David Hamilton, Victoria Bruno and
Hillary Kistenbroker, The Daily Record Newswire
The U.S. Department of Labor last week released its long-awaited and controversial fiduciary rule expanding the definition of who is a fiduciary when providing investment advice on retirement accounts. The rule aims to eliminate conflicts of interest and to give investors transparent information about the total cost of investments, including fees and commissions.
The new rule covers anyone who gets paid directly or indirectly for providing retirement investment advice. This includes anyone who advises or makes recommendations on 401(k) plans and IRAs, which account for trillions of dollars of invested assets. This marks a radical shift for brokers and broker-dealer firms, who will no longer be judged by a suitability standard but instead owe a higher, fiduciary duty to put their clients’ best interest first. A game-changing corollary is the rule’s prohibition of commission-based fee arrangements and other forms of conflicted compensation that are commonplace throughout the brokerage industry.
The fiduciary rule leaves investment professionals who want to continue to receive otherwise-prohibited compensation with a couple of fundamental choices: provide no advice or take advantage of the rule’s “best interest contract” (BIC) exemption. The BIC imposes strict conditions. Under the rule’s expanded definition of who is a fiduciary, advisers of retirement accounts must:
• Acknowledge their fiduciary owed to clients;
• Adhere to uniform standards of impartial conduct requiring them to give advice in the client’s best interest, charge no more than reasonable compensation, and make no misleading statements about investments, compensation, or conflicts of interest;
• Implement policies and procedures to prevent violation of the above standards; and
• Fairly disclose upfront information about the total cost of each new investment, fees, compensation, and conflicts of interest.
In the case of IRAs and non-ERISA plans, these conditions must be set forth in an enforceable contract with the client. The BIC requirements likely will increase costs of compliance and regulatory scrutiny while reducing income.
Those effects may be too heavy a price to pay for some brokers and the investors they serve. The options for brokers include conversion to fee-based relationships and shedding accounts that are simply marginally profitable.
“By substituting its judgment for that of investors in deciding the type of financial professional and fee structure all investors should use when investing their retirement savings, the DOL’s final rule has only further extended the nanny state’s reach into the wallets of hard-working Americans across the country,” says Dan Gallagher, a former SEC commissioner and president of Patomak Global Partners, a regulatory consulting firm for the financial services industry. “The DOL’s final rule continues to ignore the benefits to investors of a disclosure-based approach to mitigating potential conflicts of interest. Investors benefit from choice: choice of products, choice in advice providers and choice in making decisions for themselves, all of which will now be severely limited under the DOL’s heavy-handed rule.”
What are the other regulatory and legal consequences for breaching the new fiduciary duty rule? Brokers and other advisers of retirement accounts could face enforcement actions by the DOL or be exposed to tax penalties levied by the IRS. Above and beyond regulatory action, clients can bring a private cause of action for breach of the BIC. The rule bars provisions in the BIC that limit liability to clients or preclude them from enforcing the contract through class actions.
It remains to be seen how courts will apply the “best of interest of the client” standard in individual cases. This uncertainty will make it more complex for institutional and individual advisers to quantify their litigation exposure and look for ways to mitigate that risk through insurance and other risk-transfer mechanisms. At the very least, the fiduciary rule makes clear the requirement to document each client’s individual needs for each new investment recommended. Such records would be discoverable in a client lawsuit. Failing to handle and preserve them properly may lead to sanctions or even a monetary judgment for the client.
On the upside, the new rule creates significant opportunities for independent brokers and smaller brokerage firms to step in and meet the needs of more moderate investors. The calculus for whether to comply with the fiduciary rule may look different when you consider that tens of trillions of dollars of wealth accumulated by the baby-boomer generation will transfer to their children and their children’s children over the next 30 years.
But stay tuned. Political and industry leaders have criticized the fiduciary rule as unworkable and ineffective at protecting the retirement accounts of average Americans. The DOL may face legal challenges to its authority to promulgate the rule and lobbying efforts to override or replace it. Moreover, the SEC has yet to decide whether to change its own fiduciary standard for registered investment advisers. If the SEC and DOL standards conflict, some financial advisers will face their own logistical challenges on how to ensure compliance with both.
Whatever changes happen at the regulatory, judicial, or legislative level, the financial advisory industry will need to change significantly. Navigating the new rule’s requirements and many exceptions will be difficult. Investing in the right compliance and litigation strategy can help brokers harness the business opportunities that a fiduciary standard will create while managing a reasonable level of risk.
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David Hamilton, Victoria Bruno and Hillary Kistenbroker are attorneys at Womble Carlyle in Baltimore. David is the office’s Managing Partner. They represent clients in the financial services industry on compliance and litigation matters and can be reached through Womble Carlyle’s website.
