The Fiduciary Rule: What’s Next (Part 4)?

This is my 88th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is the fourth of my four-part series on the critical questions raised by the 5th Circuit Court of Appeals decision to “vacate,” or throw out, the Fiduciary Rule. The first article (Angles #85) discussed the general legal issues created by the 5th Circuit decision to vacate the Fiduciary Rule. Then, Angles #86 and Angles #87 described fiduciary status for advisors under the “old” 5-part test and the standard of care for fiduciary advisors. This post discusses conflicts of interest for fiduciary advisors under ERISA and the Code—and what the future may hold.

The most difficult of the three issues is how the regulators will deal with conflicts of interest. That is true for two reasons. (This article does not discuss the SEC’s new proposed Regulation Best Interest. That will be covered in future articles.)

The first is that the approach taken by the SEC and DOL in the past have been very different and are foundational to their thinking and, most likely, in how they may go forward. For example, the Department of Labor must comply with ERISA and Internal Revenue Code provisions on prohibited transactions for financial conflicts of interest. Generally speaking, fiduciary conflicts of interest are strictly prohibited under both ERISA and the Code. As a result, to permit financial conflicts of interest that result from fiduciary advice, the DOL must issue exceptions (called “exemptions”) from the prohibited transaction rules. In order to do that, the DOL must determine that the conditions of the exemption are adequate to protect the interests of retirement investors. On the other hand, the SEC has, by and large, relied on disclosures to mitigate the potentially harmful effects of conflicts of interest. The SEC’s expectation appears to be that, if conflicts are disclosed, investors will review those disclosures and make reasoned investment decisions.

The second reason is that, because of the prevalence of 401(k) and 403(b) plans, some relatively unsophisticated retirement investors are accumulating significant amounts of money. That raises the issue of whether disclosures of conflicts of interest, without more, will adequately protect those investors. Unfortunately, disclosure documents can be lengthy and complex, which may make it difficult for less sophisticated investors to appreciate the full significance of the disclosed conflicts.

The DOL may require more than just disclosures in their new prohibited transaction exemptions—which could be released, in proposed form, in the third quarter of this year.

Also, with regard to the SEC, Chairman Clayton has suggested that there should be a shorter (perhaps four pages), more transparent, disclosure document for the conflicts of interest of RIAs and broker-dealers. It remains to be seen whether something that short could adequately cover the material conflicts of interest with sufficient detail to fully inform an investor.

On April 18, 2018, the SEC proposed a new Regulation Best Interest and short disclosure documents. The proposed regulation would impose a best interest standard of care on broker-dealers.

It is likely—at least in my view—that the DOL will follow suit and issue a proposed regulation re-defining fiduciary advice—perhaps more broadly than the new 5-part test, but less expansive than the Fiduciary Rule.

The DOL will also need to issue prohibited transaction exemptions. (Note: The BIC exemption provided relief for a number of common fiduciary prohibited transactions. However, the 5th Circuit also vacated the BIC exemption.) I suspect that the DOL exemptions will, for the most part, follow the SEC’s disclosure requirements, but perhaps adding additional protections for retirement investors.

For both the SEC and DOL proposals, there will be comment periods following the issuance of the proposals. After receiving comments, the SEC and the DOL will develop their final guidance. Then, I suspect that both agencies will delay the applicability of the final rules—perhaps to January 1, 2020—to allow broker-dealers, RIAs and other service providers to make necessary changes.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

The Fiduciary Rule: What’s Next (Part 3)?

This is my 87th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is the third of my four-part series on the critical questions raised by the 5th Circuit Court of Appeals decision to “vacate,” or throw out, the Fiduciary Rule. The first article, Angles #85, discusses the three critical questions for the SEC and DOL to answer. The second article, Angles #86, discussed the first critical question, “Who is a fiduciary?”

This post covers the second critical question, “What is the fiduciary standard of care?”

For purposes of advice to retirement plans and participants, that’s an easy answer. It’s ERISA’s prudent man rule and duty of loyalty. That standard is statutory and, as a result, it cannot be modified by rule or regulation—by the DOL or SEC.

There is a large amount of guidance, both from the DOL and the courts, on how to comply with the standard. For example, a fiduciary advisor must engage in a prudent process—at the level of a hypothetical, knowledgeable person—taking into account that the purpose of the investments is to provide retirement benefits. That means that an advisor must consider the “relevant” factors for making a prudent recommendation. You might call that a “duty to investigate,” and then to evaluate. Courts have also said that fiduciaries must use generally accepted investment theories and prevailing investment industry standards (e.g., for asset allocation and selection of investments).

But, of course, those standards only apply if an advisor is a fiduciary. Fiduciary status was discussed in Angles #86.

The issue is more complex for fiduciary advice to IRAs. Where an advisor to an IRA owner does not engage in prohibited transactions—for example, charges a reasonable level fee (and the advisor, supervisory entity and all affiliated and relates parties do not receive anything in addition to that fee), there is not a prohibited transaction. As a result, neither the IRS nor the DOL have a basis for further regulating the advisor. On the other hand, where an advisor (or the supervisory entity, or any affiliated or related party) receives conflicted compensation, that would be a prohibited transaction and an exemption would be needed. Generally speaking, there are two forms of conflicted compensation. The first, and most common, is any payment from a third party (for example, a 12b-1 fee from a mutual fund or a commission from an insurance company). The second form of conflicted compensation is sometimes referred to as “variable” compensation (for example, a commission on each recommended transaction in a brokerage account).

Before the 5th Circuit decision, the primary exemption for those conflicts was BICE (the Best Interest Contract Exemption). That exemption permitted conflicted compensation if the advisor and the supervisory entity (e.g., a broker-dealer) adhered to the best interest standard of care (and other Impartial Conduct Standards). However, the 5th Circuit Court of Appeals threw out BICE, as well as the fiduciary regulation. After that decision, there are only a few exemptions for conflicted advice—and they are very limited.

However, the DOL will likely issue a new exemption to replace BICE, and will impose conditions. It remains to be seen what those will be. But, it’s possible that some standard of care would be imposed, perhaps the new standard that the SEC is working on—and it’s almost certain that disclosures will be required.

One thing that is certain is that the limitation for reasonable compensation will be a requirement of the exemption. It’s a statutory provision in both the Code and ERISA.

At this point, it’s impossible to know what the SEC’s new standard of care will be. There are important questions to be answered. For example, will the standard be the same for RIAs and broker-dealers when investment advice is given to retail investors, such as IRA owners? While uncertain, it is possible that a duty of loyalty will be applied to both types of advisors. And, since RIAs are already fiduciaries under the securities laws, it’s hard to imagine that a lower standard of care would be required for RIAs.

On the other hand, there is some discussion that the SEC might develop an “enhanced” suitability standard for broker-dealers. While that sounds interesting on paper, it’s more difficult to imagine what it would be. For example, the DOL has said that, if a recommendation is not suitable, it would not be prudent. However, the DOL went on to say that, if a recommendation is suitable, that doesn’t necessarily mean that it’s prudent. So, the question is, will the SEC draw a line between those two standards and, if so, where will that line be?

On a related point, and as a guess, I don’t believe the DOL or the SEC will say that the new standards can be enforced by retail investors. In other words, it is likely that the standards will only be enforceable by regulators. While that may be the outcome for the case for IRAs and other retail accounts, ERISA allows for private claims for violations of its provisions, and those statutory rights cannot be taken away by rules or regulations. As a result, advice to plans and participants will be enforceable as private claims.

Since the SEC’s proposed guidance will be issued in the near future, we will know the answers soon enough.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

The Fiduciary Rule: What’s Next (Part 2)?

This is my 86th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is the second of my four-part series on the critical questions raised by the 5th Circuit Court of Appeals decision to “vacate,” or throw out, the Fiduciary Rule. My last post, Angles #85, introduced the questions:

  • Who is a fiduciary?
  • What is the fiduciary standard of care?
  • How will conflicts of interest be treated under the new rules?

This post discusses the first question: “Who is a fiduciary?”

Assuming that the 5th Circuit Court of Appeals decision is the final word, the old 5-part fiduciary test will automatically be reinstated. That means that, in order for an advisor to be a fiduciary, all 5 requirements in the regulation must be satisfied. (Keep in mind, though, that this only applies to non-discretionary investment advice. Where an advisor has discretion, the advisor is a fiduciary under a different rule.) The 5-part test is that the advisor must:

  • Make investment or insurance recommendations for compensation;
  • Provide the advice on a regular basis;
  • Have a mutual understanding with the retirement investor that:
    • The advice will serve as a primary basis for investment decisions; and
    • The advice will be individualized and based on the particular needs of the retirement investor.

The definition covers investment and insurance advice to “retirement investors,” in other words, to plans, participants and IRA owners.

Let’s look at each of the 5 parts of the definition.

With regard to the first requirement—recommendations for compensation, it appears that virtually all recommendations to retirement investors would satisfy that requirement, if the advisor (or his supervisory entity, e.g., broker-dealer or RIA) will receive compensation, directly or indirectly, when the recommendation is accepted.

The second requirement—that the advice be given on a regular basis—is a more interesting issue and will vary from case to case. Let me explain. Where an advisor regularly meets with a retirement investor and updates the advice (e.g., asset allocation or investments), it is likely that the requirement is satisfied. That would apply, for example, to an advisor for a 401(k) plan who meets with a plan sponsor on a quarterly or annual basis. Similarly, it might apply where an advisor recommends an individual variable annuity or individual fixed indexed annuity to an IRA owner, with the contemplation that they will meet periodically to review the investments, indexes, etc. However, it would not apply to a one-time sale, where the advisor sells an investment or insurance product and does not provide any ongoing advice.

The third requirement is that there be a mutual understanding, arrangement or agreement, between the retirement investor and the advisor that the advice satisfies the 4th and 5th requirements (below). While some people believe that refers to a subjective understanding in the minds of the advisor and the investor, the DOL will probably use the standard of what a reasonable third party would conclude based on the communications between the advisor and the investor.

The fourth requirement is that the recommendations be understood to be a primary basis for making investment or insurance decisions. It is frequently described incorrectly as “the” primary basis. However, if you look at the wording of the regulation (and if you look back into the history of the regulation), the recommendation simply has to be one of the primary bases. In other words, it doesn’t have to be the sole, or even the predominant, basis for making decisions. As a result, it seems like this condition would usually be satisfied, because recommendations are typically made for the purpose of being seriously considered by an investor.

The last requirement is that there is a mutual understanding that the advice is individualized and based on the particular needs of the retirement investor. While the expectation, and perhaps the understanding in most cases, is that investment recommendation is designed for the particular investor, there are cases where communications about investments may not be fiduciary advice. For example, if a broker-dealer has a list of preferred mutual funds or stocks, the list would likely be viewed as generic and, therefore, as not being intended for any particular investor. However, if that list was narrowed by an advisor and then presented to an investor, that would probably tip the scales in the other direction.

The moral to this story is that, even if the 5th Circuit decision becomes the final word on the fiduciary rule, many—if not most—advisors to retirement plans will still be fiduciaries.

On the other hand, it may make a difference for IRAs. For example, RIAs may generally be fiduciaries, even in the IRA world, because they provide investment services on a regular—or ongoing—basis and there is usually an understanding that the advice is individualized. In addition, many RIAs provide discretionary investment management services for IRAs, which is automatically fiduciary advice.

However, insurance agents and representatives of broker-dealers may, in some cases, make recommendations on an isolated basis, and there may be an understanding that it is a sale, where the advisor will not be providing continuous services. But, where an insurance agent or a representative of a broker-dealer satisfies the 5-part test, the agent/advisor will be a fiduciary.

The fiduciary standard of care will be discussed in the next article, Angles #87.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.