The “old” rules will again prevail—but the old rules will not be applied in the old ways, and this will have some significant impacts on broker-dealers.
As the DOL has not asked for a rehearing of the Fifth Circuit’s decision vacating the Fiduciary Rule, or yet sought to appeal the decision, it is widely anticipated that the March 15 ruling will soon take effect, restoring the DOL’s 1975 regulation defining fiduciary investment advice to plan and IRA investors (we say “widely anticipated” because, while the official mandate vacating the Fiduciary Rule is expected soon, it has been delayed while the court considers efforts from certain states and other third parties to intervene in the case). While the SEC has proposed new regulations for broker-dealers, and while we expect the DOL to propose new prohibited transaction exemptions or regulations that will coordinate with the SEC’s actions, it will be at least a year before these initiatives could begin to apply.
Prior to the DOL fiduciary rule, the regulated community had fallen into a comfortable set of assumptions about the DOL’s 1975 regulation. Registered representatives of broker-dealers, insurance agents, and similar “sales”-oriented advisors typically did not view themselves as fiduciaries when advising plans and IRAs. While we may be returning to the “old” rule, those days are gone, and broker-dealer firms and advisors cannot afford to assume that they won’t be ERISA fiduciaries in the “new” day of the “old” rule. Here’s why:
On its face, the now-reinstated 1975 standard, referred to as the “Five-Part Test,” does not treat brokers differently from RIAs or any other type of institution. It is a functional test that simply states that advice for a fee (or other compensation, direct or indirect) is “fiduciary” advice, if it is:
- Regarding the value of securities or other property, or as to the advisability of investing in, purchasing or selling securities or other property;
- provided on a regular basis;
- provided pursuant to a mutual agreement or understanding, written or otherwise;
- that the advice will be a primary basis for investment decisions; and
- individualized, based on the particular needs of the investor.
We should point out that the DOL’s Five-Part Test standard is different from the “fiduciary” standard in the Investment Advisers Act of 1940 (requiring disclosure of conflicts of interest), which may also apply to brokers who give advice for a direct fee, as opposed to commissions or other indirect compensation. In any case, it has been longstanding industry practice to presume that brokers would generally not fall within the DOL’s fiduciary standard when selling investment and insurance products (whether for direct fees or indirect compensation) because one or more of the “regularly provided,” “mutual understanding,” “primary basis” or “individualized advice” prongs would not be satisfied. We do not believe this presumption can be sustained going forward. The Fiduciary Rule and the developments that came along with it have caused investors and regulators to scrutinize these issues and re-examine previous understandings. Going forward, broker-dealers should expect to be held to the “letter” of the Five-Part Test.
This doesn’t mean that every recommendation to a plan fiduciary, plan participant or IRA owner will constitute fiduciary advice under the 1975 DOL standard. The Five-Part Test is a more narrow definition than the vacated Fiduciary Rule, and the prongs do materially limit the scope of fiduciary advice. For example, a recommendation to a participant to take a distribution and roll it over to an IRA likely will not be fiduciary advice under the 1975 standard because the recommendation is “one-time” advice that is not provided on a regular basis. The Fifth Circuit’s decision vacating the DOL Rule in toto likely means that previous DOL guidance on distribution and rollover recommendations rescinded by the Rule (such as Advisory Opinion 2005-23A) is again applicable. Under that guidance, as long as a person recommending an IRA rollover is not already a plan fiduciary, the recommendation is not treated as a fiduciary act even if it’s coupled with advice on how to invest the IRA. Brokers should recognize, however, that IRA rollover recommendations – even if not “fiduciary” under the Five-Part Test – are subject to the standards set forth in FINRA Regulatory Notice 13-45.
Rollovers are not the only example of recommendations that may not rise to a fiduciary level – recommendations to transfer IRAs, and various types of “sales” recommendations provided only sporadically and/or on a non-individualized basis, will not satisfy all five prongs.
But consider a broker who has a longstanding relationship with a 401(k) plan sponsor, offering regular recommendations on plan investment options. If the advice has been followed by the plan fiduciaries (as is typically the case), it will be increasingly difficult to argue that there is no “mutual understanding” that the advice is “a primary basis” for investment decisions. Because the “understanding” can be written “or otherwise,” contractual provisions disclaiming such an understanding may be helpful to refute a claim of fiduciary status, but not dispositive.
Likewise, it may prove difficult for brokers to ensure adherence to FINRA’s suitability standards on the one hand (requiring evaluation of an investor’s financial situation and needs, investment objectives and time horizon, liquidity needs, risk tolerance, etc.) but still avoid providing “individualized” advice on the other.
While we await further rulemaking from the DOL, broker-dealers find themselves at somewhat of a crossroads; that is, “old” rules viewed through the lens of a new day. We recommend that firms assess carefully when, and under what circumstances, their representatives’ recommendations may constitute fiduciary advice under the Five-Part Test.
Fiduciary status under the Five-Part Test – or lack thereof – determines whether a broker is held to ERISA’s prudence and loyalty standards for advice to plans and participants. Just as significantly, for plan and IRA investors alike, this status determines whether commissions or other forms of variable compensation are prohibited transactions for which an exemption must be available (and its requirements satisfied). While the 1975 definition of fiduciary advice is more limited than the DOL Fiduciary Rule, its application will be broader than it was perceived to be in the past. In a coming post, we will examine in more detail the prohibited transaction and exemption issues presented by the Fifth Circuit’s decision, the DOL enforcement policy announced on May 7, 2018, and the effect of these developments on broker-dealer compensation.