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DOL's Fiduciary Proposal Misses the Mark

The Department of Labor should go back to the drawing board on its fiduciary proposal before any further damage is done.

Mercer Bullard, 06/14/2011

The Department of Labor ("DOL") has proposed a substantial expansion of the category of persons treated as fiduciaries under the Employee Retirement Income Security Act of 1974 ("ERISA"). The proposal reflects DOL's strong commitment to protect participants in 401(k) and other pension plans. It follows a series of laudable regulatory initiatives that address qualified default investment alternatives, fee disclosure, conflicted fees structures, and annuity options.

Although DOL's fiduciary proposal is equally well-intentioned and has real potential, it badly misses the mark. It is unfair to the industry because it disregards decades of administrative law and practice under ERISA. It is bad for investors because it strips them of fiduciary protections when they are needed most.

The proposal has provided fuel for anti-government forces that seek to weaken financial services regulation generally. And it may inadvertently help the insurance lobby derail the SEC's plan to extend a fiduciary duty to broker-dealers who provide retail, personalized investment advice.

DOL has dug itself a hole. Its best strategy at this point would be to stop digging and publicly announce that it is going back to the drawing board on its fiduciary proposal before any further damage is done.

ERISA "Fiduciaries"
A fiduciary under ERISA includes a person who provides "investment advice," which DOL has interpreted to include only advice that is both "regular" (i.e., not advice regarding a single transaction) and provided under an agreement that it will be "a primary basis" for investment decisions about plan assets.

This interpretation substantially narrows the normal usage of the term "fiduciary." For example, the Investment Advisers Act fiduciary duty applies to one-off investment recommendations and recommendations that do not serve as a primary basis for a client's decisions. The same holds for the common law fiduciary duty if the adviser's relationship with the recipient is one of trust and confidence.

DOL concedes that its current interpretation narrows even "the plain language" of ERISA, so it has proposed to remove the "regular" and "primary basis" restrictions. Its reinterpretation would bring the meaning of "fiduciary" in line with common usage of the term and harmonize the meaning of fiduciary under ERISA with the Advisers Act and the common law. So far so good.

But fiduciary status under ERISA, in contrast with fiduciary status under the Advisers Act and common law, triggers particularly onerous consequences. Fiduciary status under ERISA generally means that the fiduciary cannot enter into many arrangements that are otherwise permitted and often routine for fiduciaries. The analysis of these "prohibited transaction rules" is complex and costly; the penalties for violating them are draconian. ERISA is a model full-employment-for-lawyers statute and every financial professional's worst nightmare.

In short, ERISA is fundamentally incompatible with modern defined contribution plans and individual retirement accounts, but a full discussion of this broader problem must be held for another article. The immediate issue is how DOL expects new fiduciaries to adapt to the prohibited transaction rules.

ERISA's Prohibited Transaction Exemptions
DOL has created a partial solution to ERISA's onerous rules by issuing a series of prohibited transaction exemptions, known as "PTEs." PTEs permit fiduciaries to engage in prohibited transactions if they comply with DOL-created investor protection conditions. PTEs adopted by DOL have substantially displaced ERISA, creating a kind of ghost statute under which the industry actually operates.

In some cases, new fiduciaries under DOL's proposal will be able to rely on existing PTEs and, after modifying their compliance procedures to comply with PTE conditions, conduct business as usual. In other cases, modifications of some PTEs may be necessary (and appropriate) for new fiduciaries to be able to continue servicing clients that are subject to ERISA. Some firms may be unable to adapt to fiduciary standards.

However, DOL did not discuss PTEs in its proposal, much less analyze or request comment on the extent to which existing PTEs would accommodate new fiduciaries or what modifications were needed. DOL has proposed to impose its new fiduciary interpretation seemingly without any consideration of the system of PTEs that it has created, effectively adopting a shoot-first, ask-questions-later approach.

DOL's proposal has ignited a firestorm of protest from the industry and members of Congress. Republicans and Democrats alike have criticized the new interpretation, in part because of the extent to which it would upset established business practices. DOL has received hundreds of comment letters expressing near unanimous opposition to the proposal. Nonetheless, DOL's lead administrator on the rulemaking has been adamant that the Department will proceed, apparently without any major concessions.

DOL's reinterpretation of "fiduciary" is long overdue, but fairness and law dictate that it suspend its proposal and reconsider its approach. DOL should not--and under the principles and text of administrative procedure law arguably cannot--throw new fiduciaries under ERISA's prohibited transaction bus unless and until the newly prohibited activities of new fiduciaries can be thoroughly vetted under the same PTE process--a process that DOL itself has established as the de facto mechanism for a substantial part of ERISA compliance.

The Seller Exemption
There is also a strong investor protection reason for DOL to withdraw its proposal. Its new rule would exclude persons from being fiduciaries if the recipient of the advice should know that: (1) the person is acting as a purchaser or seller whose interests are "adverse" to the recipient's and (2) the person's recommendations are not intended to be impartial. The provision, which Scott Simon correctly describes as the "fiduciary exemption that swallows the rule," substantially weakens ERISA's fiduciary provisions by allowing current fiduciaries to absolve themselves of fiduciary liability even while making personalized recommendations.

DOL's seller exemption fundamentally misunderstands the nature of the fiduciary relationship. The basis for finding a fiduciary duty is a relationship of dependence, whether through trust, informational disadvantage, relative incapacity, or some combination thereof that results in potential overreliance on the fiduciary's advice. Simply knowing that a fiduciary has a conflict of interest changes none of the factors that make fiduciary standards necessary. It may even exacerbate the client's overreliance on the conflicted fiduciary's advice if the candid admission of the conflict engenders even greater, but still misplaced trust.

The fiduciary duty is based on the likelihood that the client will misjudge the fiduciary's advice, including any conflicts about which the client may have been fully informed. The fiduciary relationship assumes the client's lessened capacity to evaluate rationally the conflict of interest, whether or not "known," yet DOL's seller exemption assumes that knowledge somehow corrects the client's lessened capacity. Worse yet, the seller exemption applies when the fiduciary is acting as principal in a transaction with the client--when the potential for abuse is greatest. Both industry and investor interests militate for DOL to withdraw its proposal and start over from scratch.

Sideswiping the SEC
DOL's fiduciary proposal is not the only at-risk fiduciary initiative. The SEC has indicated that it expects to propose important rules imposing a fiduciary duty on broker-dealers who provide retail, personalized investment advice. The battle raging over DOL's proposal may indirectly increase the risk that the SEC's proposal is weakened, if not shelved altogether.

Opponents of a broker-dealer fiduciary duty are using DOL's proposal to stymie the SEC. House Republicans have asked that the SEC "factor into [its] analysis and subsequent activities so as to minimize harm or disruption to the provision of financial services to investors." Broker-dealers have seized upon this argument. Forcing the SEC to fully coordinate its proposal with DOL's would effectively paralyze the SEC's rulemaking effort.

Tying the SEC's proposal to DOL's reflects a smart, if cynical, inside-Washington tactic. If a rulemaking cannot be defeated--because, like the SEC's proposal, it has broad industry support, reflects an express Congressional authorization, is promulgated by an independent agency, and is good public policy--then link it to another rulemaking that, like DOL's proposal, is universally opposed by industry, opposed by both parties in Congress, is promulgated by a political agency, and as currently formulated is bad public policy.

The risk of DOL's proposal helping to derail the work of its SEC counterpart provides yet another reason for DOL to stand aside at least until the SEC has adopted its rule.

The Better Part of Valor
My recommendation to withdraw the fiduciary proposal is made reluctantly. Having submitted letters and testified before Congressional committees strongly supporting a number of pro-investor DOL initiatives, it is distressing to be unable to support DOL's position. But the proposal is patently unfair to industry and bad for investors. It adds fuel to the current conflagration of anti-regulatory, anti-government sentiment in Washington and thereby threatens better conceived, more broadly supported pro-investor initiatives.

When Shakespeare's Falstaff famously said: "The better part of valor is discretion," he had just feigned death to avoid being killed by soldiers loyal to the rebel Hotspur. This phrase, while originally used to describe cowardice, has come to reflect prudence. DOL should heed the popular meaning of Falstaff's advice and yield, for the time being, in order to gather strength to fight another day.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. He has testified frequently before Congress on regulatory issues. He can be reached at bullardm@funddemocracy.com.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. He has testified frequently before Congress on regulatory issues. He can be reached at bullardm@funddemocracy.com. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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