Posted by: William R James, Senior Content Specialist
Published: June 28, 2018
Disclaimer: William R. James is a Senior Editor at Kaplan Financial Education. The opinions expressed in this article are solely those of the author based on personal research and observations. They should not be viewed as legal advice.
Following a loss of two federal appeals court hearings and the passing of a deadline to seek a Supreme Court review, it is safe to say that the Department of Labor’s Fiduciary Rule is dead. The objective of the rule was to ensure that financial professionals (broker-dealers and registered representatives) put their customers’ financial interests ahead of their own when recommending retirement investments. President Trump ordered a review of the rule “to determine whether it may adversely affect the ability of Americans to gain access to retirement information and financial advice.”
So where does that leave us? After laying out $5 billion to implement the DOL’s regulatory thrust, there’s much bewildered head-scratching in the financial services industry. What was that all about? In some ways, there’s a sense of relief that regulation is settling back to its customary regulatory provider by registered advisers and broker-dealers. But, Congress’s view of two separate authorities acting in different capacities was tamped down, leaving the whole matter in a legal mess.
Congress looked explicitly to the DOL for regulatory protections of retirement plans rather than the SEC, reasoning that the Commission operates under a different regulatory framework and that it has no jurisdiction over advice appertaining to an investment that is not a security. In other words, special protections would be desirable for retirement accounts and that, in the view of Congress, would be best handled by the DOL. The Fifth Circuit was mindful of that. But it then found that the DOL did not have the authority to adopt the new fiduciary advice definition (“the Fiduciary Rule…is inconsistent with the entirety of ERISA’s ‘fiduciary’ definition”) and, that by adopting the Fiduciary Rule, it acted arbitrarily and capriciously (“the Rule fails to pass the tests of reasonableness as viewed under the Administrative Procedures Act”). The court vacated the Fiduciary Rule in toto, striking down both its new fiduciary advice definition and the exemptions from it.
What drove the DOL to turn its back on a wealth of available expertise is inexplicable. The SEC has decades of experience dealing with disclosure, and yet the DOL sought no counsel or advice. In fact, that reach was slapped by the Fifth Circuit, which called out the DOL’s highly questionable authority and vacated its controversial, checked-out rule. The Fifth and Tenth Circuits found it wanting, ordering the DOL to vacate the rule, declaring it unreasonable. It constituted "an arbitrary and capricious exercise of administrative power.” The Department of Labor’s overstepping to transform and regulate in entirely new ways many thousands of financial services providers and insurance companies for retirement plans, falls outside of what is reasonable.
Stepping up quickly to fill the void, the SEC announced its own long-anticipated alternate rule. Known as Regulation Best Interest (Reg BI), the Commission took a decidedly different approach. SEC Chairman Clayton voiced the concern of many that there needs to be “clarity and harmony to investment advisor, broker-dealer standards of conduct.” SEC Commissioner Michael Piwowar, who along with Clayton voted in favor of the Best Interest proposal, stated, “A solid building block, it imposes a new best-interest standard.”
Despite Congress’s intentions, Reg BI is the Commission’s answer to the Labor Department’s now defunct rule with the aim of providing a unified fiduciary standard. Commissioner Piwowar has made his distaste for the DOL’s effort obvious. He described it as a “terrible, horrible, no good, very bad” rule due in part to the DOL acting unilaterally without any input from the SEC, FINRA, state securities, and insurance regulators.
The SEC-proposed rule appears to offer a gentler approach than the DOL. By introducing a uniform standard of conduct for broker-dealers and registered advisers in light of their different relationship types and models for providing advice, the Commission offers a deft touch to regulation. Brokers would be required to disclose conflicts of interest and look to eliminate or “mitigate” them. But, brokerages would be required to mitigate every material conflict of interest. That means the door is open for a carefully applied sales contest. The SEC has stated: “We do not intend our standard to prohibit a broker-dealer from having conflicts when making a recommendation."
With this shift, financial services firms are now free to review their policies as they pertain to retirement accounts. Even with the departure of the Fiduciary Rule, firms want to keep clients’ best interests in the forefront and consistent with just and equitable principles of trade.
So, how do the rules differ? Here are some of the main differences.
In the view of some commissioners, one of the failings of the DOL rule was that it dismissed the SEC’s experience dealing with conflict of interest disclosure. In this requirement, the SEC is addressing the confusion from the use of misleading titles by financial services professionals. Retail investors must be able to distinguish between the types of financial service providers they can choose. This may include those member firms and associated persons who sell products and those who offer advice as a fiduciary.
Currently, the many impressive sounding titles used by financial services professionals offer investors little help. For example, under current regulations, anyone can use financial “adviser” or “advisor,” regardless of whether they are registered investment advisers complying with investor protections or not.
The SEC’s new Form CRS will require financial services professionals to provide their retail customers a simple disclosure form to clarify the scope of customers’ relationships with those who offer them financial services.
In looking for a regulatory alternative to the DOL Fiduciary Rule, the Commission is seeking to ultimately adopt a clear rule for which compliance is not so difficult that firms stop offering retail investors services they can pay for through commissions or other transaction-based fees. This is in stark contrast to the DOL rule. The “best interest” standard is altogether different from the long-established Investment Adviser’s Act fiduciary standard and FINRA’s suitability standard. The ambiguity in the SEC’s proposed rule may likely make it difficult for broker-dealers to know how to comply with it, which could then lead to a decision to stop offering transaction-based services.
The question must be considered, will Reg BI raise compliance costs to such a level that it becomes disadvantageous for broker-dealers to offer retail investors transaction-based advice?
The SEC’s proposed rule will require:
The issue hasn’t received the same hard look as the broker-dealer standard of conduct. Most would be able to identify the “fiduciary duty” as the standard of conduct for investment advisers, but readily identifiable parameters may not be so easy to find. In other words, what precisely does the fiduciary duty demand? The Investment Advisers Act offers few particular obligations related to the standard. Consequently, the proposed interpretation places its requirements from common law principles.
The DOL’s heavy legal hand will not be missed. The specter of class-action lawsuits no matter how watered down by exemptions or looming private right of action had a chilling effect, causing the abandonment of entire lines of business, in addition to the $5 billion price tag before it was vacated.
The Commission’s best-interest rule drubbed out the legal axe that hung over the necks of broker-dealers and their associates who failed to pick up the nuances of the DOL’s Fiduciary Rule. The DOL provided a path for customers to sue brokers in class-action lawsuits. The SEC-proposed rule has no such blade in it. This suggests to careful readers that FINRA’s Code of Arbitration will remain the backbone of dispute resolution.
The legality of the SEC stepping up to plug the hole left by the DOL’s Fiduciary Rule being vacated has yet to be decided. The current congress has not made any appreciable noise about it. In that absence, it is safe to say that the SEC’s take is correct. Apart from the plain language approach, which is a welcome break, providing customers more choice is a good thing. The Commission sent a clear message to the financial services industry: inform clients of and eliminate or greatly diminish (not eliminate) conflicts. Informed choice is the underlying principle over the ponderous and legal morass facing those firms that did not toe the line with the Labor Department’s rule.
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