Department of Labor Final Fiduciary Rule and Current Landscape of Litigation

July 06, 2016
Synopsis of the New Fiduciary Rule

On April 8, 2016, the Department of Labor (DOL) published the final new fiduciary rule under the Employee Retirement Income Security Act (ERISA) in the Federal Register. The new rule is the first financial advisory regulatory initiative with substantive changes in more than 40 years, despite a financial market which has seen many shifts, not the least of which entails the transition from defined benefit plans to self-directed IRAs and 401(k)s.

The new rule redefines who is considered a “fiduciary” of an employee benefit plan, and modifies several prohibited transaction exemptions (PTEs) to allow the receipt of commissions and other potentially conflicted compensation, provided that the fiduciary complies with all requirements and disclosures. In the future, those considered fiduciaries through providing investment advice must either preclude conflicts of interest via compensation arrangements that create such, or comply with the terns of an exemption the DOL issues.

The final rule was effective as of June 7, 2016, and has an applicability date of April 10, 2017, to provide time for affected plans and their financial service providers to transition from non-fiduciary to fiduciary status.

Provisions of the New Rule

“Fiduciary” as Defined by the final rule. Under ERISA and the Code, a person is a fiduciary to a plan or IRA to the extent that the person engages in specified plan activities, including rendering “investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan…[.]” 29 C.F.R. §§ 2509, 2510, and 2550 (April 8, 2016).

Paragraph (a)(1) of the final rule provides specifics for communications considered to cross the threshold into investment advice, particularly if a fee or other compensation, direct or indirect, is involved. These include:  

  • recommendations as to the management of securities or other investment property;
  • recommendations with respect to rollovers, distributions or transfers from a plan or IRA; or
  • recommendations on how securities or other investment property should be invested post rollover/distribution or transfer.

The final rule also determines the types of relationships that must exist for communications to be considered recommendations that denote fiduciary investment advice responsibilities. The following establishes a foundation of fiduciary responsibility:

  • Recommendations by person(s) who represent or acknowledge that they are acting as a fiduciary within the meaning of the Act or Code;
  • Advice rendered pursuant to a written or verbal agreement, arrangement, or understanding that the advice is based on the particular investment needs of the advice recipient;
  • Recommendations directed to a specific advice recipient(s) regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA

Communication or Recommendation? Paragraph (b)(1) of the final rule sets forth that ““recommendation” means a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.” Id.  

The types of communication that could be considered a recommendation include:

  • A communication tailored to the individual advice recipient or recipients about investment property or strategy is more likely to be viewed as a recommendation;
  • Providing a selective list of securities as appropriate for an advice recipient would be a recommendation as to the advisability of acquiring securities even if no recommendation is made with respect to any one security;
  • A series of actions, directly or indirectly that may not constitute a recommendation individually can be considered a recommendation when considered in the aggregate.

Non-Fiduciary Communications. The proposed rule contained examples of communications that were classified as “carve-outs” from the scope of the definition of “fiduciary” and the final rule, while not classifying these as carve-outs, does denote specific instances where communications fall short of constituting “recommendations.”

Communications that would not fall under the definition of a recommendation include marketing materials that constitute investment education or retirement education.

Exemptions. Under the final rule, amendments were adopted for existing exemptions and two new exemptions added. These exemptions require, among other things, that financial institutions and advisors adhere to enforceable standards of fiduciary conduct and fair dealing (“Impartial Conduct Standards”) which obligate the fiduciary to act in the best interest of the customer, avoid misleading statements, and receive no more than reasonable compensation. Certain instances of communication fall under the exemption umbrella, such as:

  • Advisors selling investment products in arms-length transactions to financially sophisticated counterparts;
  • Plan sponsor employees offering advice in their capacity as employees;
  • Recordkeepers who present available investment options to plan sponsors;
  • Service providers who provide responses to replacement fund searches based on objective criteria; and
  • Providing education.

The new exemptions include the Best Interest Contract Exemption and the Principal Transactions Exemption.

  • Best Interest Contract Exemption. If service providers do not fit into one of the above-listed exemptions, they may rely on the Best Interest Contract Exemption to provide certain types of conflicted advice. This exemption covers conflicts of interest associated with the wide variety of payments advisors receive in connection with retail transactions involving plans and IRAs, such as providing advice to participants about IRA rollovers.
  • The Principal Transactions Exemption. This exemption permits investment advice fiduciaries to sell or purchase certain debt securities and other investments out of their own inventories to or from plans and IRAs.

Although the prohibited transaction exemptions become available upon the applicability date of the rule (April 10, 2017), full compliance with the Best Interest Contract Exemption and Principal Transactions Exemption will be required as of January 1, 2018.

Lawsuits Filed to Overturn the New Rule

Less than two months after its publication, multiple lawsuits were filed to overturn the rule.

The first lawsuit was filed in the United States District Court for the Northern District of Texas on June 1, 2016 (Chamber of Commerce of the United States of America et al v. U.S. Department of Labor et al, Case No. 3:16-cv-1476), and two subsequent lawsuits filed in that venue have been consolidated with the lead case noted above. The complaint alleges that the DOL improperly exceeded its authority in violation of ERISA, the Internal Revenue Code (IRC) and the Administrative Procedure Act. Another count alleges that the final fiduciary rule violates the Federal Arbitration Act (FAA), as federal agencies are prohibited from overriding the FAA’s protections of the enforcement of arbitration agreements, unless Congress has conferred such authority. Other counts allege that the rule violates the Administrative Procedure Act because it is arbitrary, capricious and irreconcilable with the language of the ERISA and IRC; the Dodd-Frank Act bars the DOL’s regulation through its best interest contract exemption of fixed-index annuities and group variable annuities; and the best contract exemption impermissibly burdens speech in violation of the First Amendment.

The National Association for Fixed Annuities (NAFA) filed a suit on June 2, 2016 in the United States District Court for the District of Columbia (National Association for Fixed Annuities v. United States Department of Labor, et al. Case No. 1:16-cv-01035). The lawsuit seeks a preliminary injunction to stay the rule prior to its effective date in April 2017, alleging ‘irreparable harm’ to its members. The suit further alleges that the DOL rule is invalid on the grounds that the agency exceeded its authority to regulate IRAs and that it improperly categorizes insurance agents as fiduciaries, and that the rule creates a private right of action, which only Congress can do. A hearing is set for August 25, 2016 on NAFA’s request for a preliminary injunction. The NAFA represents insurance companies that issue fixed annuities and the interests of insurance agents that make up the majority of the fixed annuity market.

Another lawsuit, filed on June 8, 2016 in the United States District Court for the District of Kansas (Market Synergy Group Inc. v. U.S. Department of Labor et al, Case No. 5:16-cv-4083), also seeks to overturn the Department of Labor’s final fiduciary rule.

President Obama previously vetoed a resolution that had been approved by both the House and Senate to block the fiduciary rule, and neither chamber was able to gain a supermajority to override the veto, so the only option for the industry now falls into the venue of the courts. It is expected that the Obama Administration’s Justice Department will strongly defend the final rule and, in fact, U.S. Secretary of Labor, Thomas E. Perez, said recently that, “I appreciate the right that people have to file lawsuits, [but] have every confidence we will succeed. I have confidence because not only is [the rule] a solid product, but a product that’s a result of a very robust process.”