Expert attorneys warn the new 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 impartial conduct standards.
I am here on Amelia Island, FL about to start our panel on fiduciary law developments: the SEC release (and what it means practically-speaking, the delta between adviser and broker-dealer duties, the issues around the new disclosures, etc.), the latest on the DOL Fiduciary Rule (FAB 2018-02, the Fifth Circuit decision, how firms should proceed with compliance), what is in store from state legislatures and regulators, and the recent DOL ESG guidance and how managers should view the guidance. There are over 200 attendees here and, based on questions I received last night, there is a real need for clarity on fiduciary governance at the federal and state levels!
We just wrapped up our panel discussion on ESG considerations for ERISA fiduciaries. Jason Blackwell of Mercer (left) and Ali Caffery of Envestnet (center) joined me to discuss how advisers can account for ESG factors through the prism of a fiduciary. We started with the confusion over what is meant by ‘ESG,’ why the DOL worries about fiduciaries pursuing objectives unrelated to financial performance, how the brand new DOL guidance preserves the concept of an ESG factor creating alpha opportunities (and why that direct link to investment performance matters from a legal perspective), the different tools and indices that are out there, how ESG can be incorporated into an IPS, how managers can demonstrate their ESG stripes, DOL’s concerns about ESG-themed QDIAs, and shareholder engagement. Blaine Aikin, Executive Chairman of Fi360, is also pictured (far right) and deserves a ton of credit for allowing us to do this panel at such an important event!
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.
©2018 ACA Insight and ACA Compliance Group. All rights reserved. Reproduced with written permission of the publisher.
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.
I penned an op-ed in Pensions & Investments on why fiduciaries should consider their best execution obligations in connection with rebates paid to broker-dealers by trading venues. (subscription required)