Understanding the DOL’s Conflict of Interest Rule

The DOL called Wall Street's bluff, with a big sniff test.

W. Scott Simon


Julius Caesar, in a letter to the Roman Senate, purportedly said in describing a quick victory in a short   war: “Veni, vidi, vici”: “I came, I saw, I conquered.”

I thought of a variation of this phrase after hearing Tom Perez, Secretary of the U.S. Department of Labor (DOL), explain the final conflict of interest rule (Rule) issued by the DOL on April 8: “I came, I saw, I caved.”

“Caved” as in capitulating to the non-fiduciary business model championed by Wall Street and actively followed by many on Main Street who are, in fact, the ones on the front lines dealing with investors all over America–both in the (non-taxable) retirement investment environment (which falls under the purview of the DOL’s Rule) as well as in the (taxable) retail investment one (which doesn’t fall under the Rule).

In preparing to write a series of columns on the Rule, naturally enough I began by reading the first of its approximately 66,000 words (which take up 58 pages in the Federal Register and are said to cover 1,023 pages of 11 by 8.5 inch paper, double-spaced). A clue about the length of the Rule should have been its longish 12-word title: “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule – Retirement Investment Advice.”

After a few starts and stops in attempting to read every word of the Rule’s text, I was reminded of a warning given to me by my mother when I was but a mere tyke. One of the games my little buddies and I used to play was, “Who Can Cross Their Eyes and Hold Them That Way the Longest.” Mom, who eventually got wind of this socially useful behavior through the Mother’s Neighborhood Communication System, sat me down and warned me sternly that if I kept engaging in such a silly activity, my crossed eyes would remain permanently stuck for the rest of my life. My mother’s warning took hold, and I recalled it as I tried to get some traction in beginning to read the Rule. After a number of fitful attempts to do so, I decided that I didn’t want to go through the rest of my life with permanently crossed eyes and gave up.

I did skim the Rule and referenced it often as I did my penance for not being up to reading every last word by devouring, since April, nearly 340,000 words of commentary on, and legal analyses of, the Rule. As might be expected, opinions about the Rule and its implications are diverse. Most say that the Rule is the best thing since sliced bread so offending advisors will now be reined in. Others say that it is much ado about nothing, so offending advisors will continue to run amok.

Since April, though, I have detected in my reading an increasing uncertainty about the sundry implications of the Rule. It’s as if those in the race to scoop the competition right out of the gate have now gone back to the drawing board and perhaps come to realize that some of their initial opinions and conclusions may lead to different places than they originally thought. After all, the law of unintended consequences is bound to appear in some places within the 66,000 words of a regulation drafted by government attorneys. The DOL has said that it will issue “rolling” FAQs (and answers thereto) “this fall,” which may help to clear up some of these uncertainties.

After digesting the commentary and legal analyses since April, I’ve come to change my initial opinion that Secretary Perez came, saw, and caved to one where he came, he saw, he devised a very long, quite complicated Rule. In fact, the DOL could have saved us all a lot of time and trouble by simply banning, say, commissions, 12b-1 fees, and revenue-sharing, and calling it a day. No muss, no fuss.

But that likely would have been politically impossible. Given that fact, it seems to me that the DOL did the next best thing. In effect, it called Wall Street’s (and, by extension, Main Street’s) bluff by saying, OK, you can earn your variable compensation (e.g., commissions, 12b-1 fees, revenue-sharing) and while we’ll deem them prohibited transactions, we’ll allow you exemptions (e.g., the best interest contract exemption, the amended prohibited transaction exemption 84-24) so that you can continue to earn your conflicted revenue.

However, in exchange for all that, we’ll require you to agree to run through a rat maze of requirements and disclosures. Part of that maze will require you to document in writing (and maintain in your internal files) the reason(s) why you recommended, say, rolling over from an ERISA plan to an IRA, or transferring an IRA, or changing from a commissioned account to a level fee account (e.g., A shares paying 25 basis points to an advisory fee of 75 basis points). You’ll also have to explain, among other things, why those recommendations meet the Rule’s best interest standard.

No doubt, it would be quite interesting to be a fly on the wall in the office where those offering an “investment” such as a non-traded real estate investment trust (REIT) featuring a front-load commission of, say, 8% with a lock-up period of, say, six to eight years in which the REIT is illiquid are attempting to come up with valid reasons for recommending this kind of REIT and why those reasons meet the Rule’s best interest standard.

Although I don’t see how such an investment could ever be justified to pass that sniff test, the DOL is willing to let Financial Institutions/advisors such as those in this example knock themselves out in trying to do so. However, in requiring such providers to lay out their reason(s) why this kind of REIT is in the best interest of retirement investors, it seems that the DOL has, in effect, left a trail of crumbs for the plaintiffs’ bar in filing class action lawsuits against such providers. Although it’s likely that lots of class actions will be filed, it’s uncertain whether they will meaningfully change the behavior of advisors following conflicted business models. I suspect that with time, such models will change for the better even if the plaintiffs’ bar doesn’t make much headway via the class action route.

In next month’s column, I’ll describe how the investment retirement market has changed since 1974, the primary reason for the DOL’s promulgation of the Rule, and why at least some advisors are unhappy with the DOL for poking its nose into their IRA business. Ensuing columns will delve into such subjects as “Fiduciary Central” of the Employee Retirement Income Security Income Act of 1974, a (hopefully) easy- to-understand inquiry to determine if an advisor is subject to the Rule, and those forces that may (or may not) actually be helpful in enforcing the Rule.

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™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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