Fifth Circuit issues mandate officially vacating fiduciary rules

The Fifth Circuit Court of Appeals has issued a mandate officially vacating in toto the fiduciary conflict of interest rules, including the Best Interest Contract Exemption (BICE), the Principal Transaction Exemption, and revised PTE 84-24. Given the refusal of the Department of Labor to defend the fiduciary rules in the Fifth Circuit or in the Supreme Court, the mandate implementing the panel’s March 2018 judgment invalidating the rules was expected. What may not have been expected was the panel’s imposition on the government of the costs of appeal (See Chamber of Commerce of the United States of America v. United States Department of Labor, CA-5 (2018), U.S. Court of Appeals, Fifth Circuit, No. 17-10238, June 21, 2018).
Absent further guidance, the former 5-part test for determining fiduciary status will go back into effect. However, the Labor Department has issued a temporary enforcement policy that will allow for the maintenance of practices implemented in reliance on the now abrogated rules. In addition, the Securities and Exchange Commission (SEC) has issued proposed rules covering the retirement industry that in some measure reflect the best interest standard of BICE. Accordingly, the rules governing investment advice with respect to retirement plans remain somewhat fluid.
The history of the fiduciary rules saga is highlighted below

Final rules issued in April 2016

The Department of Labor, in April 2016, issued long-awaited, final rules, six years in gestation, that were intended to protect plan participants and IRA owners from potentially conflicted investment advice by subjecting a broad range of retirement and investment advisors to ERISA’s fiduciary requirements. Under the rules, parties that provide investment advice for a fee to plans, plan sponsors, fiduciaries, plan participants, beneficiaries and IRAs and IRA owners would have been required to make prudent investment recommendations, without regard to their own interests in order to avoid liability for fiduciary breach under ERISA. The rules, while making significant exceptions for investment education and compensation and marketing practices, reflected the understanding of the DOL that the disclosure of conflicts of interest alone is not sufficient to mitigate the negative impact of conflicted investment advice on the retirement savings of ERISA plan and IRA investors.

Fifth Circuit vacates fiduciary rule as unreasonable exercise of DOL authority

In March 2018, a divided Fifth Circuit panel vacated the fiduciary conflict of interest rules, including the Best Interest Contract Exemption (BICE) and revised PTE 84-24, as an invalid exercise of regulatory authority by the Department of Labor (Chamber of Commerce of the United States of America v. United States Department of Labor). The fiduciary rule, in expanding the parties subject to the duties of loyalty and prudence as investment advice fiduciaries, the panel opined, conflicts with the traditional common law understanding of fiduciary responsibility expressed in ERISA and was an unreasonable, arbitrary and capricious exercise of authority in an area best left to Congress.
Central to the court’s ruling was its understanding of the fiduciary rule as improperly extending fiduciary responsibility to “mere sales conduct,” dispensing with the common law and longstanding DOL understanding that investment advice for a fee requires an “intimate,” substantial and ongoing relationship between the adviser and client, which does not typically include sales transactions conducted by stockbrokers and insurance agents. According to the court, had “Congress intended to abrogate both the cornerstone of fiduciary status-the relationship of trust and confidence- and the widely shared understanding that financial salespeople are not fiduciaries absent that special relationship, one would reasonably expect Congress to say so.”

Judicial avenues of redress closed

The DOL declined to appeal the panel decision to the full Fifth Circuit or to the U.S. Supreme Court. In addition, the Fifth Circuit has rejected attempts by the states of California, New York, and Oregon to secure a full Fifth Circuit review of the panel decision overturning the fiduciary conflict of interest rules.

FAB allows continued reliance on temporary enforcement policy

While the status of the regulations was in flux, the DOL, on May 7, 2018, DOL issued a Field Assistance Bulletin, indicating that, pending the issuance of additional guidance, it will not pursue prohibited transactions claims against investment advice fiduciaries who are “working diligently and in good faith” to comply with the impartial conduct standards for transactions that would have been exempted in the BIC Exemption and Principal Transactions Exemption, or treat such fiduciaries as violating the applicable prohibited transaction rules (Field Assistance Bulletin 2018-02). Investment advice fiduciaries are advised that they may also rely upon other available exemptions to the extent applicable after the Fifth Circuit’s decision. However, the DOL will not treat an adviser’s failure to rely upon such other exemptions as resulting in a violation of the prohibited transaction rules if the adviser meets the terms of the enforcement policy.

Enforcement policy will allow fiduciaries to maintain current practices.

In FAB 2018-02, the DOL acknowledged that many financial institutions have created and implemented compliance structures designed to ensure satisfaction of the impartial conduct standards and that the “uncertainty about fiduciary obligations and the scope of the exemptive relief could disrupt existing investment advice arrangements to the detriment of retirement plans, retirement investors, and financial institutions.” The enforcement policy is an attempt to minimize disruption by effectively allowing financial advisers to maintain practices that have been implemented in anticipation of the rules being in effect.

SEC proposes “best interest” standard for broker-dealers

FAB 2018-02 remains the latest official guidance with respect to retirement investment advice, especially with respect to rollovers. However, the SEC has proposed a package of rules concerning the standards of care applicable to investment advice given by broker-dealers and investment advisers. The proposals would: impose an enhanced “best interest” standard of conduct on broker-dealers and associated persons when recommending securities transactions to retail customers; place new restrictions on the use of the term “adviser” or “advisor” by broker-dealers; require both brokers and advisers to provide a brief relationship summary to retail investors on new Form CRS; and mandate an interpretation by the Commission of the standard of conduct for investment advisers.

Regulation best interest.

Under the proposed regulation best interest, broker-dealers making recommendations to retail customers would have a duty to act in the best interest of the customer at the time the recommendation is made, without putting the financial or other interest of the broker-dealer ahead of the retail customer. A broker-dealer would have three specific obligations in order to discharge this duty under the rule:

  1. Disclosure: The broker-dealer must disclose to the retail customer the key facts about the relationship, including material conflicts of interest.
  2. Care: The broker-dealer must exercise reasonable diligence, care, skill, and prudence to (a) understand the product; (b) have a reasonable basis to believe that the product is in the retail customer’s best interest; and (c) have a reasonable basis to believe that a series of transactions is in the retail customer’s best interest.
  3. Conflicts of interest obligation: The broker-dealer must have and enforce policies and procedures reasonably designed to identify and then disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives; other material conflicts of interest must be at least disclosed.

Note: The proposed SEC rules were criticized upon release as being too accommodating of the investment advice industry by focusing on disclosure. However, the SEC’s adoption of the bet interest concept, as well as widespread industry embrace of the standard, suggests that the animating force behind the fiduciary rules may be maintained in future guidance.

Source: Chamber of Commerce of the United States of America v. United States Department of Labor, CA-5 (2018), U.S. Court of Appeals, Fifth Circuit, No. 17-10238.
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