DOL's Fiduciary Rule Vacated—But the Best Interest Concept Appears Here to Stay
On June 21, 2018, the US Court of Appeals for the Fifth Circuit issued a mandate that gives effect to its March 15, 2018 opinion vacating the DOLs fiduciary rule and related prohibited transaction exemptions. The DOL rule applied to all categories of providers—broker-dealers, investment advisers, insurance agencies and bank trust departments. The mandate has been eagerly awaited by financial institutions because it results in the immediate removal of the fiduciary rule from federal law and, subject to a temporary DOL enforcement policy that allows financial institutions to continue to rely on the Best Interest Contract exemption (the BIC exemption), the return, at least for now, of pre-fiduciary rule law for determining fiduciary status under ERISA and the Internal Revenue Code, as applicable to retirement plans, IRAs and other tax-qualified savings vehicles (generally, "ERISA plans and IRAs").
Prior to the vacatur of the DOL fiduciary rule, broker-dealers, registered investment advisors and bank trust departments were potentially subject to different standards of care: the "best interest" of the customer standard of care applied to sales of products and services to ERISA plans and IRAs; the lower SEC "suitability" standard of care applied to sales to other types of accounts by broker-dealers; and a fiduciary standard applied to registered investment advisers (RIAs) and bank trust departments that provided investment advice. These different standards of care resulted in substantial complexity for financial institutions and often confusion on the part of customers. In reaction, many financial industry trade associations took the position that the SEC, and not the DOL, is the appropriate federal agency to regulate broker-dealers and investment advisers and that the SEC should establish a uniform standard of care for the sale of products by these SEC-regulated firms applicable to ERISA plans and IRAs and other types of accounts on the same basis.
On April 18, 2018, the SEC issued a set of proposals and interpretations of existing securities laws that are intended to enhance and clarify the duties that broker-dealers and investment advisers owe to their customers and clients. These include:
- a new "Regulation Best Interest" (Reg BI);
- a new rule to restrict broker-dealers and their personnel from using the term "adviser" or "advisor" when communicating with retail investors;
- a new Interpretation that expounds upon the existing fiduciary duties of RIAs;
- new and amended rules and forms to require RIAs and broker-dealers to provide relationship summaries to retail customers; and
- new rules to require broker-dealers, RIAs, and their related persons to disclose their registration status and relationships to retail investors.
This action by the SEC likely means that, despite the demise of the DOL fiduciary rule, the best interest concept and similar consumer protections are here to stay. Indeed, the SEC's ongoing "Mutual Fund Share Class Selection Disclosure Initiative" appears to borrow concepts from the fee structures required for ERISA plans and IRAs. Moreover, the SEC is not alone in picking up on the best interest concept. As discussed further below, a number of states, including New York, New Jersey and Nevada, have imposed, or are considering imposing, best interest obligations or other enhanced standards on financial institutions and their personnel.
Controversial Fiduciary Rule Vacated
The DOL fiduciary rule has been controversial since it was first proposed in 2010. Both the original 2010 proposal and the DOL 2015 re-proposal of the rule generated a high volume of comment letters and letters to legislators in which consumer advocacy groups generally favored the rule and financial institutions generally opposed the rule. The fiduciary rule significantly broadened fiduciary status and required that any financial institution or individual adviser that was an investment advice fiduciary in respect of an ERISA plan or IRA act in the customer's best interest in order for the institution or adviser to receive compensation that the DOL viewed as conflicted (e.g., transaction based compensation, such as sales commissions).1
Following the adoption of the final rule in 2016, a number of financial industry trade associations challenged the rule in federal district court in Texas, but the district court upheld the rule. On appeal, the US Court of Appeals for the Fifth Circuit, in a surprise 2-1 decision, overturned the district court and vacated the entire fiduciary rule, including the related new prohibited transaction exemptions (such as the BIC exemption), on the grounds that the rule was "unreasonable" and an "arbitrary and capricious" exercise of administrative power. Following several unsuccessful attempts by AARP and the states of New York, California, and Oregon to intervene in the case in order to pursue a rehearing or appeal of the decision, the vacatur finally went into effect on June 21, 2018 when the Fifth Circuit issued its mandate. As a result, the DOL fiduciary rule is no longer part of federal law.
From the time the final fiduciary rule came into effect on June 9, 2017 until the Fifth Circuit issued the mandate vacating the rule on June 21, 2018, financial institutions were required to comply with the rule on a transitional basis and were able to avoid DOL enforcement action so long as they were "working diligently and in good faith to comply with the fiduciary rule and exemptions."2 During the transition period, any fiduciary that utilized any of the new or amended prohibited transaction exemptions, such as the BIC exemption, was required to satisfy the "impartial conduct standards." This generally required providing advice in the retirement investor's best interest, charging no more than reasonable compensation, and avoiding misleading statements. Even though the full requirements of the rule were not in effect, compliance with the impartial conduct standards, particularly the best interest requirement, caused many financial institutions to make significant changes to their business models and longstanding sales and compensation practices.
Now that the DOL fiduciary rule has been vacated, financial institutions should revisit the changes they made to comply with the fiduciary rule. Because pre-fiduciary rule law attaches fiduciary status to a far smaller range of activities, it is likely that certain business practices may no longer need to rely on a prohibited transaction exemption. As a general matter, pre-fiduciary rule law under ERISA and the Internal Revenue Code is more flexible and financial institutions may consider taking advantage of that flexibility. Even in the absence of the fiduciary rule, however, concerns among federal and state regulators and plaintiffs' counsel about the sale of poorly performing or high-priced products to ERISA plans and IRAs, as well as concerns about arguably conflicted compensation to brokers and other financial advisors, are likely to linger.
One downside of the vacatur of the DOL fiduciary rule is that all of the related new and amended prohibited transaction exemptions are also vacated. For all of its faults, the BIC exemption generally allowed fiduciaries to be paid compensation that is viewed by DOL as conflicted (e.g., transaction-based compensation) in connection with fiduciary investment advice to ERISA plans and IRAs. For financial institutions and advisors who relied on the BIC exemption to receive such compensation and who are still fiduciaries after that vacatur of the fiduciary rule, there are few, if any, ways, to continue to receive such compensation under other prohibited transaction exemptions, absent a credit back of those fees for the benefit of the customer in accordance with DOL's Frost opinion letter.3 Recognizing that some financial institutions structured their affairs to rely on the BIC exemption and may wish to continue doing so, on May 7, 2018, the DOL issued a temporary enforcement policy stating that, until further regulations, exemptions or guidance is issued, the DOL will not pursue prohibited transaction claims for transactions that would have been exempt under the BIC exemption (or the also-vacated principal transaction exemption) against fiduciaries who are working diligently and in good faith to comply with the impartial conduct standards for transactions that would have been exempted by the BIC exemption. It is worth noting, however, that DOL's temporary enforcement policy only applies to DOL and IRS enforcement actions, so it is possible that private claims might be brought by customers against financial institutions that choose to rely on the policy. Further, because the DOL enforcement policy is only temporary, any financial institution that needs to rely on the policy after vacatur of the fiduciary rule may wish to consider its alternatives in the event DOL decides to end the temporary policy.
SEC Proposes New Retail Investor Protections
As noted above, the debate surrounding the DOL fiduciary rule has focused the SEC's attention on protections for the benefit of retail customers of broker-dealers and RIAs.4 The SEC's latest proposals span three releases and are summarized as follows.
Use of the Terms "Adviser" or "Advisor" By Broker-Dealers.
Under the SEC's proposed rules, when communicating with a retail customer, broker-dealers and their associated natural persons would be prohibited from using the term "adviser" or "advisor" as part of a name or title unless the firm is registered with the SEC or a State as an investment adviser, or the individual is a supervised person of, and is acting on behalf of, such a RIA. This proposed change is meant to address confusion among retail customers as to the use and import of such titles.5
Reg BI: Standards for Broker-Dealers and Their Personnel
Under proposed Reg BI, whenever a broker-dealer or a natural person associated with a broker-dealer recommends a securities transaction or investment strategy to a retail customer they would have to "act in the best interest of the retail customer" without placing their own financial or other interests ahead of the interests of that customer.6 This "best interest" standard is not the same as a fiduciary standard applicable to RIAs: the SEC notes that Reg BI "would be separate and distinct from the fiduciary duty that has developed under the Advisers Act."7 The "best interest" standard would be met if the broker-dealer or natural person complied with certain standards of care, disclosure, and conflict management requirements summarized below.
- Disclosure. The firm or natural person would have to disclose, in writing, the material facts as to the scope and terms of the relationship with the customer, including all material conflicts of interest associated with a recommendation.
- Care. The broker-dealer or natural person would have to use reasonable diligence, care, skill, and prudence to:
- Understand the risks and rewards of a recommendation and have a reasonable basis to believe the recommendation could be in the best interest of at least some retail customers;
- Form a reasonable basis to believe the recommendation is in the best interest of a particular retail customer based on that customer's investment profile and the potential risks and rewards of the recommendation; and
- Have a reasonable basis to believe a series of recommended transactions, even if in the retail customer's best interest when viewed in isolation, is not excessive and is in the retail customer's overall best interest.
- Conflict Management. The broker-dealer would have to establish, maintain, and enforce written policies and procedures reasonably designed:
- To identify and, at a minimum, disclose, or eliminate, all material conflicts of interest that are associated with a recommendation, and
- To identify and disclose and mitigate or eliminate, material conflicts of interest arising from financial incentives associated with such recommendation.
Proposed Reg BI would have a broader application than the DOL fiduciary rule: it would apply to all securities transactions or strategies that a broker-dealer or associated natural person recommends to a retail customer, generally including ERISA plan and IRA rollovers. A retail customer is defined as "a person or the legal representative of such person, who . . . [u]ses the recommendation primarily for personal, family, or household purposes." Individuals and any type of account held by an individual (whether a standard or retirement account) would receive the benefit of the rule with respect to recommended securities transactions or strategies. Thus, proposed Reg BI is not focused on the type of account, but on the nature of the customer and the type of instrument that is recommended.
Aspects of these proposed standards, such as the requirement to understand the risk/reward characteristics of a given security or strategy, and the customer's investment profile, draw from suitability obligations reflected in the rules of the Financial Industry Regulatory Authority (FINRA). They are also more flexible and principles-based than the highly technical and burdensome standards associated with the DOL fiduciary rule and related prohibited transaction exemptions. The "best interest" standard is new, however, and the SEC has decided not to provide an explicit definition, leaving that to the facts and circumstances of each case.
Thus, proposed Reg BI appears to call for a standard of conduct that is more than "suitability" but somehow less than "fiduciary," and its ultimate parameters will be subject to development, debate and litigation. In this regard, both the SEC and FINRA will have examination and enforcement authority for compliance with Reg BI. In determining how regulators may view certain practices under the potential new standards, retail broker-dealers may find that FINRA's 2013 Report on Conflicts of Interest, which describes certain conflict management practices, provides a useful starting point.
Standards for Registered Investment Advisers
In a separate release, the SEC has proposed a new Interpretation of the Standard of Conduct for Investment Advisers, and requested comments on three potential enhancements to its regulations for RIAs.8 The proposed Interpretation expounds upon the existing core duties of care and loyalty for RIAs providing services to all types of customers, whether retail or institutional, and no matter the type of account. Thus, the proposed Interpretation would apply "not just to potential investments, but to all advice the RIA provides to clients, including advice about an investment strategy or engaging a sub-adviser and advice about whether to rollover a retirement account so that the investment adviser manages that account."9 The proposed Interpretation notes that an RIA's duty of care includes:
- The duty to act and to provide advice that is in the best interest of the client. This requires an RIA to determine a client's investment profile by learning their financial situation, relative financial sophistication, investment experience and objectives and then to provide personalized advice that is suitable for, and in the best interest of, the client.
- An investment profile should be periodically updated based on the passage of time, significant life events, changes in tax laws or any other events that may cause the RIA's advice to be inaccurate or inappropriate for the client.
- Fees, compensation and other costs of investing would be one of many factors to consider when determining whether a security or strategy is in the best interest of a client. Though an RIA would not have to automatically select the lowest-cost option, it would not be acting in the client's best interest if it recommended a security that was more expensive than a cheaper, but otherwise identical security (especially if additional compensation flowed to the RIA without the client's informed consent).
- The duty to seek best execution. Where an RIA is responsible for selecting broker-dealers to execute trades, it must seek executions such that the client's total cost or proceeds in each transaction are the most favorable under the circumstances.
- In this regard, an RIA should assess the full range and quality of a broker's services, including execution capability, commissions, research, financial responsibility, and responsiveness. An RIA should periodically and systematically evaluate execution quality.
- The duty to provide advice and monitoring over the course of the relationship. The proposed Interpretation states that an RIA's duty of care includes an obligation to provide advice and monitoring over the course of an advisory relationship "at a frequency that is both in the best interest of the client and consistent with the scope of advisory services agreed upon."10 This would include evaluation of whether a particular account or program type continues to be in the client's best interest.
As to an RIA's duty of loyalty, the proposed Interpretation notes that an RIA must put its client's interests first and that it may not favor its own interests over those of a client or unfairly favor one client over another (such as by favoring clients that pay higher fees). The RIA must make full, fair and specific disclosures of all material conflicts so that a client is able to decide whether to provide informed consent. For purposes of disclosing conflicts, simply stating that the RIA "may" have a conflict is not adequate disclosure when the conflict actually exists. If a conflict cannot adequately be disclosed and understood by the client, the SEC "expect[s] an adviser to eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed."11
Finally, the SEC has sought comment as to whether it should take action in three areas where investment adviser regulation may not include requirements that apply to broker dealers: (a) whether it should require licensing and continuing education standards for RIA personnel, (b) whether RIAs should have to provide account statements (regardless of whether they have custody of client assets), and (c) whether RIAs should be subject to financial responsibility standards (such as minimum capital levels, annual audits or fidelity bond requirements).
New Forms and Disclosures
Finally, the SEC proposals would require both broker-dealers and RIAs to provide retail customers with a new customer relationship summary (Form CRS) that will disclose among other things, the nature of the client or customer relationship, the applicable standard of protection, conflicts of interest, and fee structures. Broker-dealers, RIAs, and their related persons would also have to disclose their registration status and firm relationships in communications with retail investors.12
Individual states have also been pursuing changes to increase the protections available to retail investors. For example, the New York Department of Financial Services recently issued a proposal that would require sellers of life insurance and annuities to act in the best interests of their customers.13 Legislation pending in New Jersey would require a financial services provider to provide specifically-worded written disclosures to individual investors to explain where there is no fiduciary relationship. In a non-fiduciary relationship, the statement must read: "I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks, and expected returns for you."14 In Nevada, recent legislation also imposes fiduciary duties on broker-dealers, investment advisers and their personnel, and authorizes the state's securities regulator to adopt regulations relating to this fiduciary duty.15
Impacts of Vacatur, the SEC's Proposal and State Activities
Financial institutions that have been working to comply with the DOL fiduciary rule will need to quickly change course and evaluate what changes, if any, they should make to their sales and compensation practices, and related policies and procedures, in respect of ERISA plan and IRA accounts now that the fiduciary rule and its related exemptions are vacated and pre-fiduciary rule legal standards are again in place (subject to DOL's temporary enforcement policy). In order to comply with the fiduciary rule, many financial institutions made significant changes to their business models, sales and compensation practices, and related policies and procedures, and those institutions should consider which, if any, of those changes they wish to retain and how their current policies and procedures may need to be conformed to comply with pre-fiduciary rule law. Further, financial institutions should consider the impact of proposed Reg BI for broker-dealers, the SEC's proposed new guidance for RIAs, and recent developments at the state level on their business model and compliance programs, as well as whether to submit comments as part of the SEC's rulemaking.
With the DOL fiduciary rule vacated, the SEC, FINRA and the states are leading the regulatory efforts to heighten the standard of care that financial institutions and their personnel owe to their customers. Financial institutions should be aware, however, that the political winds may change and a future administration may revive a version of the fiduciary rule targeted at ERISA plan and IRA accounts that again imposes more onerous obligations than those proposed by the SEC. Financial institutions should also keep in mind that, despite its demise, the DOL fiduciary rule focused public attention on the issue of the sale of poorly performing or overpriced products to retail customers. If potentially abusive sales practices are identified, federal and state securities regulators, FINRA, state attorneys general and the plaintiffs' bar have many tools available even in the absence of the fiduciary rule to launch investigations of, or make claims against, financial services providers.
© Arnold & Porter Kaye Scholer LLP 2018 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
See Arnold & Porter Advisory, "Department of Labor Adopts Sweeping Rules Regarding Fiduciary Investment Advice," 21 April 2016.
The SEC has grappled for years with the standards that apply to investment advisers and broker-dealers when dealing with retail customers. In 2006, the SEC retained the RAND Corporation's Institute for Civil Justice (RAND) to conduct research for an analysis of the different regulatory systems that apply to broker-dealers and investment advisers and how they impact investors.See RAND Institute for Civil Justice, Investor and Industry Perspectives on Investment Advisers and Broker-Dealers (2008) (RAND Study). The RAND Study "concluded that … market participants had difficulty determining whether a financial professional was an investment adviser or a broker-dealer and instead believed that investment advisers and broker-dealers offered the same services and were subject to the same duties." 83 FR 21578-21579, n. 28. In 2011, SEC staff conducted a study as required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), and recommended, among other things, that the SEC implement a uniform fiduciary standard of conduct for broker-dealers and investment advisers. Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011).
83 FR 21207. The Commission specifically confirmed that the duties described in the proposed Interpretation apply to algorithmic "robo-advisers." However, the proposed Interpretation would not apply to advisers that provide impersonal investment advice (i.e., "advisory services provided by means of written material or oral statements that do not purport to meet the objectives or needs of specific individuals or accounts" such as newsletter publishers). 83 FR 21203, citing Advisers Act Rule 203A–3.