If you are familiar with those, skip to the “Prudence - and the Prudent Expert” section for the good stuff.
SEC Regulation Best Interest ("RBI") went into effect on June 29, 2020. I've written extensively about RBI and the implications for broker-dealer obligations to clients and won’t cover that here.
Instead, I want to focus on the Department of Labor (“DOL”) proposed class exemption (“DOL Proposal”) that was also released on June 29, 2020.
While much ink has been spilled on RBI and its implementation, on the same day it went into effect the Department of Labor released a proposed update to the Employee Retirement Income Security Act of 1974 ("ERISA").
The DOL Proposal has received much less focus. It shouldn't have. This potential change to ERISA could make almost anyone advising on IRA rollovers, and their investments, a fiduciary.
Indeed, the release appears to be a Trojan horse for the broker-dealer community. It allows for a host of prohibited transactions (welcomed), but will hold those making the recommendations to the prudent expert standard, the highest fiduciary standard in the land (most unwelcomed).
As will be discussed below, many of those criticizing the DOL release, including the Public Investors Advocate Bar Association (“PIABA”) and the State of California Attorney General, (who is leading a coalition to oppose the DOL proposal), appear to have not understood the entirety of the DOL's proposal, or at least not fully understood its terms.
Before reviewing the DOL Proposal, it is helpful to review a quick timeline of how we got here. Additionally, you can access all my writings on the original DOL Fiduciary Rule here.
In 2010, the DOL began work to clarify that anyone advising on IRA rollovers and their assets was subject to ERISA and thus a fiduciary. Six years later, in 2016, the DOL published its final Fiduciary Rule.
The Fiduciary Rule was vigorously opposed by the broker-dealer community, which sued and won a Fifth Circuit Court of Appeals ruling in 2018. This vacated the Fiduciary Rule.
In the mean time, the SEC undertook to create a heightened standard of care for investment professionals dealing with retail clients, Regulation Best Interest (“RBI”). In 2019 it finalized RBI, which requires a neither-fish-nor-fowl "best interest" standard that lies between the FINRA suitability standard and the Investment Advisor fiduciary standard. (Notably, the SEC could not find the spine to define what "best interest" actually means.)
In June, the DOL quietly proposed changes to ERISA that would provide exemptions from prohibited transactions, and also significantly clarified the "five-part test" for fiduciary status. There was a short one-month comment period that has now come and gone.
The DOL Proposal
The DOL Proposal provides prohibited transaction exemptions for IRA rollover accounts:
This exemption permits Financial Institutions and Investment Professionals who provide fiduciary investment advice to Retirement Investors to receive otherwise prohibited compensation and engage in riskless principal transactions and certain other principal transactions (Covered Principal Transactions) as described below.
This exemption permits Financial Institutions and Investment Professionals, and their affiliates and related entities, to engage in the following transactions, including as part of a rollover for a Plan to an IRA as defined in Code section 4975(e)(1)(B)... (Emphasis added)
IRA accounts are significant because roughly 40 percent of U.S. household assets are held in them. According to IRS data, at year-end 2017, there were $9.4 trillion in IRA assets for 60.3 million taxpayers. Furthermore, rollovers are a significant source of new funds for brokers and investment advisors. In 2017, there were 4.7 million rollovers totaling $478 billion in assets.
These trends will almost certainly accelerate as increasing numbers of Baby Boomers retire and roll over their pensions, which were the dominant saving vehicle at the beginning and middle of their careers, and 401(k) accounts, which became popular in the later part of their careers.
Importantly, the DOL proposal also reverses a key 2005 ruling, and now requires the advising broker to satisfy the Impartial Conduct Standards and other conditions.
Reversing Advisory Opinion 2005-32A the "Deseret Letter”
The DOL has specifically put rollovers into fiduciary play by reversing a 2005 ruling known as the “Deseret Letter”, writing:
In light of potential conflicts of interest related to rollovers from Plans to IRAs, ERISA and the Code prohibit an investment advice fiduciary from receiving fees resulting from investment advice to Plan participants to roll over assets from a Plan to an IRA, unless an exemption applies. The proposed exemption would provide relief, as needed, for this prohibited transaction, if the Financial Institution and Investment Professional provide investment advice that satisfies the Impartial Conduct Standards and they comply with the other applicable conditions discussed below. (Emphasis added)
In particular, the Financial Institution would be required to document the reasons that the advice to roll over was in the Retirement Investor's best interest. In addition, investment advice fiduciaries under Title I of ERISA would remain subject to the fiduciary duties imposed by section 404 of that statute.
In determining the fiduciary status of an investment advice provider in this context, the Department does not intend to apply the analysis in Advisory Opinion 2005-23A (the Deseret Letter), which suggested that advice to roll assets out of a Plan did not generally constitute investment advice. The Department believes that the analysis in the Deseret Letter was incorrect and that advice to take a distribution of assets from an ERISA-covered Plan is actually advice to sell, withdraw, or transfer investment assets currently held in the Plan. A recommendation to roll assets out of a Plan is necessarily a recommendation to liquidate or transfer the Plan's property interest in the affected assets, the participant's associated property interest in the Plan investments, and the fiduciary oversight structure that applies to the assets. (Emphasis added)
Typically the assets, fees, asset management structure, investment options, and investment service options all change with the decision to roll money out of the Plan. Accordingly, the better view is that a recommendation to roll assets out of a Plan is advice with respect to moneys or other property of the Plan. Moreover, a distribution recommendation commonly involves either advice to change specific investments in the Plan or to change fees and services directly affecting the return on those investments. (Emphasis added)
The last part of this is in agreement with SEC and FINRA guidance, which note that a rollover almost always involves a securities transaction. Under RBI the SEC has written:
… it is our view that Regulation Best Interest should apply broadly to recommendations of securities transactions and investment strategies involving securities. Accordingly, the Commission is including in the rule text account recommendations as recommendations that will be covered by Regulation Best (sic). “Account recommendations” include recommendations of securities account types generally (e.g., to open an IRA or other brokerage account), as well as recommendation to roll over or transfer assets from one type of account to another (e.g., a workplace retirement plan account to an IRA). (Emphasis added)
Similarly, FINRA has put its members on notice that:
a broker-dealer’s recommendation that an investor roll over retirement plan assets to an IRA typically involves securities recommendations subject to FINRA rules.
Critically, the IRA rollover recommendations and subsequent investment recommendations would enjoy the exemptions from prohibited transactions only if the broker (and broker-dealer) met the Impartial Conduct Standards.
The importance of this language cannot be overstated.
The Impartial Conduct Standards
The DOL proposal would require broker compliance with the Impartial Conduct Standards, which have three components:
- Providing advice that is in Retirement Investors’ best interest;
- Charging only reasonable compensation, and;
- Making no materially misleading statements about the investment transaction and other relevant matters.
Furthermore, the DOL proposal would require:
Financial Institutions, prior to engaging in a transaction pursuant to the exemption, to provide a written disclosure to the Retirement Investor acknowledging that the Financial Institution and its Investment Professionals are fiduciaries under ERISA and the CODE, as applicable.
The disclosure also would be required to provide a written description, accurate in all material respects regarding the services to be provided and the Financial Institution’s and Investment Professional’s material conflicts of interest. (Emphasis added)
Critics of the DOL proposal have taken aim at the best interest element of the Impartial Conduct Standards. For instance, PIABA, in its comment letter, wrote:
The first prong of the Impartial Conduct Standards, the best interest obligation, is to be interpreted and applied consistent with the best interest standard as defined by the Commission’s recently enacted Reg. BI.
While PIABA quote the DOL Proposal accurately, the spirit of the DOL Proposal reflects stronger medicine:
This proposed best interest standard is based on longstanding concepts derived from ERISA and the high fiduciary standards developed under the common law of trusts, and is intended to comprise objective standards of care and undivided loyalty, consistent with the requirements of ERISA section 404. (Emphasis added)
This DOL Proposal language echoes the language propounded in the Impartial Conduct Standard in the proposed Best Interest Contract Exemption on April 8, 2016. At the time, the DOL wrote:
(the Impartial Conduct Standards) are fundamental obligations of fair dealing and fiduciary conduct, and include obligations to act in the customer’s best interests, avoid misleading statements, and receive no more than reasonable compensation.
The Impartial Conduct Standards represent fundamental obligations of fair dealing and fiduciary conduct. The concepts of prudence, undivided loyalty and reasonable compensation are all deeply rooted in ERISA and the common law of agency and trusts. (Emphasis added)
Prudence - and the Prudent Expert
“Prudence” is a word that appears throughout ERISA and the DOL Proposal. However, it was assiduously removed from the originally proposed RBI and did not make the final rule. It’s appearance in the DOL Proposal provides an important distinction between RBI and ERISA.
Critically, the DOL’s version of fiduciary conduct contained within the Impartial Conduct Standards is the prudent expert standard, the absolute highest fiduciary standard in the land.
ERISA Section 404(a)-1 Investment duties, lays out the prudent expert standard:
… a fiduciary shall discharge his duties with respect to a plan with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. (Emphasis added)
The DOL Proposal reiterates the prudent expert standard language, essentially verbatim from ERISA Section 404(a)-1:
Investment advice is, at the time it is provided, in the Best Interest of the Retirement Investor. As defined in Section V(a), such advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person, acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, and does not place the financial or other interests of the Investment Professional, Financial Institution or any affiliate, related entity, or other party ahead of the interest of the Retirement Investor, or subordinate the Retirement Investor’s interest to their own. (Emphasis added)
After the 2016 DOL Fiduciary Rule was vacated by the Fifth Circuit, the DOL issued Field Assistance Bulletin (“Bulletin”) No. 2018-02 that kept the Impartial Conduct Standards in effect. The current DOL Proposal describes the Bulletin guidance:
In the FAB, the Department stated it would not pursue prohibited transactions claims against investment advice fiduciaries who worked diligently and in good faith to comply with “Impartial Conduct Standards” for transactions that would have been exempted in the new exemptions, or treat the fiduciaries as violating the applicable prohibited transaction rules. (Emphasis added)
The Impartial Conduct Standards discussed in the Bulletin were originally articulated in the Best Interest Contract Exemption proposal, the language of which will by now be familiar:
As defined in the (Best Interest Contract) exemption, a Financial Institution and Adviser act in the Best Interest of a Retirement Investor when they provide investment advice “that reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.” (Emphasis added)
Thus, the Impartial Conduct Standards from the now-vacated Fiduciary Rule/Best Interest Contract Exemption have been in effect under the May 7, 2018 DOL temporary enforcement policy, and would remain in effect under the DOL Proposal.
The point of tracing this language back to the original ERISA text is to show the continuity of the prudent expert standard. It has not changed. From ERISA Section 404(a)-1, to the Fiduciary Rule/Best Interest Contract Exemption, to the Bulletin, to the new DOL Proposal, the prudent expert standard has remained intact.
Shifting the Burden of Proof
PIABA and others were correct to flag the adoption of the RBI version of “best interest” in the DOL Proposal. PIABA summarized it well:
None of the foregoing obligations actually requires the firm to place the customer’s interests ahead of the adviser’s. Instead, Reg BI states that the advisor cannot “place its own interests ahead of the customers’ interests. Consequently, Reg BI allows the adviser to put its own interests on equal footing with the customers’ interests.” In baseball terms, a tie goes to the adviser. This is contrary to the fundamental premise of a fiduciary duty: that the investors’ interests must always come first. Similarly, the Department has said that the Impartial Conduct Standard will only require that the Investment Advice Fiduciary may not place their interests ahead of the retirement investors’ interests. (Emphasis added)
There is no doubt that the RBI “best interest” language is less rigorous than the fundamental fiduciary duty that the client’s interests must always come first, which has always existed under ERISA and the Investment Advisors Act. There are no “ties” of interest with the traditional fiduciary duty, the client’s interests win every time.
However, I believe PIABA (and the other critics) have missed the significance of the prudent expert standard, which imposes an even more rigorous standard by:
- Holding the advice to the standard of what a third-party expert fiduciary would do in the same circumstances, and;
- Without regard to their own financial interests.
These elements of the prudent expert standard raise the bar exceedingly high, much higher than the suitability standard, higher than RBI (which has a version of the prudent expert standard) and arguably higher than even the fiduciary standard of an investment advisor.
Chart 1: The Shrinking Universe of Investment Options
Chart 1, above, shows how the available investment options shrink under successively more exacting standards, with the prudent expert standard being the most rigorous.
Where PIABA is worried that the DOL Proposal allows for the interests of the advisor and client to be pari passu, that potential fails under the prudent expert standard.
No prudent expert, giving advice without regard to their own financial interests, would recommend an investment or investment strategy that put their own interests equal with their clients. This is simply due to the simple math of compensation: all broker compensation comes at the expense of the client.
The Defense Will Have to Make Its Case
In the typical lawsuit, the plaintiff is required to prove their case against a standard. That will change under the DOL Proposal.
At a hearing, a defendant fiduciary will have to prove they met the prudent expert standard, including:
- Proving the contemporaneous application of care, skill, prudence, and diligence that a prudent expert would have undertaken in a similar situation for a similar client, and;
- Proving that the recommendations made were consistent with what a prudent expert would have made without regard to their own remuneration.
This is a completely different context than what has existed for broker-dealer clients under the suitability standard, more rigorous that what exists under RBI, and possibly more rigorous that what exists under the Advisers Act.
Changing the Arbiter
Under FINRA’s Suitability Rule 2111, the standard of care is that the broker must have a reasonable basis to believe the recommendation made was suitable for the client. The rule is from the perspective of the broker. Under this rule, the broker is the arbiter of the reasonableness of the recommendation.
Under the DOL Proposal, the rule is from the perspective of an impartial prudent expert observer. That third-party prudent expert is the arbiter of whether skill, care, prudence, and diligence were applied in the making the recommendation.
This shift is enormous. The arbiter is no longer the broker but an expert fiduciary. The standard is not determined by the broker but by the expert fiduciary. The standard is no longer subjective, but objective.
Even more stark is that “reasonableness” is an opinion. It requires no evidence. In contrast, the application of skill, care, prudence, and diligence is objective and requires contemporaneous evidence. (A broker can claim to have come to an opinion about reasonableness with nothing in her files, however, she cannot credibly claim to have applied skill, care, prudence, and diligence in the manner of a prudent expert with an empty file.)
Additionally, how thorough the work was undertaken is objective and the conclusions drawn from that work can be easily weighed.
In most securities litigations I’ve been involved with, the defense has been something like this: the client wanted growth and the broker gave them growth investments, therefore they were suitable. This argument was made with a straight face no matter how expensive, illiquid, speculative, and tax-inefficient the “growth” investment was.
Under the FINRA Suitability Rule, virtually any vaguely plausible investment and/or investment strategy could be argued to be “suitable”, although those arguments frequently failed in arbitrations and in SRO disciplinary proceedings.
Under the DOL Proposal they will be per se deficient.
The burden of proof will shift from the client having to prove that the investments recommended to her were unsuitable, to the broker having to prove that she undertook the required care, skill, prudence, and diligence, and after that work determined the investments recommended were in the client’s best interest. Even more daunting, the broker will have to prove that a prudent investment expert, acting without concern for her own remuneration, would have made the same recommendation, in the same situation, for the same client.
In my experience, the vast majority of “vaguely plausible” investment defenses will wither in the face of the prudent expert standard. Fiduciary defendants will not be able to demonstrate the contemporaneous “care, skill, prudence, and diligence” required to have met the standard, nor will they be able to show their recommendations would have been the same if they had been advising without regard to their own compensation.
Indeed, in the majority of cases I have participated in, brokers typically have very few notes and no evidence of any care, skill, prudence, and diligence being applied to their investment recommendations. Frequently, there is absolutely nothing in the record except the trade confirmation, sent to the client after the trade.
This fact pattern will epically fail the prudent expert standard.
Additionally, accounts that get loaded with multiple “product of the month” type of investments, including (but not limited to): new issues such as closed-end funds, as well as structured products, high fee and high load mutual funds, and insurance products will also fail to meet the prudent expert standard.
In almost all instances the investment thesis behind any high-fee and/or illiquid products can be expressed in low (or no) fee products and/or by shifting the asset allocation of an account.
While brokers are certainly entitled to reasonable compensation, the prudent expert standard shifts the arbiter from the profit maximizing broker to an impartial prudent expert fiduciary deciding without regard to her own remuneration.
These standards are worlds apart.
Once the rigor of the prudent expert standard is established, I would expect IRA-related securities litigations to settle, and for higher percentages of claimed damages.
I would also expect this to further accelerate the shift away from charging commissions on products to fee-based accounts where no product commissions are charged. The later generally eliminate the conflicts of interest inherent to commission-based broker compensation and greatly reduce the required supervisory effort.
To meet the prudent expert standard, broker-dealers will need to create policies and procedures to ensure that their brokers are undertaking and documenting the necessary care, skill, prudence, and diligence for each recommendation.
While this will require more oversight, the costs should not be large. In my experience of reviewing the compliance and supervisory systems of broker-dealers of all sizes and geographies, even the smallest firms have the supervisory, CRM, and other systems in place to implement the required policies.
While the capital expenditure required will likely be small, the supervisory effort will be larger.
As always, the real issue with broker-dealer policies and procedures is not their existence (every broker-dealer has them, and all but a few are sufficient), but their implementation.
In my next post, I will examine the DOL’s clarification of the five-part test to determine fiduciary status and how it will make almost all brokers fiduciaries when recommending rollovers and the reinvestment of the proceeds.
 29 CFR Part 2550 [Application No. D-12011] ZRIN 1210-ZA29; Improving Investment Advice for Workers & Retirees. Available at :https://www.govinfo.gov/content/pkg/FR-2020-07-07/pdf/2020-14261.pdf; Accessed August 14, 2020.
 Public Investors Advocate Bar Association; Comments Letter RE: Application No. D-12011. Available at: https://www.piaba.org/system/files/2020-08/Press%20Release%2C%20DOL%20Comment%20Letter%20%28August%206%2C%202020%29.pdf; Accessed August 21, 2020.
 Attorney General Becerra Opposes DOL Proposal; August 6, 2020. Available at: https://oag.ca.gov/system/files/attachments/press-docs/FINAL%20Comment%20Ltr%20to%20DOL.pdf; Accessed August 21, 2020.
 29 CFR Part 2550 at 40862.
 IRS; SOI Tax Stats – Accumulation and Distribution of Individual Retirement Arrangements (IRA); Available at: https://www.irs.gov/statistics/soi-tax-stats-accumulation-and-distribution-of-individual-retirement-arrangements; Accessed August 21, 2020.
 29 CRF Part 2550 at 40839.
 Federal Register; 17 CFR Part 240; Release No. 34-86031; Regulation Best Interest; 33339. Available at: https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12164.pdf; Accessed August 21, 2020.
 FINRA Regulatory Notice 13-45; Rollovers to Individual Retirement Accounts; December 2013; 2. Available at: https://www.finra.org/sites/default/files/NoticeDocument/p418695.pdf; Accessed August 21, 2020.
 29 CFR Part 2550 at 40842.
 PIABA Letter at 6. XXX
 29 CFR Part 2550 at 40842.
 29 CFR Part 2550; [Application No. D-11712]; ZRIN 1210-ZA25; Best Interest Contract Exemption; 21007. Available at: https://www.dolfiduciaryrule.com/portalresource/2016-04-08FedReg-DOLBestInterestContractExemption.pdf; Accessed August 21, 2020.
 Id. at 21026.
 17 CFR Part 240; Release No. 34-86031; Regulation Best Interest: The Broker-Dealer Standard of Conduct; 247. “… in response to comments, we are revising the Care Obligation to remove the term “prudence”.
 29 CFR Section 2550.404a-1 – Investment duties. Available at: https://www.law.cornell.edu/cfr/text/29/2550.404a-1#:~:text=Section%20404(a)(1,like%20capacity%20and%20familiar%20with; Accessed September 9, 2020.
 29 CFR Part 2550 at 40862.
 29 CRF Part 2550 at 40835.
 PIABA Letter at 8.
 See, for instance, FINRA RN 12-25 – Suitability; Acting in a Customer’s Best Interest. This Regulatory Notice, gives six examples of fact patterns where FINRA and SEC regulators have found investments and/or investment strategies that might have been “vaguely plausible” to have not met the suitability standard if they were not consistent with the customer’s best interests. Available at: https://www.finra.org/rules-guidance/notices/12-25; Accessed September 24, 2020.
To learn more about suitability and fiduciary expert Jack Duval, click here.