DOL Fiduciary Rule P II: The SEC Story

While the previous post discussed the Department of Labor’s (DOL) fiduciary rule, it is not the only government agency tackling the issue. In 2010, President Obama signed into law the Dodd-Frank Act, which authorized the Securities and Exchange Commission (SEC) to create its own uniform standard of care for financial advisors. To aid in this endeavor, it also authorized the creation of an Investor Advisory Committee (IAC) whose purpose was to submit recommendations to the SEC regarding, amongst other things, the regulation of securities products and the protection of investor interests.[i] In November 2013, the IAC issued a report endorsing, “that advisory services offered as a part of a transaction-based securities business can and should be conducted in a way that is consistent with a fiduciary standard of conduct.”[ii]

SEC Chairwoman Mary Jo White supports tighter regulations for those making funding recommendation to investors. At an industry conference, Ms. White stated that it was her “’personal view’” that brokers and those for whom the Commission provides oversight should be required to put “clients’ interests ahead of personal gain.”[iii]  Arthur Levitt, SEC chairman from 1993 to 2001, believes the SEC should have addressed the issue long before now, given the complexity of the products being presented to investors by brokers. “’I do not accept the notion that a broker is an order taker. If he’s a good broker, he’s much more than that.”[iv] Industry leaders, including Kenneth Bentsen, president and chief executive of the Securities Industry and Financial Markets Association, have expressed support in the SEC taking the lead in this matter. “’They’ve got the technical expertise.’”[v]

In testimony before the House Subcommittee on Financial Services and General Government Committee on Appropriations, Chairwoman White would not offer a timeframe for the completion, but made it clear that the SEC would be issuing its own fiduciary standards. Though the purposed rules may be similar, she stated that the SEC’s would differ from that of the DOL’s, even though the SEC did provide “’substantial technical assistance’” in crafting the DOL version.[vi]

Mark Trupo, DOL spokesman, claims there was close coordination between the two departments and that, “engagement with the SEC was comprehensive, and that the SEC’s input was incorporated into the plan.”[vii] The SEC refused to comment. Others, however, were more vocal in their questioning in the validity of the statement.

In his report, The Labor Department’s Fiduciary Rule: How a Flawed Process Could Hurt Retirement Savers, Sen. Ron Johnson, chairman of the Senate Homeland Security and Governmental Affairs Committee, claimed the DOL rule failed to address 26 significant concerns posited by the SEC. These included issues regarding the best interest contract exemption, “’conflicts with federal securities laws and [Financial Industry Regulatory Authority] rules, and a lack of cost-benefit analysis of alternatives.’”[viii]

So why hasn’t the SEC issued its own rule yet? It may have to do with administrative structure. While the DOL operates under a single administrator, the SEC has a five-person commission, complicating the approval process. Some believe the make-up of this commission would lead to a 3-2 vote on any fiduciary rule, given the current SEC commissioner and incoming commissioner, both republicans, are likely to vote against such a measure.[ix]

Only time will tell when the SEC releases its own fiduciary rule and how greatly it will differ from that of the DOL. Until then, one can only expect continued speculation and debate, a debate that many believe is long overdue.

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[i] U.S. Securities and Exchange Commission (2012). “Investment Advisory Committee” [Electronic format]. Retrieved from: http://www.sec.gov/spotlight/investor-advisory-committee-2012.shtml

[ii] U.S. Securities and Exchange Commission (2013).  “Recommendation of the Investor Advisory Committee Broker-Dealer Fiduciary Duty” [Electronic format]. Retrieved from: http://www.sec.gov/spotlight/investor-advisory-committee-2012/fiduciary-duty-recommendation-2013.pdf

[iii] Baer, J. & Ackerman A. (2015, March 17) SEC Head Backs Fiduciary Standards for Brokers, Advisors [Electronic format]. Retrieved from: http://www.wsj.com/articles/sec-head-seeks-uniformity-in-fiduciary-duties-among-brokers-advisers-1426607955?mg=id-wsj

[iv] Ibid.

[v] Ibid

[vi] SEC, DOL Fiduciary Rules Will Likely Be Different, White Says (2016, March 22). [Electronic format] Retrieved from: http://www.thinkadvisor.com/2016/03/22/sec-dol-fiduciary-rules-will-likely-be-different-w

[vii] Barlyn, S & Lynch, S (2016, February 24) U.S. Labor Dept., SEC Clash Over Retirement Advice Rule: Report [Electronic format]. Retrieved from: http://www.reuters.com/article/us-usa-brokers-fiduciary-idUSKCN0VX0XZ

[viii] Senator Blasts DOL for Ignoring SEC’s Fiduciary Rule Concerns (2016, February 24). [Electronic format]. Retrieved from: http://www.thinkadvisor.com/2016/02/24/senator-blasts-dol-for-ignoring-secs-fiduciary-rul

[ix] Why SEC Fiduciary Rule May Be ‘Unattainable’ (2016, March 10). [Electronic format]. Retrieved from: http://www.thinkadvisor.com/2016/03/10/why-sec-fiduciary-rule-may-be-unattainable?ref=related-embedded

DOL Fiduciary Rule: Part I

After much nail-biting by many in the industry, the Department of Labor (DOL) recently released its anticipated and long-awaited final fiduciary rule, which it touts as the fulfillment of its mission to protect the retirement of investors through education and empowerment.[i] In this first installment of a multi-part series, we take a quick look at the rule responsible for making waves in the American financial sector.

The rule is the culmination of a multi-year project to modernize the Employee Retirement Income Security Act (ERISA) of 1974, in response to the growth of unregulated market products. The consequence of this growth has been an array of investment professionals who could advise in the direction of their own personal gain over the best interests of their clients, so long as the recommendation was “suitable;” unacceptable behavior for fiduciaries.[ii]

The DOL rule expands the scope of those who qualify as “fiduciaries,” such as those related to individual retirement accounts or IRAs. “Any advisor who makes investment recommendations …in exchange for compensation will be considered a fiduciary (and)…are legally required to recommend investments that are in their client’s best interest, not their own.”[iii]  According to the White House, the conflicts of interest that exist when the client’s needs do not take precedent cost American families an estimated $17 billion a year.[iv]In the same manner, another goal of the rule was to curb billions of dollars currently being lost by investors in fees paid when transferring money out of 401ks and into IRAs.[v]

Some don’t consider this the fail-safe that the government is touting it to be. Situations in which conflicts are present, such as with mutual fund families and broker-dealers, will still continue to operate, only with the additional “Best Interest Contract Exemption” (BICE) disclosure.[vi]  As one author surmised, “Just picture the speed with which you click ‘Agree’ everytime (sic) iTunes does a software update, and you can imagine how little of an impediment this sort of thing represents.”[vii] 

The former head of the DOL’s Employee Benefits Security Administration, Brad Campbell, considers BICE to represent the most significant issue in the rule. “’There are frivolous litigation risks and liability risks in the BICE that still remain, and that are going to increase costs for small businesses where advisors are willing to use the BICE exemption at all.’”[viii]  There are others who have expressed concerns regarding the DOL rule, including the Securities and Exchange Commission, the insurance and securities industries, as well as politicians, which shall be discussed in future postings.

Still, many in the government feel the rule is a victory. Department of Labor Secretary Tom Perez expressed that putting the client first is, “now the law,”[ix] while Senator Elizabeth Warren (D., Mass) proclaimed the rule a day in which the government was working, “for the people.” [x]  This is assuming, of course, the next administration doesn’t kill it altogether before the final 2018 implementation deadline.

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[i] United States Department of Labor. (2016, April 13) Department of Labor Finalizes Rule to Address Conflicts of Interest in Retirement Advice, Saving Middle-Class Families Billions of Dollars Every Year [Electronic format]. Retrieved from http://www.dol.gov/ebsa/newsroom/fs-conflict-of-interest.html

[ii] Ibid.

[iii] Brandon, E. (2016, April 8) The New Retirement Account Fiduciary Standard [Electronic format]. Retrieved from http://money.usnews.com/money/blogs/planning-to-retire/articles/2016-04-08/the-new-retirement-account-fiduciary-standard

[iv] The White House. (2016, April 13) Fact Sheet: Middle Class Economics: Strengthening Retirement Security by Cracking Down on Conflicts of Interest in Retirement Savings [Electronic format]. Retrieved from http://www.whitehouse.gov/the-press-office/2016/04/06/fact-sheet-middle-class-economics-strengthening-retirement-security

[v] Hayashi Y. & Prior A. (2016, April 6) U.S. Unveils Retirement-Savings Revamp, but With a Few Concessions to Industry [Electronic format]. Retrieved from http://www.wsj.com/articles/u-s-unveils-retirement-savings-revamp-but-with-a-few-concessions-to-industry-1459936802

[vi] Brown, J. (2016, April 6) Wall Street Dodged a Bullet on the Retirement Fiduciary Rule [Electronic format]. Retrieved from http://www.fortune.com/2016/04/06/retirement-savings-fiduciary-rule/

[vii] (Brown, J., 2016, April 6)

[viii] Campbell, B. (2016, April 11) DOL Fiduciary Rule: The Good, the Bad and the Ugly [Electronic format]. Retrieved from http://www.thinkadvisor.com/2016/04/11/dol-fiduciary-rule-the-good-the-bad-and-the-ugle

[ix] (Ebeling, A., 2016, April 7)

[x] (Hayashi Y. & Prior A., 2016, April 6)

Investment Adviser Fiduciary Duty Standard Includes a Duty to Explain Investment Activity

The Securities and Exchange Commission regulates larger investment advisers under the Investment Advisers Act of 1940 (the “Act”). In a previous posting, we noted that perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients and which has been interpreted by the Supreme Court as imposing on advisers a fiduciary duty to their clients. See Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17 (1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to act in the clients’ best interests, to fully disclose any material conflicts the adviser has with its clients, to seek best execution for client transactions, to provide only suitable investment advice, and to have a reasonable basis for client recommendations. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333; Status of Investment Advisory Programs under the Investment Company Act of 1940, SEC Release No. IA-1623.

From these fiduciary obligations arises the duty to properly explain investments or an investment strategy to clients. Where a financial adviser provides advice about investments, “a fiduciary duty is breached when the client is encouraged to purchase an investment with a level of risk that is not appropriate for the client, or is not properly informed of the speculative nature of an investment.” Sakai v. Merrill Lynch Life Ins. Co., C-06-2581 MMC, 2008 WL 4193058 (N.D. Cal. Sept. 10, 2008) (citing Vucinich v. Paine, Webber, Jackson & Curtis, Inc., 803 F.2d 454, 460-61 (9th Cir.1986) (holding that broker had fiduciary duty to fully inform client of nature and risks of selling short, “in terms capable of being understood by someone of [client’s] education and experience.”)).

 “A fiduciary must provide a proper disclosure and explanation of the investment activity, and should warn a client to exercise caution if an investment presents a greater risk than tolerable, given the client’s goals and circumstances.” Id.; see also Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042, 1049-50 (11th Cir. 1987) (finding that where adviser assisted clients in establishing speculative option trading account, “[a] more studied opinion of the risks of option trading in light of the [clients’] then-existing investment objective was owed by [the adviser] to [his clients]. This he failed to do, in breach of his fiduciary duty.”); In re Old Naples Sec., Inc., 343 B.R. 310, 324 (Bankr. M.D. Fla. 2006) (stating that “failing to disclose and fully explain the risk of an investment to an investor can be a breach of the broker’s fiduciary duty.”); Rupert v. Clayton Brokerage Co. of St. Louis, Inc., 737 P.2d 1106, 1109 (Colo. 1987) (“A broker who becomes a fiduciary of his client must act with utmost good faith, reasonable care, and loyalty concerning the customer’s account, and owes a duty . . . to keep the customer informed as to each completed transaction, and to explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged.”).

A good example of the application of the fiduciary duty to explain comes from Faron v. Waddell & Reed, Inc., 930 S.W.2d 508 (Mo. App. E.D. 1996).  Although this case involves a broker-dealer as opposed to an investment adviser, Missouri imposes an unambiguous fiduciary standard on broker-dealers.  In Faron, the client approached a registered representative of the broker-dealer inquiring whether he could obtain money from a trust to purchase a new home. He asked whether it would “cost any money.” Id. at 510. After he consulted with the registered representative he felt assured he could get the money and the transaction would result in no cost to him. He did not specifically consider tax ramifications nor did he directly ask about tax consequences. He assumed Waddell & Reed was lending the money to him to use, at no cost. However, instead of a loan the transaction actually consisted of a redemption of mutual funds. Id. He obtained the $250,000 from Waddell & Reed, returning the same amount within the required 21 days. The client’s accountant discovered the tax liability in the amount of approximately $32,000 while preparing an income tax return. The accountant brought it to the attention of the client, who brought suit against Waddell & Reed.

The trial court granted summary judgment for Waddell & Reed, finding that Waddell & Reed had no duty to provide tax information because none was requested.  On appeal, the court noted:

In Missouri, stockbrokers owe customers a fiduciary duty. This fiduciary duty includes at least these obligations: to manage the account as dictated by the customer's needs and objectives, to inform of risks in particular investments, to refrain from self-dealing, to follow order instructions, to disclose any self-interest, to stay abreast of market changes, and to explain strategies. Implicit in these obligations is a duty to disclose to the customer material facts.

 Id. at 511 (emphasis added).

The court of appeals found that Waddell & Reed was privy to information and had expertise not yet proven on summary judgment to be equally or reasonably available to the client. In particular, the registered representative was aware of details of the transaction which consisted of a redemption of mutual funds, while the clients understood the transaction to amount to a short-term loan. Id. Waddell & Reed had a duty to manage the account according to the client’s expressed needs and objectives, to bridge finance by use of trust assets with “no loss whatsoever,” if possible, or to inform the client of the costs. Id. The client communicated his concerns about possible costs associated with the proposed transaction to the registered representative. The client was not told how the transaction would occur but was told it would not cost any money. The court of appeals concluded that what was meant by “costs” in the discussions between the parties remained uncertain. This implicated an unresolved question of fact, making summary judgment for Waddell & Reed inappropriate. Id.

In sum, the fiduciary duty standard requires that the client be properly informed of the nature of an investment or investment strategy. What is necessary in order to meet this standard will depend on the facts and circumstances of each case. A more in depth explanation of the risks of an investment or investment strategy will be necessary where the client’s related education and experience is minimal. Similarly, a more detailed explanation of strategy will become necessary where the strategy being implemented is more speculative in nature. Whether the fiduciary duty to explain has been met will usually be a question of fact to be decided by the judge, jury, or arbitrator after hearing all of the evidence.

Investment Adviser Fiduciary Duty Standard Requires Reasonable Basis for Client Recommendation

The Securities and Exchange Commission regulates investment advisers under the Investment Advisers Act of 1940 (the “Act”). Perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients. The Supreme Court has interpreted this provision as imposing on advisers a fiduciary obligation to their clients. See Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17 (1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”).

The federal fiduciary standard requires that an investment adviser act in the “best interest” of its advisory client. Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 503 (3d Cir. 2013) (citing SEC v. Tambone, 550 F.3d 106, 146 (1st Cir.2008) (“[15 U.S.C. § 80b–6] imposes a fiduciary duty on investment advisers to act at all times in the best interest of the fund and its investors.”). Under a “best interest” test, an adviser may benefit from a transaction with or by a client, but the details of the transaction must be fully disclosed. See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 191-92 (1963) (stating that Advisers Act was meant to “eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser–consciously or unconsciously–to render advice which was not disinterested”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to fully disclose any material conflicts the adviser has with its clients, to seek best execution for client transactions, to provide only suitable investment advice, and to have a reasonable basis for client recommendations. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333; Status of Investment Advisory Programs under the Investment Company Act of 1940, SEC Release No. IA-1623.

As noted by the Third Circuit in Belmont, even when a private litigant brings a cause of action for common law breach of fiduciary duty “the evolution of duties governing investment advisers as fiduciaries appears to have been shaped exclusively by the Advisers Act and federal common law.” 708 F.3d at 500-01. The Belmont court noted that one might reasonably wonder why the cause of action is presented as springing from state law if one looks to federal law for the statement of the duty and the standard to which investment advisers are to be held. 708 F.3d at 502. However, the court found that the answer was straightforward: no federal cause of action is permitted. Id. The court found that while “[t]hat reality ought to call into serious question whether a limitation in federal law can be circumvented simply by hanging the label ‘state law’ on an otherwise forbidden federal claim, that is the labeling game that has been played in this corner of the securities field, and the confusion it engenders may explain why there has been little development in either state or federal law on the applicable standards.” Id.

Based on the foregoing, a common law breach of fiduciary duty claim can in all likelihood be based on an investment adviser’s failure to have a “reasonable basis” for making a client recommendation. The question then becomes what constitutes a “reasonable basis” in the context of making such recommendations? This is not an issue that has been faced by many courts in the context of private causes of action brought by clients against investment advisers. For example, no Missouri case has addressed the issue.

However, in other situations where a reasonableness standard is employed, Missouri courts utilize an objective standard. See Graham v. McGrath, 243 S.W.3d 459, 463 (Mo. Ct. App. 2007) (noting that when damages are capable of ascertainment for purposes of statutes of limitations, Missouri utilizes an objective reasonable person standard); Robin Farms, Inc. v. Bartholome, 989 S.W.2d 238, 247 (Mo. Ct. App. 1999) (noting that the test for determining disqualification of a judge based on bias is whether a reasonable person would have factual grounds to doubt the impartiality of the court, “which is an objective standard[.].”).

As such, in Missouri and other jurisdictions that utilize the objective standard for reasonableness in other situations, the determination of whether an investment adviser had a “reasonable basis” for making a particular recommendation will likely be measured by an objective standard. This means that the fact finder will have to determine whether a reasonable person in the investment adviser’s circumstances might have made the same recommendation as the investment adviser, and need not consider what the adviser may have honestly -- but perhaps mistakenly -- believed.

SEC’s Investor Advisory Committee Recommends Extending Fiduciary Duty to Broker-Dealers

Section 911 of the Dodd-Frank Act established the Investor Advisory Committee to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace.  On November 22, 2013, the Committee issued a recommendation to extend the fiduciary duty to broker-dealers.

The Committee preliminarily stated its conclusion: that personalized investment advice to retail customers should be governed by a fiduciary duty, regardless of whether that advice is provided by an investment adviser or a broker-dealer.  In approaching this issue, the Committee noted that the SEC's goal should be to eliminate the regulatory gap that allows broker-dealers to offer investment advice without beings subject to the same fiduciary duty as other investment advisers.  However, the Committee noted that the SEC should not eliminate the ability of broker-dealers to offer transaction-specific advice compensated through transaction-based payments.

The Committee made two specific recommendations for action by the SEC.  First, the Committee recommended that the SEC should conduct a rulemaking to impose a fiduciary duty on broker-dealers when they provide personalized investment advice to retail investors.  Second, as a part of its rulemaking, the SEC should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers that covers basic information about the nature of services offered, fees and compensation, conflicts of interest, and disciplinary record.

In the stated "Supporting Rationale" for its recommendation that the SEC should engage in rulemaking to impose a fiduciary duty on broker-dealers when they provide personal investment advice, the Commission noted that in arriving at this decision they took into account a broad consensus among widely disparate groups that broker-dealers and investment advisers should be subject to a uniform fiduciary standard.  The Committee also noted that these various stakeholder groups generally agree that the fiduciary duty should not apply to all brokerage services, but only to those services that fall within a reasonable definition of personalized investment advice to retail customers.

The Committee also addressed some of the limited opposition that exists.  First, some argue that broker-dealers are already extensively regulated under existing law and self-regulatory organization rules.  The Committee believed, however, that while the existing regulatory scheme may adequately regulate broker-dealers when they act as salespeople, it does not offer adequate investor protection when they offer advisory services, since under the suitability standard they generally remain free to put their own interests ahead of those of their customers.  Second, some argue that regulation is not needed because investors are capable of choosing for themselves whether they prefer to work with a broker-dealer operating under a suitability standard or an investment adviser who is a fiduciary.  However, the Committee found that various studies had indicated that investors do not distinguish between broker-dealers and investment advisers, do not know that broker-dealers and investment advisers are subject to different legal standards, do not understand the difference between suitability standard and a fiduciary duty, and expect broker-dealers and investment advisers alike to act in their best interests when giving advice and making recommendations.

The Committee noted that the SEC has a range of options available to it in order to implement this regulatory goal.  These include the rulemaking authority under Section 913(g) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as existing authority under the Investment Advisers Act to regulate non-incidental advice by broker-dealers.

The Committee's second recommendation was that the Commission should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers.  The Committee believed that improved disclosure was necessary to help investors select a financial professional.  Relevant topics could include what services are provided, how the broker-dealer or investment adviser is compensated, and what conflicts of interest exist.

The Committee's recommendation is another step towards the establishment of a fiduciary duty standard for broker-dealers.  This position has already been applauded by the NASAA, which in a statement supporting the recommendation said that:  "A fiduciary standard for broker-dealers will guarantee that all financial professionals providing investment advice will act in the best interests of their clients, and in turn, enhance investor confidence in the financial services industry and securities markets."

Circuit Split. Which Standard of Review Applies to ERISA Top-Hat Plans?

The Employee Retirement Income Security Act (“ERISA”) regulates the operation of private sector employee benefit plans once a plan has been established by an employer. ERISA requires employers to implement certain safeguards for employee benefit plans by setting minimum standards for things such as for participation, vesting, benefit accrual, funding, and reporting.  In addition, ERISA establishes fiduciary responsibilities for plan administrators.  ERISA generally defines a fiduciary as anyone who exercises discretionary authority or control over a plan's management or assets, including anyone who provides investment advice to the plan.

Generally, when a plan participant has a claim for benefits, there are specific procedures that must be exhausted.  The claims and review process is usually spelled out in the Summary Plan Description.  If a claim for benefits is denied, ERISA requires that the reason for any denial of benefits is explained to the employee in writing and that employee must be given an opportunity for full and fair review of the decision through an internal appeals process. 

If benefits are again denied after the internal appeals process, the employee can then file a claim in court.  Generally, the reviewing court applies a de novo standard (allowing the court to substitute its own judgment) when reviewing a claim denial, unless the language of the plan gives the plan administrator discretion to interpret and apply the plan.  If a plan provides such discretion, the reviewing court applies an abuse of discretion standard and gives the benefit denial deferential treatment.  When announcing this standard of review, the Supreme Court in Firestone Tire and Rubber Co. v. Bruch reasoned that since the plan administrator is a fiduciary, his or her exercise of discretion should not be subject to control by the court. 

This standard of review poses significant problems for ERISA top-hat plans.  To be designated a top hat plan, ERISA requires that the plan be (1) unfunded and (2) maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.  Top hat plans are specifically exempt from ERISA’s provisions on participation, vesting, funding, and fiduciary responsibility but are subject to ERISA’s enforcement provisions.  Thus, top-hat plans are merely contractual agreements. 

Top-hat plans are unique in that plan participants must utilize ERISA’s enforcement provisions when challenging benefit denials, yet none of the substantive and fiduciary provisions apply to such plans.  Under ERISA (modeled after trust law) a plan administrator or fiduciary is required to make all decisions in the plan participant’s best interest.  However, since top-hat administrators are not fiduciaries, they are not required to make any decisions in the best interest of the top-hat plan participant.  Since an unfunded top-hat plan is essentially an unsecured promise to pay benefits at termination or later, an inherent conflict of interest is present when the role of the plan administrator and employer overlap.  Paying the benefits to the top-hat plan participants will always have a direct and immediate impact on the cost to the employer.

Furthermore, when a plan confers discretion upon the administrator in a top-hat plan, the trust principals relied on by the Supreme Court in Firestone are not present.  If following the holding in Firestone, the decision of a plan administrator with discretion to interpret and apply the plan, owing no fiduciary duties to the top-hat employees and where a conflict of interest is present, would still be subject to an abuse of discretion standard.  This hardly seems fair when top-hat employees are afforded no remedies under fiduciary duty claim and their plans are not required to be funded. This nearly renders the promises and obligations of the employer illusory.    

After the holding in Firestone, courts have grappled with whether or not to apply the abuse of discretion standard to top-hat plans because of their unique nature.  The Eight Circuit has concluded de novo review applies to top hat plans even when it give their administrators interpretive discretion because “a top hat administrator has no fiduciary responsibilities” under ERISA.  The Third Circuit has also declined to extend the holding in Firestone to top-hat plans because top-hat plans are unilateral contracts and the principals of federal common law should be applied. 

However, without a discussion distinguishing top-hat plans from ordinary ERISA plans, the Seventh and Second Circuits have held that the abuse of discretion standard articulated in Firestone applies to top-hat plans that provide the administrator with discretion.  The Ninth Circuit also held that abuse of discretion standard applies to top-hat plans with discretionary language reasoning that the application of a de novo standard does not materially change the outcome and applying a different standard to top-hat plans would create unnecessary confusion.  The Sixth Circuit sided with the Ninth Circuit’s reasoning that “the same conclusion would be reached under either standard,” although it was unclear whether it was applying that reasoning solely to the case at bar or more broadly.  The remaining Circuits have taken no position.    

Therefore, top-hat ERISA participants have a higher burden to overcome in “abuse of discretion” circuits than in “de novo” circuits.   

New Year, New Fiduciary Standard?

It has been about six months since the passing of the Dodd-Frank financial reform law—and that means the results from the many studies commissioned by the Act will begin to be released. Dodd-Frank specifically required the Securities and Exchange Commission to look into regulatory standards and oversight gaps between investment advisors and brokers. Last week, the SEC released the results of its study on Section 913 and 914 dealing with the fiduciary duty issue and stricter investment-adviser examinations, respectively.

The issue of whether to impose a uniform fiduciary standard has been met with both fierce support and opposition. Currently, advisers are held to a fiduciary standard that requires them to act in the best interest of their clients, while brokers are only required to offer suitable products to retail customers. The problem with the dual standard arises where brokers offer advice and sell investment products—blurring the lines for retail investors and making it hard to tell when they are receiving sound investment advice or just a sales pitch.

However, last Friday, the SEC handed over its staff study to Congress recommending a uniform fiduciary standard. The study, if implemented as is, would hold brokers to the same fiduciary level as investment advisers under the Advisers Act when brokers are providing personalized investment advice about securities to retail investors. Therefore, under this study, brokers would only be held to a higher fiduciary duty when acting like an investment advisor.

Justification for a uniform standard stems from the issue of retail investors being unable to distinguish between a broker and an investment advisor. According to the SEC, if consumers are receiving investment advice, regardless of the source—broker or advisor—retail consumers should be protected uniformly. Accordingly, such a standard would achieve that goal. The SEC study also states that it attempted to balance retail investors’ need for protection with their ability to have access to various investment products. Because the standard only applied to brokers when giving investment advice, the SEC takes the position that a wide array of products will continue to still be available.

Further, in an attempt to close oversight gaps and keep implementation costs “to a minimum,” the SEC study also “recommends that when broker-dealers and investment advisers are performing the same or substantially similar functions” the regulatory protections should be “harmonized”, but the study lacks specific details on how to achieve this “harmonization.”

Ultimately, however, the staff study suggests additional research and analysis into this area before any implementation. Additionally, there is no statutory deadline for any follow-up rulemaking pursuant to this study, so it seems unlikely that much will be done without further research and analysis. SEC Commissioners Kathleen Casey and Troy Paredes share this view in their Statement Regarding Study on Investment Advisers and Broker-Dealers and emphasized the need for further research before any uniform fiduciary standard rulemaking begins.

The Wrongful Distribution of Retirement Benefits to a Plan Fiduciary is Prohibited by ERISA Section 406(b)

Although the distribution of benefits to a plan participant is not a “transaction” as that term is used in Section 406(a), the wrongful distribution of benefits to a plan fiduciary is clearly prohibited conduct under Section 406(b). For example, in Lockheed Corp. v. Spink, 517 U.S. 882 (1996), the plaintiff brought suit against his employer (administrator of his 401(k) plan) under Section 406(a)(1)(D) because the employer wrongfully allowed some of its employees to receive early retirement benefits that the plaintiff was unable to receive. Id. at 892-93. The respondent argued that the payment of benefits is not a “transaction” under Section 406(a). Id. at 892. In its holding, the Court agreed with the respondent, but made clear that its holding was strictly limited to the language of Section 406(a). Indeed, the Court clarified that “the payment of benefits is in fact not a ‘transaction’ in the sense that Congress used that term in § 406(a).” Id. at 892 (emphasis added).

The narrow scope of Lockheed becomes clear upon a review of subsequent federal caselaw. See Armstrong, 2004 WL 1745774, at *10 (holding “payments to participants in accordance with plan terms not to be transactions within the meaning of [Section 406(a)]”); Owen v. SoundView Financial Group, Inc., 54 F.Supp.2d 305, 323 (S.D. N.Y. 1999) (holding that “ERISA's “Prohibited Transaction” rules, see 29 U.S.C. §§ 1106(a) [ERISA Section 406(a)]…are not applicable to the payment of Plan benefits to a Plan beneficiary, because the beneficiary is not a “party in interest”). The limited scope of Lockheed is confirmed by the equally limited scope of Section 406(a). For instance, Section 406(a), entitled, “Transactions between plan and party in interest,” is plainly intended to govern only those transactions in which fiduciaries cause a plan to engage. Indeed, Section 406(a)(1) begins with the following language: “A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect. . . .” (emphasis added). Section 406(a)(1) then lists five narrow types of transactions in which a fiduciary should not cause a plan to engage. Courts have determined that the purpose of Section 406(a) is limited to “prevent[ing] plan fiduciaries from engaging in certain transactions that benefit third parties at the expense of plan participants and beneficiaries.” Armstrong v. Amsted Industries, Inc., 2004 WL 1745774, at *10 (N.D. Ill. 2004); Marks v. Independence Blue Cross, 71 F.Supp.2d 432, 437 (E.D. Pa. 1999).

The limited holding of Lockheed (and the subsequent federal court decisions) does not, however, apply in many cases. Indeed, a plaintiff’s prohibited transactions claim against a defendant may be brought under a completely separate ERISA provision: Section 406(b). This Section, entitled “Transactions between plan and fiduciary,” may more clearly apply to a defendant’s conduct. Importantly, unlike Section 406(a), Section 406(b) does not specifically limit which types of transactions apply to the Section. As such, the “transactions” contemplated under Section 406(b) are much broader in scope than those specifically set forth in Section 406(a). Moreover, rather than aiming to prevent plan fiduciaries from engaging in transactions that benefit third parties at the expense of plan participants and beneficiaries, Section 406(b) aims to prevent—among other things—plan fiduciaries from engaging in prohibited transactions for their own account. A plan fiduciary wrongfully using his or her power to obtain a higher distribution than is warranted, for example, obviously falls under the broad conduct contemplated under Section 406(b).

Finally, Section 408(c)(1) reads as follows:

Nothing in [ERISA Section 406] shall be construed to prohibit any fiduciary from—

(1) receiving any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.

A plain reading of this Section establishes that Section 406 should be construed to prohibit a fiduciary from receiving a benefit that is computed and paid on a basis which is inconsistent with the terms of the plan as applied to all other participants and beneficiaries.

DEPARTMENT OF LABOR PROPOSES RULE TO EXPAND THE DEFINITION OF “FIDUCIARY” UNDER ERISA

On October 21, 2010, in an effort to further protect employee benefit plan participants and beneficiaries, the U.S. Department of Labor’s Employee Benefits Security Administration announced a proposed rule to expand the definition of “fiduciary” under ERISA. Specifically, the proposed rule would more broadly define the circumstances under which a person is considered to be a “fiduciary” by reason of giving investment advice to an employee benefit plan or a plan’s participants.

ERISA Section 504 imposes a number of duties on plan fiduciaries, including a duty of undivided loyalty, a duty to act for the exclusive purposes of providing plan benefits and defraying reasonable expenses of administering the plan, and a duty of care grounded in the prudent man standard. Despite the care taken to protect plan participants from poor fiduciary conduct, the definition of “fiduciary” has been left unchanged since ERISA’s enactment in 1975. And given the significant changes to employee benefit plans, the financial industry and the expectations of plan participants, the Department of Labor recognizes that the current definition of “fiduciary” may inappropriately limit the types of investment advisory relationships that give rise to fiduciary duties on the part of the investment advisor. Indeed, the Department of Labor noted in the new proposed rule that since 1975:

the retirement plan community has changed significantly, with a shift from defined benefit (DB) plans to defined contribution (DC) plans. The financial marketplace also has changed significantly, and the types and complexity of investment products and services available to plans have increased. With the resulting changes in plan investment practices, and relationships between advisers and their plan clients, the Department [of Labor] believes there is a need to re-examine the types of advisory relationships that should give rise to fiduciary duties on the part of those providing advisory services.

The proposed rule was published in the Federal Register on October 22, 2010, and written comments on the proposed regulations must be submitted to the Department of Labor on or before January 20, 2011.

A complete copy of the proposed rule can be found here.

Senate and House Strike Deal on Fiduciary Duty Issue

On June 24, 2010, lawmakers from the House and Senate working to merge two versions of the financial-regulation overhaul into a single bill agreed to let the SEC impose a fiduciary duty on brokers once the regulator completes a six-month review. House lawmakers had earlier proposed implementing stiffer rules without a study period, prompting opposition from senators led by Tim Johnson, a South Dakota Democrat.

Johnson proposed language that could have, among other things, maintained the study requirement. However, Johnson's proposal made it even more difficult for the SEC to act on its findings by allowing the SEC to set new rules regarding the fiduciary duty standard only if the agency concluded after its study that regulatory gaps between certain brokers and investment advisors could not be addressed through other approaches.

A fiduciary duty would obligate brokers to act in the best interest of their clients and to disclose all conflicts of interest. Brokers now only have to ensure a product is suitable before marketing it to a customer. As discussed in an earlier blog post, the expansion of the fiduciary duty has met resistance from the broker-dealer and insurance industries whose sales practices would be subject to the new fiduciary duty standard. Whereas consumer advocates have said the fiduciary obligation is needed because investors can be misled into buying products they don’t understand and are often confused by the titles used by financial advisers.

However, the debate is not over just yet, even if federal lawmakers pass the legislation. Once the job of conducting the study and making the rules goes to the SEC, the debate over the details of just how the new rules will apply will likely continue.

A copy of the Businessweek article discussing this development can be found here, and an article from Financial Advisor Magazine can be found here.

FEDERAL COURTS ADOPT A LIBERAL PLEADING STANDARD FOR ERISA PLAINTIFFS UNDER FEDERAL RULE OF CIVIL PROCEDURE 8

On November 25, 2009, the Eighth Circuit Court of Appeals issued an important decision in Braden v. Wal-Mart Stores, Inc. aimed at preserving employee benefit plan participants’ right to bring suit against ERISA plan fiduciaries despite participants’ limited access to inside information about their plan. In Braden, the plaintiffs brought suit alleging that Wal-Mart’s 401(k) plan paid excessive management fees and that the trustee of the plan breached certain fiduciary duties. Wal-Mart and the other defendants moved for dismissal under Rules 12(b)(1) and 12(b)(6) of the Federal Rules of Civil Procedure—lack of subject matter jurisdiction and failure to state a claim respectively. The District Court for the Western District of Missouri granted the defendants’ motion to dismiss, holding in part that the plaintiff’s complaint was inadequate under Rule 8 of the Federal Rules of Civil Procedure because it did not allege sufficient facts to show how the defendants’ decision-making process was flawed.

On appeal, the Eighth Circuit refused to honor the District Court’s strict interpretation of Rule 8, which requires that a complaint present "a short and plain statement of the claim showing that the pleader is entitled to relief." In order to meet the Rule 8 pleading standard and survive a motion to dismiss under Rule 12(b)(6), a complaint must contain sufficient factual matter, accepted as true, to state a claim to relief that is plausible on its face. A complaint states a plausible claim for relief if its factual content allows the court to draw a reasonable inference that the defendant is liable for the misconduct alleged in the complaint. In Braden, the Eighth Circuit determined that the District Court erred in two ways: (1) the court ignored reasonable inferences supported by the facts alleged, and (2) the court drew inferences in defendants’ favor. As the Eighth Circuit noted, “[e]ach of these errors violates the familiar axiom that on a motion to dismiss, inferences are to be drawn in favor of the non-moving party.”

In its decision, the Eighth Circuit acknowledged that in interpreting Rule 8’s pleading standard, courts must not “ignore the significant costs of discovery in complex litigation and the attendant waste and expense that can be inflicted upon innocent parties by meritless claims.” However, the court further emphasized that in applying Rule 8, courts must be “attendant to ERISA’s remedial purpose and evident intent to prevent through private civil litigation ‘misuse and mismanagement of plan assets.’" Moreover, the court recognized that ERISA plaintiffs often (and perhaps most of the time) lack important information necessary to plead their claims in detail. Accordingly, the court essentially held that the intent behind ERISA requires courts to interpret Rule 8 loosely for ERISA plaintiffs:

Congress intended that private individuals would play an important role in enforcing ERISA's fiduciary duties—duties which have been described as "the highest known to the law." Donovan v. Bierwirth, 680 F.2d 263, 272 n.8 (2d Cir. 1982). In giving effect to this intent, we must be cognizant of the practical context of ERISA litigation. No matter how clever or diligent, ERISA plaintiffs generally lack the inside information necessary to make out their claims in detail unless and until discovery commences. Thus, while a plaintiff must offer sufficient factual allegations to show that he or she is not merely engaged in a fishing expedition or strike suit, we must also take account of their limited access to crucial information. If plaintiffs cannot state a claim without pleading facts which tend systemically to be in the sole possession of defendants, the remedial scheme of the statute will fail, and the crucial rights secured by ERISA will suffer. These considerations counsel careful and holistic evaluation of an ERISA complaint's factual allegations before concluding that they do not support a plausible inference that the plaintiff is entitled to relief.

In the short time since Braden, federal courts have unanimously upheld the Eighth Circuit’s holding, thereby preserving the intent behind ERISA and giving employee benefit plan participants the means to enforce ERISA’s fiduciary duties. See e.g., Jones v. MEMC Electronic Material, Inc., 2010 WL 1038536, at *3-5 (E.D. Mo. March 17, 2010) (denying the defendants’ motion to dismiss and noting that “ERISA plaintiffs generally lack the inside information necessary to make out their claims in detail).

The Eighth Circuit’s decision in Braden will protect future ERISA plaintiffs from motions to dismiss filed by plan fiduciaries which directly conflict with the intent behind ERISA. This will in turn lead to more lawsuits filed against plan fiduciaries for their wrongful conduct, which should ultimately motivate plan fiduciaries to take better care in the administration of their employee benefit plans.

SEC CHAIRMAN SCHAPIRO ACKNOWLEDGES FINANCIAL SERVICES REVOLUTION

On December 3, 2009, SEC Chairman Mary Schapiro spoke at the Consumer Federation of America's 21st Annual Financial Services Conference. Ms. Schapiro noted that as a result of last year's financial turmoil the country is undergoing a "financial services revolution." While the market has improved in recent months, the SEC Chairman reminded the audience that this does not mean that the weaknesses in our financial regulatory system have been resolved. To the contrary, Ms. Schapiro urged that the country must continue efforts to reform the financial regulatory system - both at the Congressional level and at the agency level.

On the legislative front, Ms. Schapiro noted that the regulatory regime needs to focus on identifying and minimizing systematic risk. In this regard, the Chairman identified a number of areas where regulations are being reinforced or need to be reinforced by proposed legislation: 1) the creation of a regime that permits large institutions to fail without taking the system or taxpayers down with them; 2) a need to bring managers of hedge funds and other private funds under the regulatory umbrella; 3) a strong fiduciary standard for all securities professionals; and 4) greater transparency and stability to the over the counter derivatives markets - including real-time data on securities-related OTC derivatives.

Ms. Schapiro also identified that regulatory reform does not exist solely at the Congressional level. She noted that the SEC must put thought and energy into how to protect individuals who are entrusting their money to the capital markets. Ms. Schapiro discussed initiatives underway at the SEC to address issues encountered by individual investors - and she did so by discussing them from the perspective of such an investor.

First, Ms. Schapiro addressed the move to a singular standard for brokers and investment advisors. She noted that when an investor steps into the office of a local securities professional, he does not often look to see whether it says broker-dealer or investment advisor. All he wants is helpful, investor-focused advice. However, currently the duty owed to an investor is different depending on the securities professional's designation. If it is a broker-dealer, the investor is sold a product that is "suitable" for him. If it is an investment adviser, he gets treated under the higher "fiduciary duty" standard.

Ms. Schapiro stated that she is of the belief that all securities professionals should be subject to the same fiduciary duty, same licensing and qualification requirements, and the same oversight regime. Although this may disrupt a number of entrenched interests, Ms. Schapiro noted that the SEC is doing no service to retail investors by continuing with a different regulatory approach for professionals who perform virtually the same or similar services.

Second, Ms. Schapiro addressed the disclosures made by securities professionals with regard to compensation and conflicts. She noted that after an investor sits down with a securities professional, he is not always provided with understandable information about the products that his securities professional is trying to sell him. Ms. Schapiro stated that retail investors should be provided clear, simple, and meaningful disclosure at the time they are making an investment decision.

This should include information about the product being sold, including the compensation being received by the professional and information regarding any conflicts that may be causing the advisor or salesman to steer the investor to a certain investment. Directly related to this is the issue of 12b-1 fees which are automatically deducted from mutual funds to compensate securities professionals for sales and services provided to mutual fund investors. Ms. Schapiro stated that she believes these fees must be rethought not just with respect to their disclosure, but also with respect to whether they continue to be appropriate. This is an area Ms. Schapiro has asked the staff for a recomendation on the 12b-1 fees for SEC consideration in 2010.

Finally, Ms. Schapiro noted that while the SEC has the will to succeed, it is stretching existing resources and will not likely be able to achieve all it seeks to do without additional funding. As an example, Ms. Schapiro noted that the examination staff numbers less than 500, but is tasked with inspecting 11,000 investment advisory firms and 8,000 mutual funds. As a result, she noted that an investor has about a 10% chance of walking into an investment adviser who has been inspected by the SEC in the previous year. For this reason, Ms. Schapiro has been advocating for the SEC to be able to fund its own operations through fees it currently collects. The amount of these fees currently surpasses the amount appropriated by Congress to the SEC each fiscal year.

Ms. Schapiro wrapped up by noting that 2010 will be another year in which the SEC will pursue an ambitious reform agenda in order to restore confidence and provide the protections investors expect and deserve. We at Cosgrove Law, LLC will continue to monitor the steps taken by the SEC in carrying out this agenda. A complete copy of Ms. Schapiro's speech can be found here.

401(k) Plans Carry Frequently Ignored Fiduciary Duties for Plan Administrators

Last year the U.S. Supreme Court held that a 401(k) plan participant could sue for an alleged breach of fiduciary duty as long as the allegations related to the proper management, administration, and investment of asset plans. This past Friday the St. Louis Business Journal published an article reviewing the millions of dollars in losses suffered by the 401(k) plans of dozens of large St Louis employers in 2008. Some of the plans noted in the article had losses exceeding 30%. While a mere substantial loss alone, particularly in such a difficult economic and market environment, is not a sufficient basis for a law suit, it may (hint-should) prompt you to have a professional take a look at your plan to make sure it is and was being administered diligently, prudently, and consistent with your and your other plan participants' best interests. Cosgrove Law, LLC works with investment professionals on a variety of matters, including the legal and financial assessment of 401(k) plans--plans in which rest your hopes for a decent retirement.

THE SEC TO RE-ASSESS REGULATORY REGIMES GOVERNING FINANCIAL SERVICE PROVIDERS

On June 18, 2009, just one day after President Obama unveiled his white paper, SEC Chairman Mary L. Schapiro gave an address at the New York Financial Writers' Association Annual Awards Dinner in which she acknowledged that Obama's regulatory reform plan makes real progress in strengthening the SEC and ultimately improving investor protection.

In her address, Ms. Schapiro emphasized that under Obama's new plan the SEC still has an underlying duty to protect individual investors, and opined that one way to protect investors is to resolve the inherent problems associated with the regulatory regimes governing financial service providers. Accordingly, the SEC is re-assessing the standards of conduct applicable to all financial service providers in an effort to help investors more fully understand what is required of their financial professionals. “Investors are not well-served by a confusing array of varying disclosure, liability, recordkeeping and conflict management requirements,” Ms. Schapiro said.

Ms. Schapiro noted that although there are a multitude of choices for investors to consider when seeking financial advice or assistance, financial service providers often perform similar and overlapping functions. However, despite this commonality of services, financial professionals such as broker-dealers and investment advisors are subject to varying and inconsistent legal standards. Such a regulator structure, Ms. Schapiro stated, is faulty in that “when investors receive similar services from similar financial service providers, they should be subject to the same standard of conduct.” As such, the SEC is now focused on instituting consistent fiduciary standards of conduct applicable to all financial service providers that provide personalized investment advise about securities, regardless of their labels, which will help ensure that these professionals act at all times in the interests of the individual investors.

Harmonizing the regulatory regimes for financial service providers will no doubt minimize the confusion investors must face under the current regimes. However, in her address, Ms. Schapiro correctly acknowledged that the implementation of consistent fiduciary standards of conduct will do nothing to ensure that financial professionals adhere to the requisite standards. Instead, such a change is merely a first step aimed at protecting individual investors.

Our firm provides effective legal advice and representation for individuals who have been subject to investment fraud, negligent misrepresentation or breach of fiduciary duty by their financial advisers. For more information, please visit our website here.