Fifth Circuit Axes Fiduciary Rule: Over to the SEC

By Jerri-Lynn Scofield, who has worked as a securities lawyer and a derivatives trader. She now spends much of her time in Asia and is currently working on a book about textile artisans.

Last week, on 15th March, a panel of the United States Court of Appeals for the Fifth Circuit struck down the Department of Labor’s (DoL) fiduciary rule in  a split 2-1 decision.

The rule had been enacted in 2016, during the previous administration. On the campaign trail and as President, Trump had singled out the measure for criticism. In February 2017, he issued a Presidential Memorandum on Fiduciary Duty Rule, in which he directed the DoL to conduct an examination of the rule that was due to come into effect in April (as I wrote in Fourth Federal District Court Looks Likely to Uphold Fiduciary Rule). The Trump memo was mere bluster and had no legal effect, but in June 2017, the DoL delayed full implementation of the new rule, as well as enforcement, as it considered its next steps.

Meanwhile, a coalition of business interests– including the Financial Services Institute, the Securities Industry and Financial Markets Association, and the U.S. Chamber of Commerce– had brought a lawsuit challenging the rule. Their arguments were rejected by a federal district court sitting in Dallas that upheld the original DOL rule.

As MarketWatch noted on 17th March in Is the fiduciary rule dead or alive? What its fate means to you:

The Obama administration, which proposed the rule, claimed it would save Americans $17 billion a year from conflicted advice. The U.S. rule was weaker than what other countries have in place to protect investors, such as in the U.K., where commissions are banned and advisers must pass harder tests, said Betsey Stevenson, a former member of the President’s Council of Economic Advisers who worked on the fiduciary rule, and currently a public policy and economics professor at the University of Michigan. “With the court undoing that, it means you have to ask really hard questions if you’re going to a financial adviser,” she said.

Now what?

It’s unclear what the Department of Labor– the ostensible loser in this lawsuit– will do next.

The department could ask for review  by the entire Fifth Circuit, which could affirm or overturn the panel decision. Alternatively, the department could ask the United States Supreme Court to consider the case, and since a split in the appellate circuits is  developing– a factor the Court often weighs heavily in deciding whether to hear a case– the Court may very well decide to grant certiorari. As reported by Investment News:

The 10th Circuit Court of Appeals upheld the rule Tuesday, although on a much narrower question than the broader suit in the Fifth Circuit, which is based in New Orleans. A hearing on another suit against the rule is pending in the D.C. Circuit Court of Appeals.

The department could also opt not to contest the Fifth Circuit panel’s decision, thus allowing it to stand, and cease supporting, implementing, or enforcing the rule.

The SEC Mulls New Standard

Separately and independently, the Securities and Exchange Commission (SEC) is mulling its own version of a new standard to apply to brokers who service retail investors. Whereas Labor’s fiduciary rule covered only retirement accounts (e.g. 401 Ks and IRAs), the SEC rule would apply more broadly to non-retirement accounts as well, as reported by the Wall Street Journal on 15th March in Brokers Will Have to Reveal More to Investors Under Coming SEC Rule:

Critics of the SEC’s current standard for brokers say the regulations are too loose and need to be upgraded to protect unsophisticated investors from biased investment advice. Brokers are required to provide advice that is “suitable,” meaning it fits a client’s goals and risk tolerance. Brokers are typically paid on sales commissions, which can skew their recommendations toward products that pay them more.

The SEC’s proposed rule is likely to require brokers to provide advice that puts the client’s interest before their own financial incentives. Wall Street is eager to see how the SEC describes that duty in its proposal, because it will affect the range of products that brokers can recommend and potentially expose them to greater liability.

The industry has favoured adoption of a best interest standard that would apply to both retirement and non-retirement accounts, as reported by the Wall Street Journal in February 2017 in Amid Threat to Fiduciary Rule, an Opening for a Uniform Standard? The SEC’s failure thus far to develop standard is part of the unfinished agenda set forth in the 2010 Dodd-Frank legislation.  The failure to complete necessary rule-makings quickly and efficiently is a major failing of the leadership of previous SEC chairs Mary Shapiro and Mary Jo White.

As further reported  in the 15th March Journal piece cited above:

SEC Chairman Jay Clayton has said brokers and investors should face a common set of regulations regardless of the type of account they have.

The SEC’s rule proposal is also likely to restrict the ability of brokers to use titles such as “financial adviser,” Mr. Clayton has said. Some investor advocates say the name misleads clients into thinking that brokers have the same legal duties as money managers, who under law must put their clients’ best interest first.

Money managers, also known as investment advisers, have to comply with different regulatory standards than brokers do, even though they sometimes provide similar services to investors. Investment advisers have complained for years that the rules for brokers are too permissive and that, by using titles such as “financial adviser,” they confuse clients who don’t understand the difference between the two professions.

The SEC hopes to vote to propose its rule by the end of the second quarter of 2018, according to people familiar with the matter. [SEC Commissioner Hester] Peirce said in an interview Thursday that she believes the five-member commission will vote on the proposal “relatively soon.” A period of public comment would follow before the agency could vote to adopt the measure as a final rule.

Several states have weighed in and asked the SEC to enact a firm standard, as reported in the 17th March MarketWatch piece cited above:

Treasurers from 11 states have written to the SEC asking for a more stringent fiduciary rule, saying in a March 8 letter that “any standard less robust than [the DOL’s rule] does not provide adequate protection for investors.” Those states are Pennsylvania, Oregon, Iowa, Maryland, Rhode Island, Illinois, Washington, South Carolina, Vermont, Utah and Wyoming. “This implementation delay, and the accompanying non-enforcement agreement, represent a step back in terms of protecting the interests of retirement savers and investors,” they wrote.

Wall Street’s Stance?

Where does Wall Street stand on these measures? This is not as clear as one might think. As I wrote in an August 2017 post,  Fiduciary Rule: Helps Not Hurts Wall Street, So Full Rescission Unlikely, quoting from reporting done by the Wall Street Journal:

The Wall Street Journal reported last week in Who Is Winning With the Fiduciary Rule? Wall Street that the fiercely-resisted fiduciary rule has proven to be a boon thus far to Wall Street– contrary to the idea that its implementation would spell the end of Western civilisation as we know it:

The brokerage business fiercely fought the new retirement advice rule. But so far for Wall Street, it has been a gift.

The rule requires brokers to act in the best interests of retirement savers, rather than sell products that are merely suitable but could make brokers more money. Financial firms decried the restriction, which began to take effect in June, as limiting consumer choice while raising their compliance costs and potential liability.

But adherence is proving a positive. Firms are pushing customers toward accounts that charge an annual fee on their assets, rather than commissions which can violate the rule, and such fee-based accounts have long been more lucrative for the industry. In earnings calls, executives are citing the Department of Labor rule, known varyingly as the DOL or fiduciary rule, as a boon.

Now, taking my tongue out of my cheek for a moment.  As I’ve written before, it’s no surprise that implementation of the fiduciary rule had more or less proceeded as planned– despite Trumpian sturm und drang to the contrary– given that Wall Street firms had taken steps necessary to comply given the rule’s planned implementation date before Trump was elected as President (as I wrote in this February post, Fourth Federal District Court Looks Likely to Uphold Fiduciary Rule). Notwithstanding Trump’s February memorandum directing the Department of Labour to revisit the rule– especially given the dubious legal significance of that action–  firms were not going to roll back these arrangements.

Given that many firms have already undertaken the transition to the rule for retirement accounts– and have found their operations to be profitable– it is by no means certain they’d like to see a full rollback to the status quo ante.  A 16th March MarketWatch opinion piece, Opinion: Court ruling can’t stop market forces pushing for the fiduciary rule, makes a similar point:

Since the original proposal, some of the largest adviser groups in the world have made changes to better serve clients. Given the recent ruling can be appealed, these changes are unlikely to be rolled back. Bank of America Merrill Lynch BAC, +0.22%  moved clients from commission-based accounts to fee-based ones. Fidelity has been aggressively pushing fiduciary services for retirement plans. BlackRock BLK, +1.03%  and JPMorgan ChaseJPM, +0.17%  have embraced technology to improve investment decision-making. Morgan Stanley MS, +0.51%has invested heavily in technology firms to improve the products and services it offers wealth-management customers.

This may indeed be the case. But not every firm has necessarily made such changes. Those that have may have applied them to retirement accounts only. And absent effective regulation and enforcement, firms could opt to change their policies and practices at any time. In the wake of the Fifth Circuit decision, the focus shifts to what the SEC will do in this area.

Jay Clayton’s SEC has thus far not pursued an aggressive deregulatory agenda– as have  other Trump appointees– such as Scott Pruitt at the Environmental Protection Agency. Clayton merely follows in the inadequate policy pathways blazed by predecessors Mary Schapiro and MaryJo White, as I wrote in
Trump SEC Fails to Pursue Aggressive Deregulatory Agenda (Albeit from Previous Pathetic Baseline). So I will remain open-minded until I see what the full SEC finally decides what to do about this issue.

I should reiterate, however, that as I also mentioned in that piece, the SEC’s recent enforcement record is worse than that of his predecessors, and continues to plumb new lows, as  Yves discussed at greater length last week in her piece on Theranos, Jay Clayton’s SEC Lets Theranos Founder Elizabeth Holmes Get Away With Brazen Fraud.