Court strikes down Labor Department’s fiduciary rule—what’s next?

Signaling the latest chapter in the ongoing saga of the Department of Labor’s “fiduciary rule”—which requires that retirement advisers (e.g., broker-dealers, investment advisers, and insurance agents) act first and foremost in their clients’ best interests—the U.S. Court of Appeals for the Fifth Circuit has ruled in favor of plaintiffs who challenged its legality.

“The court has ruled on the side of America’s retirement savers, preserving access to affordable financial advice. Our organizations have long supported the development of a best interest standard of care, and the Securities and Exchange Commission should now take the lead on a clear, consistent, and workable standard that does not limit choice for investors,” plaintiffs—including The U.S. Chamber of Commerce, Financial Services Institute, Financial Services Roundtable, Insured Retirement Institute, and Securities Industry and Financial Markets Association—wrote in a joint statement.

By a 2-1 vote, the appellate judges ruled that the Department of Labor exceeded its statutory authority under the Employee Retirement Income Security Act.

The rule and its controversy

In April 2016, the Department of Labor finalized a new rule that creates a fiduciary duty for brokers and registered investment advisers who offer retirement advice. The rule—originally scheduled to be phased in between April 10, 2017, and Jan. 1, 2018—expanded the “investment advice fiduciary” definition under the Employee Retirement Income Security Act.

The rule provided exemptions that, if applied for and granted, would allow covered advisers to maintain fee-based arrangements. Unless fiduciaries qualify for an exemption, they are prohibited from receiving commissions, which are considered to present a conflict of interest. They are held to a higher standard of customer care, one with best practices and prohibitions on conflict of interest.

The new rule creates a new exemption called BICE (Best Interest Contract Exemption) for fixed index annuities and variable annuities and allows fiduciaries to receive commissions only if they adhere to certain conditions, including signing a written contract with the consumer that contains enumerated provisions intended to protect their interests.

Very quickly, critics of the changes mustered their forces. Notable business groups developed the aforementioned legal challenge and, in the interest of favorable venue shopping, aligned with co-plaintiffs—among them the Greater Irving-Las Colinas’ Chamber of Commerce, Lake Houston Area Chamber of Commerce, Lubbock Chamber of Commerce, and Texas Association of Business—to bring the case to the U.S. District Court for the Northern District of Texas.

The challenge, as presented to that Dallas court, covered a variety of grievances, including: the rule’s inconsistency with the governing statutes; the imposition of legally unauthorized contract terms to enforce the new regulations; First Amendment violations; and the rule’s arbitrary and capricious treatment of variable and fixed indexed annuities.

Other arguments: the rule’s promulgation did not include an adequate cost-benefit analysis; the “arbitrary and capricious” process ignored public comments; and the rule enacted an “impermissible departure” from the historical understanding of a fiduciary and their obligations. The rule, these critics claimed, also went too far by regulating certain insurance products (including fixed-indexed annuities) that the Dodd-Frank Act expressly left to oversight by state regulators. Another bone of contention: It, unlawfully, created a private right of action.

Very few of those arguments ultimately proved persuasive for Chief Judge Barbara Lynn. In an 81-page ruling, made public in February 2017, she decisively sided with the Labor Department.

Lynn shot down, for example, the plaintiff’s argument that the fiduciary rule exceeds the coverage of ERISA because it imposes fiduciary status on those who earn a commission merely for selling a product, regardless of whether advice is given. The rule “plainly does not make one a fiduciary from selling a product without a recommendation,” she wrote.

Plaintiffs had argued that the Labor Department’s exemptive authority is limited to reducing regulatory burdens and BICE. Based on its requirements, it is a mandate that exceeds its authority rather than an exemption. “Any exemption the DoL grants from the prohibited transaction rules reduces the industry’s regulatory burden,” Lynn countered. “Although BICE imposes different obligations than did previous exemptions, it does not follow that the new exemptions exceed the Labor Department’s authority. Although the industry will likely respond in different ways to BICE, [it] does not appear to be a ‘Hobson’s choice,’ and the exemption’s conditions have been deemed workable by many in the industry.”

Despite Lynn’s full-throated defense of the rule, the Fifth Circuit, with a 2-1 ruling, sided with the business groups challenging it.

The opinion points out that the “fiduciary rule is of monumental significance to the financial services and insurance sectors of the economy,” with estimates that compliance costs imposed on the regulated parties might amount to $31.5 billion over ten years.

The Court rejected the way the rule upends decades of established law and Congressional intent. “Critically, the new definition dispenses with the ‘regular basis’ and ‘primary basis’ criteria used in the regulation for the past forty years,” it says. “Consequently, it encompasses virtually all financial and insurance professionals who do business with ERISA plans and IRA holders. Stockbrokers and insurance salespeople, for instance, are exposed to regulations including the prohibited transaction rules.”

“The decision is riddled with flaws. The court misapplied the law, deviated from the decisions of every other court to consider the rule, and turned a blind eye to dramatic changes in the retirement landscape over the last 40 years.”
Stephen Hall, Legal Director, Better Markets

The fiduciary rule “has already spawned significant market consequences,” the Court said, citing the withdrawal of several major companies, including MetLife, AIG, and Merrill Lynch, from segments of the brokerage and retirement investor market.

The BICE exemptions were also criticized. “When brokers and insurance representatives use the BICE exemptions, as they must in order to preserve their commissions, they are required to expose themselves to potential liability beyond the tax penalties provided for in ERISA,” the Court’s opinion says.

“Throughout the financial services industry, thousands of brokers and insurance agents who deal with IRA investors must either forgo commission-based transactions and move to fees for account management or accept the burdensome regulations and heightened lawsuit exposure required by the BICE contract provisions,” it added. “It is likely that many financial service providers will exit the market for retirement investors rather than accept the new regulatory regime.”

The Court also questioned whether the Obama Administration, in its zeal to issue the rule, ignored a Dodd-Frank Act mandate for the SEC as well as turned a blind eye to additional controls under the purview of states.

“The 2010 Dodd-Frank Act amended both the Securities Exchange Act and the Investment Advisers Act of 1940, empowering the Securities and Exchange Commission to promulgate enhanced, uniform standards of conduct for broker-dealers and investment advisers who render ‘personalized’ investment advice about securities to a retail customer,” the opinion says. “Significantly, Dodd-Frank prohibits the SEC from eliminating broker-dealers’ commissions or other standard compensation.”

What’s next?

Despite the latest ruling, the final fate of the fiduciary rule is far from fully written.

“The 5th Circuit’s decision to vacate the Labor Department’s fiduciary rule in its entirety creates a new round of uncertainty in the ongoing saga of the rule,” says Josh Lichtenstein, tax and benefit partner for law firm Ropes & Gray. “The 5th Circuit is now at odds with multiple other courts that have upheld the rule, including the 10th Circuit. While the government decides whether to request an en banc review of the ruling [a rehearing before all of the appellate court’s judges], appeal the case to the Supreme Court, or take no action, financial institutions are forced to decide how to react, especially if part of their operations is located in the 5th Circuit.”

“This possibility of having the rule apply in some parts of the country but not in others creates new risks and compliance challenges for institutions, reopening the period of uncertainty around the rule shortly after the DoL had resolved similar uncertainties by delaying the compliance date for portions of the rule,” he adds. “It also remains to be seen whether state regulators will move forward with new enforcement actions or create new rules in response to the new uncertainty that this decision brings.”

Stephen Hall, legal director and securities specialist for the investor advocacy group Better Markets, blasted the appellate court’s decision to vacate the rule.

“The decision is riddled with flaws,” he argued. “The court misapplied the law, deviated from the decisions of every other court to consider the rule, and turned a blind eye to dramatic changes in the retirement landscape over the last 40 years.”

“Moreover, the opinion is infused with hostility toward the Labor Department and the rule itself,” he adds. “That tenor has no place in a decision of a federal circuit court, particularly on a matter of such enormous importance to the public … This decision is also a slap in the face to the dedicated and hardworking public servants at the Labor Department who labored for more than five years conducting rigorous analysis and outreach to all affected groups, including most prominently industry, who insisted on, and received, unprecedented access and input.”

The Labor Department “should pursue every possible avenue for challenging the court’s decision,” Hall says.

Meanwhile, it is increasingly likely that the SEC will step into the fray with a proposal of its own.

“With the Labor Department’s fiduciary rule now partially in effect, it is important that the Commission make all reasonable efforts to bring clarity and consistency to this area,” Chairman Jay Clayton said in a July 2017 speech. “It is my hope that we can act in concert with our colleagues at the Department of Labor in a way that best serves the long-term interests of Mr. and Ms. 401(k).” The Commission subsequently solicited public comments to help guide its proposal.

Elizabeth Kelly, senior vice president of operations at United Income, a FinTech firm that leverages technology to provide financial planning and money management services for people nearing or entering retirement, is among the outspoken defenders of the fiduciary rule.

She served as special assistant to the President at the White House National Economic Council during the Obama Administration and was tasked with engagement and outreach to federal agencies on behalf of the rule and other retirement initiatives and policy.

Kelly dismisses accusations by critics that the rule was hastily forced through the administration in its waning days. “We ran an incredibly thorough process; there were over 100 in-person meeting, thousands of comments, and three days of public hearings,” she says. “There were substantial changes made to the rule to reflect the input we received. I think there are many people who were in the administration who would say it was one of the most thoughtful, careful, and detailed rulemaking processes they have ever seen. The Labor Department did an outstanding job.”

Her hope is that one of the judges on the Fifth Circuit will take internal action to keep the most recent ruling from going into effect and seek en banc rehearing of the case by the full court.

“There is a clear circuit split between the Fifth Circuit, a 10th Circuit Court of Appeals decision issued recently and, potentially, a D.C. Circuit hearing on this case that is coming up shortly,” Kelly says. “This is something that could go to the Supreme Court and, in my opinion, should.”

As for her current firm, it proves that the fiduciary rule is not as onerous as critics claim, she says: “We have been fully compliant with the rule since Day One and, given our experience, it is workable for both the business and its clients’ best interests.”