The Fiduciary Exemption That Swallows the Rule

A proposed EBSA rule doesn't appear to be much better than the current rule in helping rein in the bad conduct it's aimed at curbing.

W. Scott Simon


This month’s column is a continuation of last month’s column, which concerned a new rule proposed by the Employee Benefits Security Administration (EBSA). That rule would revamp the EBSA’s current 35- year-old five-part rule (set forth in relevant part in last month’s column) that defines “investment advice” given by investment advisors to their retirement plan clients. Under the current rule, an investment advisor is deemed to be a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA), but only when all five parts of the rule are satisfied for any given instance of advice.

The effect of the EBSA’s proposed rule is to change what constitutes “investment advice” under ERISA section 3(21)(A)(ii) (“…a person is a fiduciary with respect to a plan to the extent … (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so.”) (my emphasis). That, in turn, will change the definition of a “fiduciary” thereunder so that (purportedly) the fiduciary moniker can be pinned on a greater number of advisors.

In proposing to jettison the current five-part rule, the EBSA would replace it with a new rule that defines a “fiduciary” as anyone who provides “investment advice,” which is defined as either (1) “recommendations on investing in, purchasing, holding, or selling securities;” or (2) “recommendations as to the management of securities or other property.”

If either kind of advice is present, then the individual must also meet one of the following conditions to be considered a fiduciary providing investment advice: (a) the individual represents to a plan, participant or beneficiary that it is acting as an ERISA fiduciary; or (b) it is already an ERISA fiduciary to the plan by virtue of having any control over the management or disposition of plan assets (under ERISA section 3(21)(A)(i)) or by having discretionary authority over the administration of the plan (under ERISA section 3(21)(A)(iii); or (c) it is an investment advisor (RIA) under the Investment Advisers Act of 1940; or (d) it provides the advice pursuant to an agreement or understanding that the advice may be considered in connection with investment or management decisions with respect to retirement plan assets and will be individualized to the needs of the plan.

The Road to Hell Is Paved with Good Intentions

It is said that the current rule has allowed certain service providers over the years to offer advice without being subject to ERISA’s fiduciary standards. That is true enough, and certainly the all-important motivation to change the current rule. The problem is that the proposed rule doesn’t appear to be much better than the current rule in helping rein in the bad conduct it’s aimed at curbing.

Suppose that a broker provides either one of the two proposed types of investment advice. But if (1) the broker represents that it isn’t an ERISA fiduciary, (2) the broker isn’t an ERISA fiduciary under either

ERISA sections 3(21)(A)(i) or 3(21)(A)(iii), (3) the broker isn’t an RIA, and (4) the broker doesn’t provide individualized advice that’s understood to be in connection with investment or management decisions with respect to plan assets, then it won’t be considered as providing ERISA-defined “investment advice” and therefore won’t be an ERISA-defined “fiduciary.”

Given the preceding set of suppositions, it would appear that the broker couldn’t do any business with a retirement plan. But appearances, as is said, can often be deceiving. In fact, the broker could continue on its merry way and offer retirement plans the same kind of “help” (i.e., recommendations on investing in, purchasing, holding, or selling securities; or recommendations as to the management of securities or other property) that the proposed rule was designed to eliminate, or at least mitigate.

This possibility is brought to brokers courtesy of an exemption to the proposed rule known as the seller’s exemption (a second exemption is the platform provider’s exemption). Here’s a way of looking at the effect of this exemption: It’s so gaping that every Sherman tank in General George Patton’s Third Army could rumble through it without a scratch. Another way: The exemption essentially swallows the proposed rule. To wit, suppose that a broker provides either one of the two proposed types of advice: All it would need to then do would be to drive its tank through the seller’s exemption, which recognizes that certain activities should not result in fiduciary status. One such activity would be the broker representing itself not to be an ERISA fiduciary, and also making it clear to the plan that it was acting for a purchaser/seller on the opposite side of the transaction from the plan rather than providing impartial advice to the plan.

Just like Captain Yossarian marveled in Catch-22, “That’s some catch, that Catch-22,” we can marvel, “That’s some exemption, that exemption which can swallow a rule.” And by the way, the EBSA is going to permit non-fiduciaries to provide “partial” (read, biased and conflict-ridden) investment advice–even if that fact is disclosed clearly to plan fiduciaries–in the fiduciary-imbued environment of ERISA qualified retirement plans.

Bad Words in Disclosures

But wait, there’s more. Even with a 98-pound weakling rule and two gaping exemptions to that rule, the politically powerful trade association lobbyists that represent those whose bad conduct the proposed rule is supposed to curb still aren’t satisfied. The seller’s exemption provides that a commission-based broker or other advisor will not be considered to be a fiduciary if the person receiving the investment recommendations understands that they are not receiving impartial investment advice. In addition, such advisor must disclose to plan fiduciaries and participants that its interests are adverse to the interests of the plan or its participants.

These lobbyists, who are attempting to shape the proposed rule to favor their own members at the expense of those who are (or are supposed to be) the DOL’s constituents–participants (and their beneficiaries) of ERISA-governed retirement plans–want to delete the bad word “adverse” from the required disclosure of the proposed rule. They maintain that since these advisors are focused solely on the interests of retirement plans and their participants, any disclosure containing such a harsh-sounding word would be confusing to the recipients of the advisors’ investment recommendations. The lobbyists also want the phrase “not receiving impartial investment advice” to be softened. That’s easy to understand since lack of impartiality sounds so, oh I don’t know, biased or conflict of interest-like.

A bigger problem than the particular wording of the disclosure in the EBSA’s proposed rule is the fact that a disclosure format is being proposed at all. This again plays into the hands of the lobbyists and those

they represent, whose bad conduct the proposed rule is supposed to limit. Brokers love disclosures because their mere appearance (naturally in font sizes approved by attorneys) at crucial places in various documents serve to largely absolve brokers of any ensuing responsibility and liability for bad acts towards their clients.

What’s even better for such brokers is that most of their clients never bother to read the disclosures. And even when they do, how many really understand them? After all, there’s a big difference between a clearly worded disclosure and a clear understanding of the meaning of that disclosure.

It’s said that an investment salesperson will be successful only when he or she attains a sufficient level of trust with an investor. In the EBSA’s proposed rule, though, an advisor must tell an investor in cases where the advisor is disclaiming fiduciary status that it may have interests adverse to the investor. But even in such cases where a clearly written disclosure contains the words “adverse” and “biased,” and the phrase “rampant conflicts of interest,” the prodigious skills of an expert sales-oriented investment advisor in one-on-one meetings with an investor will, more often than not, convince the investor that the advisor is acting in the investor’s best interests–even when it clearly is not. A DOL attorney remarked on the value of written disclosures to investors at the EBSA hearing on March 1: “‘The mere fact that there was disclosure of the conflict may actually encourage [investors] to believe, ‘This [advisor] really does have my [best] interests at heart. Look how honest he was. He told me about the conflict.'”

As I’ve noted in this column a number of times over the years, brokers just don’t want to be fiduciaries. There’s nothing in the EBSA proposed rule that will change that. The result is that brokers will continue to be able to interact with ERISA-governed retirement plans in a non-fiduciary capacity.

W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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