The First Challenge To The Conflict Of Interest Rule And Related Exemptions Goes To The Department Of Labor

• Posted on: Nov 22 2016

On November 4, 2016, a judge sitting in the United States District Court for the District of Columbia upheld the Department of Labor’s (“DOL”) fiduciary duty rules that were adopted to curtail conflicts of interest by financial advisors providing investment recommendations for retirement accounts.  In a 92-page ruling, Judge Randolph Moss rejected arguments that the new rules would have “catastrophic consequences” for the fixed indexed annuities industry, that the DOL exceeded its authority in promulgating the rules, and that the industry could not meet the April 2017 effective date. The rules, which took six years to craft, require financial advisors to act in the “best interest” of their client when, among other things, they provide investment recommendations for retirement accounts.  (This Blog wrote about the new rules in May 2016.  See here.)

In the National Association for Fixed Annuities v. Perez, No. CV 16-1035 (RDM) (D.D.C. Nov. 4, 2016), Judge Moss granted the DOL’s motion for summary judgment and dismissed the claims brought by the National Association for Fixed Annuities (“NAFA”).  The ruling can be found here. In granting summary judgment, Judge Moss reviewed the legislative history of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. § 1001 et seq., and the DOL’s rulemaking authority.  The court ruled that, among other things, the DOL’s decision to hold financial advisors who recommend retirement investments to a fiduciary standard was reasonable considering the growth of IRAs (since first introduced in 1974) and other retirement plans as a future source of income. NAFA has announced that it will appeal the decision.

The Challenges and Ruling:

NAFA brought its action under the Administrative Procedures Act, the Regulatory Flexibility Act (“RFA”) and the Due Process Clause of the Fifth Amendment to challenge three rules promulgated by the DOL on April 8, 2016. NAFA argued that: (i) the DOL exceeded its authority by replacing an established regulation that, among other things, made a financial advisor a “fiduciary” only if she or he rendered “investment advice” for a fee “on a regular basis”; (ii) the DOL improperly applied the new rules to IRAs and other retirement plans that are not subject to Title I of the ERISA statute; (iii) the written contract requirement contained in the Best Interest Contract (“BIC”) Exemption impermissibly created a private right of action; (iv) the “reasonable compensation” condition set forth in the BIC Exemption is constitutionally vague; (v) the decision to move fixed indexed annuities (“FIAs”) to the BIC Exemption was improper; and (vi) the DOL failed to conduct a regulatory impact analysis required by the RFA.

Judge Moss rejected each of the foregoing challenges.

The DOL Did Not Exceed its Authority by Replacing a 1975 Regulation with the New Rules and the Definitions Set Forth Therein

The court rejected NAFA’s argument that the DOL exceeded its rule-making authority by, among other things, discarding the limitations set forth in a 1975 regulation. The regulation in question created a five-part test to determine whether an advisor “renders investment advice” to a plan or IRA. The test limited the fiduciary duty reach of ERISA to only those advisors who rendered investment advice “on a regular basis.” The new rules eliminate that limitation “in favor of a definition that encompasses, among other activity, ‘[a] recommendation as to the advisability of acquiring . . . investment property’ that is rendered ‘pursuant to [an] . . . understanding that the advice is based on the particular investment needs of the advice recipient.’” The new rules define “investment advice” to include advice even if not given “on a regular basis.”

In ruling against NAFA, the court held that the DOL was entitled to deference in its interpretation of the term “investment advice” under the two-step framework established in Chevron, USA, Inc., v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984), and that nothing in the ERISA statute foreclosed the DOL’s interpretation.  In fact, the court concluded that the DOL’s interpretation hews closer to the text and purpose of ERISA than the 1975 rule.

As to step one of the Chevron analysis, the court held that there is nothing in the ERISA statute that “forecloses the Department’s current interpretation.” Indeed, the court found that “[t]he statute does not define the phrase ‘investment advice,’ and the ERISA statute expressly authorizes the Secretary to adopt regulations defining ‘technical and trade terms used’ in the statute.”  Those terms, which the new rules define, the court held, comport with their ordinary usage: “Indeed, if anything, it is the five-part test—and not the current rule—that is difficult to reconcile with the statutory text. Nothing in the phrase ‘renders investment advice’ suggests that the statute applies only to advice provided ‘on a regular basis.’”

As to step two of the Chevron analysis, the court deferred to the DOL’s interpretation of the ERISA statute. The court found that the DOL’s interpretation was “reasonable and reasonably explained.” The new interpretation, rather than the five-part test embraced by NAFA, fit comfortably with the text and purpose of ERISA to protect the interests of retirement plan participants. The court rejected NAFA’s contention that market changes alone could justify the change in the definition of “fiduciary”, finding that the DOL did not distort the statutory meaning of “rendering investment advice” simply to achieve a regulatory end. In fact, the DOL supported the change with an extensive explanation of the relationship between advisers and investors and how that relationship has changed. Further, citing to the commentary accompanying the new rules, the court further rejected NAFA’s argument that the definition of “rendering investment advice” is too broad, sweeping up “relationships that are not appropriately regarded as fiduciary in nature and that the Department does not believe Congress intended to cover as fiduciary relationships.” (Internal quotation marks omitted.)

The DOL Did Not Exceed its Authority By  Requiring Financial Advisers Who Provide Advice Regarding Investments Held in IRAs and other Non-Title I Plans to Comply with the Duties of Loyalty and Prudence to Qualify for the BIC Exemption

The court rejected NAFA’s argument that the DOL exceeded its rule making authority by extending the duties of loyalty and prudence found in Title I of ERISA to individuals who advise IRAs and other non-Title I plans.  The court determined that the DOL had the authority to condition prohibited transaction exemptions on compliance with ERISA’s duties of loyalty and prudence. The court reasoned that “the mere fact that title I imposes certain duties or obligations on employee benefit plans does not, as a matter of logic or the rules of statutory interpretation, mean that Congress intended to preclude the Department from imposing a similar duty or obligation as a condition of granting an exemption under 26 U.S.C. § 4975(c)(2).” Indeed, the ERISA statute authorizes the DOL to adopt non-statutory exemptions and limitations on those transactions. Subjecting financial advisers who recommend Title II plans to ERISA duties only if they are paid commissions is the point of the exemption, since the DOL is concerned about conflicted advice resulting from commission arrangements: “Importantly, there is also a clear nexus between the risk that commission-based compensation will skew investment advice and the condition that advisers paid on a commission basis must provide advice that satisfies the duties of loyalty and prudence.” Although it “may be difficult and costly for financial institutions to move away from that model of compensation, the prospect of alternative compensation methods is not illusory. The choice may not be pleasant one, but it is real.”

The Written Contract Requirement Contained In The BIC Exemption Does Not Create a Private Cause Of Action

The court rejected NAFA’s argument that the new rules “impermissibly creates a private right of action” for violations of the BIC Exemption.  The court found that the BIC Exemption “merely dictates terms that otherwise conflicted financial institutions must include in written contracts with IRA and other non-title I owners in order to qualify for the exemption.” Enforcement of these contractual terms “would be brought under state law,” which both parties agreed during oral argument would occur. As such, the court concluded that “although the BIC Exemption dictates what must be included in the contract, the cause of action and right to recover are dictated by state law. Federal law merely requires the inclusion of specific contractual terms as a condition of the prohibited transaction exemption.”

The “Reasonable Compensation” Condition in the BIC Exemption is not Void for Vagueness

The court rejected NAFA’s argument that the “reasonable compensation” requirement of the BIC Exemption was void for vagueness under the Due Process Clause of the Constitution. “Under that condition, a financial institution must agree in writing that ‘[t]he recommended transaction will not cause [it], [the] [a]dviser or their [a]ffiliates or [r]elated [e]ntites to receive, directly or indirectly, compensation for their services that is in excess of reasonable compensation within the meaning of [29 U.S.C. § 1108(b)(2)] and [26 U.S.C. §] 4975(d)(2).’” The court found that the concept of “reasonable compensation” is commonly used throughout the U.S. Code, including in the ERISA statute, and “is sufficiently clear to provide financial institutions with ‘fair warning of what the regulations require.’” (Citation omitted.) Indeed, the phrase is one that “a reasonably prudent person, familiar with the conditions the BIC Exemption is meant to address and the objectives the exemption and conditions are meant to achieve, would have fair warning of what the regulations require.”

The Industry Had Ample Time to Comment on The New Rules

The court rejected NAFA’s argument that the DOL failed to give it an opportunity to comment on the decision to make FIAs ineligible for PTE 84-24.  PTE 84-24 created a limited exemption to the prohibited transaction rules set forth in Title I and Title II of the ERISA statute.  Under PTE 84-24, it was permissible to compensate investment advisors and their employees and agents “on a commission basis for sales of variable and fixed annuity products held in ERISA employee benefit plans and IRAs, as long as either (1) the relevant investment advice was not provided ‘on a regular basis,’ or (2) the terms of the transaction were at least as favorable as those offered in arm’s-length transactions and the relevant fees and commissions were reasonable.”

NAFA challenged the new rules on the grounds that the decision to subject FIAs to the BIC Exemption was different than originally proposed. The court dismissed this challenge noting that the DOL “expressly requested comment on its decision to ‘continue to allow IRA transactions involving’ fixed indexed annuities ‘to occur under the conditions of PTE 84-24,’ while requiring that similar transactions involving variable annuities occur under the conditions contained in the proposed BIC Exemption.” In fact, to remove any doubt about the bankruptcy of NAFA’s argument, the court observed that “NAFA, along with other industry groups, provided comments on that very issue.”

The DOL Did Not Violate the RFA

The court rejected NAFA’s argument that the DOL failed to accompany the final rule with a “final regulatory flexibility analysis” required by the RFA – that is, an assessment of the impact of the new rules on small businesses.  According to the court, the final regulatory flexibility analysis is only a procedural requirement, not a substantive one. In any event, the court found that DOL put forth a reasonable good-faith effort to comply with the statute, as evidenced by the DOL’s “382-page final Regulatory Impact Analysis.”

Takeaway:

The NAFA decision is thoughtful and well-reasoned. It is not only a win for the DOL, but also a victory for investors looking for retirement investment opportunities.  As such, it could influence and inform the decisions of other courts that are also considering the legality of the new rules.

To date, there are six cases filed by industry professionals and state attorneys general against the DOL’s new rules. Three were consolidated into one case in the United States District Court for the Northern District of Texas. Oral argument was heard the Texas consolidated action and in the Kansas action (one of the remaining cases). Decisions are likely in the coming months. As the NAFA action shows, whatever the results in those cases, appeals will likely follow, ultimately creating an opportunity for the Supreme Court to weigh.

All though the DOL has won round one in the courts, there is also a legislative fight that could spell the end of the new rules. The Republican-controlled Congress previously passed legislation to nullify the new rules; President Obama vetoed that legislation. It stands to reason that the newly elected Republican-controlled Congress will do same once Donald J. Trump is inaugurated. Though there is no indication of what the new president will do, he has already expressed an interest in reducing jobs-killing regulations during the campaign and transition. (See, e.g., https://www.greatagain.gov/policy/regulatory-reform.html.) One thing is for certain: despite the win, the DOL’s new fiduciary duty rules remain in jeopardy.

Tagged with: Securities Arbitration