Regulatory Rule Roundup (May 5)

Mike & Co. —

During the lull on the Hill with the Senate in recess this week, attention shifted to the regulatory front, with two agencies making news with major proposed rules addressing issues at opposites ends of the financial industry spectrum.  

On Tuesday, the Fed issued the long-awaited rule on the treatment of qualified financial contracts (QFC) in the event of a G-SIB default.  And today, CFPB released proposed rule to prohibit banks from requiring customers to sign an arbitration agreement that waives their rights to join  a class-action lawsuit.

Details on these two high-stakes rules below.  

Best,

Dana

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CFPB:  Arbitration and Class Actions

This afternoon, the Consumer Financial Protection Bureau unveiled a rule disallowing banks from including arbitration clauses in their contracts with customers prohibiting them from joining  class-action lawsuits.

Most contracts with big American banks, from loan documents to credit card agreements, contain a clause allowing both the customer and bank to pursue arbitration as a method for settling disputes.  It helps banks save costs of defending disputes in a court and is a useful remedy available to customers as well.

But arbitration clauses have increasingly included language barring customers from pursuing a class-action lawsuit in lieu of arbitration.  For example a credit card agreement may contain:

“There will be no right or authority for claims to be arbitrated on a class action basis or on bases involving claims brought in a purported representative capacity on behalf of the general public, other card members, or other persons similarly situated.”

The clause limits the legal options available to customers who have a problem with their bank.  Arbitration without a class-action option can be exceedingly expensive for the customer.  If they’re trying to recoup a small amount of money then it’s rarely worth the cost to pursue arbitration.  Few customers ever make it to arbitration as their legal costs begin to add up — and those that do seem to rarely win cases.

A class-action lawsuit is the legal vehicle designed for customers to recoup small amounts of money — like a $35 overdraft fee.  By preventing customers from entering into such lawsuits banks can protect themselves from costly judgements and settlements, as well as from agreements which require they amend business practices.

Implications for Banks, Non-Banks

Banks have objected to the rule, saying that it will prevent customers from being able to pursue arbitration in the future.  It’s unlikely that the rule would affect the incidence of arbitration cases when a customer wants to pursue it.  CFPB is preventing arbitration agreements which prohibit class action lawsuits, not preventing arbitration agreements full stop:

“the proposed rule would prohibit covered providers of certain consumer financial products and services from using an agreement with a consumer that provides for arbitration of any future dispute between the parties to bar the consumer from filing or participating in a class action with respect to the covered consumer financial product or service”

Other important details to keep in mind:

  •  the rule will only affect institutions that CFPB has authority to regulate (lenders, credit card companies, and banks)
  •   it would apply to new contracts only – customers with existing arbitration agreements in their contracts may still be prevented from joining or initiating a class-action law suit.

The Fed:  Contracts in a Crisis

On Tuesday, the Federal Reserve issued a rule limiting the rights of parties to a Qualified Financial Contract (QFC) in the event that a counterparty goes into default.  It expands on the resolution frameworks within the Federal Deposit Insurance Act and Dodd-Frank and will apply those frameworks to all QFCs entered into by American GSIBs (global systemically important banks), as well as domestic subsidiaries of foreign GSIBs.

The rule will limit certain rights afforded  counterparties to a QFC, such as the termination of the contract and seizure and liquidation of the counterparty’s collateral.  The Fed rule aims to prevent “runs” on big banks in the event of default.  QFC counterparties, under current rules, don’t have to wait in line with other creditors to receive payment.  Big banks already agreed to waive these rights in 2014, but hedge funds and asset managers have not.

The most controversial provision of the rule may be its retroactive nature — if requires that banks’ QFCs be brought into compliance with the rule for them to continue trading.  The scope of the rule is noteworthy.  By requiring the biggest banks to comply with these rules the Fed is essentially forcing investment funds and other firms to adopt these contracts as well – or else cease trading with the country’s largest banks.

Historical Context

When Lehman Brothers collapsed during the 2007 crisis, its trading partners terminated thousands of swaps and effectively sent huge amounts of cash tumbling out of Lehman to its counterparties before authorities could get a grip on its default process.  These payments were financed by asset sales that later constrained the bankruptcy process.

The rule strives to forestall this kind of run in the future by injecting clarity regarding claims and increasing flexibility  in the resolution of large financial firms under Dodd-Frank.

According to Fed Chair Janet Yellen, the new rule “will help manage the risk when a very large firm fails and will thus strengthen the resiliency of the financial system as a whole.”  Fed officials have claimed that the cost of the rule would be relatively small, and that the benefits to the financial system would massively outweigh them.

Next Steps 

Both of the rules proposed this week are subject to open comment periods, ending in about 90 days.  Moving forward, we should expect to see a companion to the Fed’s QFC rule come out of OCC shortly, which would extend the Fed requirements beyond the largest banks to national banks and thrifts.

Thereafter, the coming weeks may see a number of additional rules from regulators. The SEC may release its own fiduciary rule to complement DOL version. And the Fed has solicited feedback from banks on how to expand mobile banking access to underserved customers.

SEC Nominations (Apr. 20)

Mike & Co. — 

Hillary’s commanding victory in the New York primary last night is cause for celebration and bring the Secretary a decisive step toward  the Democratic nomination.  Tremendous effort and outcome —  congratulations all around. 

Speaking of nominations, the path forward has gotten still murkier this month in Senate Banking.  Four Committee Democrats are bucking  administration wishes, blocking its two outstanding and previously-agreed SEC nominees.  At stake is a progressive policy goal, one which HRC supports — requiring publicly traded companies to disclose their political donations.  More on this and the nominations below. 

Best,

Dana

 

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Banking Committee’s Recent Record

What was supposed to be a routine Senate Banking vote on the administration’s nominees for two vacant seats on the five-member Securities and Exchange Commission  during their confirmation hearing on April 7.

But without warning, four Committee Democrats refused to support their own party’s nominee.  The Democrats were joined by Tim Scott of South Carolina in voting “nay” on a group of five regulatory nominees, including two SEC commissioners.

The Committee has not yet held another vote on the matter, and there have been no hints from the Shelby office on the timing for a new vote.  It’s considered likely that the Banking Chairman will want to move before Memorial Day.   The Committee approved its first nomination in 15 months and faces nomination backlogs on several key fronts.

The Protest

Sens. Schumer, Menendez, Warren, and Merkley declared at the hearing that they would not support the nomination of Lisa Fairfax, a Democrat, or Hester Pierce, a Republican, until they were assured by each nominee that they would support rules requiring publicly traded companies disclose their political donations.

The only option to block each SEC hopeful was to block the nominees for other agencies bundled with them.  Conspicuously missing from the Democratic “gang of four” was committee Ranking Member Sherrod Brown.

The group’s actions caused Committee chairman Richard Shelby to withdraw the voice vote; he has not announced a return date.  With only five “nay” votes in Committee, Shelby could easily have ruled that the ayes have it and waved the package of nominees through to the full Senate.  Shelby has offered no insight on why he decided not to allow the vote to move forward.

It’s worth noting that HRC happens to agree with the position taken by the four Senators.  The Secretary has long called for businesses to disclose their political donations, and is on record calling on the SEC to draft a rule requiring such.

SEC Future

So the SEC will continue to operate at three-fifths capacity.  This has become the new normal — these two seats on the Commission have remained vacant since  mid-2015.  If the vacancies remain open for much longer, it may be difficult for Char Mary Jo White to push forward with her own policy agenda in what is likely her last year in the post.  The SEC requires a three-vote minimum to set an agenda or even hold a meeting.  As things stand the Republican voice on the commission, Michael Piwowar, holds an effective veto power over the action by the SEC.

Next Steps

The full set of nominees considered by the Committee included officials for Treasury, the FDIC, and the United States Mint.  As the Senate session creeps to a close observers believe that Majority Leader Mitch McConnell will devote little time on the floor to debate nominee confirmations, meaning that the best shot for many lingering nominees is for the full Senate to approve them by unanimous consent — which a single senator can block.  Democrats who object to the nominee’s lack of position on disclosure requirements need to ask themselves if they’d rather have a crippled SEC or one atbfull strength without securing a public commitment by the nominees regarding the public disclosure rule.

 

 

 

Fed/FDIC on Living Wills (Apr. 13)

Mike & Co.,

Two weeks after the MetLife decision was handed down, here come the Fed/FDIC living will findings that half of the nation’s eight SIFI banks failed to submit “credible” plans. 

The main policy takeaways from two developments appear at first blush to diverge sharply.   MetLife restricts the authority of the USG (or FSOC) to designate SIFIs, while the Fed/FDIC verdict extends USG’s its reach over the biggest banks further than it has before. 

But from another perspective, the two developments demonstrate the operation of law, slow to engage at first perhaps, and not always linear — but the FSOC appeal might lead on the more confidence In DFA and its successes attack in fighting TBTF and protecting taxpayers.  More below.

Best,

Dana

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The Federal Reserve and FDIC announced today that five of the eight U.S. based global systemically important banks do not have “credible” living wills.  The regulators said JPMorgan Chase, Bank of America, Wells Fargo, Bank of New York Mellon and State Street failed to show that they could be safely unwound during bankruptcy.  The delinquent banks have until October 1 to bring their plans into order or face stricter regulations.  The next round of wills comes due July 2017.

Report Cards 

Mostly Satisfied:  Citigroup

Failed:

  • JPMorgan
  • Chase
  • Bank of America
  • Wells Fargo
  • Bank of New York Mellon

Split Decision:

  • Goldman Sachs (FDIC/fail; Fed/pass)
  • Morgan Stanley (FDIC/pass; Fed/fail)

Living Wills vs. Short-termism

The living will process underscores or at least reinforces the theme of fighting short-termism along two fronts.  One obvious, one less so:

  • Penalties Constrain Corporate Finance.  If banks miss the October 1deadline for cleaning up their dissolution documents they are set to face unspecified regulatory increases.  In the past these have taken the shape of limits on stock buybacks, dividend payments, and other corporate finance moves that emphasize short-term profit over long-term investment and growth.
  • Living Wills = Longer-Term ThinkingThe process of writing a living will is inherently a risk-mitigating venture; nobody wants to make plans for their own funeral.  Banks are forced to take a long and hard look in the mirror when writing out these documents, which itself may cause them to behave in a more self-aware manner, or the theory is.

Signs of DFA’s Strength or Weakness?

While some (Neil Kashkari?) might see today’s events as reason to move forward with plans to break up big banks, a more objective view would be that the living wills system is working as intended – if perhaps a bit slowly.  As mentioned above, the system itself takes a two-pronged approach to changing the ways that big banks operate (by punishing inadequately prepared banks and forcing banks to confront their risky behavior and quantify it) which has already resulted in three GSIBs publishing acceptable, if not perfect, will documents.

A Proposal on the Table

At least one way in which regulators can improve upon the living will process, according to the Government Accountability Office, is by increasing their transparency.

In a paper issued yesterday, the GAO said that the Federal Reserve and FDIC should publish the criteria they use to judge wills so that banks will have an easier time meeting their requirements.  The Fed and FDIC have both agreed with the GAO’s assessment, at least in part, and are working on ways to implement those recommendations.  The two regulators have already signaled that they’re on board with the proposal.   Candidates who embrace the idea will be putting their money where their mouth is on financial regulation – signaling that they support regulations but that they have faith in the ability of regulators.

On the topic of transparency: the release this morning gave at least some details on why banks fell short.  JPMorgan, according to the regulators, did not have sufficient models for estimating how it would keep money flowing to its significant operations during a bankruptcy resolution.  Bank of America had a shortcoming in its plan to wind down its portfolio of derivatives.

Regulators are sure to have in mind the CFTC’s ongoing legal battle with MetLife, the giant life insurance company and erstwhile SIFI.  Transparency (a lack of) was a central issue in the MetLife ruling, and has also become the subject of Senate legislation concerning the Commodity Futures Trading Commission.

Consequences & Calendar for the Five 

The five banks which failed outright have until October 1, 2016 to get their wills up to snuff, while the two “split decision” banks were provided with guidance on how to adjust their own plans to better align with regulators’ wishes but won’t face a hard deadline.  Banks are due to submit their next living wills in July 2017.

Beyond the obvious consequences if banks fail to meet the October 1 deadline for updated wills, today’s announcement sets in motion more serious developments.  Under DFA the FSOC can force big banks to restructure or sell off certain assets if they remain too big to fail for too long – today’s findings are another step forward in building that case if regulators decide to pursue such action.

 

 

 

 

CFTC Reauthorization (Apr. 12)  

Mike & Co. —

The WSJ reported this afternoon that federal regulators are preparing to inform at least half of the nation’s eight systemically important banks that their living wills, the documents that dictate their bankruptcy plans, are not adequate.

For these firms, such an announcement would have many effects, from requiring that they go back to drawing board on living wills to or faceBsanctions — being required to hold higher levels of capital, which restricts borrowing, stock purchases, dividends, and protects against losses — that can eat into profitability.  If they fail to submit credible strategies repeatedly, regulators could force them to divest certain assets.  The shoe is expected to drop later this week when regulators release their findings.

Meanwhile, in other financial regulation news this week, Senate Agriculture is planning a CFTC reauthorization markup this Thursday, in a bid to move the commission off year-to-year funding for the first time since 2013.  More below.

Best,

Dana

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The Senate Agriculture Committee will conduct a markup hearing this Thursday on a reauthorization bill for the Commodity Futures Trading Commission which will be introduced by Chairman Roberts.  In the meantime a draft of the legislation has been made available.

Since 2013, the CFTC has relied on year-to-year funding for its operations, reflecting a Congressional inability to reach compromise for more permanent funding.  President Obama’s FY17 budget increases the CFTC budget to $330 million, up $80 million from 2016’s enacted $250 million amount.

The Commodity End-User Relief Act would fund the CFTC through 2019, assuming it can pass the Senate.

Provisions of the Reauthorization

Within the bill are a number of reform measures aimed at providing farmers, utilities, and other “end users” greater flexibility in hedging through the use of derivatives contracts, as well as new privacy protection for derivatives users.

  •   allows farmers, ranchers, and energy providers (end-users) to hedge against operational risks through derivatives
  • requires electronic confirmation of customer account balances and require that firms notify regulators when moving account balances
  • requires the commission to review and take action on the London Metal Exchange’s application as a foreign board of trade
  • strengthens protection of proprietary or sensitive information provided to the commission through disclosure requirements
  •  provides judicial oversight of the commission’s rulemaking by allowing CFTC-regulated firms to bring suit through federal appeals courts
  • requires the CFTC to maintain an $8 billion threshold for companies to be considered registered swap dealers as it keeps studying whether or not that level is appropriate

House vs. Senate

A House Reauthorization bill, passed last June along party lines, included a number of “nonstarter” provisions that are absent from the Senate measure, including a cost-benefit analysis requirement.  It drew a veto threat by President Obama.

Ranking Committee Member Sen. Debbie Stabenow:  “I don’t believe that we should be tinkering with active rulemaking decisions at the Commission.  If we are serious about offering end-user relief, then one part of that goal should be empowering the experts at the Commission to put in place the right rules for end-users and the market as a whole. As it stands, I do not believe this bill will receive the broad, bipartisan support necessary to pass the Senate.”

Reauthorization vs. Annual Funding

Reauthorization is technically part of how Congress funds the CFTC, but the agency can keep operating without it.  In practice, reauthorization gives the agriculture committees a vehicle to try to impose changes on the agency.  The most recent CFTC reauthorization was approved in 2008 and expired in September 2013.

If a compromise can be reached on the bill then the CFTC stands to benefit from a firm Congressional endorsement, which will lend some stability to their operation and help reduce uncertainty in the derivatives markets.

Visions of Regulators’ Futures

Roberts’ package of CFTC reforms is particularly topical in the wake of the MetLife v FSOC ruling, which has raised questions regarding the advisability of a federal judge ruling on the merits of a regulators’ actions.  This is something to watch closely as debate moves forward – after the MetLife victory opponents of financial regulation will be sure to want to expand the ability of financial entities to press court challenges against their regulators.

End-Users — Who Are They?

Pension funds, farmers and other downstream users of derivatives would get a “bona fide” exemption from certain hedging rules imposed by the CFTC under Senate Republican legislation released today.

The legislation is aimed at helping what are called “end-users” of derivatives, meaning the individuals who hold and execute a derivative contract.  End-users are distinct from dealers and investors in the sense that they use derivatives specifically to mitigate their operational risks.

Many end-users also happen to be the producers of commodities which form the basis of derivatives contracts, and rely on futures contracts for some financial safety due to their vulnerability in the face of commodities price changes.

Treasury’s New Inversions Rule (Apr. 8)

Mike & Co — 

The week opened with an announcement by Treasury of rules designed to curb corporate inversions.  By week’s end, the rules — which take effect on Monday — had their first success, or victim, depending on your perspective, as the proposed $70 billion Pfizer/Allergan merger was called off.  

Secretary Clinton released a statement on the new rules, implying that she would go further than the Treasury by imposing an “exit tax” on any company trying to leave the US to lower its tax bill.   “We need to close the loopholes that let corporations escape paying their taxes.”

Next: a look at Sanders’ statements to the NY Daily News about banks?  Or in/action on the SEC nomination front?  You decide. 

Good weekends all,

Dana 

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Operation of the Rules 

Proponents say the rule help to make inversion deals less palatable to foreign firms, while critics claim it only raises the cost of capital for foreign firms doing business in America which will ultimately lead to a decrease in international business activity here.

The main culprit in Treasury’s eyes, is earnings stripping — agent a foreign acquiring company “loans” a large amount of money to its new domestic subsidiary (actually, the U.S. firm just             distributes a note to its parent company and pays interest thereafter), to take advantage of the tax deductibility of interest payments.

Previous rules to curb inversions have led to an increase in mergers between roughly equally sized companies and large foreign firms buying up small American ones.  Monday’s rules will apply to all cross-border combinations, meaning that it will affect companies of any size, leveling the playing field for large, medium, and small businesses which may be inversion targets.

The rule defines related-party debt as stock under certain circumstances.   Under the new rules the IRS would have the authority to designate the note created by these deals as stock, not debt – making the interest payments into dividend payments, not eligible for tax deductions.

Per Treasury: “Specifically, the proposed regulations require key information be documented, including a binding obligation for issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship.”

Current inversion laws require that a foreign parent company own a certain amount of stock in the company it targets for an inversion – the new rules state that stock owned by a foreign parent company that was acquired through a separate inversion within three years will not count toward that minimum.

Legal Challenges

There are two areas where Treasury is thought to be on thin ice legally — its rule to limit “recidivist” corporate inverters by tackling multi-step inversions and the guidance on earnings stripping that usesauthority granted to Treasury in 1969 through Section 385 of the tax code.  385 allows Treasury to distinguish debt from equity, but some tax lawyers consider it to be superseded by more recent legislation.  The former problem, regulating multi-step inversions, may run up against the challenge that Treasury cannot decide to unilaterally ignore the manner in which stock is accumulated for inversion purposes.

Although administration officials have claimed that the IRS’ ability to consider some debt as stock would only be utilized under specific conditions, industry lobbyists have claimed that the rule’s broad scope would act to increase the cost of capital for all foreign firms in the United States.

Congressional Action 

Treasury Secreatary Lew said after the release of these new rules that it’s up to Congress to put a stop to inversions permanently – saying that until such legislation passes “… creative accountants and lawyers will continue to seek new ways for companies to move their tax residences overseas and avoid paying taxes here at home.”

Earnings stripping has been the subject of debate for some time now, with Reps. Levin and Van Hollen putting forward a bill to deal with the tactic in February of this year.  Senator Schumer has argued in the past that earnings stripping is the primary reason driving inversions in the first place, saying “the only way to slam the door on inversions for good is to pass tough, strong legislation and reform our tax laws.”

GOP reactions are predictably negative, with Rep. Charles Boustany claiming that “This proposal will do little to stop actual inversions, but will make it more difficult for foreign firms to invest in the United States.”  The new proposals, American Action Forum President Doug Holtz-Eakin said, “have nothing to do with inversions.”

Eye of the Beholder

Complicating matters is that the two parties see earnings stripping in vastly different lights — to Democrats the tactic is a key motivating factor in inversion agreements (See: Sen. Schumer), while Republicans think inversions are driven by a hostile domestic tax system for companies.  JCT last year pointed out that a 2007 Treasury report “did not find conclusive evidence that foreign-controlled domestic corporations are engaged in earnings stripping, and could not determine with precision whether Code section 163(j) is effective in preventing earnings stripping by foreign-controlled domestic corporations.”

Under the new rules, the IRS would have the authority to designate the note created by these deals as stock, not debt – making the interest payments into dividend payments, not eligible for tax deductions.  Treasury: “Specifically, the proposed regulations require key information be documented, including a binding obligation for issuer to repay the principal amount borrowed, creditor’s rights, a reasonable expectation of repayment, and evidence of ongoing debtor-creditor relationship.”

Current inversion laws require that a foreign parent company own a certain amount of stock in the company it targets for an inversion – the new rules state that stock owned by a foreign parent company that was acquired through a separate inversion within three years will not count toward that minimum.

Treasury Secreatary Lew said after the release of these new rules that it’s up to Congress to put a stop to inversions permanently – saying that until such legislation passes “… creative accountants and lawyers will continue to seek new ways for companies to move their tax residences overseas and avoid paying taxes here at home.”

Earnings stripping has been the subject of debate for some time now, with Reps. Levin and Van Hollen putting forward a bill to deal with the tactic in February of this year.  Senator Schumer has argued in the past that earnings stripping is the primary reason driving inversions in the first place, saying “the only way to slam the door on inversions for good is to pass tough, strong legislation and reform our tax laws.”

Republican reactions are predictably negative, with Charles Boustany claiming that “This proposal will do little to stop actual inversions, but will make it more difficult for foreign firms to invest in the United States.”  The new proposals, American Action Forum President Doug Holtz-Eakin said, “have nothing to do with inversions.”

For Democrats’ part, it’s rapidly become gospel that earnings stripping is a critical issue in the inversion problem.  Considering the general strength of feeling that each party has on the matter, support for the new rules will come down along party lines.

Although administration officials have claimed that the IRS’ ability to consider some debt as stock would only be utilized under specific conditions, industry lobbyists have claimed that the rule’s broad scope would act to increase the cost of capital for all foreign firms in the United States.

“Glad to hear Pfizer is calling off the merger.  We need to close the loopholes that let corporations escape paying their taxes,” Clinton said on Twitter.  HRC  would impose further “exit tax” on any company trying to leave U.S. to lower its tax bill.

 

 

 

DOL Fiduciary Rule, Pt. 2 (Apr. 6)

Mike & Co. —

Good seeing you and others at Julie Chon’s tonight.  

As you know, Labor Secretary Tom Perez announced the final DOL Fiduciary Rule this morning at the Center for American Progress.  The Rule was six years in the making, the product of tense negotiations between some moderate Democrats and the Secretary as well as a strong lobbying effort from the financial industry.

Secretary Clinton lauded new Rule today, saying they would “stop Wall Street from ripping off families” and that it can help boost the economy for the middle class and said she would protect President Obama’s efforts to curb Wall Street’s power. Though the Rule’s compliance requirements will not be fully implemented for another two years, the Rule announcement is landmark: with $24 trillion dollars held in retirement savings, including $7 trillion in IRAs, it’s not a surprise that it is getting attention. 

Treasury’s inversion policy initiative, which got even more attention this week, is covered tomorrow. 

Best,

Dana 

 

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The Rule, first proposed last April, will require brokers to act in their clients’ best financial interest when offering retirement investing advice. That’s a higher standard than brokers face now.

In one of the biggest changes from the initial proposal, the final rule simplifies the “best interest contract,” a provision that allows brokers to continue to get paid commissions as long as they make a host of disclosures to customers. Specifically, the final version eliminates a list of financial products that would have effectively been banned in retirement accounts, a key break for listed options and non-traded “Real Estate Investment Trusts,” for example.

In addition, the rule loosens previously proposed disclosure requirements for fees. While the initial rule required annual disclosure of fees, the final rule removes that requirement. The final rule also eliminates a requirement to provide clients with one-, five- and ten-year projections of fees at the point of sale.

Secretary Clinton lauded new White House rules on financial advisers today, saying they would “stop Wall Street from ripping off families” and that the new Rule can help boost the economy for the middle class and said she would protect President Obama’s efforts to curb Wall Street’s power.

Per Labor Secretary Perez: “Are you for consumers, putting their best interests first, or do you think that the only way financial advisers can provide advice is to put their financial interests first?”

The Rule has been among the largest regulatory undertakings for the Labor Department under Obama, as the most recent comment period spanned five months, generated 3,000 comment letters and involved over 100 meetings.

The Rule streamlines earlier requirements — they give advisers a flexible time frame to present a contract outlining any potential conflicts, after industry groups raised concerns that advisers would have to present such paperwork before even beginning a conversation with a potential client.

It also jettisons the idea of requiring firms to provide projections for possible investments, amid concerns such a system would be difficult and expensive to implement.  Investment advisers do not have to meet as strict of data retention requirements as originally envisioned in the proposed Rule.  DOL originally  suggested an eight-month window to fully comply with the new rules.  That window has now expanded to at least one year, but full compliance is not required until the beginning of 2018.

As a result of an extraordinarily lengthy comment and negotiating process, the final Rule issued today contains some key concessions for industry interests aimed at softening the transition period for advisers, curbing disclosure and paperwork requirements, and allowing advisers some leeway to continue hocking their firm’s own products.

How did we get here?

Changes from the Proposed Rule

Foremost among these:

  •  Longer implementation period:

Firms will have until April 2017 to come follow some provisions, and January 2018 to be fully compliant with the new rule – a boon to both small firms and opponents, as skeptical lawmakers will have more time to dilute or reverse the rule during that time.

  •  Proprietary products exemption

Advisers can continue to sell their firm’s proprietary products, as long as they follow best interest standards laid out in the final rule.  For instance, a MetLife employee wouldn’t be obligated to mention a competitor’s products if they had a reasonable basis to believe his firm’s own products are within the client’s best interests.

  •  Commission-based activities clarified:

The final Rule makes more clear what commission-based activities are acceptable under the fiduciary guidelines.

  •  Paperwork reduction:

The Rule clarifies that advisers and clients only need to sign one “best interest contract” when an account is opened, rather than each time they speak with each other or do business.  It also allows firms to simply notify existing clients of the it obligations, rather than sign a new contract.

  •  Annuities rules tightened:

Originally exempted from the Rule, so-called fixed-index annuities have been added to the pool of products requiring a “best interest contract.”  This is one of the few cases of a rule being tightened between the first and final rule.

Impact on Industry

A major concern from independent advisers and small-medium sized firms was the cost of a short period for compliance (originally set to eight months) and the cost of strict disclosure and paperwork requirements.  The Rule aims to quell those worries through its lengthy compliance period and streamlined paperwork and reporting requirements.  When discussing the first draft rule, from April 2015, a mid-size firm with 2,800 advisers estimated its compliance cost at $15 million in the first year.  As companies pore over the new Rule costs in the wake of the new changes will become clearer.

Beyond the cost of compliance, perhaps the greatest cost of all will be through lost business at smaller firms and with independent advisers.  Exemptions for giving advice to independent fiduciaries (such as company plan sponsors), using asset allocation models, and clarifying that an adviser marketing himself is not an “investment recommendation” is meant to help these firms stay competitive.

Big firms stand to gain the most from the new rule, and low-cost annual fee-based investment companies are especially fortunate.  BlackRock, Vanguard, WisdomTree, and State Street all offer low-cost options through index mutual funds or ETFs, which critics claim were given an unfair advantage in the proposed rule; the final rule has removed that particular provision (called the low-fee streamlined option).  Nevertheless, larger firms will be better able to bear the burden of compliance, reporting and paperwork.  They are also able to offer a more comprehensive list of products for investors that comply with the rule, and their business models already favor annual-fee contracts versus commission-based income.

As the final Rule is studied further and its implications are better understood, the picture moving forward will become clearer.  It’s reasonable to expect large firms, like those listed above, to rapidly gain market share as small-account investors move their money over.  Index mutual funds will see a surge and businesses like Vanguard will take an even larger portion of stock ownership to satisfy their new customers.

Impact on investors and Retirees

Per the administration, investors stand to gain back $17 billion lost each year to conflicted advice.  For holders of existing accounts who may be concerned that their current investments will become defunct because of conflict of interest provisions, the final rule contains a grandfathering clause allowing for “recommendations to hold [current investments] and systematic purchase agreements” to continue carrying commission fees.  After the Applicability Date, however, new investments must comply to “basic best interest and reasonable compensation requirements.”

What does that mean in practice?  More retirement advisers will recommend to their smaller accounts that they invest in low-cost fixed-fee products, rather than more complex investments that can contain withdrawal penalties and commission fees.  The DOL sees this as a benefit of the rule, while industry advocates and opponents think it translates to poorer quality advice for savers.

With carve outs for the use of investment models and the provision of advice to “independent fiduciaries” with financial training (more likely to be found heading company-sponsored plans), it’s likely that these plans won’t operate much differently than before.  Adding to that, most company plans are large enough to operate with annual fees rather than through commission, meaning that the reasonable compensation requirements shouldn’t affect their fee structure.

Next Steps

Initial reactions from industry are more or less positive.  No doubt we will hear their full opinions once the rule has been properly analyzed, but the truth is that much of the final Rule dovetails rather nicely with the changes that industry leaders have been making for the past few years.  Shifting to an annual fee-based model, pushing low-cost index funds and ETFs, and increasing education for retirement savers are all popular services offered by leading investment advisory firms.

The future of the myriad bills in Congress aimed at stopping the rule from taking effect isn’t certain – if the changes seen in today’s rule (of which there are many) are enough to placate moderate Democrats and Republicans then their chances will be severely diminished.

The SEC, which has previously warned DOL that its preliminary rule could be harmful, has not yet released an opinion on the Rule.   SEC Commissioner Piwowar, a Republican, said the Obama administration’s rule “seems to ignore the chorus of voices that questioned whether it will restrict middle-class families’ and minority communities’ access to professional financial advice.”

Brokers will need to comply with certain aspects of the rule by April 2017 to take advantage of the best-interest contract. Other requirements will go into full effect on Jan. 1, 2018.

DOL Fiduciary Rule, Pt. 1 (Apr. 5)

Mike & Co. —

Tonight, fingers crossed for the Secretary in the Badger State.

Tomorrow, Labor Secretary Perez will release the final version of the long awaited DOL Fiduciary Rule, ending a long slog toward placing fiduciary responsibilities on myriad investment brokers.  The winners and losers of the Rule aren’t always clear, but one thing is for sure – the amount of coverage and intense lobbying that this ostensibly simple Rule has generated indicates that somebody stands to make a lot of money, and somebody else stands to lose it.

Below is a what-to-look for guide to the outstanding questions the Rule is expected to address.  Tomorrow will feature a summary and analysis of the Rule and its prospects.  Then, Treasury’s inversions initiative.

Best,

Dana

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Questions the Rule May Answer

  • Who is to be covered under the Rule?

The Rule will cover any individual who receives payment in exchange for providing investment advice that is specialized to the customer or directed toward a retirement plan sponsor, a plan participant, or an IRA owner.  This means that an adviser is required to provide investment advice that is in the best interest of the investor, and to explicitly disclose fees and commission payments they might receive.

  • Who will benefit, who doesn’t? Smaller brokerage firms and individual advisers, particularly those who deal with many small investors, stand to suffer during the transition period.  These groups will need to switch from a commission-based system to accepting annual fees; these fees may not be enough when applied to smaller accounts.  Large firms, which predominantly advise larger investors, and low-cost ETF and Index Mutual Funds stand to see a big payday.  The Rule will likely encourage the use of low-cost investment products like index funds, and larger advising firms already make enough off annual fees to continue operating.
  • Will the Rule ever come into effect?Two House bills and three Senate proposals have been put forward to stop the final rule from coming into effect – both House bills would require that the DOL rule be approved by Congress, and would apply looser standards to advisers if the rule was not approved.  The GOP uniformally opposed the proposed rule, and some moderate Democrats have cold feet over it.  If bipartisan support can be built up despite the election year chill, it is possible that the rule won’t see the light of day in its current state.  To combat this, Secretary Perez has been negotiating with Democrats over the past months to make sure their concerns are assuaged in the final Rule.

What’s in a Rule?

The DOL’s proposed definition, released a year ago, identifies a “fiduciary advisor” as any individual receiving compensation for providing advice that is individualized or specifically directed to a particular plan sponsor (e.g. an employer with a retirement plan), plan participant, or IRA owner for consideration in making a retirement investment decision.  This is an exceptionally broad definition and has some brokers spooked.

Some exemptions were included in the 2015 draft of the Rule:

  • Principal Transaction Exemption: Allows advisers to recommend certain securities and sell them to the customer directly from the adviser’s own inventory, as long as the adviser adheres to consumer-protective conditions.
  • Pre-existing Transaction Exemption (Grandfather clause): Allows advisers to receive on-going compensation payments in connection with a prohibited transaction that was completed before the enactment of the proposed rule, as long as the adviser does not provide additional advice to the plan or IRA regarding the same asset after enactment of the proposed rule.
  • Best Interest Contract Exemption:To qualify for the “best interest contract exemption” advisers and firms must enter into a contract with their clients that:

—  commits the firm and adviser to providing advice in the client’s best interest

—  warrants that the firm has adopted policies and procedures designed to mitigate conflicts of interest

—  clearly and prominently discloses any conflicts of interest that may prevent the adviser from providing advice in the client’s best interests

At least two activities will not make someone a fiduciary:

  • Education: The DOL Rule will provide a carve-out for people providing investment education, allowing for advisers and plan sponsors to continue to provide general education on investment decisions.
  • Order Taking: A broker that is simply executing a trade on behalf of an investor, without providing any investment advice, is not considered a fiduciary.

DOL could bring action against fiduciary advisers who do not provide advice in their client’s best interest, while the IRS may levy excise taxes on transactions that are not eligible for an exemption in the rule.  Clients would also be able to bring action against a fiduciary adviser, both as plan participants and IRA owners.

Winners and losers

The DOL Rule will be a boon for larger brokerage firms, many of which already rely on annual fees from larger investors.  They already have little incentive to offer advice that could violate a fiduciary obligation.  The Rule will also boost investment firms which specialize in low-fee investments, like Vanguard and State Street Global Advisors.  Expect to see the major index mutual fund and exchange-traded fund firms to take an even larger share of stocks as a result.

The transition for brokerages and individual advisers, who often rely on commission compensation to operate, could end up hit hardest by the rule.  They claim that the commission broker’s earn is the only thing that makes advising small investors worthwhile, and that switching these accounts to an annual fee would result in brokers dropping their smallest clients.  Smaller firms have also expressed concerns about being able to pay for ensuring their brokers comply with the DOL Rule.

The administration claims that investors lost between $6 billion and $17 billion per year based on bad investment advice, but has so far had a difficult time providing data to support that claim.  That’s in part to the difficulties inherent in quantifying such a loss – these losses are often caused by perfectly legal actions making it hard to use legal records, and other customers may not know that they’ve been fleeced by their adviser at all.

What’s even less clear is how much the winners in this rule stand to gain from its enactment – certainly an increase in ETFs and Index Mutual Funds will result, but whether or not their competitors can accommodate smaller investors on annual fees alone may be a major determinant in how retirement investments are made in the wake of the Rule.