July 21, 2016. By Matthew Okaty, J.D.:
While perhaps not as widely publicized in the mainstream media, the Department of Labor’s new Fiduciary Rule (or Conflict of Interest Rule to be precise) has been in the headlines of every major financial news outlet for at least a year now. Finally released on April 6th of this year, the hotly debated piece of legislation had been in the works since 2010 when the Department of Labor (DOL) released its first proposal for a rule designed to limit conflicts of interest and raise investment-advice standards for retirement accounts. With the final rule now in place, every financial professional who provides investment advice for a fee with regards to a retirement account will be held to a fiduciary standard, broker-dealers and investment advisers alike.
To provide some background and context, in the aftermath of the financial crisis of 2008, legislation was passed called the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which introduced sweeping reforms to the industry. One of its provisions gave the Securities and Exchange Commission (SEC) the authority to craft a uniform fiduciary duty standard so that both broker-dealers and registered investment advisers would be held to the same standard with respect to the investment advice they provide. While the SEC has engaged in studies regarding the costs and benefits of a uniform fiduciary rule and has stated that it is in the process of creating one, it has yet to release such a rule and is not expected to do so until at least April 2017. The DOL, however, who has substantial authority over the regulation of pension plans and retirement accounts, essentially promulgated its own version by redefining and expanding who is considered a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA).
What many investors find confusing is the fact that broker-dealers and investment advisers provide similar services and yet have been held to different standards of conduct. How did that come about? Historically, the different standards and regulatory schemes can be traced back to two landmark laws, the Securities and Exchange Act of 1934 and the Investment Advisers Act of 1940 (if you recall, the most devastating stock market crash in history referred to as “Black Tuesday” occurred in 1929, so you should notice a pattern here: crisis, legislative reform, crisis, legislative reform…). The Exchange Act codified and formed the basis for the regulation of the financial markets (the exchanges where securities are traded) as well as the participants (i.e. broker-dealers), and also led to the establishment of the SEC. After its establishment, the SEC found many abuses in the industry by people purporting to provide investment advice, leading to the passage of the Adviser Act and the regulation of investment advisers.
Originally, there were clear differences between the activities of broker-dealers and investment advisers, but over the years some of those lines have blurred. While broker-dealers still perform separate and unique functions, such as underwriting and market-making (providing liquidity to the market and matching buyers and sellers), many full service B-D’s also provide ongoing investment advice to retail clients similar to that provided by registered investment advisers. Understandably, many investors are unaware of the distinction and why it can matter. Putting aside the new DOL Fiduciary Rule, broker-dealers are generally held to what is referred to as a “suitability standard”, which means that the investment strategy or recommendation must be suitable for the customer based on the customer’s financial needs, objectives and circumstances. A shortcoming of this standard is that although an investment recommendation may be suitable for a customer, it may not be the best or cheapest option available. Furthermore, broker-dealers might recommend products that produce higher fees or commissions for themselves at the customer’s expense. In contrast, investment advisers are held to a fiduciary standard, which obligates the adviser to always act in the client’s best interest and place the client’s interests above his or her own.
By redefining and expanding who is a fiduciary under the law, the new DOL Fiduciary Rule represents a significant change and is expected to have a major impact in the industry, particularly for broker-dealers. It is important to make clear, though, that a broker-dealer’s fiduciary status under the new rule only applies to advice given with respect to retirement accounts, which includes employer-based plans such as 401(k)’s as well as Individual Retirement Accounts (IRA’s), as the Department of Labor does not have regulatory authority over other types of non-retirement accounts. This is one reason why many people in support of a uniform fiduciary standard thought that it would be better if such a rule came from the SEC, since they are the agency with responsibility over the securities industry at large. It is also important to note that investment advisors will be affected by the new rule as well, even though they are already treated as fiduciaries under the Investment Advisers Act of 1940. While there are certain similarities with the Advisers Act, the new rule (and by extension ERISA) carries its own set of requirements and proscriptions.
More details will be provided later as we continue to review the new rule and implement any necessary changes. At roughly 1,000 pages in its entirety, the new law is being phased-in with a full compliance deadline of January 1, 2018 in order to allow everyone in the industry sufficient time to adjust to the new regulations. Several lawsuits have been filed by various trade groups challenging the validity of the rule and many of its provisions (similar to what happened with the passage of the Affordable Care Act), which of course adds an element of uncertainty to the situation. Stay tuned.