Advice exemption stands – for now, anyway

To the surprise of many stakeholders, the Department of Labor under the Biden administration let a Trump-era investment-advice exemption take effect in February, but the debate on the issue is far from over as focus turns to the department's next move.

The new administration allowed a prohibited transaction exemption that permits investment-advice fiduciaries to receive compensation for more types of guidance, including advice to roll over assets from a retirement plan to an individual retirement account, to go into effect on Feb. 16 as scheduled.

The exemption was finalized in December under the Trump administration but needed 60 days to take effect. Upon taking office Jan. 20, the Biden administration had the ability to halt and review any rule-making effort that was not in effect.

During a 30-day comment period and at a subsequent hearing on the proposed exemption in September, a variety of stakeholders criticized the proposal, including participant groups like the AARP and the Consumer Federation of America, which broadly said that the exemption does not sufficiently protect investors.

"I thought because of that DOL would delay the exemption so that they would get input and comments as to whether to let it go into effect," said Kent Mason, a partner with law firm Davis & Harman LLP in Washington who testified at a Labor Department hearing in September on the proposed exemption on behalf of brokerage firm, mutual fund, insurance company and asset manager clients.

But while the Biden administration allowed the exemption to take effect, it signaled that it would soon have more to say on the issue.

"We recognize that investment-advice providers have been preparing for the exemption, and this step will allow them to implement important system changes," said Ali Khawar, deputy assistant secretary of labor for the Employee Benefits Security Administration, in a statement shortly before the exemption took effect. "That said, we will continue our stakeholder outreach to determine how we might improve this exemption, the rule defining who is an investment-advice fiduciary, and related exemptions to build on this approach."

The Employee Retirement Income Security Act of 1974 prohibits investment-advice fiduciaries from self-dealing, or taking actions that would provide additional compensation from transactions for themselves, their affiliates or related entities involving plans and individual retirement accounts.

Investment-advice fiduciaries — like registered investment advisers, broker-dealers, banks and insurance companies — relying on the exemption would have to provide advice in the best interest of retirement investors and give those investors basic information about conflicts of interests.

"There's a lot in flux right now, but ultimately what the exemption provides is broad relief and a lot of flexibility in terms of how you structure your business," said Jennifer Eller, a Washington-based partner at Groom Law Group. "The conditions are definitely something to contend with, they're meaty, there's real work to comply with the conditions so it's not going to be great for everyone."

When proposing the exemption in June, the Labor Department also announced a final rule reinstating the five-part test used to determine whether an investment professional or financial institution is a fiduciary. It was in 2016 that the Labor Department under the Obama administration finalized a rule, commonly known as the fiduciary rule, that aimed to replace the five-part test by broadening the definition of when a person or entity is taking on fiduciary responsibilities. The rule was struck down in federal court in 2018 due to regulatory overreach.

With respect to rollover advice, the Labor Department in June also stated that its previous analysis — a 2005 advisory opinion known as the Deseret Letter, which found that rollover advice did not constitute investment advice — was incorrect.

The Labor Department in its final exemption's preamble stated that "the facts and circumstances analysis required by the five-part test applies to rollover recommendations."

Mr. Mason said the exemption's preamble includes new interpretations of the five-part test that would very significantly expand the scope of who is considered a fiduciary, in direct contradiction to the federal court's ruling in 2018.

Firms are now struggling with how to handle the preamble, Mr. Mason said.

"Technically, a preamble is not the law so on a technical legal analysis the preamble is invalid," he said. "On the other hand, companies tend to be conservative so they're struggling with this notion of whether to follow what I think is the law or the preamble."

He added: "The exemption requires you to say you're a fiduciary, and when you say that you're accepting a tremendous amount of potential liability. There's a lot of uncertainty with how to proceed."

Barbara Roper, Pueblo, Colo.-based director of investor protection at the Consumer Federation of America, did not support the Labor Department's exemption as drafted, but now that it's in effect, she said it's "better than nothing while they're getting that additional work done."

The five-part test makes it "too easy for firms to avoid responsibility when they're clearly functioning as fiduciary advisers," Ms. Roper said, and has urged the Labor Department to "close loopholes" in its investment advice definition.

She likes that the new exemption requires an adviser to document the basis on which they determine that a rollover recommendation was in the best interest of a customer but said the language in the preamble makes it simple for an adviser to make the best-interest case without having to do the due diligence.

"You could arguably get away with saying, 'Well there's a broader investment menu and more services available through the IRA,' and not have to do a meaningful analysis of the relative costs of those recommendations or whether the customer needs or would benefit from those added services or selections," Ms. Roper said.

Members of the Center for Board Certified Fiduciaries, a newly formed public benefit corporation aimed to help develop exemplary fiduciaries, said the exemption is imperfect, but an upgrade for fiduciary standards.

Phoenix-based CBCF Chairman Don Jones said the exemption is likely a placeholder. "I think there's more to come," he said. "It's still too easy — whether it's fair or not — not to become a fiduciary and that by and large has not been good for the industry."

Exactly what the administration will do next remains to be seen, but Ms. Roper would like to see guidance issued that clearly defines what "best interest" means and what financial professionals who utilize the exemption can do with respect to conflicts of interest. "There's room for (the Labor Department) to send a strong message that they expect to see real, meaningful steps to rein in conflicts in order to comply with the rule," Ms. Roper said.

Sarah Buescher, associate general counsel at the Investment Adviser Association in Washington, said she'd like the Labor Department to tackle any issues that spring up from the new exemption before undertaking a new rule-making process.

One change the IAA would like to see is making the exemption available to all digital advice. The exemption excludes investment advice "generated solely by an interactive website in which computer software-based models or applications provide investment advice based on personal information each investor supplies through the website, without any personal interaction or advice with an investment professional."

But any further rule-making on this issue could be subject to legal challenge, Mr. Mason said. "What I expect is they will revive a good part of the 2016 set of rules; that will then face legal challenges," he said.

For Ms. Roper, who is in favor of stronger fiduciary standards, another round of court challenges are not reason to fret.

"There's nothing magical about the 5th Circuit ruling," she said, referencing the federal court that made the 2018 decision to strike down the Labor Department rule. "It was just a game of musical chairs and they turned off the music at that point."

The rule survived previous challenges in lower courts, but not a ruling from the 5th Circuit Court of Appeals. The Trump administration did not appeal the decision. "There's a strong reason to believe a rule to close (conflict of interest) loopholes would survive legal challenge," Ms. Roper said.