DOL’s rapid pace is too quick, many are saying

The latest chapter in the ongoing debate concerning investment advice regulation is raising eyebrows from stakeholders on both sides, with sources saying the Department of Labor's now lapsed 30-day comment period was insufficient for interested parties to provide proper feedback.

The Labor Department on June 29 unveiled a proposed prohibited transaction exemption that would permit investment advice fiduciaries to receive compensation for their advice and to engage in certain principal transactions that are now forbidden. Currently, the Employee Retirement Income Security Act prohibits investment advice fiduciaries from self-dealing, or taking actions that would provide additional compensation from transactions involving plans and individual retirement accounts for themselves, their affiliates or related entities.

Investment advice fiduciaries relying on the exemption would have to provide advice in the best interest of retirement investors. The standard would be interpreted and applied consistent with the Securities and Exchange Commission's best-interest standard, known as Reg BI, which went into effect June 30.

It will likely take months for the Labor Department to finalize the rule.

Also on June 29, the Labor Department 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 on when a person or entity is taking on fiduciary responsibilities. The 2016 rule was struck down in federal court in 2018. Labor Secretary Eugene Scalia, then a partner at Gibson, Dunn & Crutcher LLP, was part of a team representing the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association and other associations in successful challenges against the rule, arguing the Labor Department exceeded its authority.

But now, stakeholders that applauded Mr. Scalia's efforts in doing away with the 2016 fiduciary rule are confused by the current proposal's preamble, specifically the section that deals with the five-part test and rollover advice, which become a regulatory Rorschach test for those on opposing sides of the debate.

The Labor Department in the preamble said the five-part test's "regular basis" prong would be satisfied when an entity with a pre-existing advice relationship with a retirement investor advises them to roll over assets from a plan to an individual retirement account. But it also said that an investment advice provider who establishes a new relationship with a plan participant and advises a rollover "could satisfy the regular basis prong of the five-part test depending on the facts and circumstances."

Kent Mason, a partner with law firm Davis & Harman LLP in Washington who testified at a Sept. 3 Labor Department hearing on the proposal on behalf of brokerage firm, mutual fund, insurance company and asset manager clients, said the language in the preamble effectively reinstates the 2016 fiduciary rule. He took issue with a section that he said essentially eliminates the mutual understanding and primary basis prongs of the five-part test.

"There are millions of broker-client relationships where there's no mutual understanding of reliance," Mr. Mason said. "For the preamble to say out of the blue that typically any individualized recommendation satisfies mutual understanding and primary basis, there is no basis for it."

Mr. Mason urged the Labor Department to repudiate the preamble language when it issues its final exemption, adding that as currently written the language is "invalid" because it contradicts the 2018 court ruling and the regulation itself.

But Barbara Roper, Pueblo, Colo.-based director of investor protection at the Consumer Federation of America, said there's "plenty of room for firms to craft a new way to establish that the recommendation isn't intended to create a primary basis for the investor's decision. (The critiques are) just hyperbole on the part of the firms."

Ms. Roper would like any recommendation or call to action made by an investment professional to be explicitly covered by the test, especially rollover advice.

If the proposal and preamble were to go into effect as written, the potential for litigation from investors would rise and many financial professionals would stop serving small accounts, Mr. Mason said. He referenced research published in 2017 by Deloitte that surveyed 21 SIFMA member firms and found that 53% of financial advisers reported limiting or eliminating access to brokerage advice for retirement accounts after the 2016 fiduciary rule was announced.

Moreover, to satisfy the exemptions a financial professional would have to acknowledge fiduciary status. "People will give less advice because it exposes them to liability," he said. "Others who don't pull back will be forced to accept fiduciary status and because of the liability will stop serving small accounts. It was ill-advised to require it."

Andrea Seidt, Columbus-based Ohio securities commissioner, said the test "needs to be clear when you are, either through agreement or mutual understanding, serving in a fiduciary capacity to an investor that you are in fact a fiduciary and that all of the obligations that come with that should apply." Ms. Seidt testified on behalf of the North American Securities Administrators Association during the Labor Department hearing.

The Labor Department proposal was unveiled the day before the SEC's best-interest standard took effect. The SEC Reg BI package aims to, among other things, compel brokers to put clients' financial interests above their own and requires them to mitigate financial conflicts.

Critics of the SEC package, like Ms. Roper, say it doesn't go nearly far enough to protect investors and doesn't define what "best interest" means. Supporters, like those in the brokerage and insurance industries, say the package is much tougher than the suitability rule, which was the standard to which brokers were previously held.

Ms. Roper said that the Labor Department, nor anyone else, has conducted an analysis of Reg BI yet since it's so new. "We do not know to which extent it's going to have any meaningful impact on changing the incentives that brokers have to make recommendations that are not in the their customers' best interest," she said. "So we think at the very least it's premature for the department with no evidence that Reg BI is effective to base an exemption on that untested regulatory approach."

Ms. Seidt made a similar point during her testimony and referenced a yet-to-be released North American Securities Administrators Association survey of broker-dealers and investment advisers about their practices in 2018, prior to Reg BI's implementation. The survey found that broker-dealers were much more likely than investment advisers — who are already held to a fiduciary standard — to recommend the more expensive products, like leveraged and inverse exchange-traded funds and variable annuities, to clients.

"The reality is investment advisers stay away from them because they're often not in a client's best interest because they cost more and they have illiquidity issues," Ms. Seidt said. "We hope to see that gap close with Reg BI but we don't know if that's going to happen. We urge the DOL to wait until the evidence is in on that gap."

A wide swatch of stakeholders have called on the Labor Department to reopen its comment period, saying that 30 days wasn't enough time to hear from all interested parties and noted that the Sept. 3 hearing was announced only nine days in advance.

James C. Allen, Washington-based head of Americas capital markets policy for the CFA Institute, said ERISA and investment advice issues are complex and to "try and meld those two together is difficult in the best of times and to shorten that time period to 30 days, my goodness that's really pushing it."

Rule-makings typically have 60- or 90-day comment periods, sources said.

Ms. Seidt said it's important for the DOL to take its time and get it right. "You should welcome, not chill or deter comments from interested parties," she said. "They need to extend the comment period to give everyone that opportunity. Moreover, since they are suggesting following the SEC's new and untested Reg BI approach, they're going to need significant time to review that test."