decision to abandon the defense of the DOL's fiduciary rule and his view that the SEC's proposed Regulation Best Interest (“Reg BI”) announced in April 2018 would not sufficiently protect New Jersey investors.

Notice of Pre-Proposal

On Oct. 15, 2018, the Bureau issued a Notice of Pre-Proposal (the “Notice”) soliciting comments for the purpose of amending Section 13:47A-6.3 of the New Jersey Administrative Code, which sets forth examples of dishonest or unethical business practices on the part of brokerage and advisory professionals. The Bureau is considering making it a dishonest or unethical practice not to act in accordance with a fiduciary standard in connection with recommending an investment strategy or the purchase, sale or exchange of securities, or providing investment advisory services.

Other than raising the level of conduct required by a broker-dealer beyond the current suitability standard established by the Financial Industry Regulatory Authority (FINRA), Governor Murphy did not offer any details as to the contours of the proposed regulation. Despite the absence of any details, what is clear is that the standard of care which the Bureau seeks to impose on broker-dealers would apply in a wide variety of circumstances, i.e., the purchase, sale or exchange of a security or the recommendation of an investment strategy. Interestingly, despite the likely breadth of the uniform fiduciary standard, the Notice is silent on whether the standard would apply where the broker-dealer merely recommends that the customer continue to hold a specific security (FINRA's suitability rule does apply to recommendations to hold). Of course, that gap in the Notice may be filled once the Bureau actually issues the proposed rule.

We also expect that the proposed uniform fiduciary standard will extend beyond Reg BI's requirement that non-fiduciary investment advisers plainly disclose their lack of fiduciary status with the client, and will seek to impose a standard of conduct much closer to the DOL fiduciary rule. The Notice nonetheless makes clear the Bureau's view as to the propriety of a uniform fiduciary standard. Such a standard “protects investors against the abuses that can result when financial professionals place their own interests above those of their customers.”

To that end, the Bureau solicited comments on: (i) the legal and factual bases for applying a fiduciary standard to all financial services professionals; (ii) the scope of the duty in terms of duration and when it arises; (iii) the types of recommendations that would trigger the duty; and (iv) the scope of the duty in terms of to whom it would be owed. As part of the comment period, the Bureau held two public hearings in November 2018 to solicit feedback on the proposed uniform fiduciary standard applicable to all investment advisers and broker-dealers doing business in the state.

Full Steam Ahead: Reg BI is Nothing New

Proponents of the fiduciary rule, such as the Consumer Federation of America, favor a state standard because they believe that Reg BI does not sufficiently protect investors. They argue that Reg BI may “do little more than rebrand the existing FINRA suitability standard as a best interest standard.”

Others, such as Richard Barry, the former Enforcement Chief of the Bureau, assert that while there may be a variety of products that are technically “suitable” for the investor based on the client's risk profile, current standards do not require the broker to disclose that: (i) there may be lower cost options available; or (ii) the broker's recommendation may be driven by potential incentives creating a conflict of interest.

Those like Tamar Frankel, Professor of Law Emerita, Boston University School of Law, have therefore pushed for adopting a duty of loyalty that includes “fully and fairly disclosing the nature of the conflicts of interest so that the client can either reject the broker's recommendation or provide a written, informed client consent.”

Adoption is Premature: Wait and See What the SEC Does Before Acting

Trade groups representing the financial services industry also support a uniform standard of care, but consider New Jersey's proposed rule to be premature. They advocate for the Bureau to wait until the SEC and DOL finalize their rulemaking before deciding whether to move forward with the adoption of a uniform fiduciary standard. The delay would be temporary as the DOL announced plans to issue a revised, final fiduciary rule in tandem with the SEC's final release of Reg BI by September 2019.

Those favoring deferral of the state rulemaking, such as the Financial Services Institute (FSI), submit that a patchwork state standard would: (i) confuse investors by creating duplicative legislation and different and conflicting state standards; (ii) create undue costs on investors; and (iii) reduce consumer choice and access to investment guidance and products.

The Securities Industry and Financial Markets Association (SIFMA) contends that Reg BI addresses current concerns and already contains “all the hallmarks of a fiduciary standard, as specifically tailored to the broker-dealer model.” Reg BI imposes obligations at the time of the recommendation that are generally consistent with the fiduciary obligation imposed on an investment adviser. Reg BI proposes that at the point of sale, a broker-dealer must: (i) act in the client's best interest, without placing their financial or other interests ahead of the client's interest; (ii) act with diligence, care, skill and prudence and weigh the cost of the security in determining whether to make the recommendation; and (iii) disclose and mitigate or eliminate material conflicts of interest.

FSI and the U.S. Chamber of Commerce also caution that creating a state fiduciary duty will lead to unintended and adverse consequences, such as causing harm to the very investors that the rule is intended to protect. The rule may lead to increased costs that will ultimately be passed down to Main Street investors and limitations on market access. This warning was substantiated by a Deloitte & Touche study that found that, in response to the DOL fiduciary rule, 53 percent of the 21 firms surveyed had adopted plans to discontinue offering certain commission-based retirement planning services.

The National Association of Insurance & Financial Advisors – New Jersey (NAIFA NJ) likewise maintains that a fiduciary rule could push brokers into denying access to commission-based accounts for those who hold small account balances. A fiduciary standard may result in middle-income New Jersey residents being driven toward online brokerage services and losing out on quality investment guidance, since some fee-based accounts have high minimum asset thresholds.

A New Jersey fiduciary rule could face preemption challenges. The American Retirement Association cautions that the rule may be preempted by Employee Retirement Security Act of 1974 (ERISA) §514(a), if the proposed rule creates fiduciary obligations on qualified ERISA retirement plans. The National Securities Markets Improvement Act of 1996 (NSMIA) also expressly preempts a state's ability to impose record keeping requirements on broker-dealers that differ from those under the Exchange Act. Some commentators note, however, that NSMIA contains a broad savings clause that permits state enforcement action with respect to “fraud or deceit,” and the breach of a fiduciary duty may constitute constructive fraud.

Although N.J.S.A. §49:3-67(a) provides the Bureau Chief with rulemaking powers that are “reasonably necessary to carry out the provisions” of the New Jersey Uniform Securities Laws, the proposed fiduciary rule may also be met with constitutional challenges. Similar to the recent constitutional challenge brought by the National Association of Insurance and Financial Advisors for New York State (NAIFA-NYS) against the New York Department of Financial Services' (NYDFS) “best-interest” regulation (Regulation 187, 11 N.Y.C.R.R. §224), a proposed fiduciary rule that sidesteps the legislative process may be found to be ultra vires if it lacks a state constitutional or statutory predicate.

The opportunity for stakeholders to comment on the Pre-Proposal closed on Dec. 14, 2018. The Bureau is currently reviewing the comments received in response to the Pre-Proposal. Once the Bureau proposes the rule, the public will have an additional 60-day period to comment.

KPMG's Ten Key Regulatory Challenges of 2019 listed “divergent regulation” as the greatest challenge affecting financial services firms. As New Jersey intends to proceed with its fiduciary rule proposal, the state regulation will be yet another example of individual state promulgated regulations that may differ from similar federal laws, raising “the likelihood of inconsistency among regulators.”

David J. Libowsky is a shareholder and principal in the Securities Litigation and Regulation group of Bressler, Amery & Ross, in Florham Park. Daniel Strashun is an associate at the firm and counsels broker-dealers and investment advisers on regulatory issues.