DOL rule, Dodd-Frank up in the air: What now for advisors?

By Warren S. Hersch

February 15, 2017 at 03:15 AM

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President Trump's flurry of executive actions since taking office is upending the established order in the nation's capital. Financial services professionals have a huge stake in the outcome for two of them.

Those executive orders — one calling for an "updated economic legal analysis" of the Department of Labor's fiduciary rule, the other detailing "core principles" that could gut the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 — have unsettled federal oversight of financial services to a degree unseen since the end of the 2007-2009 downturn.

For industry stakeholders, the actions bring a welcome respite from impending regulatory changes for which many were ill-prepared.

That's notably true in respect to the fiduciary rule, which was due to be phased in beginning on April 10. The myriad requirements of the DOL "conflict of interest rule," stretching to 1,000-plus pages, had called into question business development plans for players throughout the distribution channel.

"The executive order [respecting the rule] is a positive development because much of the industry wasn't ready for the April 10 applicability date," says Jason Smith, founder and chairman of Clarity 2 Prosperity, a Westlake, Ohio-based independent marketing organization. "Business partners I've spoken with — advisors, broker-dealers, and other IMOs — had all halted or substantially slowed their development efforts. The delay was definitely needed."

Putting the rule on hold

The DOL filed on February 9 a Notice of Proposed Rulemaking with the Office of Management and Budget to delay the fiduciary rule's implementation. The OMB's review of the notice, expected to last 14 days before being approved and published in the Federal Register, doesn't stipulate a new implementation date. But market-watchers anticipate a delay of up to 180 days, which would shift the original phase-in from April to October 2017. Whether the DOL thereafter elects to revise or repeal the rule may hinge, in part, on recent court rulings, all of which have sided with the DOL's position on the rule under the Obama administration.

Prominent among the decisions: a February 9 opinion by Texas federal trial Judge Barbara M.G. Lynn favoring the DOL in a much-watched case brought by 9 plaintiffs. They included, among others, the U.S. Chamber of Commerce, the American Council of Life Insurers (ACLI), and the National Association of Insurance and Financial Advisors (NAIFA).

If the DOL decides on revisions, critics of the rule are hoping they'll be significant. The desired revamp starts with an overhaul of a best interest contract exemption (BICE) under which sales commissions are allowed, but which many perceive as overly complex.

The industry is concerned about the potential for costly lawsuits owing to a DOL rule provision allowing for a private cause of action by the class action bar. (Photo: Thinkstock)

A myriad of provisions

To satisfy the BIC exemption, financial professionals advising on ERISA-compliant qualified retirement plans must acknowledge to the client their fiduciary status, give prudent and impartial advice, disclose potential conflicts of interest, and convey how they get paid — compensation that also must be judged "reasonable."

To boot, they have to use one of four best interest contracts when engaging the client: one for advice governing IRAs and non-ERISA plans ("full-blown BIC"); a second for ERISA plans ("disclosure BIC"); a third applying to level-fee fiduciaries ("streamlined BIC"); and fourth "transition BIC" for those not ready to adopt the full-blown BIC.

"The fiduciary rule is so complex," says Chris Chen, an advisor at Insight Financial Strategists. "It's hard to know what one must to do. The rule should definitely be simplified — and the paperwork lightened."

Adds Mark Germain, an advisor and principal of Beacon Wealth Management: "The DOL fiduciary rule is the foundation of independent financial advice. I don't believe blanket repeal makes sense, but regulation that is redundant and expensive [also] makes no sense."

Of greater concerns to the industry is the potential for lawsuits against advisors, broker-dealers or IMOs alleged to be in violation of the fiduciary rule. The reason: a provision therein allowing for a private cause of action by the class action bar, to which the DOL has effectively outsourced enforcement of the regulation's best interest standard.

Advisors will bear some of this litigation risk, though Chen notes that financial institutions with deeper pockets — IMOs, broker-dealers and life insurers — may be more tempting targets for plaintiffs.

Regardless, the heightened prospect of class actions suits, if not addressed during the DOL's review, is likely to drive up the cost of compliance, including errors and omissions (E&O) insurance. Upshot: Advisors unwilling to navigate the BICE's legal minefield could abandon the qualified plan space — leaving retirement savers with a smaller pool of financial professionals to consult.

"This is the scariest thing about the rule," says Herbert Daroff, an advisor at Baystate Financial. "Every class action attorney will be displaying a billboard saying, 'If you've ever lost money in the market, call this number. We'll get it back for you.'

"In an attempt to stop some small percentage of the brokers from offering substandard advice, the DOL is laying the foundation for tort liability litigation on a gigantic scale," he adds. "The DOL definitely needs to replace the rule's private right of action with an arbitration provision."

If that doesn't happen, keep an eye out for some big, multi-party lawsuits. Morningstar Senior Equity Analyst Michael Wong pegs long-term class action litigation settlements stemming from use of the BICE at $70 million to $150 million. Factoring in a "bearish scenario," such legal settlements could reduce advisory firms' operating margins for commission-based IRA assets by 24 to 36 percent.

And these numbers don't even account for a jaw-dropping $20 billion revenue dip that market research firm A.T. Kearney estimates will result from the DOL rule's phase-in. Uday Singh, partner of the Americas, at A.T. Kearney's Financial Institutions Practice, attributes the precipitous drop to several factors, including:

1. 1. 1. An expected decline in commissions as advisors drop low-balance retirement accounts that will no longer be profitable to serve;
    2. A slowdown in IRA rollovers from 401(k)s and other employer-sponsored retirement plans; and
    3. A shift among retirement savers to low-cost exchange-traded funds.

Absent changes, the DOL rule could shake up sales of qualified retirement plan products, including variable and fixed indexed annuities subject to the rule's BIC exemption. (Photo: Thinkstock)

Two standards for different plans

Costs aside, a major concern of observers is the rule's limited scope. Whereas the rule governs qualified plans, a lower product suitability standard applies to non-qualified plans, such as executive bonus arrangements, deferred and compensation plans; as well as other non-qualified taxable investment accounts (stocks, mutual funds, exchange-traded funds, etc.) beyond the DOL's purview.

This disconnect, critics say, may cause confusion among consumers unclear as to which standard of care the advisor is bound by. Even if a fiduciary standard is deemed necessary, a better option, some suggest, would be for the DOL to repeal the rule and allow the SEC to propose its own — one that would apply to all securities, both qualified and non-qualified.

An SEC-crafted fiduciary rule also would be in keeping with the Dodd-Frank Act, which called on that agency — not the DOL — to examine the merits of creating a harmonized standard of care for broker-dealers and registered investment advisors (RIAs). In promulgating its own standard, the DOL overstepped its authority, insists Daroff.

"The problem is that the DOL has no jurisdiction over IRAs — none. They're not ERISA plans," he says. "What the DOL has done is akin to the Department of Commerce deciding to regulate health care and human services for individuals with a disease because they're travelling across state lines."

Absent changes, the DOL rule could also result in a shake-up in sales of retirement plan products. Producers unprepared to work with the BIC exemption could jettison variable and fixed indexed annuities subject to the rule in favor of traditional fixed annuities and insurance governed by prohibited transaction exemption 84-24 (PTE 84-24). The latter also imposes a best interest standard for qualified plan products, but requires neither a formal contract with a client nor a financial institution to sign off on a transaction.

Some market-watchers expect, however, an increase in FIA sales if an addition to the rule — a recently proposed class exemption for independent market organizations seeking to become financial institutions under the BICE — remains intact. That's because of the high threshold the proposal sets to qualify as an FI: $1.5 billion in in annual average premium revenue over three years.

"In establishing the $1.5 billion threshold, the DOL is indirectly creating a conflict of interest," says Clarity 2 Prosperity's Smith. "IMOs and their advisors would be incentivized to sell more fixed indexed annuities to meet the threshold. And that may run counter to a more suitable solution: putting retirement money into [fee-based] assets under management."

Repeal or a watering down of the Dodd-Frank Act could give rise once more to practices that brought banking behemoths to a financial precipice during the Great Recession. (Photo: Thinkstock)

Without modifications, the DOL rule could also suppress insurance sales under the BICE. Daroff says he's been unable to identify a single carrier offering life insurance policy illustrations for DOL rule-compliant retirement plans.

Yet, many of the industry's carriers and wholesaling partners invested heavily during 2016 in revised businesses processes and systems needed to comply with the fiduciary rule. If the DOL repeals it — a decision that even some of rule's critics think ill-advised — much of this investment may be for naught.

"The additional investment [needed] to undo that work seems inconsistent with sound business practices," says Mary Anne Durall, a senior vice president of strategy and corporate planning at SE2, a provider of business processing and technology solutions to the insurance industry. "We have all watched the industry change over the years, moving to fee-based services, with many investment professionals already acting in the best interest of their client. Continuing the directional move to a more standardized, transparent model is the future."

That other executive order

Adding to the regulatory uncertainty for market stakeholders is the president's additional executive order respecting the Dodd-Frank Act. Repeal or a watering down of the landmark legislation, many fear, could give rise once more to practices — proprietary trading by banks, the securitization of subprime mortgage loans charging sky-high interest rates — that brought banking behemoths to a financial precipice during 2007-2009 Great Recession.

For agents and advisors, another issue is the regulation of industry products, including fixed indexed annuities. Absent the Harkin amendment — a section of the Dodd-Frank law providing a "safe harbor" or exemption from securities regulations for annuities and life products that meet minimum requirements or "tests" of the NAIC Annuity Transactions Model Regulations of 2010 — FIAs could fall under the purview of the Securities and Exchange Commission. That could result in the imposition of the SEC's existing fiduciary standard governing investment advisors.

If, however, the Dodd-Frank Act remains intact and the DOL rule is repealed, might producers be able to revert to business as usual? Possibly not.

The years-long debate over a fiduciary rule for retirement advisors, observers say, has raised public expectations as to the standard of care needed in the sale of investment products. If the government doesn't impose a fiduciary standard, then industry players might introduce a palatable version of their own — if only to keep the regulators at bay.

"Consumers are now better informed that there are two worlds: the broker-dealer world and the RIA world," says Daroff. "With or without a fiduciary rule, clients expect that advisors will put them in the right investments, be it a taxable account, an employee benefit plan or an IRA."

Adds Chen: "Broker-dealers have significant conflicts of interests because of the financial incentives to sell products offering the highest commissions. I may be biased, but as an RIA I think you have to have a fiduciary standard to ensure brokers are acting in their clients' best interest."

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