In a troubling development, the US Department of Labor (DOL) has announced its expectation that it will proceed to propose yet another iteration of investment advice guidance under the Employee Retirement Income Security Act of 1974, as amended (ERISA) – which would become Rule 4.0 – possibly on even more radical terms than its 2016 Rule 2.0 that was vacated by the Fifth Circuit Court of Appeals.

To briefly recap, after its Rule 1.0 proposal was withdrawn in 2011 in light of bipartisan political opposition and its Rule 2.0 was vacated as regulatory overreach in 2018, the Trump DOL published in December 2020:

• New guidance on rollover advice that was positioned as faithful to the 5-part test of “investment advice” fiduciary status adopted in 1975 and affirmed by the Fifth Circuit; and
• Prohibited Transaction Exemption (PTE) 2020-02 permitting regulated financial services companies to provide conflicted investment advice provided they meet the core fiduciary standards of ERISA and other conditions intended to integrate with financial services regulation more broadly.

Although Rule 3.0 was susceptible to review and reversal as a “midnight regulation,” the Biden DOL announced on February 12 that it would allow that rule to take effect as scheduled on February 16.  The press release making that announcement, however, stated that DOL “will continue our stakeholder outreach to determine how we might improve this exemption, the rule defining who is an investment advice fiduciary, and related exemptions to build on this approach.”

Taking into account the value of finality and the other priorities facing the private retirement system, we wrote at the time that in the absence of an empirical record over a meaningful time period demonstrating that retirement investors were being significantly disserved notwithstanding the heightened regulation of financial services providers under their primary bodies of regulation as well as ERISA, DOL should let Rule 3.0 stand.  We added:

At this writing, the reaction to Rule 3.0 from consumer advocates and from financial services providers has largely been comparable – that the Rule reflects an imperfect but responsible regulatory approach that they would prefer be improved in particular, albeit different ways. This, one might think, is precisely the sort of outcome that an Administration committed to finding common ground and calming political divisiveness would embrace.

After apparently completing the needed outreach in only 60 more days, DOL has already determined that this will not be its objective.  In a set of FAQs elaborating Rule 3.0 that was published on April 12, DOL previewed its next steps:

The Department is reviewing issues of fact, law, and policy related to PTE 2020-02, and more generally, its regulation of fiduciary investment advice. The Department anticipates taking further regulatory and sub-regulatory actions, as appropriate, including amending the investment advice fiduciary regulation, amending PTE 2020-02, and amending or revoking some of the other existing class exemptions available to investment advice fiduciaries. Regulatory actions will be preceded by notice and an opportunity for public comment. [FAQ 5; emphases added]

As we read it, in this FAQ DOL is serving notice that, absent unanticipated circumstances, it will proceed with each of the specified actions, either through rulemakings or subregulatory guidance as administrative law requires.

It was commendable of DOL to provide advance warning of what apparently will be yet another controversial proposal.  Otherwise, there is much to be concerned about in the FAQs. 

1. DOL is compelling the regulated community to comply with Rule 3.0 by December 20 notwithstanding its intention to change the governing rules in the near term.

In FAQ1, 2 and 3, DOL reiterated that:

• It remains prepared to enforce its new interpretive position on rollover recommendations effective as of February 16.  Financial service providers therefore are immediately exposed to enforcement risk on this issue;
• PTE 2020-02, which took effect the same day, is available for rollover recommendations; and
• The temporary enforcement policy, which also is currently available as a compliance solution for rollover advice, will sunset on December 20 and, at least at this time, is not being extended notwithstanding reasonable requests for more transition time particularly in light of the uncertainties created by the change in Administrations.

That is, DOL is instructing the regulated community, on pain of at least regulatory enforcement consequences, to design, install, document, test and train to a rollover compliance solution, other than the temporary enforcement policy, by December 20.  The regulatory estimate of the first year compliance costs for PTE 2020-02 was $87.8 million.  A real-world estimate would be less than the $5 billion spent on Rule 2.0 compliance but, particularly in light of substantive positions taken in the FAQs (discussed below), is likely in the hundreds of millions of dollars if not more.

DOL then intends, during this process or soon thereafter, to modify the terms of the compliance solutions it has just compelled financial services providers to implement.  It has suggested that it might, for example, revoke an existing PTE implemented as a rollover compliance solution by some providers, forcing them to start over again from scratch.  And it might add conditions to another PTE that renders it uneconomic or otherwise impractical for a provider to utilize in the rollover setting.  The modifications certainly will affect the calculus for providers as to which of the available compliance solutions best serves its retirement investors and business model.

This regulatory whiplash is hard to justify or accept, from the perspective of both providers and retirement investors.  If DOL is determined to proceed with Rule 4.0, the sensible solution is to extend the temporary enforcement policy until after Rule 4.0 is adopted.  DOL’s response – that the core components of Rule 3.0, including the impartial conduct standards and a “strong” policies and procedures requirement, are “fundamental investor protections which should not be delayed” – does not survive scrutiny:

• The temporary enforcement policy requires compliance with the same impartial conduct standards as Rule 3.0, so nothing is gained in this respect; and
• The Rule 3.0 policies and procedures requirement is of course an adjunct to and functionally a corollary of those substantive standards (whether or not explicitly demanded by regulation).

And the two rounds of compliance costs will as always be borne directly or indirectly by the retirement investors whose interests DOL is seeking to protect.  Moreover, retirement investors almost certainly are finding the constantly shifting ERISA landscape confusing.  Consider a retirement investor served by a responsible financial professional representing a broker-dealer firm who has had to communicate that, while she is not a fiduciary for purpose of any other body of law (and SEC rules prohibit her from suggesting to the contrary), she was an ERISA fiduciary in 2017, not an ERISA fiduciary in 2018, back to being an ERISA fiduciary for rollover advice in 2021, and then possibly an ERISA fiduciary more broadly whenever Rule 4.0 takes effect, with each change in status entailing a different set of expectations, documents and disclosures, as well as affecting investor choice among the products and services the professional can offer. 

This cannot be the way to best advance the interests of retirement investors and their confidence in the regulatory system.    

2. DOL is on the path to recreating Rule 2.0 (other than the private right of action for IRA owners) notwithstanding the vacatur of that rule.

We have previously documented how PTE 2020-02 structurally and functionally replicates the vacated Best Interest Contract Exemption (BICE) of Rule 2.0, leaving aside the invention of a private right of action for IRA owners. 

We note that the regulatory actions described in FAQ5 parallel the actions DOL took to install Rule 2.0.  It seems predictable that the existing PTEs DOL intends to amend or revoke in Rule 4.0 include at least the exemptions amended or revoked in Rule 2.0. 

Consider also the gloss on the fiduciary definition and PTE 2020-02 that DOL offered in the FAQs, such as the following:

• With respect to the fiduciary definition:

In applying the 1975 test, the Department intends to consider the reasonable understandings of the parties based on the totality of the circumstances. Firms and investment professionals cannot use written disclaimers to undermine reasonable investor understandings. Similarly, written statements disclaiming other parts of the 1975 test will not be determinative of fiduciary status.[FAQ8; emphasis added]

         DOL is arguing for an interpretation that reads “mutuality” out of the definition,
         which Rule 2.0 did explicitly. 

• With respect to conflicts for investment professionals: 

Financial institutions must take special care in developing and monitoring compensation systems to ensure that their investment professionals satisfy the fundamental obligation to provide advice that is in the retirement investor’s best interest…. [F]inancial institutions must be careful not to use quotas, bonuses, prizes, or performance standards as incentives that a reasonable person would conclude are likely to encourage investment professionals to make recommendations that are not in retirement investors’ best interest.The financial institution should aim to eliminate such conflicts to the extent possible, not create them….Financial institutions’ policies and procedures must also include supervisory oversight of investment recommendations, particularly in areas in which differential compensation remains….However, in many circumstances, supervisory oversight is not an effective substitute for meaningful mitigation or elimination of dangerous compensation incentives.[FAQ16; emphasis added]

In this FAQ, DOL appears to express greater skepticism about mitigation of conflicts than it did in the Rule 3.0 preamble, and the use of the word “danger” variously in the FAQs is an escalation in rhetoric.It may not be happenstance that the same FAQ emphasizes that ERISA compliance is not determined by compliance with other laws:

As the Department stated in the preamble of PTE 2020-02, financial institutions must comply with the standards of the exemption to obtain relief from the prohibited transaction rules. There is no safe harbor based solely on compliance with other regulators’ standards. [FAQ16]

• With respect to payout grids: 

Grids with one or several modest or gradual increases are less likely to create impermissible incentives than grids characterized by large increases…. As the investment professional reaches a threshold on the grid, any resulting increase in compensation rate should generally be prospective – the new rate should apply only to new investments made once the threshold is reached….As discussed in Q16, financial institutions employing escalating grids should establish a system to monitor and supervise investment professional recommendations, both at or near compensation thresholds and at a greater distance….To be prudent and loyal, fiduciaries should design compensation structures that minimize the dangers associated with conflicts of interest, as opposed to designing structures that create or reinforce conflicts of interest that run contrary to the interests of the investor.[FAQ17; emphasis added]

This commentary also is highly reminiscent of DOL’s Rule 2.0 commentary, and suggests that DOL views financial institutions as individually culpable for compensation structures that may in fact be driven by their primary regulation and/or industry function.

• With respect to the retrospective annual compliance review: 

The Department expects financial institutions to use the results of the review to find more effective ways to help ensure that investment professionals are providing investment advice in accordance with the Impartial Conduct Standards and to correct any deficiencies in existing policies and procedures. Senior executive officers should carefully review the report before making the required certifications, so that they can make the certifications with confidence. Making the certifications without carefully reviewing the report would constitute a violation of the exemption.[FAQ 19]

This FAQ again appears to be a warning shot directed at financial institutions.

In these ways and more, these FAQs are in tone and/or substance more consonant with DOL’s commentary on Rule 2.0 than with, for example, the SEC’s commentary on Regulation Best Interest (Reg BI).  Firms that were depending on Reg BI compliance programs as the core of their ERISA compliance – as DOL has previously led firms to believe would be appropriate – may need to reconsider that approach.

And DOL’s statement in FAQ5 that it is reconsidering its overall approach to the regulation of investment advice may suggest an even more radical revision is pending.

3. DOL may be steering financial services providers to a fiduciary model, notwithstanding how they are treated by their primary regulation.

In the second set of FAQs published on April 12, directed to retirement investors, DOL revealed a skepticism that any model other than a fiduciary model could serve the best interest of investors.  And in the FAQs for providers, DOL seemed particularly enamored of the fiduciary acknowledgement requirement of PTE 2020-02, perhaps foreshadowing broader usage of this approach:

The written fiduciary acknowledgment is designed to ensure that the fiduciary nature of the relationship under Title I of ERISA and/or the Code is clear to the financial institution and investment professional, as well as the retirement investor, at the time of the recommended investment transaction. This requirement reflects the Department’s view that parties wishing to take advantage of the broad prohibited transaction relief in the new exemption should make a conscious up-front determination that they are acting as fiduciaries; tell their retirement investor customers that they are rendering advice as fiduciaries; and, based on their decision to act as fiduciaries, implement and follow the exemption’s conditions. In assessing compliance with this condition, the Department expects financial institutions and investment professionals to be clear about their fiduciary status with respect to any transaction for which they are relying on the exemption. Ambiguous statements of fiduciary status that would leave a reasonable investor unsure of whether any particular recommendation is rendered in a fiduciary capacity under Title I of ERISA or the Code are insufficient.  [FAQ13]

We might add that a fiduciary acknowledgement also addresses DOL’s longstanding frustration with its need to investigate and prove fiduciary status in enforcement settings.

If DOL were to add fiduciary acknowledgement generally to the other relevant PTEs as part of Rule 4.0, thereby eliminating them as a solution for the “inadvertent fiduciary” exposure that DOL’s rollover interpretation has exacerbated, it would put significant pressure on all providers to move to an explicit fiduciary model – thereby achieving a key Rule 2.0 objective.

4. In sum, the signals point to DOL resuming its Rule 2.0 effort to restructure the financial services industries.

All of the foregoing suggests that DOL may in Rule 4.0 resume its Rule 2.0 undertaking to restructure the financial services industries at least as they do business in the retirement markets, which Rule 3.0 carefully avoided.  This does not bode well, including in the following respects:

• Despite the resources DOL has put into this project since 2010, its core competence is not financial services regulation.  The FAQs continue to demonstrate DOL’s limited expertise and experience; for example, the FAQ18 discussion of the IMO/FMO/BGA insurance distribution channel evidences the limits of DOL’s understanding.
• DOL views its role as focused solely on the protection of retirement investors, and does not seem greatly concerned with the concomitant need to foster an effective, reliable market of providers.
• The consequences of any such restructuring extend far beyond considerations for which DOL has the remit or competence to make judgements, including:
  • The national interest in robust capital and insurance markets.  This consideration figured strongly in the 1975 rulemaking that produced the 5-part test, but has been missing entirely from the current series of rulemakings;
  • The inconsistency of asking financial services firms meant and regulated as selling firms to also be “eye single” fiduciaries to investors;
  • Consolidation and employment in the financial services industries;
  • The importance of choice for retirement investors; and
  • The wealth gap.  DOL’s apparent preference for a fiduciary model would have the unintended consequences of reducing both (i) the services and choices available to existing retirement investors with smaller accounts and (ii) the business case for financial services providers to bring new small investors into the retirement system

By way of comparison, despite the invitation from Congress in the Dodd-Frank Act and after extensive study, the SEC concluded that a harmonized fiduciary standard for investment advisers and broker-dealers was inappropriate.  DOL shows no qualms in reaching the opposite conclusion.

If so, this would seem a rather bold way for DOL to proceed in light of the limits on its authority reflected in the Fifth Circuit opinion vacating Rule 2.0.

5. Given the range of best interest standards recently extended to financial services providers under other bodies of law, there cannot be an updated empirical record that justifies further regulation by DOL.

The circumstances of the financial services industries in 2021 are very different than they were in 2010, when DOL undertook its fiduciary project.  In response to legislation, regulation, litigation and market demand, these industries have transformed themselves to be far more transparent and accountable today than in earlier decades.  The research on which DOL relied to support Rule 1.0 and Rule 2.0 no longer reflects the current state of the market.  To take an obvious example, we do not see how there could yet be any study covering a meaningful time period that takes account of the effect for retirement investors of Reg BI (effective in June 2020) or the best interest initiatives in the insurance and securities industries recently pursued in the states.  The SEC’s second round of Reg BI examinations, which currently are in progress, may well result in a further evolution in industry practice. 

A legislature, of course, need not wait for a reliable record before acting, but an agency must do so.  If DOL were to proceed without such a record, it would simply be enacting the predispositions of its current decision makers, and its rulemaking again would be exposed to vacatur in the courts.

DOL has already had a significant role in achieving substantial improvements in the investment products and services offered to retirement investors.  Absent updated empirical evidence that retirement investors are still materially disserved notwithstanding those improvements, DOL does not have a basis to proceed with additional, disruptive regulation and should not do so.

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