Fiduciary Rule Client Advisory

The Department of Labor's Employee Benefits Security Administration will soon be publishing in the Federal Register a proposed change to the definition of the term "fiduciary" under section 3(21) of Employee Retirement Income Security Act of 1974 (ERISA) (29 CFR § 2510.3-21), as well as amendments to two current class exemptions, Prohibited Transaction Exemption (PTE) 84-24 and PTE 2020-02.

The following summary is a brief overview of the proposals and their anticipated effects. Detailed advisories relating to each of the proposed amendments will be provided in the coming weeks.

The proposal was announced by the White House on October 31, 2023, folded into the White House initiative against junk fees in investments. While not a perfect fit, the amendments give the Administration a segue into its main aims in the fiduciary area: 

• Covering one-time advice with respect to rollovers and thereby avoiding the adverse decision in American Securities Association v. United States Department of Labor, No. 8:22-cv-330-VMC-CPT (M.D. Fla. Feb. 13, 2023), which the Department initially appealed but then withdrew in May of this year.
• Covering independent insurance agents.
• Covering all products.
• Covering advice to plans, participants, and Individual Retirement Accounts (IRA) owners.

While it was widely expected that the Department of Labor (the Department) would amend either PTE 2020-02 or PTE 84-24 to put independent insurance agents under a federal best interest standard, and, in the Department’s view, "level the playing field" between insurance agents and brokers, this proposal goes further.

A Little History

The amendment of the definition of fiduciary has a long and tangled history. At the start of the Obama Administration, the Department proposed a poorly conceived amendment to the definition, without any exemptions that would allow everyday transactions to continue. After a raft of negative comments, the Department withdrew the rule and started over. The Department re-proposed the changes in 2015, had an extended comment period and a hearing, and then issued final rules. That proposal had unforeseen consequences, including but not limited to a huge shift to fee-based advice for retirement accounts; the inability of many retirement accounts to buy fixed income securities, closed end funds, alternative investments, or foreign investments; and a great deal of confusion regarding applicable exemptions. The rule was challenged repeatedly, and after some early successes for the Department, the US Court of Appeals for the Fifth Circuit held that the Department did not have the authority to change the five-part test in the 1975 regulation implementing ERISA section 3(21) and vacated the rule and all of the exemption amendments.

In vacating the rule, the court stated:

We conclude that DOL's interpretation of an "investment advice fiduciary" relies too narrowly on a purely semantic construction of one isolated provision and wrongly presupposes that the provision is inherently ambiguous. Properly construed, the statutory text is not ambiguous. Ambiguity, to the contrary, "is a creature not of definitional possibilities but of statutory context." Brown v. Gardner, 513 U.S. 115, 118 (1994). Moreover, all relevant sources indicate that Congress codified the touchstone of common law fiduciary status—the parties' underlying relationship of trust and confidence—and nothing in the statute "requires" departing from the touchstone.

Chamber of Commerce of the USA v. U.S. Dep't of Labor, 885 F. 3d 360, 369 (5th Cir. 2018). 

The Department's Proposed Rule

In its latest proposal, the Department again drops three of the elements of the five-part test (primary basis, regular basis, and mutual agreement) and supplants them with a test based on whether (1) the advisor makes a recommendation of any securities or other investment transactions or any investment strategy involving securities or other investment property to the plan, plan fiduciary, plan participant or beneficiary, IRA, IRA owner or beneficiary or IRA fiduciary (retirement investor); (2) the advisor "makes investment recommendations to investors on a regular basis as part of their business"; and (3) the recommendation is provided under circumstances indicating that the recommendation is based on the particular needs or individual circumstances of the retirement investor and "may be relied upon by the retirement investor as a basis for investment decisions that are in the retirement investor’s best interest."

The formulation is at least a little odd. The fact that a financial professional has a "trust and confidence" relationship with others in the course of the professional’s business seems irrelevant to whether the professional has such a relationship with any particular person. Under the proposal, there does not need to be any agreement or understanding between the parties as to whether the recommendations are merely examples of choices available, education, or individualized advice. The definition is not likely to address the concerns of the industry or a reviewing court applying the reasoning of the Fifth Circuit. 

A more serious concern is the lack of a sophisticated institutional investor test or seller’s exception. As formulated, this proposed definition will change the information that dealers and counterparties will be willing to provide professional asset managers about the market, a particular trade, or risk analytics. It is unclear why the Department did not want to take the institutional sell side out of this debate.

Moreover, given that many financial institutions have been operating under a best interest standard since the Security and Exchange Commission’s (SEC) Regulation Best Interest was promulgated in 2016, and many are in compliance with PTE 2020-02, it is unclear what abuses the Department hoped to correct that could not have been addressed by amending PTE 2020-02. Had the Department simply made a few changes in the PTE 2020-02 regime, around which institutions have already adopted policies and compliance, trained, and expended significant sums, and brought PTE 84-24 in line with PTE 2020-02, the changes likely would not have been controversial.   

The Class Exemptions

In issuing PTE 2020-02 during the Trump Administration, the Department sought to encourage advisors to accept fiduciary status voluntarily, without changing the definition of the term, by providing a broad principles-based class exemption to sell products. With its latest proposed definitional amendment, the Department is assuming that everyone who makes recommendations as a regular part of their business will be a fiduciary with respect to all investment conversations, and has amended two class exemptions to enable such fiduciaries to sell investment products to plans for a fee. PTE 84-24 covers insurance products and investment company shares (including open end mutual funds, ETFs and closed end funds). PTE 2020-02 covers rollovers, and virtually all other investment products, although the rule limits the securities that can be sold on a principal basis.¹ Those limitations are largely unchanged in these amendments.  

PTE 2020-02

Briefly, the amendments to PTE 2020-02 would do the following:

• Allow more advisors to use the exemption (pooled plans, robo-advisors).
• Require additional disclosures to participants, including:
  • Notice of the best interest standard, for which the Department provides model language.
  • Notice of the right to obtain specific information regarding costs, fees, and compensation that is described in dollar amounts, percentages, formulas, or other means reasonably designed to present materially accurate disclosure of their scope, magnitude, and nature.
  • More rollover disclosure (oddly, the Department describes a change from a brokerage account to an advised account as a rollover).
  • Additional disclosure where the financial institution’s business model is based on proprietary products or only products that pay third party fees. This is a throwback to 2016 and the ill-fated and widely derided Best Interest Contract (BIC) exemption.
• The Department seeks comment on whether it should require web disclosure for all of the financial institution’s customers. This too is a throwback to the BIC exemption, and will likely receive a similar negative reception seven years later.
• Prohibit the "if I give advice, I am a fiduciary" formulation.
• Require the filing of excise tax returns for prohibited transactions. This requirement apparently addresses the fact that few institutions have used the Department’s reporting mechanism for prohibited transactions, and the Department doubts that financial institutions are complying with the law.
• Reverse the widely praised formulation in PTE 2020-02 that made only the financial institution that is convicted of an asset management crime ineligible to use the exemption. The Department is proposing to extend the disqualification to include "Affiliates" of the financial institution, as defined in the amendment, claiming that it remains concerned that a financial institution facing ineligibility for its actions affecting retirement investors could merely change its corporate form and continue to rely on the exemption.² This element of the amendment could render more than a dozen large financial institutions automatically unable to use PTE 2020-02.
• Set forth the specific crimes (including foreign crimes) that could cause ineligibility, as in Part I(g) of the Qualified Professional Asset Manager (QPAM) Exemption. The Department states that it is concerned that the existing limitation to "any crime described in ERISA section 411 arising out of such person's provision of investment advice” is too narrow. Like the addition of Affiliates, the Department expressed its belief that this will help foster a culture of compliance throughout the organization in recognition of the importance of investment advice to retirement investors.
• Significantly shorten the winding down period, in a change that is not likely to make transitions for participants easy or seamless.
• Create an administrative hearing process for entities convicted of certain crimes.
• Add substantial additional disclosure requirements, including to state regulators, unions and others.

PTE 84-24

The Department's effort to "level the playing field" for insurance agents is accomplished through the amendments to PTE 84-24, which, as noted above, covers investment company products and insurance products. The proposed amendment would exclude investment advice fiduciaries from the current relief in PTE 84-24, while proposing relief under a new section of the exemption with specific conditions for independent insurance agents providing investment advice. The new section of PTE 84-24 is intended for independent insurance agents (called Independent Producers) who work with multiple insurance companies to sell non-securities annuities or other insurance products not regulated by the SEC to "Retirement Investors," as defined in the amendment. It would not cover sales by Independent Producers of investment products other than annuities, such as mutual funds, stocks and bonds, and certificates of deposit, nor does it cover insurance agents who sell products for only one insurance company. Independent Producers must rely on PTE 2020-02 when receiving fees or other compensation in connection with investment recommendations related to those products. Specifically, the proposed amendments:

• Exclude investment advice fiduciaries from the existing relief provided in PTE 84-24.
• Provide a narrowly tailored exemption under a new section of PTE 84-24 allowing Independent Producers to receive commissions or fees from insurance companies with respect to annuity recommendations. The new section provides relief only for Independent Producers, not for insurance companies.
• Condition relief under the exemption for Independent Producers on a written acknowledgement of the Independent Producer's fiduciary status. The insurance company selling its product through the Independent Producer would not be required to acknowledge fiduciary status.
• Require the insurance company selling its products through the Independent Producer to exercise supervisory authority only over the Independent Producer’s recommendation of the insurance company's own products, and not over the Independent Producer’s recommendations of products offered by other insurers. The insurance company would not be treated as a fiduciary merely because it exercised such oversight responsibilities over Independent Producers under the exemption.
• Provide relief only for the Independent Producer’s receipt of commissions or fees as defined in the amendment, which would have to be fully disclosed to the Retirement Investor.
• Impose other conditions for relief under the exemption for Independent Producers that are similar to the conditions contained in PTE 2020-02
• In addition, an insurance company’s systematic pattern or practice of violating the conditions of the exemption in connection with otherwise non-exempt prohibited transactions could cause Independent Producers to lose the exemption with respect to that insurance company’s products.

These amendments seem destined to draw challenge from the insurance industry.

Amendments to Other Exemptions

The Department proposes changes to other exemptions to ensure they cannot be used by investment advice fiduciaries.

For additional questions, please contact Melanie Nussdorf, Paul Ondrasik, Eric Serron, Scott Sinder, Nick Sutter, and Raisa Daigneault.

Endnotes

¹ Section V(d) defines "Covered Principal Transaction" as a principal transaction that:

(1) For sales to a Plan or an IRA:

(A) Involves a US dollar denominated debt security issued by a US corporation and offered pursuant to a registration statement under the Securities Act of 1933, a US Treasury Security, a debt security issued or guaranteed by a US federal government agency other than the US Department of Treasury, a debt security issued or guaranteed by a government-sponsored enterprise, a municipal security, a certificate of deposit, an interest in a Unit Investment Trust, or any investment permitted to be sold by an investment advice fiduciary to a Retirement Investor under an individual exemption granted by the Department after the effective date of this exemption that includes the same conditions as this exemption; and

(B) If the recommended investment is a debt security, the security is recommended pursuant to written policies and procedures adopted by the Financial Institution that are reasonably designed to ensure that the security, at the time of the recommendation, has no greater than moderate credit risk and sufficient liquidity that it could be sold at or near carrying value within a reasonably short period of time; and

(2) For purchases from a Plan or an IRA, involves any securities or investment property.

² The Department recognizes in the proposal that there has been some confusion about what entities would be considered financial institutions in the same Controlled Group, and included Affiliates (as opposed to financial institutions) in the same Controlled Group in the hope that the provision would be better understood by the parties involved. Moreover, the Department stated its belief that the inclusion of Affiliates ensures that financial institutions would be diligent in their obligation to monitor the actions of their Affiliates and foster a culture of compliance throughout the organization.