DOL fiduciary rule: On a collision course with the law?

By Warren S. Hersch

August 16, 2016 at 05:45 AM

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If the Department of Labor's final fiduciary rule were an infrastructure project, perhaps the best analogy would be to a catastrophically leaky dam.

Like their peers in the civil engineering world, insurance and financial services experts assessing the legal foundations of the DOL's hole-ridden edifice — a 1,000-plus-page document that stretches definitions, makes new jurisdictional claims and defies historical precedent — have to ask themselves this question: When (not if) will the department's paper dam break?

That's the conclusion to be drawn if a growing number of critics are right in their assertion that the department badly overstepped its authority in promulgating its "conflict of interest final rule" last April. Those critics are now fighting back in the courts, and it's a fair bet that the rule will meet its demise there, potentially this month.

On August 25, a U.S. District Court judge for D.C. overseeing one of several lawsuits against the department, The National Association for Fixed Annuities v. [DOL Secretary] Thomas E. Perez et al., will hear motions for preliminary injunction and summary judgment. A ruling in favor of the plaintiffs will, absent a successful appeal, spare the industry a lengthy and expensive trial, plus months of regulatory uncertainty.

Should the DOL's attorneys prevail in the NAFA case, they'll have to brace themselves for counteroffensives on two other fronts: (1) a suit filed by the Market Synergy Group in Kansas; and (2) a 9-party complaint filed in a U.S. District Court for the Northern Texas.

The latter may be the key case to watch, for it consolidates three lawsuits: one a complaint filed by 9 trade organizations and Texas business associations led by the U.S. Chamber of Commerce; a second by American Council of Life Insurers (ACLI) and the National Association of Insurance and Financial Advisors (NAIFA); and a four-party suit of insurers filing under the banner of the Indexed Annuity Leadership Council (IALC).

A litany of grievances

The three lawsuits differ on some counts, notably in respect to alleged constitutional violations: NAFA contends the DOL's rule's definition of reasonable compensation is "unduly vague" and infringes on the 5^th's amendment's due process cause; the 9-party Texas suit argues the rule's best interest contract exemption (BICE) runs afoul of the first amendment's right of free speech (i.e., by prohibiting "truthful, non-misleading" communications with clients and prospects outside the confines of a fiduciary relationship).

But the lawsuits also have much in common. Chief among the shared charges: that the DOL overstepped its authority in crafting the conflict of interest rule, starting with its expanded definition of fiduciary. The Texas suit (to which the Insured Retirement Institute, Financial Services Roundtable, and Securities Industry and Financial Markets Association (SIFMA), among others, are also parties) is detailed on this count.

The 9-party complaint claims the DOL's expanded interpretation of "fiduciary" encompasses activities that have "long been understood to be sales-related" (i.e., not those of a fiduciary).

The long-held definition of fiduciary — as established under the law of trusts, the Investment Advisers Act of 1940 and ERISA law (the DOL's province) — makes clear that these duties are consistent with "ongoing and continuous investment discretion" of financial professionals charged with managing clients' assets. These responsibilities, the suit alleges, were never interpreted to apply to one-time product sales transacted by brokers who provide only "incidental investment advice," and who don't have a client relationship built on "heightened trust and confidence."

Hence the long-established distinction between the fiduciary standard of care that registered investment advisors owe under the Security and Exchange Commission's Investment Advisers Act of 1940; and the (non-fiduciary) product suitability standard that brokers-dealers and their registered reps are bound by. On this key point, the Texas complaint pulls no punches.

"[The DOL] referred disparagingly to the 'fine legal distinction' —a distinction created by Congress — between broker-dealers and registered investment advisers…and it forthrightly proclaimed its "reject[ion] of the purported dichotomy between a mere 'sales' recommendation . . . and advice . . . in the context of the retail market for investment products," the complaint states. "This 'dichotomy' is not 'purported' — it is established by Congress as a matter of federal law."

During a June 2^nd media conference call presented by chiefs of 5 of the 9 organizations represented in the Texas suit, an attorney of the plaintiffs' law firm emphasized the point.

"The DOL has given 'fiduciary' a meaning that's unrecognizable — one different from how Congress and the securities laws intended," said Eugene Scalia, the attorney and a partner at Eugene Dunn. "So we start out [in the complaint] by pointing out the legal error of the DOL in formulating an overbroad definition of fiduciary."

The DOL's "arbitrary" and "capricious" missteps mount form there. And many of them — from the department's BIC exemption requirements to its folding of non-ERISA IRAs and fixed indexed annuities into the rule — amount to an "impermissible departure" from the industry's historical understanding of fiduciary, the Texas suit contends. Add to this a larger perceived transgression: the DOL's fundamental misreading as to what falls under its purview.

Take the myriad compliance requirements — disclosure of (among other things) costs, fees and compensation relating to a recommended product — that the DOL mandates for brokers receiving a sales commission under the BICE.

By "exploiting its exemptive authority to obligate financial services professionals to accept special duties and liabilities" absent from ERISA law and the Internal Revenue Code, the complaint asserts, the DOL improperly extended its authority to an area that Congress vested in the SEC. This has been a longstanding sore point of the DOL's critics. They've argued since Congress' passage of the Dodd-Frank Act of 2010 (which assigned exclusively to the SEC a review of standards of care for broker-dealers and investment advisors) that the DOL had no business crafting its fiduciary rule.

Tug of war over FIAs

But craft it did — and in the process felled jurisdictional walls once thought to be set in stone. Among the Texas complaint's allegations: that ERISA granted the DOL regulatory authority over qualified employee benefits, but not to non-ERISA, tax-favored plans like IRAs; and that the DOL exceeded its mandate (and violated Congress' intent under Dodd-Frank) in extending the fiduciary rule to sales of fixed indexed annuities.

The latter move was a particular shock to FIA players, and not only because the DOL left the products out of earlier versions the rule.

Industry veterans will recall the bruising battle over the SEC's proposed Rule 151A, which sought to regulate FIAs as securities, rather than insurance products. Thanks to a 2010 decision of the U.S. Court of Appeal in D.C., that rule was vacated; a subsequent amendment to the Dodd-Frank Act sought to ensure that regulation of indexed annuities remained with the states.

So more than a few state insurance commissioners (not to mention the insurers, agents and brokers they oversee) were surprised to learn that FIAs, like other products now subject to the DOL rule, will fall under federal jurisdiction after all.

The Texas plaintiffs aren't the only ones crying foul over the DOL's perceived power grab. The NAFA lawsuit takes direct aim at the department's inclusion of FIAs under the BIC exemption. One bone of contention: that ERISA plan fiduciaries (insurance agents and brokers, among others) will no longer be able receive a commission under ERISA's prohibited transaction exemption (PTE) 84-24.

Participants in a July 26 roundtable hosted by LifeHealthPro and National Underwriter concurred that the DOL had overreached in engineering the PTE 84-24-to-BICE swap; and in upending "settled law" that exempts fixed-indexed annuities from federal securities regulations.

"One of the issues we have is the last-minute switch to put fixed indexed annuities under the BICE and to treat FIAs as securities, which is contrary to law," said NAFA Executive Director Chip Anderson during the roundtable. Added Pamela Heinrich, an attorney for NAFA: "It's clear from the [PTE-to-BICE] switch that [DOL staffers] don't really understand what fixed annuities are or how they differ from variable annuities. They offer no evidence there is a problem that needs solving in regard to fixed-indexed annuities."

What's reasonable compensation?

Also lacking in the DOL's handiwork, the roundtable participants noted, is guidance as to what constitutes "reasonable compensation" for advisors under the BICE. Industry associations commenting on DOL's revised/pre-final rule repeatedly requested specifics. They got only (as the NAFA complaint alleges) a "bald statement that the essential question is whether [an advisor's] charges are reasonable in relation to what the retirement saver receives."

The issue is hardly academic. Compensation, among other perceived violations, could spur class action suits against advisors and their companies under the rule. For many industry stakeholders, not least insurers, this is the truly scary part of the new regulatory regime.

Once again, the rule's opponents assert, the DOL overreached in misusing its exemptive authority under the BICE to "create a private right of action" for clients entering into a best interest contract with an advisor. In effect, the Texas suit alleges, the DOL is subcontracting to class action lawyers enforcement of a rule that "it lacks the power to enforce itself." The NAFA suit echoes the point, noting that only Congress — not a federal agency — can create a private cause of action.

"When we talked to the DOL [about the provision], they replied, 'We don't have the ability and we don't foresee us actually [enforcing the rule]. We're going to leave that up to the clients and the clients' attorneys,'" said NAFA's Chip Anderson. The prospect of class action suits by scores of disaffected clients months or even years after advising on a retirement product or plan will, added Anderson, make working under the rule "extremely hard" for advisors.

Potentially costly, too, and not only due to court-ordered damages for which they may be liable. Also to weigh is a rise increase in errors and omission (E&O) insurance premiums that have advisors may have to cough up to guard against greater legal exposure under a fiduciary standard.

Such heighted financial risk, combined with other increased compliance costs anticipated under a fiduciary regime, may be for too much for many advisors to bear. The result could be an exodus of insurance and financial services professionals from the retirement space.

And one potentially comparable in magnitude to Great Britain's experience. Between 2011 and 2014, during which time the U.K.'s Financial Conduct Authority imposed its Retail Distribution Review, an estimated 9,000 advisors left the profession — nearly a quarter of the pre-RDR field force. One reason: the banning of commissions on sales of insurance and investment products.

Those remaining had to assess fees for investment advice, to the detriment of U.K. consumers unable to pay them. And it's precisely these outcomes — a downsizing of the profession and the charging of fees beyond the budgets of middle income consumers — that industry players in the U.S. fear will result from the fiduciary rule. Particularly concerning, the Texas plaintiffs assert, is the DOL's failure to account for the additional cost to retirement savers stemming from a commission-to-fee revamp. Morningstar pegs the tab at $13 billion.

"The Department…nowhere considered the downstream impact that the Rule's costs for the industry will have on consumers in the form of increased prices for services and products, which will prevent some consumers from being able to afford valuable retirement savings help," the 9-party complaint states.

David Hirschmann, president and CEO of the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness, spoke to this point during the media conference call outlining the complaint.

"The rule will have serious adverse consequences for American investors and small businesses," he said. "Rather than making it easier for Americans to save, the DOL has made it much harder. We hope that by going to court, we can reverse that course."

If only the DOL had listened

Did it have to come to this? Many think not. Representatives of several of the organizations participating in the Texas lawsuit have long supported a harmonized fiduciary standard for RIAs and broker-dealers. Identifying problems with the DOL's revised proposed rule, they sought changes — through nearly 3,000 comment letters and in public hearings the DOL held with 90 industry and consumer groups — to simplify the rule's mechanics and make it compatible with existing business models. Among the requested changes was a broad "seller's exception" disclosing that the financial professional is acting a salesperson, not a fiduciary, thereby addressing potential confusion among investors as to financial conflicts of interest.

The DOL proved unaccommodating on this and many other requests. As a result, the department will have to respond to a long list of alleged offenses in the upcoming litigation. In addition to the aforementioned, they include violation of the Administrative Procedure Act; a failure to provide adequate notice and sufficiently consider/respond to industry comments; a prohibition on arbitration agreements in class action waivers for advisors relying on BIC and PTE exemptions; and the DOL's "arbitrary" and "capricious" assessment of the final rule's benefits, consequences and costs — a point repeatedly made by the Texas suit plaintiffs.

"The Financial Services Institute…has supported the uniform fiduciary standards since 2009 — before Dodd-Frank," said FSI President and CEO Dale Brown at the media conference call. "Being pro-fiduciary is not new to us or our members. But the DOL's complex and unworkable rule will only harm the smaller investors it claims to protect.

"Contrary to what supporters of this rule will claim, this legal challenge is solely about insuring that the rules governing retirement advice work for all retirement investors," he added. "This rule does not pass that test. There's no compelling evidence this rule is necessary to achieve a uniform fiduciary standard."

The DOL will contend otherwise in court. But whether the arguments the department will put forward (broadly, that the rule's provisions comply with existing statutory authority, regulations and judicial rulings) will be enough to convince the presiding judges is an open question. The hope and expectations of the suits' plaintiffs —organizations representing the combined might of an industry that oversees $3 trillion of IRA assets and $19 billion of wealth management revenue — is that the DOL will fall well short, and that its fiduciary rule be relegated to its proper place: the dustbin.

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