Fifth Circuit Opinion Vacates DOL Fiduciary Rule
The U.S. Court of Appeals for the Fifth Circuit on March 15, 2018 issued an opinion (Opinion) vacating the Department of Labor (DOL) fiduciary rule and related applicable exemptions1. The DOL had promulgated the rule and exemptions (collectively, Rule) in order to expand the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986, while including some provisions to make the resulting regime more workable2. For a more detailed explanation of the Opinion, including procedural implications and background of the Rule, please refer to the following Dechert OnPoint.
Several implications of the Opinion are particularly significant for the financial services industry, especially as financial services firms await further clarity from regulators on fiduciary (including “best interest”) standards.
Ongoing Lack of Certainty
The next steps for financial services firms in the market will likely depend on procedural developments over the coming months. The DOL and Department of Justice (DOJ) have until April 30 to seek a rehearing at the Fifth Circuit level. If no action is taken, the Fifth Circuit will issue a mandate on May 7, at which point the original definition of “fiduciary,” including the original five-part test, will apply.3 Should the DOL and DOJ decide to appeal to the U.S. Supreme Court, they currently face a deadline of June 13, but could possibly seek an extension of this deadline.
Another factor contributing to uncertainty in this area is the anticipated proposal of a uniform standard of conduct (likely a best interest standard) for broker-dealers and investment advisers by the U.S. Securities and Exchange Commission (SEC).4 In addition, the Opinion may affect ongoing collaborative efforts between the SEC and DOL,5 by giving the SEC greater freedom to act independently of the DOL.
The SEC has scheduled an open meeting on April 18, 2018, to consider whether to adopt a rule establishing a standard of conduct for broker-dealers and their associated persons when recommending any securities transaction or security-related investment strategy to a retail customer, and to propose interpretive guidance regarding investment advisers’ standard of conduct.6 The SEC appears poised to take action, whether pursuant to the mandate provided by Section 913 of the Dodd-Frank Act or through its other statutory sources of authority, for a number of reasons, including: Chairman Clayton’s focus on “Main Street” investors; resolution of long-standing, underlying policy questions; preservation of its own authority; responsiveness to industry comments that the SEC take the lead on the issue; and potentially limiting state-level fiduciary initiatives.7 As indicated by Chairman Clayton, “[t]he SEC has been reviewing this area for some time, including through the RAND study of investor perspectives commissioned in 2006, the Dodd-Frank Act Section 913 staff study conducted in 2010-2011, and, most recently, a solicitation of data and other information in 2013.”8 It is worth noting that the practical and political complexities of devising and adopting a uniform standard of conduct have thwarted past SEC rulemaking efforts – and these challenges remain, particularly if the Fifth Circuit’s vacatur of the Rule stands.
As the industry waits to see whether the DOL and DOJ will defend the Rule, and to assess the scope of an SEC proposal, affected firms are encouraged to evaluate the business and regulatory impact of the Opinion on (among other matters): distribution and product development; sales practices and compensation; and current and future compliance and supervisory policies and procedures.
Impact on Mutual Fund Distribution and Product Development
Discussed below are some of the many product, distribution, sales, compliance, and supervisory concerns that broker-dealers and mutual fund complexes may now face. Broker-dealers and investment advisers may want to revisit their product and platform development offerings and initiatives (including the type and number of share classes offered on platforms) and compensation structures (including cash and non-cash compensation to financial advisors). Mutual fund complexes also may want to revisit their product development initiatives (e.g., compensation, revenue sharing, sub-transfer agency arrangements, related share class structures) and distribution efforts.
Products, Platforms and Compensation Models
Since at least April 2016, when the Rule became final, broker-dealers and advisory firms have been developing products and distribution platforms designed to comply with the Rule and its exemptions, particularly the Best Interest Contract Exemption. In addition, many mutual fund complexes responded to requests for intermediary-specific sales charge waivers in order to facilitate intermediaries’ compliance with the Rule and to ensure uninterrupted product offerings.9 Mutual fund complexes developed T shares, as well as “clean” share classes, as possible ways to facilitate distribution partners’ level-compensation arrangements, supported by DOL statements that such arrangements might mitigate conflicts of interest and by SEC staff interpretive relief (for “clean” shares).10
In addition to product changes, broker-dealers developed new platforms for offering mutual fund products without running afoul of the Rule’s conflicts of interest provisions. These platforms were designed to ensure that individual financial advisors would receive only standardized compensation, and eliminated certain non-cash compensation (e.g., incentive travel programs) in anticipation of the impartial conduct standards.11
Broker-dealers and investment advisers to individual retirement accounts (IRAs) and mutual fund complexes may want to pause, or even roll back, the implementation of such products/platforms until the product-level impacts of an SEC proposal become apparent.
Renewed Market Participation
As noted in the Opinion, a number of major participants exited the market for servicing retirement investors as a result of the Rule.12 However, rather than exiting completely, some broker-dealers narrowed the range of products offered to retirement investors, by: removing mutual funds as options from brokerage retirement accounts; transitioning retirement brokerage accounts to advisory accounts; and/or eliminating the direct-at-fund business. Others took a more expansive approach, by eliminating class A shares from both retirement and non-retirement brokerage accounts.
It is possible that the market may see a reentry of these players and offerings, depending on the scope of the SEC’s anticipated rulemaking and the outcome of state legislative and enforcement initiatives. Further, firms with business plans that envisioned contraction in, or withdrawal from, certain highly regulated segments of the market (e.g., retirement accounts, IRA rollovers) may reconsider their long- and short-term business plans.
Compliance Considerations and Supervisory Practices
The majority in the Opinion observed that, by attempting to comply with certain of the conditions of the exemptions, broker-dealers and insurance representatives would be exposed to liabilities beyond the tax penalties imposed by Title II of ERISA.13 Since the Rule’s June 9, 2017 applicability date, most broker-dealers and mutual fund complexes likely have already undertaken certain efforts to comply with the Rule. These firms may want to consider taking inventory of their existing compliance policies and related supervisory procedures, in order to assess whether they should be revised in accordance with current law and newly undertaken activities.14
Among other actions, a number of broker-dealers and investment advisory firms have taken some or all of the following steps in anticipation of the Rule’s compliance date:
- Updated policies and procedures
- Reconfigured individual financial advisor compensation (e.g., imposing new grids and payout matrices to standardize compensation) and changed the use of non-cash compensation
- Adjusted fees to achieve level compensation for both the firm and individual financial advisors
- Eliminated certain account types and fee structures, as well as the ability to purchase certain products
- Developed scripts or other protocols for client communications, and reduced the amount of information provided to clients or prospective clients
- Revised requests for proposal and pitch materials to remove detailed, client-specific information
Mutual fund complexes, broker-dealers and advisory firms also may have taken the following steps in order to comply with the Rule:
- Complied with the requirements of the independent fiduciary exception and updated disclosures to disclaim or clarify fiduciary status (e.g., website and marketing disclosures, private fund offering documents)
- Sent notices in order to qualify for an exception, exclusion and/or exemption from the Rule
- Amended agreements (e.g., with clients, service providers and distributors)
- Discontinued distribution of educational materials (specifically on IRA rollovers) and limited call center capabilities
Enforcement and State Activity
State legislative and enforcement activity is another source of increased liability exposure. While the DOL’s temporary enforcement policy is currently in place,15 enforcement activity at the state level has raised concerns for many firms.16 Although the SEC staff looks to have drafted proposed rules relating to the standard of conduct for broker-dealers and investment advisers, several states have decided not to wait for the SEC’s action. For example, legislation on fiduciary standards has been enacted in Connecticut and Nevada and is pending in New Jersey, while a regulatory initiative is pending in New York.17 The proliferation of state activity threatens to create a patchwork quilt that could result in litigation as to whether the SEC standard preempts the states’ standards. While some may view the Opinion as a victory at the federal level, it is possible that the void of a fiduciary standard at the federal level, if not filled promptly by the SEC, will accelerate the rate at which states continue to act in this area.
In response to the Rule and market pressures, many firms have made significant changes to their products, platforms, business models and compensation structures in an effort to eschew differential compensation and traditional payment structures (e.g., commissions, revenue sharing, 12b-1 fees). Some firms have already returned to their prior practices or are otherwise reintroducing certain forms of differential compensation, particularly if they perceive that their compliance efforts have placed them at a competitive disadvantage.
Many firms, especially larger firms, have invested significant amounts of capital to facilitate their move (or their distribution partners’ move) toward a best interest standard and fee-based product offerings. These firms may also have made commitments to their customers in strategic marketing and compliance efforts. Such firms may continue on their current path, in contrast to other firms that may not have made significant changes.
There are certain challenges involved in walking back fiduciary status. It is possible that industry and market momentum will continue the movement away from traditional products, platforms and compensation structures and toward a market-driven best interest standard and further innovative business approaches. Going forward, firms might consider assessing business and sales practices as well as agreements, disclosures and notices that have been enhanced or modified in response to the Rule.
1) Chamber of Commerce of the USA, et al. v. U.S. Dep’t of Labor, et al., No. 17-10238, slip op. 46 (5th Cir. Mar. 15, 2018), a decision by a majority of a three-judge panel.
2) Further analysis of the Rule is provided in previous Dechert OnPoints.
3) Under the 1975 regulation previously defining “fiduciary,” advice did not constitute “investment advice” that would make a person a fiduciary, unless the person: (i) rendered advice as to the value of securities or other property, or made recommendations as to the advisability of investing in, purchasing or selling securities or other property, (ii) on a regular basis, (iii) pursuant to a mutual agreement, arrangement or understanding with the plan or a plan fiduciary that (iv) the advice would serve as a primary basis for investment decisions with respect to plan assets and that (v) the advice would be individualized based on the particular needs of the plan. Notably, firms and individuals relying on the transition “Best Interest Contract Exemption” (under which only the “Impartial Conduct Standards” conditions of this exemption apply) will need to seek another exemptive strategy if they are considered fiduciaries under the five-part test.
4) In 2010, Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940 (Advisers Act) to allow the SEC to implement a uniform standard of conduct for broker-dealers and investment advisers. The Advisers Act was also amended to provide that any rule promulgated may not apply a more stringent standard to broker-dealers than that applied to investment advisers under Section 206(1) and (2) of the Advisers Act. The view of the majority of the Fifth Circuit panel is that the Rule conflicts with the legislative effort to act in this area, in which Congress delegated authority (with certain restrictions) to the SEC, not the DOL. However, when the SEC proposes a best interest standard, it is not clear whether the SEC will rely on its authority under Section 913. The issuance of the Fifth Circuit’s opinion closely in advance of the SEC’s rulemaking may give the SEC confidence in its authority to promulgate rules setting forth a uniform standard of conduct.
5) See Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers, SEC Public Statement (June 1, 2017) (June 2017 Clayton Statement), in which SEC Chairman Clayton requested public comments on standards of conduct and welcomed engagement with the DOL.
6) SEC, Notice of Open Meeting on April 18, 2018 (Apr. 11, 2018). The SEC will also consider requiring registered investment advisers and registered broker-dealers to provide retail investors with a brief summary of their relationship.
7) See, e.g., SEC Chair: Fiduciary Rule Remains Top Priority, Barron’s (Feb. 23, 2018); SEC’s Clayton On Fiduciary Rule: “The Sooner the Better,” Barron’s (Mar. 19, 2018).
8) June 2017 Clayton Statement, supra note 5.
9) See Mutual Fund Fee Structures, IM Guidance Update 2016-06 (Dec. 2016).
10) See Request for Information Regarding the Fiduciary Rule and Prohibited Transaction Exemptions, 82 Fed. Reg. 31278 (July 6, 2017); see also Capital Group, SEC Staff Letter (pub. avail. Jan. 11, 2017).
11) Clean Shares, PNC Financial Services Group (last visited Mar. 19, 2018); LPL Financial Announces Details and Fund Companies for its Industry-First Mutual Fund Only Platform, LPL Financial (July 13, 2017).
12) Chamber of Commerce, supra note 1 at *11; see also, Final Department of Labor Fiduciary Rule’s Effects are Substantial, Morningstar (May 17, 2016).
13) Chamber of Commerce, supra note 1 at *35.
14) See In re Scottrade, Inc., Administrative Complaint, Docket No. E-2017-0045, filed by the Massachusetts Securities Division (Feb. 15, 2018) (alleging violations of Massachusetts securities laws for failure to comply with policies and procedures designed to comply with DOL fiduciary rule).
15) U.S. Dep’t of Labor, Field Assistance Bulletin No. 2017-02, Temporary Enforcement Policy on Fiduciary Duty Rule (May 22, 2017).
16) See In re Scottrade, Inc., supra note 14.
17) For a discussion of state fiduciary developments please refer to Dechert OnPoint, Activist States Move Forward with Fiduciary Standards for Broker-Dealers and Investment Advisers.