Risk & Reward

Key Takeaways from the GAO Report on ESG Investing by ERISA Fiduciaries

The Government Accountability Office (GAO) yesterday released a new report on ERISA fiduciaries’ incorporation of environmental, social and governance (ESG) factors into its investment process. At 63 pages, here are the key takeaways:

  1. The report is focused only on instances where fiduciaries consider ESG factors as material risk factors that are part of an ordinary prudence analysis. In other words, the GAO did not focus on other strategies (e.g., impact investing), such as those that select an ESG factor for moral reasons, etc., which is the historical association of ESG investing. In this sense, the GAO deserves a lot of credit for focusing on this sophisticated approach to ESG.  You may recall that my paper on climate change risk focused on this very issue.
  2. Rather unfortunately, the report was largely completed prior to the DOL’s issuance of Field Assistance Bulletin (FAB) 2018-01, which we discussed here. The principal recommendation by the GAO is for the DOL to issue guidance on whether a fiduciary can incorporate ESG factors into the management of a default investment option in a defined contribution plan. As you may know, FAB 2018-01 seemed to do just that, though not in an entirely clear manner. Nevertheless, the GAO addressed FAB 2018-01 at the end of the report and narrowed its initial recommendation, namely, that the DOL better explain how fiduciaries can utilize the integration strategy in a QDIA. In the DOL’s defense, FAB 2018-01 seems to address (to some extent) whether a QDIA can utilize the integration strategy; the DOL instead hit the breaks on offering a themed ESG product as a QDIA.
  3. According to the GAO, the DOL is amenable to issuing additional guidance on ESG investing, provided there is enough interest by fiduciaries. The DOL is mum on its Form 5500 project, and whether any ESG disclosures on a revised 5500 are in the works.
  4. Those close to ESG will unlikely find anything surprising in the GAO report on the various reasons why ESG is not yet widely adopted by US retirement plans: questions over the reliability/comparability of disclosures, ratings and rankings–designed to help fiduciaries incorporate ESG factors–all continue to be cited as impediments. Regulatory uncertainty, and definitional ambiguities, also remain hindrances. I recently spoke on a number of these constraints to greater adoption by fiduciaries.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

Litigator Bill Mandia Provides Key Context on the States’ Latest Efforts re. the DOL Fiduciary Rule

Undeterred by the Fifth Circuit’s rejection of their request to intervene in U.S. Chamber Commerce v. U.S. Dep’t of Labor, the States of California, New York, and Oregon moved for reconsideration in the Fifth Circuit today. The States request that the three-judge panel who heard the appeal reconsider their denial of the States’ petition to intervene or, at a minimum, refer the question of intervention to the entire Fifth Circuit for a rehearing en banc.  The States previously requested a rehearing en banc, which the court rejected as improper because the States are technically not parties to the appeal.  The States’ motion notes that the business groups that filed the action against the DOL will oppose their request and that the Department of Justice, on behalf of the DOL, takes no position on it.

It remains to be seen how the panel addresses the request, but for the reasons discussed in our prior blog post, the States face an uphill battle.  It is unlikely that the panel will reconsider its prior ruling and allow the States to intervene because the States have not presented any new lines of evidence or argument that were unavailable to them when they made their original request to intervene.  While a 2-1 decision on a significant issue always raises the possibility of a rehearing en banc, the relative weakness of the States’ arguments regarding intervention may lead the panel to conclude, even in a 2-1 vote, that the issue is not worth the entire Fifth Circuit’s time.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

DOL Provides Stopgap Prohibited Transaction Relief Amidst Fiduciary Rule Uncertainty

The Department of Labor (DOL) issued Field Assistance Bulletin (FAB) 2018-02, which states that the DOL and Internal Revenue Service (IRS) will not bring an enforcement action against firms for non-exempt prohibited transactions that arise from providing fiduciary investment advice to plans and IRA holders when they exercise reasonable diligence and act in good faith in complying the impartial conduct standards. This non-enforcement policy binds only the DOL and IRS; state regulators and private plaintiffs could potentially seek to bring an action for alleged non-compliance with the impartial conduct standards.

The impartial conduct standards are already familiar to many service providers because they were originally set forth in the Best Interest Contract Exemption, which (along with the rest of the DOL’s 2016 Fiduciary Rule) was vacated by the Fifth Circuit Court of Appeals. For the past year, service providers have been eligible for “transition relief” by complying with the impartial conduct standards, which relief is essentially encapsulated by the DOL in FAB 2018-02. This means that service providers can continue with their existing compliance approach in connection with the impartial conduct standards.

The DOL most likely issued FAB 2018-02 because of the confusion over the Fiduciary Rule’s iterations. What was designed as a sweeping and, to many, draconian, rule has since morphed into an ever narrower and more flexible slate of compliance obligations through a series of supplemental guidance issued by the DOL post-election. Uncertainty over how to comply with the Fiduciary Rule has been as much a hallmark of the rulemaking as the rule’s own conditions. FAB 2018-02 seeks to alleviate some of this confusion by allowing firms to continue the compliance approach firms have been taking since last June. The DOL then and now affords firms flexibility to fashion compliance with the impartial conduct standards in ways they determine in good faith satisfies the standards while taking into account the organization’s unique preferences and resources.

FAB 2018-02 provides relief for prohibited transactions that arise from non-discretionary investment advice. Because the DOL Fiduciary Rule was vacated by the Fifth Circuit, the test for when one becomes a fiduciary in the first place, and, therefore, needs a prohibited transaction exemption, is set forth in the original 1975 five-part test. FAB 2018-02 does not resuscitate the Fiduciary Rule or somehow indirectly continue to impose the expansive ways in which one can become an investment advice fiduciary. Rather, FAB 2018-02 appears designed to preserve existing compliance methods for securing prohibited transaction relief for these advisers who are fiduciaries under the old five-part test until the DOL issues formal guidance (likely through the proposal of a new exemption) in the future. One should first determine if they continue to constitute an investment advice fiduciary now that we are back to the much narrower five-part test and, if so, whether they have undertaken reasonably diligent and good faith efforts to satisfy the impartial conduct standards or otherwise comply with a different prohibited transaction exemption.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

Third-Parties Launch Effort To Defend The Fiduciary Rule In The Absence Of Action By The DOL – by Bill Mandia

Late last week, the states of California, New York, and Oregon (“States”), along with the American Association of Retired Persons (“AARP”), launched an eleventh hour attempt to rescue the DOL’s fiduciary rule in response to the Fifth Circuit’s ruling last month in U.S. Chamber Commerce v. U.S. Dep’t of Labor.  The States and AARP move to intervene in U.S. Chamber of Commerce for the purpose of challenging last month’s ruling by requesting a rehearing before the entire Fifth Circuit.  While this effort to defend the fiduciary rule may be popular with the respective constituents of the States and AARP, these parties face an uphill battle to secure a reversal of the U.S. Chamber of Commerce decision.

As a threshold issue, the States and AARP must convince the Fifth Circuit to grant their request to intervene in the appeal before the Fifth Circuit will even consider their request for a rehearing en banc.  To meet their burden, the Sates and AARP must demonstrate that:  (1) the motion is timely; (2) they have a legally protected interest in the action; (3) the outcome of the case may impair that interest; and (4) the existing parties do not adequately represent that interest.  Ross v. Marshall, 426 F.3d 745, 753 (5th Cir. 2005).

The States and AARP face significant obstacles in trying to persuade the Fifth Circuit to grant their request to intervene.  Among other issues, the States and AARP fact particularly difficult arguments regarding the timeliness and legally protected interest prongs.  With regard to timeliness, the States and AARP argue that their motion to intervene is timely—even though they filed it just two days before the deadline to request a rehearing en banc and after years of extensive litigation—because up until now the DOL had been defending the fiduciary rule in the Fifth Circuit and in other courts around the country.  As to the legally protectable interest prong, the States argue that they have standing because the elimination of the fiduciary rule will cause their residents “to lose billions in retirement investment gains” based on the DOL’s own projections made in support of the rule that the DOL argues will result in a substantial loss in tax revenue for the States.  AARP, in turn, argues that it has standing because its members will be harmed if the fiduciary rule is extinguished because its members will be deprived of investment advice in their retirement accounts that is in their “best interests.”

Not surprisingly, the U.S. Chamber of Commerce (“U.S. Chamber”) wasted no time in challenging the intervention request by filing a vigorous opposition yesterday.  The U.S. Chamber argues, inter alia, that the States and AARP lack standing because the injuries they claim are purely hypothetical.  With respect to the States, the U.S. Chamber asserts that the mere potential for lost future tax revenue is insufficient to show that the States have sustained an injury-in-fact.  As to AARP, the U.S. Chamber contends that its members have not suffered any harm because they can still receive financial advice that is in their “best interest” even in the absence of the fiduciary rule.  On this point, the U.S. Chamber argues that there are ample protections already in place, such as existing FINRA rules that require broker-dealers to act in their customers’ bests interests when taking certain actions, state insurance regulations that are designed to protect consumers, and federal securities laws that make registered investment advisers fiduciaries.  The U.S. Chamber thus argues that AARP’s members have not suffered harm because the type of investment advice they seek is available regardless of whether the DOL’s fiduciary rule survives.

The U.S. Chamber also attacks the request to intervene on the grounds that it is untimely.  Specifically, the U.S. Chamber argues that the underlying litigation has been ongoing for years without any effort by the States or the AARP to intervene.  The U.S. Chamber points out that the States and AARP had ample time to seek intervention because they knew more than a year ago that the day may come when the DOL may no longer defend the fiduciary rule based on the comments made by President Donald Trump’s administration when President Trump took office in January 2017.  The U.S. Chamber further notes that the States and AARP did not seek to intervene until after the Fifth Circuit issued its ruling in mid-March and, even then, they waited to seek intervention until two business days before the deadline to file a petition for rehearing en banc.

While it remains to be seen whether the Fifth Circuit will grant the request of the States and AARP to intervene, it is clear that they must overcome significant hurdles in order to make their last-ditch effort to save the fiduciary rule.  In addition to the difficult legal arguments they must contend with regarding standing and the timeliness of their request, the States and AARP must convince the Fifth Circuit that it should permit them to defend a rule that the responsible federal regulator has decided to abandon.  Moreover, the question of whether the States and AARP should be permitted to intervene is only a threshold issue they must overcome to continue their fight.  Even if the Fifth Circuit were to permit intervention, the States and AARP would still need to persuade the court that it should rehear the appeal en banc and reverse the ruling made by the three-judge panel in March.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

Trump’s DOL Expresses Its Own Views on ESG Investing

This week’s U.S. Department of Labor (DOL) Field Assistance Bulletin (FAB) 2018‑01 on environmental, social and governance (ESG) investing seems to have both caught everyone by surprise and caused confusion amongst a good many. This is unfortunate because ESG, with its various connotations, already eludes some. But despite its shortcomings, FAB 2018-01 reflects an unease by the DOL over certain ESG practices and largely clarifies existing fiduciary obligations in this space. Here are our key observations:

  • ESG guidance issued by the DOL during the Obama administration in 2015 and 2016 was largely viewed as supportive of including ESG factors in the investment process. For example, Interpretive Bulletin (IB) 2015‑01 recognized that an ESG factor can in fact have a close nexus with investment performance, and, therefore, should be considered by a fiduciary like any other material investment factor (e.g., inflation risk) in the usual prudence analysis. This acknowledgement recognized the growing body of research linking ESG factors, such as climate change, with investment performance. In respect of climate change, for example, an issuer may now be facing numerous risks, including stranded asset risk, the prospect of heightened government regulation that disproportionally affects certain industries or sectors (and the resulting litigation) and even the risk that some companies or industries may be rendered obsolete as global markets search for solutions to what is called, the transition to a low-carbon economy. IB 2015-01 also restated the historical test for ESG investing: only when competing investment options serve the plan’s interests equally well may a fiduciary use an ESG factor as the tie-breaker. This historical approach, sometimes called the tie-breaker test, was designed to address the early iterations of ESG investing, where the fiduciary would want to pursue an objective unrelated to investment performance, such as to spur jobs in the local economy. In 2016, the DOL issued IB 2016‑01 in which it permitted plan-funded shareholder engagement if “the responsible fiduciary concludes that there is a reasonable expectation that [such engagement] with management, by the plan alone or together with other shareholders, is likely to enhance the value of the plan’s investment in the corporation, after taking into account the costs involved.” Issues on which engagement may be appropriate included “the nature of long-term business plans including plans on climate change preparedness and sustainability” and “policies and practices to address environmental or social factors that have an impact on shareholder value.”
  • FAB 2018‑01 preserves the notion that an ESG factor can have a direct link to investment performance and may be added to the investment decision mix with all other material factors, such as volatility and its correlation with other securities in the portfolio. But the DOL cautioned that there must in fact be a real nexus between the ESG factor and shareholder value in order to avoid having to satisfy the tie-breaker test. Fiduciaries will want to build a record in support of the view that a particular factor bears a relationship with investment performance, and carefully consider how much weight to put on that specific factor.
  • Though hardly clear, the DOL is seemingly still comfortable with fiduciaries populating plan investment lineups with an ESG-themed investment option, provided the fiduciary can justify its inclusion on prudence grounds. The DOL is definitely wary of a fiduciary’s selection of an ESG-themed QDIA, though FAB 2018‑01 does not completely close the door on such an investment product. Moreover, the DOL, in expressing skepticism of ESG-related QDIA products, distinguished between “ESG-themed funds (e.g., Socially Responsible Index Fund, Religious Belief Investment Fund, or Environmental and Sustainable Index Fund),” from funds “in which ESG factors may be incorporated…as one of many factors in ordinary portfolio management and shareholder engagement decisions.” The former seems to be more concerning to the DOL than the latter. This potentially has the effect of favoring some ESG products and strategies over others.
  • The DOL also zeroed-in on shareholder engagement in respect of ESG issues that have a connection to the value of the plan’s investment in the company, where the plan may be paying significant expenses for the engagement or development of proxy resolutions. FAB 2018-01 states that if “a plan fiduciary is considering a routine or substantial expenditure of plan assets to actively engage with management on environmental or social factors, either directly or through the plan’s investment manager,” then that may warrant “a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.” It is not evident why the DOL raised a concern over shareholder engagement that results in an ERISA plan incurring significant expenses due to direct engagement with company boards because we are not aware of that being much of a practice (at least as of yet). The DOL may have simply taken notice of other types of institutional investors, such as very large governmental plans, which are pushing for more engagement with corporate boards as an alternative to divestment, for example.

Even with FAB 2018-01, ESG remains an entirely viable investment approach under ERISA, provided it is structured in a way that satisfies the duties of prudence and loyalty. Fiduciaries face a proliferation of data and analytic tools to help identify managers and investment opportunities that are sufficiently attuned to ESG risks and best practices. Nomenclature and disclosure remain sources of concern and confusion among ESG specialists and newcomers alike. ESG’s historical association with the pursuit of objectives unrelated to financial performance give the DOL and some fiduciaries pause, but a more nuanced understanding of how ESG factors can shape a portfolio’s performance is emerging apace.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

Watch The SEC Proposals: Standards of Conduct for Investment Advisers and Broker-Dealers

On Monday, April 23, Dave Grim, Larry Stadulis, John Baker and I presented a webcast titled “The SEC Proposals: Standards of Conduct for Investment Advisers and Broker-Dealers.” Watch a replay of the webcast here:

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

SEC Rulemaking Package Would Impose Best Interest Standard of Conduct

On April 18, the Securities and Exchange Commission (“SEC”) released for public comment a package of rulemaking proposals on the standards of conduct and required disclosures for broker-dealers and investment advisers who provide services to retail investors. The release of the long-awaited proposals was approved by a 4 – 1 vote of the Commissioners, with Commissioner Kara Stein dissenting. However, all of the Commissioners expressed some concerns with the proposals, suggesting that the rulemaking will likely need to evolve before it can be approved.

The Dodd-Frank Act authorized the SEC to adopt rules on the standards of care for broker-dealers, investment advisers, and their associated persons,1 and the SEC staff in 2011 issued a study recommending that the SEC engage in rulemaking to adopt and implement a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.2 The SEC did not propose a uniform fiduciary standard, however, but instead proposed a best interest standard for broker-dealers that it characterized as an enhancement to existing standards but separate and distinct from the fiduciary duty applicable to investment advisers. The SEC also proposed a new requirement for both broker-dealers and investment advisers to provide a brief relationship summary to retail investors, and it published for comment a proposed interpretation of the standard of conduct for investment advisers.

Regulation Best Interest

The SEC proposed to adopt rule 15l-1, titled “Regulation Best Interest,” which would require broker-dealers and their associated persons who are natural persons to act in the “best interest” of a retail customer3 at the time a recommendation4 of a securities transaction or investment strategy involving securities is made to that customer, without placing the financial or other interest of the broker-dealer or associated person ahead of the interest of the customer.5 The proposed best interest obligation draws from principles underlying and reflects the underlying intent of many of the recommendations of the 2011 staff report and also generally draws from underlying principles similar to the principles underlying the Department of Labor’s best interest standard. This “best interest” duty would be discharged if the broker-dealer or associated person complies with multiple obligations, specifically:

Disclosure Obligation

The broker-dealer or associated person must reasonably disclose to the retail customer in writing the material facts relating to the scope and terms of the relationship, including all material conflicts of interest associated with the recommendation.

Care Obligation

The broker-dealer or associated person must exercise reasonable diligence, care, skill and prudence to:

  • understand the potential risks and rewards associated with the recommendation and have a reasonable basis to believe that the recommendation could be in the best interest of at least some retail customers;
  • have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; and
  • have a reasonable basis to believe that a series of recommended transactions is not excessive and is in the retail customer’s best interest when taken together in light of the retail customer’s investment profile.

Conflict of Interest Obligations

The broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and then to:

  • at a minimum disclose, or eliminate, material conflicts of interest associated with the recommendation; and
  • disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendation.

The SEC states that Regulation Best Interest is not intended to create any new private right of action or right of rescission.  It remains to be seen, however, whether it would have an effect on existing rights of action.

Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles

The SEC also proposed to require both broker-dealers and investment advisers to provide retail investors6 with information intended to clarify the relationship via the proposed Form CRS Relationship Summary.7 Form CRS would be limited to four pages, with a mix of tabular and narrative information, and contain sections covering:

  • the relationships and services the firm offers to retail investors;
  • the standard of conduct applicable to those services;
  • the fees and costs that retail investors will pay;
  • comparisons of brokerage and investment advisory services (for standalone broker-dealers and standalone investment advisers);
  • conflicts of interest;
  • where to find additional information, including whether the firm and its financial professionals currently have reportable legal or disciplinary events and who to contact about complaints; and
  • key questions for retail investors to ask the firm’s financial professional.

Form CRS would be provided to investors, filed with the SEC, and available online. The form would not supersede the Form ADV Part 2 brochure, which investment advisers would continue to prepare and provide to clients. The SEC has provided mock-ups of Form CRS that would be used by standalone broker-dealers, standalone investment-advisers, and dually-registered firms.

The SEC also proposed (A) to require broker-dealers and investment-advisers to prominently disclose their registration status; and (B) to restrict standalone broker-dealers and their financial professionals from using the terms “adviser” and “advisor” as part of their name or title. These proposed changes are part of greater scrutiny by federal and state regulators over the titles financial professionals use that could confuse investors as to the nature of the relationship, which has been the focus of a number of state legislatures.

Notice of Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation

The third element of the package is a proposed interpretive release on the fiduciary duty that investment advisers owe to their clients.8 Existing enforcement proceedings and SEC interpretations hold that the Investment Advisers Act of 1940 establishes a federal fiduciary standard for investment advisers.  The proposed interpretation is intended to summarize the SEC’s understanding of that fiduciary duty and put the market on notice of the SEC’s views.

The release also includes a request for comments on areas where the current broker-dealer framework provides investor protections that may not have counterparts in the investment adviser context. The SEC intends to consider these comments in connection with any future proposed rules or other proposed regulatory actions with respect to these matters. Accordingly, the SEC requests comment on whether there should be federal licensing and continuing education requirements for personnel of SEC-registered investment advisers; whether registered investment advisers should be required to provide account statements, either directly or via the client’s custodian; and whether registered investment advisers should be subject to financial responsibility requirements along the lines of those that apply to broker-dealers.

The Path Forward

Each of the Commissioners expressed reservations, to varying degrees, with the proposals (and complained about their heft – in aggregate, they take up almost 1,000 pages) at the SEC open meeting at which their issuance was approved. It became clear during the open meeting that the Commissioners have concerns, including with the proposals’ clarity, the appropriate comparison to existing broker-dealer suitability standards, and the cost-benefit analysis. Public comments will weigh heavily as the SEC considers these proposals, and for this reason interested parties may wish to submit a comment letter in response to the numerous questions the SEC posed.

Comments on the proposals will be due 90 days after their publication in the Federal Register, which will likely occur at some point in the next month.  The SEC will then need time to consider what are likely to be a large number of comments.  We should not expect consideration of final rules much before the end of 2018, and final action could be considerably later.


1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 913, 124 Stat. 1376, 1824 – 30 (2010).

2 Staff of the U.S. Securities and Exchange Commission, Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Jan. 2011),
https://www.sec.gov/news/studies/2011/913studyfinal.pdf.

3 A “retail customer” is proposed to be defined under Regulation Best Interest as a person who receives a recommendation and uses it primarily for personal, family, or household purposes.

4 “Recommendation” is not defined but is proposed to be interpreted consistent with existing FINRA rules, under which factors that have historically been considered in the context of broker-dealer suitability obligations include whether the communication “reasonably could be viewed as a ‘call to action’” and “reasonably would influence an investor to trade a particular security or group of securities.”

5 Regulation Best Interest, Release No. 34-83062 (Apr. 18, 2018), https://www.sec.gov/rules/proposed/2018/34-83062.pdf.

6 For purposes of the Form CRS delivery requirement, a “retail investor” is proposed to be defined as a prospective or existing client or customer who is a natural person, including a trust or other similar entity that represents natural persons.

7 Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, Release Nos. 34-83063, IA-4888 (Apr. 18, 2018), https://www.sec.gov/rules/proposed/2018/34-83063.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-a.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-b.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-c.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-d.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-e.pdf;
https://www.sec.gov/rules/proposed/2018/34-83063-appendix-f.pdf.
“CRS” stands for “Customer Relationship Summary.”

8 Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, Release No. IA-4889 (Apr. 18, 2018), https://www.sec.gov/rules/proposed/2018/ia-4889.pdf.

Lawrence Stadulis advises clients in matters pertaining to the registration and regulation of investment advisers and investment companies under federal and state securities laws. He also manages related issues pertaining to investment advisers and investment companies, including matters involving ERISA, broker-dealer regulation and banking laws.

The SEC Proposals: Standards of Conduct for Investment Advisers and Broker-Dealers

During an open meeting this Wednesday, the Securities and Exchange Commission (SEC) is expected to unveil proposals on (1) new and amended rules and forms to require registered investment advisers and registered broker-dealers to provide a brief relationship summary to retail investors, (2) establishing a standard of conduct for broker-dealers and natural persons who are associated persons of a broker-dealer when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, and (3) an SEC interpretation of the standard of conduct for investment advisers.

Stradley Ronon’s Fiduciary Governance Group will host a webcast on Monday, April 23 at 1:00 p.m. (EDT) to discuss these proposals and preliminary reactions. Speakers: David Grim, Larry Stadulis, John Baker and George Michael Gerstein

Register to attend the webcast here.

Lawrence Stadulis advises clients in matters pertaining to the registration and regulation of investment advisers and investment companies under federal and state securities laws. He also manages related issues pertaining to investment advisers and investment companies, including matters involving ERISA, broker-dealer regulation and banking laws.

Fiduciary Governance 2.0

We are pleased to introduce Stradley Ronon’s new Fiduciary Governance Group, comprised of federal and state securities, banking, insurance and ERISA/governmental plan law attorneys who help clients determine (1) whether one becomes a fiduciary or assumes a similar role under common law and applicable regulatory regimes, (2) how to comply with such fiduciary or similar duties under each set of laws and identify daylight between them, and (3) ways to leverage existing compliance procedures under one regime to comply with other applicable regimes. Whether it’s the Department of Labor (DOL) Fiduciary Rule, a new Securities and Exchange Commission (SEC) fiduciary standard, or emerging state investment advice laws implicating broker-dealers and SEC-registered investment advisers, the Fiduciary Governance Group helps guide financial institutions on ways to address compliance risk in a holistic fashion and, where possible, create harmonized procedures that satisfy multiple applicable fiduciary rules and standards. Commentary from the group on fiduciary topics will be available through client alerts and on its blog at fiduciarygovernanceblog.com.

Here Today, Gone Tomorrow?

In one fell swoop, the 5th Circuit Court of Appeals dropped the hammer on the DOL Fiduciary Rule, tossing out the expanded scope of fiduciary “investment advice” and the related exemptions, including the Best Interest Contract Exemption. Barring a petition for rehearing or appeal, the court’s ruling will go into effect in early May, at which point the 1975 DOL regulation defining investment advice via a five-part test would re-emerge.

Nevertheless, until there is certainty that there will be no rehearing or appeal, we caution against any major changes to compliance, even though the DOL has told the press that it will not enforce the rule until further notice. But now might be a good time to consider a post-DOL Fiduciary Rule world by:

  • Inventorying the type and nature of typical communications with retirement investors (e.g., other fiduciaries, plan participants, IRAs, etc.) and tagging those that might satisfy all five prongs of the 1975 regulation: (1) providing advice as to the value of securities or other property, or making recommendations as to the advisability of investing in, purchasing, or selling securities or other property; (2) on a regular basis; (3) pursuant to a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary; that (4) the advice serves as a primary basis for investment decisions with respect to plan assets; and that (5) the advice is individualized based on the particular needs of the plan or IRA.
  • Identifying any representations, disclosures or statements regarding fiduciary status that were made in light of the Fiduciary Rule’s scope, which may at some point need correction.
    Re-examining what changes were made to internal policies and procedures to account for the DOL Fiduciary Rule, and considering whether to retain such changes even if no longer legally required, particularly in light of the fact that federal and state regulators could seek enforcement against institutions for failing to follow these policies and procedures.
  • Reconsidering any revisions to contracts in order to satisfy the DOL’s guidance on 408(b)(2) disclosures that it issued last August. Recall that the DOL said: “In the case of a service provider who is providing or reasonably expects to provide fiduciary investment advice services within the meaning of the currently applicable Fiduciary Rule and whose contract with or disclosures to an ERISA pension plan client include a statement that the service provider is not a fiduciary or is not providing fiduciary services, the Department would not treat the service provider as having furnished the plan with an accurate and complete description of the services that will be performed under the contract or arrangement until a revised contract or disclosure is provided that removes or corrects that affirmatively incorrect statement.” Because these same services may no longer be fiduciary in nature post-Fiduciary Rule, and recognizing the uncertainty service providers face at this time, rethinking these changes may make sense.
  • Re-evaluating whether to continue excluding small plans and IRAs from investing in private funds, if that determination had been made to prevent a fund manager from inadvertently becoming an investment advice fiduciary to an IRA investor or small plan during the sales and subscription process.
    We do not think it is a foregone conclusion that the 1975 five-part test of what it means to be an investment advice fiduciary under ERISA will be reinstated and that the DOL Fiduciary Rule has begun its ride into the sunset. We do believe, however, it is reasonable to begin considering tasks that will be necessary to transition to a post-DOL Fiduciary Rule world.

SEC’s New Best Interest Standard … Coming (Very) Soon?

Regardless of whether the DOL seeks to preserve its Fiduciary Rule, Jay Clayton, the Chair of the SEC, has made clear that he expects the SEC to propose its own uniform standard of conduct for investment advisers and broker-dealers who provide personalized investment advice about securities. The 2010 Dodd-Frank Act authorized the SEC to adopt a uniform standard for broker-dealers and investment advisers to act in the best interest of the customer without regard to the financial or other interest of the entity providing the advice. We understand that the SEC is working on a rule proposal. Following the 5th Circuit decision on the DOL rule, Clayton reiterated that he hopes to get a proposal out as soon as possible, which we understand could be in a matter of weeks.

One likely aspect of the SEC proposal will be a requirement to deliver a summary disclosure document that will describe services, fees, conflicts, product offerings and other pertinent information. Such a document has been in the wings since the SEC staff’s 2012 study on financial literacy among investors, which found that investors prefer, wherever possible, the use of a summary document containing key information about an investment product or service. The proposal may not expressly use the term “fiduciary,” but will most likely impose a uniform duty to act in the “best interests” of clients and prohibit, or at least limit, the use by broker-dealers of certain titles, such as “financial adviser,” in marketing and sales materials.

As a general principle, we expect the SEC to use as its base the federal fiduciary standard applicable to investment advisers, as laid out in Capital Gains Research, where the U.S. Supreme Court noted:

[t]he Investment Advisers Act of 1940 reflects a congressional recognition of the delicate fiduciary nature of an investment advisory relationship as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.

As such, the federal fiduciary duty that flows from being registered under the Advisers Act provides that advisers have “an affirmative obligation of utmost good faith and full and fair disclosure of all facts material to the client’s engagement of the adviser to its clients, as well as a duty to avoid misleading them.”

State Action: Already Several Shots Across the Bow

We have been closely tracking the state developments on retail investment advice. Much has been reported on Nevada’s newly revised financial planner law, which went into effect last summer. Our conference call last fall came on the heels of our attendance at the Nevada Security Division’s Workshop on the new law and prospective regulations. As things stand, federally regulated investment advisers, broker-dealers and sales representatives that render financial planning services are now newly-minted “financial planners” under Nevada law, and as a result are subject to:

  • The “duty of a fiduciary toward a client” and;
  • A time-of-sale disclosure of “any gain the financial planner may receive, such as profit or commission, if the advice is followed” and;
  • A duty to undertake a “diligent inquiry of each client to ascertain initially, and keep currently informed concerning, the client’s financial circumstances and obligations and the client’s present and anticipated obligations to and goals for his or her family.”

Importantly, Nevada’s financial planner law provides for a private right of action for breaches of “any element” of this fiduciary duty, or when the financial planner is “grossly negligent in selecting the course of action advised, in the light of all the client’s circumstances known to the financial planner.” There could also be civil litigation for violations of “any law of this State in recommending the investment or service.”

The Nevada Securities Division has enforcement authority, as well as the authority to “[d]efine or exclude an act, practice or course of business of a broker-dealer, sales representative, investment adviser or representative of an investment adviser as a violation of the fiduciary duty toward a client,” via regulations, which are expected to be proposed over the next couple of months. When proposed, the regulations will have to account for, and address, serious concerns that enforcement of this newly amended law may be preempted by The National Securities Markets Improvement Act of 1996 (NSMIA) and other federal law. Nevada Democratic Senate Majority Leader Aaron Ford, the sponsor of the legislation (who subsequently announced his intention to run for state attorney general), said in an interview that he is “confident” the law will “comport with what the federal government may do,” specifically referencing the DOL Fiduciary Rule. It remains to be seen whether the preemption concerns involving NSMIA are being carefully considered.

The forthcoming regulations from the Nevada Securities Division are subject to final approval by the “Legislative Counsel Bureau” (also referred to as the “Legislative Commission”), on which Ford and other legislators sit. In an interview, Ford intimated that he and others would not hesitate to send the Securities Division back to the drawing board if the regulation does not reflect (enough) of their legislative intent. He also vowed, “We’ll be back again in 2019” should the law be struck down by a court on preemption grounds.

With less fanfare, Connecticut passed a law last summer affecting financial planners, though, unlike Nevada, it did not expressly shoehorn broker-dealers and investment advisers into its scope. Rather, Connecticut defines financial planner as “a person offering individualized financial planning or investment advice to a consumer for compensation where such activity is not otherwise regulated by state or federal law.” A reasonable (though not certain) reading of that definition is that federally regulated broker-dealers and advisers are not included at this. The law establishes a number of new requirements for financial planners, including a duty to disclose “whether they have a fiduciary duty with regard to each recommendation they make” upon request.

New York and New Jersey have introduced very similar bills that take a different approach than Nevada. New York’s Investment Transparency Act, for example, applies to “investment advisors currently not subject to a fiduciary standard under existing state and federal laws or regulations or by any applicable standards of professional conduct,” or, as the bill calls them, “non-fiduciary investment advisors.” Specifically, “non-fiduciary investment advisors” includes those who identify themselves as “brokers,” “dealers,” “investment advisors,” “financial advisors,” “financial planners,” “financial consultants,” “retirement planners,” “retirement brokers,” “retirement consultants,” or any other term that is suggestive of investment, financial planning or retirement planning knowledge or expertise. These entities will need to make a “plain language disclosure orally and in writing” at the start of the relationship that reads: “I am not a fiduciary. Therefore, I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks, and expected returns for you.” Both the New York and New Jersey bills require that “non-fiduciary investment advisors” maintain as a record the written acknowledgment signed by the client that the disclosure was in fact made. As of the date of this alert, the New York bill sits with the Committee of Codes and the New Jersey bill is pending technical review by the Legislative Counsel, after being re-introduced at the start of 2018.

Meanwhile, Maryland and Illinois are a tale of two different legislative approaches. The Maryland legislature attempted to take a Nevada-like approach, before reportedly sidelining its legislative efforts until the SEC unveils its best interest proposal. As introduced, the Maryland bills specifically imposed a fiduciary standard on broker-dealers and required a diligent inquiry of each client to determine the financial circumstances and obligations of the client, including an inquiry into the client’s present and anticipated obligations to his or her family and “for the client’s family and goals for the client’s family.” Illinois, in contrast, seems to be following more in the footsteps of New York and New Jersey: in early February, the Investment Advisor‎ Disclosure Act was introduced in the General Assembly, and while we are not aware of any text that has been proposed yet, its name suggests mandated disclosures on lack of fiduciary status could be in order.

Whether more states will act in response to the 5th Circuit’s decision on the DOL Fiduciary Rule is anyone’s guess. We know that a number of state legislatures have pointed to skepticism over rulemaking by the DOL and SEC as a basis for their own legislative and regulatory efforts. With the DOL’s own rule seemingly on life support, and the SEC’s yet to be unveiled, it is impossible to forecast if other states, which are currently on the sidelines, will move forward with their own legislative or regulatory initiatives. We are continuing to monitor this evolving situation.

It is also unclear how state enforcement agencies will respond to the 5th Circuit decision. Just in February, prior to the court decision, the Massachusetts Securities Division filed an administrative complaint against Scottrade alleging that Scottrade violated the DOL Fiduciary Rule’s “impartial conduct standards,” and, therefore, violated state law. Massachusetts was effectively seeking to enforce the DOL rule. Consider whether state securities regulators may attempt again to bring a state enforcement action that is predicated on imputing the DOL Fiduciary Rule’s “impartial conduct standards” into its own blue sky laws, even if those same standards are extinguished because the DOL Fiduciary Rule is (ultimately) abandoned. Moreover, if the SEC incorporates some aspect of the impartial conduct standards into its new proposal, would that encourage or discourage more of these state enforcement actions? In light of the Massachusetts complaint lodged against Scottrade, it is especially important for each firm to review its written policies and procedures – especially those amended to address the DOL Fiduciary Rule – to ensure that their terms are always followed, and if they are no longer legally compelled, to consider removing them from the policies and procedures, as flagged above.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.

New York Proposes Best Interest Requirements on Insurance Product Recommendations

Just over a month ago, the U.S. Department of Labor (DOL) partly explained an 18-month extension of its fiduciary rule by saying the additional time was necessary to allow for ample opportunity for input from, and, ideally, coordination with, the U.S. Securities and Exchange Commission (SEC) and state regulators. Just a few days ago, however, the state of New York announced proposed changes to its rules governing the sales of insurance and annuity transactions involving both retirement and nonretirement accounts. If implemented, these changes could have a significant effect on New York insurance agents and brokers. Though the revised rule was styled as merely “clarifying” the duties and obligations of producers when making recommendations to consumers, New York Governor Andrew Cuomo tied this proposal to the delay of the DOL fiduciary rule when he said, “As Washington continues to ignore and roll back efforts to protect Americans, New York will continue to use its role as a strong regulator of the financial services and insurance industries to fight for consumers and help ensure a level playing field.”

Here are our observations:

  • The proposed changes to New York’s annuity suitability rule would require that any “recommendation” to a consumer by an insurance agent or broker regarding a proposed or in-force “policy” be “based on an evaluation of the suitability information of the consumer that reflects the care, skill, prudence, and diligence that a prudent person familiar with such matters would use under the circumstances without regard to the financial or other interests of the producer, insurer or any other party.” The insurer would need to make this best interest determination if “no producer is involved.” This best interest requirement is in addition to the existing determination of suitability under New York law.
  • As is always the case, the devil is in the details. The proposed regulation, like the DOL fiduciary rule, broadens the types of communications that give rise to a “recommendation”: namely, “one or more statements or acts” by a broker or agent that either “reasonably may be interpreted by a consumer to be advice,” which results in “a consumer entering into or refraining from entering into a transaction” in accordance with the recommendation, or where the communication “is intended by the producer, or an insurer where no producer is involved, to result in a consumer entering into or refraining from entering into a transaction.” A “policy” means a “life insurance policy, annuity contract, or a certificate issued by a fraternal benefit society or under a group life insurance policy or group annuity contract.” As with the existing rule, policies used to fund ERISA or other plans, such as governmental plans, are exempted.
  • There are a number of other proposed changes, including a need to disclose, at the time of the recommendation, “all relevant suitability considerations and product information, whether favorable or unfavorable, that provide the basis for any recommendations,” as well as a prohibition against any recommendation stating or implying “that a recommendation to enter into a transaction is a part of financial planning, financial advice, investment management or related services unless the producer has a specific certification of professional designation in that area.” There would also be a new requirement to establish and maintain procedures “designed to prevent financial exploitation and abuse” and additional disclosures.
  • The proposed amendments to the New York annuity regulation differ from what is currently being contemplated by the National Association of Insurance Commissions (NAIC), which is in the process of adopting its own updated model suitability rule (on which the New York regulation was based). This means that, barring changes by either NAIC or New York, there may be material differences among the states regarding when a duty of best interest is required for the sale of insurance products, and what specific obligations flow from the best interest duty.
  • The New York regulation, as proposed and already in effect, along with similar regulations of other states, is generally considered coterminous with the DOL fiduciary rule, meaning that advisers are subject to both. The DOL recognized as much when it stated in the preamble to the final version of its fiduciary rule: “The Department’s obligation and overriding objective in developing regulations implementing ERISA (and the relevant prohibited transaction provisions in the Code) is to achieve the consumer protection objectives of ERISA and the Code. The Department believes the final rule reflects that obligation and objective while also reflecting that care was taken to craft the rule so that it does not require people subject to state banking, insurance or securities regulation to take steps that would conflict with applicable state statutory or regulatory requirements. The Department notes that ERISA section 514 expressly saves state regulation of insurance, banking, or securities from ERISA’s express preemption provision.”
  • New York’s best interest proposal comes on the heels of the passage of Nevada’s revisions to its financial planner law, which now imposes fiduciary duties on, and creates a cause of action against, advisers and broker-dealers. The Nevada securities regulator is still due to issue regulations sometime this year on the specific requirements of the amended financial planner law. Other states, meanwhile, have either introduced their own laws that would tighten the screws around investment advice or are contemplating doing so. The states seem committed to updating their standards as if anticipating a significant rollback of the DOL fiduciary rule. Leadership at both the DOL and the SEC appear to recognize the importance of working with the states to avoid an unwieldy maze of regulations governing the same conduct. Only time will tell whether New York’s and Nevada’s actions will expedite the DOL’s or SEC’s timetables.
  • The proposed amendments to the New York regulation are subject to a comment period that closes on Feb. 26, 2018.

George Michael Gerstein advises financial institutions on the fiduciary and prohibited transaction provisions of ERISA. As co-chair of the fiduciary governance group, he assists clients with tracking, and understanding, the numerous fiduciary developments at the federal and state levels, including the rules and regulations of governmental plans. He also advises clients with respect to the fiduciary duty implications of ESG investing.