10 Questions re: DOL Fiduciary (Conflicts of Interest) Rule

After submitting my own comments on the DOL's rule proposal, then testifying before the DOL (and seeing others testify), I respond to some questions I've received regarding the DOL's "Conflict of Interest" (fiduciary) rule proposal, and its future.

1. Will the DOL's proposed rule be finalized?

Yes. Look for a "final rule" to come out either late 2015 or early 2016, with an effective date perhaps eight months later.

2. Will there be a great deal of changes from the proposed rule to the final rule?

No. Too many changes would require a re-proposal.

There will likely be some relief from some particularly burdensome continuing disclosure requirements imposed under the BIC exemption (a.k.a. BICE). Other tweaks are possible.

It is possible that the DOL could, to effect a major change in the rule, finalize the rule but then propose a change at the same time.

3. Industry opposition seems great. Won't this stop the rule?

Threats to the DOL rule exist, and these threats may stop the DOL from proceeding, or work to suspend/repeal the DOL's Conflict of Interest rule in the future.

Opposition from the broker-dealer community (SIFMA, FSI) and the insurance industry and the asset managers (ICI, etc.) is indeed great. With the rule's application to both DC plans and IRAs, the rule would cover $14 trillion in assets.

Why is opposition so great? In a word - profits. Imposing fiduciary duties is, at its core, a restraint on greed. With a duty of care imposed, and a duty of loyalty, including the requirement of "reasonable compensation," the extraction of rents by Wall Street and the insurance companies will diminish substantially. (This might be a good time to sell stock in some BD firms, insurance companies, and some asset management firms.)

However, the DOL's rule has received strong backing from the White House. It is this support that propels the DOL's proposed rule forward.

Still, threats to the DOL's proposed rule remain. These include:

    (A) Congress could enact legislation to effectively stop the DOL from proceeding, either by mandating that "the SEC must move first" or denying appropriations to proceed with or implement the proposed rule. Additionally, attached to other bills (including budget bills, and budget extenders) will be legislation to stop the DOL from proceeding.

Huge lobbying is going on, in this regard - particularly in the U.S. Senate. If enough Democratic U.S. Senators get on board, President Obama's staunch support for the DOL's proposed rule might fade.

The core lobbying strategy is likely to be centered around SIFMA's proposal to have FINRA change its suitability rule to incorporate an explicit "best interests" standard. I have written about this proposal before, pointing out that it is a minor change to the suitability standard and is not a fiduciary standard at all. Still, given FINRA's support of this proposal (which, in my view, is deceitful), those in Congress who truly don't understand the distinctions may be persuaded by SIFMA's lobbying (and, of course, persuaded by massive campaign contributions).

Of course, other "talking points" exist from the BD and insurance community, and will be pressed.

    (B) FINRA will likely be more proactive in seeking to oversee RIAs. And then stating that advice to sell a "security" to purchase an insurance product (EIA, fixed annuity, EIUL, etc.) is "investment advice" subjecting insurance agents to registration.

FINRA will lobby for "consistent" standards, even though ERISA and the securities laws, by their terms, impose different standards of conduct. FINRA, whose members are broker-dealer firms, won't enact a true fiduciary standard.

    (C) Judicial challenges will exist, if and when the rule is finalized. These will take many forms, including attacks on the sufficiency of the economic analysis.

    (D) If a Republican is elected President in late 2016, look for the DOL's rule, which would have been effective in mid-2016 (possibly), to be suspended or repealed in late January 2017.

Any change in the Administration will bring forth new faces at the DOL. Recall that when President Obama took office, the Bush-era fiduciary rule change was extended, and subsequently withdrawn. Given the political pressure which a Republican Congress/President would feel from Wall Street and the insurance companies, instructions from a new Republican White House to an interim DOL Secretary would likely occur to "suspend" the application of the rule, followed by a repeal a few months later and/or the enactment of a new, BD-friendly, "definition of fiduciary" rule.

4. What was your biggest surprise at the DOL's four days of hearings?

My biggest surprise was Prof. Mercer Bullard's testimony, which was supported by James Keeney's testimony. While I was aware of the problems with the DOL's rule, as to its effectiveness, their testimony was illuminating in bringing forth a greater understanding of the challenges presented by some aspects of BICE and by the application of mandatory FINRA arbitration.

Prof. Bullard rightly pointed out that BICE (the "Best Interests Contract Exemption") - by focusing only on removing the economic incentives of individual advisers - and not by removing the economic incentives of broker-dealer firms - will likely not result in substantial protection for consumers. The loopholes in BICE (such as "greater compensation is justified for more complex products" - to paraphrase), and the many ways to incentivize individual brokers for selling more profitable (to the firm) investment products (other than through direct compensation), will result in major abuses.

Prof. Bullard and James Keeney (a retired FINRA arbitrator) both pointed out that FINRA arbitrators will not be trained to adjudicate disputes involving the DOL's fiduciary standard, nor will they apply it correctly in arbitration proceedings. Prof. Bullard rightfully pointed out that FINRA's leadership's statements in opposition to the DOL's proposed rule, and its fiduciary standard, will effectively negate (to a degree) the enforcement of the DOL's rule through FINRA-mandated arbitration.

5. Were the DOL's hearing merely "theatre"?

No. The DOL staff, and in particular Deputy Asst. Secretary Tim Hauser, asked some very particular questions in an attempt to understand challenges the rule posed, in an effort to ascertain tweaks that could be undertaken.

Unfortunately, most of the time the testimony was mere "talking points." Still, at times, meaningful discussion occurred.

6. Are there any surprises as to WHO is either supporting or not supporting the proposed rule?

The support by a huge coalition of groups (including AARP, Consumer Federation of America, AFL-CIO, Pension Rights Center, and many, many more) has been quite strong.

The Financial Planning Coalition (CFP Board, FPA, and NAPFA) came out with a strong 35-page comment letter. This was followed by very effective testimony by Marilyn Mohrman-Gillis (CFP Board Director of Public Policy) and Ray Ferrara (former Chair, CFP Board) during the first panel, highlighting that the DOL's proposed rule was workable. The CFP Board's own experience with "business-model-neutral" standards was effectively utilized as a good example, and Ray Ferrara's firm's business model was utilized to demonstrate how small investors are (and can be) effectively served under the DOL's proposal. Let's applaud the Financial Planning Coalition for giving their important support to the DOL's proposed rule.

I continue to be somewhat surprised by the U.S. Chamber of Commerce's opposition to the DOL's rule. One would think that a rule which protects plan sponsors (i.e., business owners) would be something the DOL supports. Indeed, the Committee on Investment of Employee Benefit Assets, which is comprised of large corporate plan sponsors, supports the DOL's proposed rule. One wonders why any business (other than broker-dealer firms and insurance companies) continues to maintain membership in the Chamber, given the undue influence of Wall Street over the Chamber.

I am somewhat surprised by FINRA's opposition to the rule, and by its endorsement of SIFMA's misleading "best interests" standard. FINRA's true colors are exposed. Instead of acting to protect consumers, FINRA and its suitability standard, which lowers the common law standard of due care applicable to nearly every other service provider continues to protect brokers, not consumers. In my opinion, FINRA's oversight of market conduct regulation should be terminated, as in its 75 years of existence FINRA has failed to effectively protect American consumers of investment advice.

7. What changes would you like to see to the DOL's proposal?

There are many, but here are the key ones.

     A) A streamlined "AUM Adviser Rollover Exemption" - similar to that proposed at page 24 of the Financial Planning Coalition's comment letter (or as proposed, using different terminology, in my own comment letter). Fee-only RIAs who subscribe to the tough "sole interests" standard of ERISA need not be subjected to BICE's requirements; standards can be established to guide fee-only advisers in providing advice on IRA rollovers.

    B) Changes to BICE, and/or clarifications.
           1) Note that additional compensation for more complex products should be minimal.
           2) Provide examples of unreasonable compensation. Commission-based compensation may be o.k. for smaller accounts, but for larger accounts commissions quickly become unreasonable. This is particularly a problem when break-point discounts are not applied. Most VAs and EIAs do not provide for breakpoint discounts.
           3) Suggest the many considerations which must be taken into account before an IRA rollover advise can be provided. (See my comment letter, published earlier in this blog.)
           4) Suggest that advisers recommending VAs, EIAs, and fixed annuities must undertake a proper cost-benefit analysis and truly understand these products before selling them. (In my view, most of the VAs and EIAs on the market today fail the cost-benefit analysis.)
           5) Permit the contract with the client to be presented and signed later (but prior to implementation); however, the terms of the contract (and the fiduciary duties) should be retroactive to all prior communications between the parties.

   C) New Proposed Rule to Make FINRA Arbitration Non-Mandatory.

There are just too many flaws in FINRA's arbitration (including the fact that the membership association of broker-dealers is in charge of arbitration involving its members, an inherent conflict of interest that has led and continues to lead to problems in arbitration fairness, and the perception of unfairness as well).

I believe the DOL should propose, separately, a rule stating that arbitration of individual claims should be voluntary, and if undertaken must be undertaken in a neutral arbitration forum chosen by agreement of both parties. Such agreement should be permitted only after a claim is known. Pre-dispute arbitration clauses should be prohibited.

Standards for the conduct of arbitration proceedings should be established. Additionally, standards for the conveying of arbitration decisions (including the publication of the determined facts, and application of the law to the facts) should be mandated by the DOL. Finally, standards for effective appeal of arbitration decisions to the courts should be specified.

While I support the idea of mandatory arbitration, as a means of protecting a firm's most valuable asset - its reputation - from frivolous claims, the fact of the matter is that the present system of arbitration under FINRA has poisoned the arbitration process so greatly that no mandatory arbitration forum, however well designed, is likely to be perceived as fair or as necessary.

8. Should the "Education Exemption" Be Expanded?

There were a great many suggestions made at the DOL hearings to expand the "Education Exemption," such as by permitting specific fund recommendations to be made during "educational" presentations.

I don't like the idea of such an expansion. Advice is advice, whether it is given in a one-on-one face-to-face meeting, via a conversation with a call center employee, or in a group presentation.

I'm not a fan of the education exemption, at all. Even suggesting a strategic asset allocation for various ages (or "years to retirement") strikes me as advice. Any discussion of specific investment products or securities seems to me to be clearly crossing the line into the "advice" realm.

9. What will the SEC do, as to the fiduciary standard's applicability?

The SEC has a black eye - by not proceeding more quickly to implement Sect. 913 of The Dodd Frank Act. This section authorizes the SEC to impose fiduciary standards upon broker-dealers and their registered representatives who provide personalized investment advice.

While the SEC still has other "mandatory" rule makings to undertake, the SEC has failed to recognize that Sect. 913 rule making is likely to be its most important, and most meaningful, if and when undertaken. All of the SEC's other "reforms" of the capital markets will result in little impact if, in the final analysis, individual investors continue to fail to receive the important protections a bona fide fiduciary standard offers.

In fact, the SEC's decisions over the past four decades, which have essentially negated the application of the Advisers Act to investment advice provided by brokers, and which have permitted waiver by fiduciaries (particularly seen with dual registrants) despite the anti-waiver clause of the Advisers Act, led to the need for the DOL to proceed.

However, I don't see any rush at the SEC to draft rules extending fiduciary protections. They may be working on it, but at the present time it does not appear to be a priority. To my knowledge, as of early August 2015 no "drafts" are being circulated within the SEC, even as to an outline of Section 913 rule-making.

And, even if the SEC proceeds, I doubt the SEC will enact a rule which truly applies fiduciary protections. It would likely be a weak, and ineffective rule.

The SEC has a fundamental problem - the revolving door between Wall Street and the SEC. Staff support for a bona fide fiduciary standard is minimal.

It would take a very strong SEC Chair, with the support of two other SEC commissioners (there are 5 SEC commissioners in total), to effect a bona fide fiduciary standard, and to effectively change several SEC decisions over the past four decades that have weakened or refused to apply the fiduciary standard. I applaud SEC Chair Mary Jo White's understanding of the issues, but she may lack the political cover to proceed strongly. Even then, she has surrounded herself with those who are used to working under the weak suitability standard, instead of surrounding herself with those who are used to working as bona fide fiduciaries.

Time has effectively run out for the SEC. Any new Administration will likely result in a new SEC Chair. If a Republican President is elected, no action will likely be taken on Section 913. If a Democratic President is elected, then the ability of the SEC to move forward (and escape any Congressional pressure to not act) will depend upon such President's public support of SEC rule-making. Given the many other issues a Democratic President will face, the use of political capital to support the SEC may not occur - at least in the first term of a new presidency.

10. How important is the DOL's Proposed Rule?

Given the inability of the SEC to protect investors, by correctly applying a strong, bona fide fiduciary standard of conduct, the DOL's proposed rule has taken on incredible importance to individual Americans, and to America itself.

The huge extraction of rents by Wall Street and the insurance companies must stop. This has caused a massive drag on U.S. economic growth, as well as impeding the individual financial security of hundreds of millions of individual Americans.

There is, indeed, a lot at stake. Let us applaud the courage of DOL Secretary Thomas Perez, Asst. Secretary Phyllis Borzi, and the DOL EBSA staff, for recognizing the importance of this issue and pursuing a strong DOL rule, despite monumental opposition from heavily monied Wall Street and insurance company interests.

Let us hope, and work toward, the adoption of a final rule and its effective implementation.

My Testimony Before the U.S. Dept. of Labor re: Conflicts of Interest Proposed Rule

Statement of Ron A. Rhoades, JD, CFP®

Asst. Professor – Finance

Chair, Financial Planning Program

Western Kentucky University

Before the U.S. Department of Labor

Employee Benefit Security Administration

Conflict of Interest Proposed Rule and Exemption Proposals

August 10, 2015

I am Ron Rhoades, Chair of the Financial Planning Program at Western Kentucky University. I am also a tax and estate planning attorney, fee-only investment adviser and Certified Financial Planner™.

Thank you for the opportunity to speak today. Like other members of The Committee for the Fiduciary Standard, a group of volunteer leaders of the profession who donate their personal time and treasure to advocate on these issues, I am here on behalf of my fellow Americans – the consumers of investment advice.

For many years we have been dismayed by the huge extraction of rents by Wall Street and the insurance companies. We have seen the harm caused to our friends and neighbors. I am here today to pronounce, for all to hear, that the substantial diversion of the returns of the capital markets, away from individual investors, and into the pockets of many of the broker-dealer firms and insurance companies, must stop.

Please permit me to summarize some of the contents of my comment letter.

Overwhelming academic research demonstrates that high fees and costs result in lower returns for investors.

Despite this, most individual investors, when receiving advice from non-fiduciary advisors, are sold high-cost products.

Economic incentives matter. When a person or a firm providing investment advice has the opportunity to receive much higher compensation from the sale of one product, compared to another, the allure of the higher compensation nearly always wins, to the detriment of the consumer.

As a result of this high extraction of rents, individual investors accumulate far less for their own retirement and other needs.

Hence, I applaud the U.S. Department of Labor’s proposed rule, which will substantially reduce the conflicts of interest existing today in financial services.

The huge extraction of rents by Wall Street and the insurance companies must stop. The size of the financial services sector, relative to the overall U.S. economy, has grown from under 3% in 1950 to well over 30%, and perhaps even 40%, today.

Wall Street is no longer the grease that fuels the modern economy; rather, it has become a sludge that cogs the engine of U.S. economic growth.

Not only did Wall Street’s conflicts of interest cause in large part the economic crisis of 2008-9, but also the International Monetary Fund now estimates that the excessive financializaton of the U.S. economy reduces growth in U.S. gross domestic product by 2% a year. In essence, Wall Street not only led us into the Great Recession, but it is also responsible for our very slow recovery from it.

The detrimental effect of conflicts of interest, resulting in sales of high-cost products, is likely to compound. The diversion of the returns of the capital markets away from individual investors leads to substantially less accumulated capital. This in turn results in higher costs of capital for firms.

Due to conflicts of interest, many individual investors have not accumulated enough for retirement. As a result, the burden upon federal, state and local governments to provide for our retired citizens increases. This results in higher taxes on all of us.

The fiduciary standard is a much-needed correction to the current unworkable system for the provision of retirement advice. The suitability standard, on the other hand, is not the answer. The suitability doctrine emerged as a way to protect brokers from being sued for brokers’ stock and bond recommendations, at a time when brokers’ services mainly related to the execution of trades.

The inherently weak suitability standard was erroneously extended by FINRA and the SEC decades ago, so that it applies to the selection of investment managers. As such, suitability has served as a shield to protect brokers and insurance agents from adherence to the duty of care so many other service providers possess.

FINRA’s recently proposed “best interests” standard is nonsensical. It is just “suitability” with very minor changes. It falls far short of the fiduciary standard. Worse, by using the term “best interests” to describe its standard, when it is clear from a close examination of FINRA’s proposal that brokers possess very little in the way of duties to their customers under it, FINRA has been misleading. As Professors Angel and McCabe observed five years ago: “[T]o give biased advice with the aura of advice in the customer’s best interest – is fraud.”

Simply put, FINRA’s proposal permits brokers to continue to act as supply-side merchandizers, instead of trusted purchaser’s representatives. FINRA tries to blur the line between representing the seller and representing the buyer. But, as an eloquent Tennessee jurist wrote 160 years ago, it is an “infallible truth that a man cannot serve two masters.” This is a time-honored phrase, repeated often by wise men for millennia.

Into the void created by the SEC and FINRA the Department of Labor has, with courage, ventured. I applaud the DOL’s efforts to protect our fellow Americans. I applaud the DOL’s leadership on this important issue.

In my comment letter I have set forth that broker-dealer firms, and insurance companies, can easily adhere to the DOL’s fiduciary requirements, simply by abandoning the conflicts of interest that differential compensation – to both the firm and the individual broker or insurance agent – create.

I also set forth the inevitable conclusion that commissions on products, if not substantially lowered as larger purchases are made, such as by the use of break-point discounts, can easily amount to unreasonable compensation.

Additionally, I set forth a listing of the characteristics of variable annuities, equity indexed annuities, and fixed annuities, which advisors should fully master, before they recommend these often-complex products. Despite comment letters from insurance agents stating that they have devoted a large amount of training relating to these products, in my many conversations with insurance agents I have discerned that they have been trained to sell these products, not to fully understand them.

The fiduciary standard requires that those who provide investment advice are experts. Extensive due diligence must be undertaken. This expert scrutiny levels the playing fields for all investment products. It is altogether certain that most of the variable annuities and equity-indexed annuities on the market today would not survive the due diligence undertaken by an expert, trusted adviser.

I have heard from opponents of the DOL’s proposal that it is difficult to adhere to different standards. Yet, it has long been understood by providers of services under two different standards of conduct that the easiest path to ensure compliance is to simply apply the higher standard to the entirety of the relationship.

I have also heard from opponents of the DOL’s proposal that they fear “unlimited” liability under a fiduciary standard. Yet, I have practiced as an attorney, and then as an investment adviser, under a fiduciary standard for nearly 30 years. I have no such fears. Just be the expert. Act as the client’s representative, and avoid conflicts of interest. Advise the client with candor and honesty. Do this, and you will look forward to going to work each day, counseling clients as a fiduciary, with no worries about liability.

The DOL, while accommodating to a degree the concerns of the industry, should act to preserve over the long term ERISA’s tough “sole interests” standard. The BIC exemption, as Mercer Bullard’s previous testimony suggested, because it does not prohibit differential compensation at the firm level, will only possess a modest impact in changing Wall Street’s conflict-ridden practices. Hence, I have suggested that the BIC exemption be strengthened, and that it be time-limited – in essence, that the BIC exemption be sunset in several years.

Let us move forward in a manner in which “particular exceptions” to the fiduciary standard, to paraphrase the late Justice Benjamin Cardoza, are not permitted to exist indefinitely. Let us conform the securities industry to the fiduciary standard. Let us not change the fiduciary standard just to preserve the conflict-ridden practices of Wall Street.

The Department of Labor should move forward to quickly implement its proposal. Let us preserve the fiduciary standard – the strongest standard of conduct under the law - and in so doing empower a new era of economic growth and prosperity for all Americans. Thank you.