Congressional and Legal Challenges Won t Stop the DOL Fiduciary Rule

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1 Congressional and Legal Challenges Won t Stop the DOL Fiduciary Rule July 12, 2016 by Ron Rhoades Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. As I write this, in early July of 2016, three months has passed since the U.S. Department of Labor (DOL) issued its Final Rules applying fiduciary status to providers of investments to nearly all investors in 401(k) plans, other ERISA qualified retirement plans and IRAs. And only nine months remain until most of the substance of the rules (i.e., the imposition of fiduciary standards) takes place, on April 10, In this article, I describe how the landscape is evolving. Specifically, I address the likelihood of the core provisions actually being implemented on April 10, Several challenges might thwart or delay their implementation. Chances are far greater than 50/50 that most of the DOL Rules will go into effect on April 10, While there is some chance that a few aspects of the rule could be delayed by litigation, the march toward fiduciary status for all providers of investment advice to ERISA-covered retirement plans and IRAs is strong. Congress The U.S. Congress will likely vote a few more times on legislation to stop the DOL rule-making prior to the presidential elections, but any legislation passed by both houses won't survive the veto process. Presidential election Page 1, 2017 Advisor Perspectives, Inc. All rights reserved.

2 One renowned pollster gives Trump a 22% chance of winning the presidential election, based on poll data as of July 5, Given the apparent divisions in the Republican Party, the lack of funding for Trump's campaign, its lack of organization and the electoral map, there is not much hope for those opposed to the DOL fiduciary rules. (Note: Even if a Republican assumes the presidency in 2017, it remains unclear how fast the DOL fiduciary rules could be repealed and replaced with new rules various statutes require extensive times for rule-making processes.) Litigation Several insurance-company lobbying groups and SIFMA have filed suits. After consolidation, three suits remain: 1. D.C. Circuit: National Association for Fixed Annuities (NAFA).This suit focuses on fixedindexed annuities (FIAs). Briefs are being submitted in July and early August. Oral argument will take place in August. A decision on the injunctive relief sought is expected by September. Any decision would likely affect only equity-indexed annuities and the applicability of the Best Interests Contract Exemption (BICE) to them (as opposed to their earlier inclusion under the more liberal exemption). Some of the arguments advanced by the insurance industry in this suit seem without merit; others will depend upon a review of the DOL's cost-benefit analysis, as applied to FIAs. Chance of insurance industry prevailing: Anything is possible in litigation. But, chances are less than 50/50 that NAFA will prevail. While the inclusion of FIAs under BICE was said to be a "surprise," several comments during the rule s review process suggested applying BICE to FIAs, and the press reported in the fall of 2015 that FIAs might fall under BICE. Despite claims in the lawsuit that BICE is "unworkable," many insurance companies and independent marketing organizations in the insurance industry have already indicated that they are adapting to the DOL rule. Meetings at the DOL have discussed "private exemptions" for independent marketing organizations permitting them to become "Financial Institutions," and the ways insurance companies themselves can operate as "Financial Institutions." Also, new and lower-cost FIAs are already emerging, indicating that a delay in applying the rule would likely harm consumers. Granting the injunction could result in the inapplicability of the Impartial Conduct Standards to FIAs, which is counter to the desire expressed by many commentators that Impartial Conduct Standards be applied in the same manner, and with the same language, across the various rules. Impact if insurance industry prevails: Minor! At most, a delay! An injunction could result in either: A return to the old exemption for FIAs. Absent a change in a final judgment or appeal, this would cause the DOL to go back to the drawing board and work to issue another amendment to or another amendment to the BICE. If a more limited injunction were to be entered (which appears possible, given that the Page 2, 2017 Advisor Perspectives, Inc. All rights reserved.

3 proposed April 2015 amendment to clearly gave notice of the impending changes eventually made in 84-24, including the Impartial Conduct Standards and their applicability), then FIAs could be regulated under 84-24, as amended by the DOL in its April 8, 2016 release. Alternatively, and perhaps more likely, the contractual requirements of BICE and certain of the oversight functions required by BICE would be stayed, while the Impartial Conduct Standards of BICE might still apply to FIAs. In fact, it is certain that, even if the DOL were to lose on all counts, the DOL would then seek to apply, with or without the contractual and other requirements of BICE, by new proposed rules, the Impartial Conduct Standards found under 84-24, as amended, to FIAs. And, these Impartial Conduct Standards are tough. Just read what the DOL's release (April 8, 2016) amending said about the Impartial Conduct Standards: "Generally stated, the Impartial Conduct Standards require that when insurance agents, insurance brokers, pension consultants, insurance companies or investment company principal underwriters provide fiduciary investment advice, they act in the plan s or IRA s Best Interest, and not make misleading statements to the plan or IRA about recommended transactions. As defined in the exemption, the insurance agent or broker, pension consultant, insurance company or investment company principal underwriter act in the Best Interest of a plan or IRA when they act with 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 Plan or IRA, without regard to the financial or other interests of the fiduciary, any affiliate or other party. " The Impartial Conduct Standards represent fundamental obligations of fair dealing and fiduciary conduct. The concepts of prudence and undivided loyalty are deeply rooted in ERISA and the common law of agency and trusts. These longstanding concepts of law and equity were developed in significant part to deal with the issues that arise when agents and persons in a position of trust have conflicting loyalties, and accordingly, are well-suited to the problems posed by conflicted investment advice. The requirement that the adviser act without regard to the adviser s own financial interests or the interests of persons other than the retirement investor is a concise expression of ERISA s duty of loyalty as expressed in section 404(a)(1)(A) of ERISA and applied in the context of advice." "These Impartial Conduct Standards are necessary to ensure that advisers recommendations reflect the best interest of their retirement investor customers, rather than the conflicting financial interests of the advisers and their financial institutions. As a result, advisers and financial institutions bear the burden of showing compliance with the exemption and face liability for engaging in a non-exempt prohibited transaction if they fail to provide advice that is prudent or otherwise in violation of the standards." "Inclusion of the standards in the exemption s conditions adds an important additional safeguard for ERISA and IRA investors alike because the party engaging in a prohibited transaction has the burden of showing compliance with an applicable exemption, when violations are alleged." Page 3, 2017 Advisor Perspectives, Inc. All rights reserved.

4 "Reasonable compensation" is already required under This will likely be subject to increased litigation, as well as greater enforcement actions. In fact, it will be very, very difficult to justify many of the pre-final Rule commission schedules for FIAs, particularly for larger transactions. Under the Impartial Conduct Standards, products will be forced to compete on their merits returns, risks and the value of their features rather than on the basis of how much commissions they pay out. Some insurers are likely to roll out new FIAs with lower commission payouts, for use under the Best Interests Contract Exemption. Look for one or more insurance companies to begin to offer "no-load" FIAs, with "level fee" or very low percentage mortality fees, with few (if any) riders. Advisers will have to undertake a tremendous amount of due diligence before selecting the "best" product (apply a prudent process and exercise good judgment during that process). As the DOL stated, in describing the Impartial Conduct Standards' requirements: "Under this standard, for example, an investment advice fiduciary, in choosing between two investments, could not select an investment because it is better for the investment advice fiduciary s bottom line." 2. Kansas Circuit Court: Market Synergy Group. The issues posed are nearly identical to those seen in the D.C. litigation. Here's a summary of the case, as provided in a joint motion recently filed with the court: "The rule and amendment to PTE 84-24, which become applicable on April 10, 2017, will require fiduciaries providing investment advice concerning fixed indexed annuities to rely on the BIC Exemption, if they wish to engage in certain prohibited transactions, rather than PTE Plaintiff filed suit on June 8, 2016, challenging the amendment of PTE under the Administrative Procedure Act ( APA ). On June 17, 2016, plaintiff filed a motion to preliminarily enjoin the Department from implementing the amendment to and partial revocation of PTE such that PTE as it existed prior to the amendment and partial revocation will remain in effect during the litigation s pendency." In early July 2016 the parties filed a joint motion for scheduling, which would lead to oral arguments sometime in August. Chance of insurance industry prevailing: Less than 50/50. See discussion above, relating to D.C. Circuit litigation. Impact if Market Synergy prevails: See discussion previously, relating to D.C. Circuit litigation. 3. Texas Consolidated Cases Chamber of Commerce, FSI and SIFMA. The issues posed in this case are far more numerous and are more pertinent to broker-dealer firms' concerns. Most of the issues are technical, relating to the DOL's authority, whether the DOL followed correct procedures in adopting the rule and even some Constitutional "free speech" arguments. Despite the complexity of the case, a schedule has already been adopted for the submission of briefs from late July through October. Oral argument has been scheduled for November 17th. Expect a decision by December Page 4, 2017 Advisor Perspectives, Inc. All rights reserved.

5 Chance of securities industry prevailing on any argument advanced: Less than 25%. The DOL did a huge economic analysis before promulgating the rule, had a re-proposal of the rule, extended periods of time for receipt of comments and held lengthy hearings. The securities industry's arguments are grasping at straws. In fact, many of the larger brokerdealers don't support the litigation. Even if the securities industry prevails, it would likely only be partially. It is entirely possible that the securities industry could strike one or more requirements of BICE, while other aspects of BICE (including the Impartial Conduct Standards, discussed above) and the application of fiduciary status could remain. Impact If the securities industry prevails: It would be "back to the drawing board" for the DOL. With a change of administrations, if a Democrat is elected president, expect a revised proposed rule in 2018 with an effective date in 2019, although delays to this schedule would be possible. Conclusion The implementation of the DOL's fiduciary rules on April 10, 2017 is highly likely. The application of the DOL's fiduciary rules to fixed indexed annuities is slightly less certain, but any loss by the DOL in that arena would be only temporary. Ron A. Rhoades is Director of the Financial Planning Program at Western Kentucky University s Gordon Ford College of Business. He is a frequent speaker on fiduciary duties, including procedures for handling conflicts of interest and due diligence. He may be contacted at ron.rhoades@wku.edu. Page 5, 2017 Advisor Perspectives, Inc. All rights reserved.