Art by Katherine Streeter

Even before the U.S. Department of Labor (DOL) signaled under President Donald Trump that it would not be defending the Obama-era DOL fiduciary rule expansion—which was vacated in mid-2018 by a U.S. circuit court—a number of state governments had already begun the process of implementing their own conflict-of-interest rules for financial advisers and broker/dealers.

But the surprise court defeat of the DOL fiduciary rule, which would have greatly expanded the number of advisers considered to be fiduciaries under the Employee Retirement Income Security Act (ERISA), accelerated such state-based efforts and has led to more states pushing to fill a perceived void created by federal deregulation.

According to written commentary shared by attorneys with Stradley Ronon, regulators and legislators in New Jersey, New York, Nevada and Maryland, among others, are currently implementing stricter standards for advisers and brokers operating in their respective jurisdictions.

One of the newest efforts kicked off on October 15, 2018, when the New Jersey Bureau of Securities issued a notice of pre-proposal to solicit comments on whether to adopt rule amendments that would require broker/dealers, sales agents, investment advisers and investment adviser representatives to be subject to “an express fiduciary duty.” The New Jersey notice highlighted concerns that investors are “often unaware of whether and to what extent those they trust to make financial recommendations are receiving undisclosed financial benefits in exchange for steering their clients to certain products.” 

According to Stradley Ronon attorneys, the pre-proposal did not include specific rule language, but the Bureau did indicate it was considering “making it a dishonest or unethical business practice for failing to act in accordance with a fiduciary duty when recommending to a customer, an investment strategy, or the purchase, sale, or exchange of any security or securities, or providing investment advisory services to a customer.”

State Timelines May Shift in 2019

Generally speaking, state-based fiduciary rule implementation timelines across the U.S. could be either extended or accelerated in 2019, depending on if and when the Securities and Exchange Commission (SEC) finalizes its own advisory standards reform effort. Back in April 2018, the SEC released a “Regulation Best Interest” proposal aimed at creating a unified conflict of interest mitigation standard for all brokers and advisers—not just those working under ERISA. During a recent speech, SEC Char Jay Clayton said the investment market regulator has made it a priority to finish work on its Regulation Best Interest proposal during 2019.

Another factor that could impact states’ timelines, according to Stradley Ronon attorneys, is that state legislatures reshaped to favor Democrats in the 2018 elections could choose to move faster in the direction of strengthening conflict-of-interest regulations. As an example, they point to New York Assemblyman Jeffrey Dinowitz and his previous, unsuccessful introduction of the Investment Transparency Act.

That measure would have required brokers, dealers, investment advisers and other financial planners that are not otherwise subject to a fiduciary standard under existing state or federal law to make a plain language disclosure to clients orally and in writing at the outset of the relationship that states the provider is not a fiduciary. The disclosure would have to stipulate the advice provider “is not required to act in your best interests,” and is “allowed to recommend investments that may earn higher fees, even if those investments may not have the best combination of fees, risks, and expected returns.”

The proposal did not advance to a floor vote following a third reading before the New York State Assembly in May 2018. However, Dinowitz has indicated that he plans to re-propose legislation this year. Naturally, the measure may fare better this time around, now that the whole New York government is controlled by Democrats.

According to Stradley Ronon attorneys, Maryland is “also worth watching,” since last May, advice-focused legislation passed in the state’s House and Senate as part of a larger financial reform bill. The law instructed the Maryland Financial Consumer Protection Commission (MFCPC) to study the DOL’s now-defunct fiduciary rule and SEC’s proposed Regulation Best Interest, “to determine whether it would be in the best interest of the state to adopt its own fiduciary rule.”

The attorneys see this prospect as something of a longshot. “Although there seems to be some support for such a rule in the Maryland legislature, MFCPC Chair Gary Gensler has recognized that adopting a new fiduciary standard will be a ‘tough lift’ for the General Assembly,” they say.

Hurdles Remain Even in Progressive States

One state that has run into some hurdles with its own implementation of stricter fiduciary standards is Nevada. That state adopted a law in 2017 to impose a statutory fiduciary duty on broker/dealers, sales representatives, and investment advisers. However, because its scope and core requirements were left to the Nevada Securities Division to decide, the measure has since remained under development.

Taking the first real step forward, on January 18, 2019, the Nevada Securities Division released its long-awaited proposed draft regulation. The proposal begins by stating that a broker/dealer or its sales representatives will owe a fiduciary duty to its clients if it “provides investment advice to clients; manages the clients’ assets; performs discretionary trading of client assets; who otherwise establishes a fiduciary relationship with clients; or uses the following titles and terms in their title, name or biographical description, or otherwise holds themselves out as having such role: (a) advisor/adviser, (b) financial planner/financial consultant, (c) retirement consultant/retirement planner, (d) wealth manager, (e) counselor, or (f) other titles that the Administrator may by order deem appropriate.”

While the proposal sets out various stipulations and exemptions, according to Stradley Ronon attorneys’ early reading, a broker/dealer (B/D) or B/D representative will also be presumed to owe a fiduciary duty to the client. However, the attorneys suggest it remains unclear whether investment advice to plan participants, fiduciaries, investment managers or entities would fall within the scope of the proposal. They warn that dual registrants and their affiliates should pay particular attention to the proposal.

As a general matter, the Stradley Ronon attorneys argue, state regulators like those in Nevada may face better odds than state legislators when it comes to actually putting stricter fiduciary rules in place—but they also remain more vulnerable to court challenges alleging a regulator acted beyond its powers.

“This means that litigation both by, and against, the states involved, such as New York and potentially New Jersey, will likely characterize state activity regarding broker/dealer and investment adviser standards of conduct in 2019,” the attorneys conclude.

Related commentary provided by attorneys with Drink, Biddle and Reath suggests the Nevada regulation is much more expansive than what most observers were expecting. They warned that, as proposed, dual registered advisers will not be able to take advantage of any exemptions the rule provides for pure broker/dealers. In addition, according the attorneys’ early read, the Nevada definition of fiduciary advice is “extremely broad.” For example, simply providing analysis or reports regarding a security—without making any specific recommendation—would seemingly be considered fiduciary activity under the proposal.

One potentially important broker exemption in the rule, the attorneys explain, is what is being called “the episodic fiduciary” exemption. The basic idea is that a broker would only be a fiduciary to a given client for a single recommendation and would not have a running duty to monitor. Importantly, to get this episodic exemption, a broker can’t call itself an “adviser,” “consultant,” “financial planner,” etc.

The attorneys expect industry comments will raise some internal inconsistencies and problems in the draft, so revisions are likely, in their opinion. Asked how the Nevada rule compares to the SEC Regulation Best Interest, the attorneys say the biggest difference is that there is a private right of action established under the Nevada regulation, meaning individual investors could sue for losses. Under SEC Regulation Best Interest, as written, only the SEC and FINRA have right of action.

As a broader public policy matter, the Drinker Biddle and Reath attorneys are concerned about the patchwork system that could be developing across the U.S. The confluence of regulatory interests makes it very hard to comply with slightly different yet simultaneously applying standards.

New Insurance-Specific Standards

Insurance brokers operating in New York will soon be subject to stricter standards. Back in July 2018, New York’s Department of Financial Services (NYDFS) approved an amendment to its insurance regulation to impose a “best interest” standard on the sale of life insurance and annuity contracts. The amendment is to take effect on August 1, 2019, for annuity contracts and February 1, 2020, for life insurance policies.

The Stradley Ronon attorneys call this a “sea change,” at least for advisers and brokers operating in New York with some interest in selling or servicing insurance products. They note how the regulation not only heightened the standard of care owed by the sellers of life insurance products, but how it also vastly expanded the breadth of the products covered from annuities to all life insurance products, including term-life insurance.

Insurance-focused brokers and advisers should also take note that the National Association of Insurance Commissioners (NAIC) is attempting to form a model standard of conduct for states to follow in connection with the sale of life insurance products. The Stradley Ronon attorneys say this process is potentially quite important from a nationwide perspective.  

“The NAIC committee tasked with revising the NAIC’s model suitability rule for the sale of annuity products was hard at work in 2018 seeking to revise its current ‘suitability’ standard for the sale of annuity products with a rule that would apply a ‘best interest’ standard,” the attorneys say. “The committee faced great debate among NAIC members regarding the future of the model rule. With states like New York and California leading the charge, the NAIC was pressured to adopt a rule that, like New York’s regulation, would impose a best interest standard for the sale of both annuity and life insurance products.”

As the attorneys note, other states have pushed back, arguing that such an approach goes too far and would be unlikely to pass in many state legislatures. Either way, because the NAIC is working to harmonize its advice standards with those of the SEC, the attorneys conclude it is “unlikely that NAIC will have its final model rule promulgated until after the SEC finalizes its rule.”

403(b)-Specific Changes to Consider

In mid-2017, Connecticut passed a law aimed at bringing non-ERISA 403(b) plans closer to ERISA 403(b) plans. The law applies to Connecticut K-12 school districts.

According to commentary shared by consultants with Hooker & Holcombe, Connecticut lawmakers decided to pass the law after teachers in the state regretted investing in certain products without being informed of fees and other charges. The law requires such plans to disclose the fee ratio and returns, net of fees, for each investment offered to participants.

The law technically has been in effect since October 1, 2017, but lawmakers gave plan sponsors until January 1, 2019, to comply. Hooker & Holcombe issued a checklist to help 403(b) plans follow ERISA best practices, starting with assigning either the school’s administration or an adviser to ensure vendors comply with the law and asking each vendor how they plan to comply with the law. The law firm says sponsors should also ask vendors for copies of draft disclosures they plan to supply participants upon enrollment and annually, and ensure that the information is in an easy-to-read format.