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Winter 2016 | Employee Benefits Committee Newsletter

U.S. Department of Labor Wins Big in First Ruling on Its New Fiduciary Rule

By: Robert Rachal, Holifield Janich Rachal & Associates, PLLC

Since 2009 the U.S. Department of Labor (DOL) has been investigating redefining what constitutes fiduciary conduct regarding rendering investment advice for a fee. The prior DOL rule, promulgated in 1975, construed this conduct narrowly, including by requiring that the advice be (i) on a regular basis and (ii) rendered pursuant to a mutual agreement that the advice will serve as the primary basis for investment decisions with respect to plan assets. In 1975 defined benefit plans were the predominant retirement vehicle, and these were typically managed by a company's financial personnel. Since 1975; however, there has been explosive growth (i) in defined contribution plans that places (often financially unsophisticated) individual participants at the center of investment decisions, and (ii) in the complexity of financial products offered these participants.

These and other concerns led the DOL to seek to expand the definition of fiduciary conduct in this area. After an extensive rulemaking process the DOL promulgated its new final rule in April 2016. This new rule has been subjected to numerous legal and now also political challenges. On the political front there has been much speculation that the new Trump administration may seek to gut or stop the rule. But there are counter political narratives and concerns (including that some prominent investment advisors are embracing and marketing their fiduciary "customer first" status), which suggest that the ultimate resolution may not necessarily be simple or expected.

On the legal front there have been six lawsuits filed, several of which have been consolidated in federal court in the Northern District of Texas before Judge Barbara M.G. Lynn, in which oral argument was recently held. And in a case filed in Kansas, Mkt. Synergy Grp., Inc. v. DOL, 2016 BL 393632, D. Kan., No. 5:16-cv-04083-DDC-KGS, 11/28/16), the DOL recently won a victory against various procedural challenges to the rule.

This article focuses on the legal challenges raised in Nat'l Ass'n for Fixed Annuities v. Perez, 2016 WL 6573480 (D.C.D.C., Nov. 4, 2016), in which the DOL recently won a substantial victory against various challenges to the new fiduciary rule brought by the National Association for Fixed Annuities (NAFA). Among other things, the new rule expanded the definition of fiduciary conduct by dropping the old rule's requirement that such investment advice must occur "on a regular basis" to be fiduciary advice. Thus, advice on major participant financial decisions affecting retirement, such as whether to roll over 401(k) funds to an IRA, and in what investments to invest those funds, will now be typically fiduciary advice under the new rule. The DOL estimates that over $2 trillion in retirement funds will be rolled over during the next five years, so the financial significance of this change to participants and to those who advise them is obvious.

Chevron Analysis. In perhaps the most significant part of his decision, Judge Randolph Moss concluded that the new rule more closely conforms to the statutory text than the old rule. Thus, Judge Moss found the new rule easily passed "step one" of Chevron analysis, since Congress obviously has not foreclosed the DOL's interpretation. Rather, "[n]othing in the phrase 'renders investment advice' suggests that the statute applies only to 'advice on a regular basis.'" Id. at *15. In response to arguments by NAFA that Congress only intended to apply fiduciary duties to those who participate in ongoing management of a plan or its assets, Judge Moss noted that Congress placed the requirements to administer or manage the plan in the other prongs of the fiduciary definition, not the one applicable to investment advice for a fee. Judge Moss reasoned that adding these requirements to the investment advice prong would thus strip it of meaning.

Judge Moss also concluded that the DOL's new rule easily passed step two of Chevron's analysis--that its interpretation is reasonable and reasonably explained. Judge Moss noted that the new rule better comports to the statutory text and to ERISA's broadly protective purposes, which impose fiduciary standards on those whose actions affect the amount of benefits retirees will receive. The DOL reasonably explained that the relationships between advisors and investors have changed since 1975, with the rise (i) in 401(k) plans and IRAs, which often put individual participants at the center of the investment decisions, and (ii) in the complexity of the products offered these participants.

Expansion to IRAs. NAFA also challenged the DOL's application of fiduciary duties to IRAs (which are regulated under Title II of ERISA) through the Best Interest Contract Exemption (BIC Exemption) and Prohibited Transaction Exemption (PTE) 84-24. NAFA argued that since Congress did not apply fiduciary duties to IRAs by statute, the DOL could not do so through rule-making. Judge Moss rejected this argument, finding that what the DOL did was a permissible exercise of its rulemaking authority under Title II to require certain conditions be met--in this case agreement to comply with fiduciary standards of loyalty and prudence--before an exemption would be granted.

Judge Moss concluded that NAFA's structural argument, that Congress put fiduciary duties only in Title I not Title II, ultimately failed because nothing in Title II unambiguously foreclosed inclusion of fiduciary duties as a condition of an exemption. Rather Congress required that exemptions be (i) administratively feasible, (ii) in the interests of the plan and its participants, and (iii) protective of the rights of the participants. And since the beginning of ERISA the DOL has used its authority to impose substantive conditions on exemptions. Here, Judge Moss observed that this exemption may not have passed muster as being in the interests of participants absent imposition of fiduciary duties of loyalty and prudence, because without these enforceable duties commissions permitted by this exemption can risk incentivizing advisors to favor their interests over those of participants.

Private Cause of Action. NAFA argued that because in order to qualify for the BIC Exemption for IRA investments an advisor must agree to enter contracts with certain terms, that this exemption violates the rule that only Congress can create a private cause of action. Judge Moss rejected this argument, noting that the DOL has elsewhere required inclusion of contractual terms to qualify for exemptions, and that the enforceability of the contracts will be determined under and pursuant to state law, not the DOL's rule. Judge Moss also noted that this approach fits within the enforcement scheme for IRAs, which are enforced under state contract and common law, and that the DOL simply conditioned its exemption on inclusion of certain terms (enforceable by state law causes of action) in those contracts.

Reasonable Compensation as Too Vague. NAFA argued that the BIC requirement that the advisor receive no more than reasonable compensation was void for vagueness. In response to comments, in the final rule the DOL cross referenced the BIC "reasonable compensation" standard to the one used elsewhere in ERISA. Judge Moss agreed the standard was sufficiently clear in context that a reasonably prudent person would know what was prohibited. Judge Moss noted that the harm this standard was meant to mitigate--conflicts of interest caused by certain compensation structures--gave further meaning to the standard, and to what may be prohibited. Judge Moss also noted that "reasonable" is used throughout the law, and "reasonable compensation" is used repeatedly in ERISA and in trust law on which it is based.

Requiring Fixed Indexed Annuities to Meet the BIC Exemption. In the final rule the DOL decided to require fixed indexed annuities (these are annuities in which the payments vary based on investment returns, but with protection from negative returns) to be subject to the BIC Exemption, not merely PTE 84-24. Judge Moss found that this placement was not "arbitrary or capricious" since the DOL could reasonably conclude that the risks and complexities associated with this product justified the need for these added protections. In response to NAFA's claims that these changes would cause market disruptions in distributing this product, Judge Moss noted that the DOL could conclude (i) that the harms to participants from conflicted advice outweighed any such effects, and (ii) that the United Kingdom's experience with similar reforms suggested that most advisers would stay in the market.

Perspectives

While there will be many more legal battles over the DOL's new fiduciary rule, the NAFA ruling, which has been appealed, was an unambiguous major win for the DOL. If Judge Moss's Chevron analysis is followed, the legal battles for the DOL likely will be mostly downhill. If, per Judge Moss, the DOL is correct that fiduciary conduct is properly defined broadly in relation to providing investment advice for a fee, then it appears that advisors will need the BIC (or some other exemption) to avoid prohibited transactions for transaction-based compensation. The political battles on this new rule may be just beginning, however.