On March 15, 2018, the Fifth Circuit struck down one of the most controversial regulatory projects upon which the Department of Labor has ever embarked: its so-called “Fiduciary Rule.” A lot will be written in the coming days about the decision, but all too little will be written about its implications for the proper functioning of our government. I will attempt to reduce that imbalance.
At its core, the Fifth Circuit’s decision is a rebuke of audacious government overreach. The Fiduciary Rule was designed to enlarge the Labor Department’s authority over investments in Individual Retirement Accounts, commonly referred to as “IRAs.” As the Fifth Circuit explained, the Labor Department “made no secret of its intent to transform the trillion-dollar market for IRA investments, annuities and insurance products, and to regulate in a new way the thousands of people and organizations working in that market.” Significantly, the Labor Department not only sought to claim new authority over the IRA market; it sought to wrest that authority away from the Securities and Exchange Commission (“SEC”), which had been expressly directed by Congress to evaluate the same standards the Labor Department took it upon itself to impose.
How could an agency expand its own authority? By regulating through the backdoor—that is, by coaxing the regulated public to “agree” to acquiesce to duties the agency had no power to impose on it, in exchange for other relief the agency could grant.
I’ll explain. The Labor Department has authority over employer-sponsored retirement plans under the Employee Retirement Income Security Act of 1974 (“ERISA”), but it has virtually no authority over IRAs, which are governed by the Internal Revenue Code. To be sure, IRA investments are extensively regulated. The SEC, together with self-regulatory organizations (such as FINRA), supervise all conduct and sales activity by broker-dealers; state insurance agencies likewise supervise insurances sales professionals; and the Treasury Department enforces the relevant requirements of the Internal Revenue Code. But IRAs have nothing to do with “labor” and little to do with the Labor Department. The Department has but two small roles that featured largely into the design of the Fiduciary Rule. First, the Labor Department has limited authority to define certain terms that appear in both ERISA and the Internal Revenue Code. Congress conferred this authority to the Department for consistency and as a matter of administrative convenience. Second, the Labor Department can grant exemptions from restrictions, called the “prohibited transaction” rules, that bar specified transactions under both ERISA and the Internal Revenue Code. Here is the source of the mischief: Although the Labor Department lacks any other authority over the Internal Revenue Code and IRAs, it can coerce agreement to various requirements from people who need exemptions from the prohibited-transactions rules.
You might be thinking that this should not a problem; surely, ERISA and the Internal Revenue Code did not prohibit so many transactions that the Labor Department could hold out potential exemptions as a means to impose restrictions on whomever it pleases. Before the Fiduciary Rule, you would have been right, but the Obama Administration’s Labor Department had not forgotten about the Department’s ability to define certain terms. The Department could simply broaden the prohibited transaction rules by redefining terms that relate to their scope. Then, more people would need exemptions, and the Labor Department could decide what price they must pay to obtain those exemptions.
Take the term “fiduciary,” for instance. The prohibited transaction rules bar fiduciaries from engaging in transactions in which they earn a commission for the sale. The term “fiduciary” had historically been reserved to a special class of dedicated advisors—those who held a special relationship of trust and confidence with their clients or beneficiaries. This settled understanding of the fiduciary relationship ensured that the prohibited transaction rules did not bar ordinary investment professionals, such as broker-dealers and insurance agents, from making any commission sales to IRA investors. But if all salespeople could be redefined as “fiduciaries,” then they would all need exemptions from the Labor Department to continue their businesses. And if the requirements that other regulators imposed on those salespeople did not satisfy the Labor Department, then the Department could withhold exemptions from them unless they agreed to adhere to additional requirements.
That is the essence of the Fiduciary Rule: The Labor Department deliberately broke the commission system so that everyone would need a fix that only the Department could provide. (Star Wars fans may find this ploy reminiscent of the senator-turned-emperor who manufactured a war so that he could claim war-time powers.) First, the Labor Department redefined “fiduciary,” eviscerating the time-honored requirement of an ongoing relationship so that anyone who made a single sale to an IRA owner would be deemed his or her fiduciary. This was not Congress’s intent, and you don’t have to take my word for it. Even the Department admitted that its new definition “could sweep in some relationships that are not appropriately regarded as fiduciary in nature and that the Department does not believe Congress intended to cover as fiduciary relationships.”
Having outlawed commission sales, the Department then dangled an exemption called the “Best Interest Contract Exemption” or “BICE.” To qualify, investment professionals would be required to make wide-ranging new disclosures and enter into written contracts with their clients, called “Best Interest Contracts” or “BICs.” The BICs obligated those investment professionals to adhere to new standards of “impartial conduct” written by the Labor Department. It also subjected those professionals to lawsuits, including in class actions, by their customers for any purported departures from those standards. Through this two-step process, the Labor Department cast off the limits of its authority and arrogated to itself the power to impose requirements that the SEC was charged with evaluating. Indeed, the Labor Department not only imposed new standards of conduct on the IRA market, but also created a private enforcement mechanism for those standards, though it lacked affirmative power to do either.
What a mighty regulatory tool! Just imagine the applications it could have. If, for example, the Labor Department grew dissatisfied with the emission standards promulgated by the Environmental Protection Agency, never to fear: The Department could perhaps impose punishing overtime rules on employers who failed to conform to its more stringent limits. Of course, there could be some confusion regarding the regulation of labor and employment. Suppose the SEC were unimpressed with the Labor Department’s workplace health and safety standards. What would stop it from requiring corporations to comply with its own, stricter standards as a condition to listing their stock on a public exchange? Just about any agency could regulate just about any subject if such backdoor regulation were lawful.
It is not.
In a 2-1 opinion in Chamber of Commerce of the U.S.A., et al. v. U.S. Department of Labor, the Fifth Circuit vacated the Fiduciary Rule “in toto.” The court applied the familiar two-part test set forth in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., examining, first, whether the Labor Department’s new definition comports with the plain text of ERISA and the Internal Revenue Code and, second, whether that interpretation is reasonable. The Fiduciary Rule flunked both tests.
First, the Rule’s definition of “fiduciary” was contrary to the text of ERISA and the Internal Revenue Code, as well as decades of court precedent and Congress’s understanding of the term as reflected multiple other statutes. The court emphasized that Congress’s use of “fiduciary” was presumptively based on the common-law meaning of that term, and the Labor Department could not stray from that meaning without statutory authority that is plainly absent from ERISA and the Internal Revenue Code.
Second, even if there were any arguable ambiguity in the terms the Labor Department redefined, the Fiduciary Rule’s interpretation was unreasonable. The court cited extensive support for this conclusion. Among other things, the court observed that the Fiduciary Rule conflated the Labor Department’s authority over employer-sponsored retirement plans with IRAs; acknowledged that sales activity differs from fiduciary activity in some provisions of the Rule, while denying that same distinction in others; abused the power to reduce regulatory burdens through exemptions as leverage to impose an entirely new architecture of regulation; improperly created private liability without any congressional authorization to do so; violated the Federal Arbitration Act by unlawfully dictating the terms of the lawsuits it would impose on investment professionals; impermissibly assumed authority over a broad swath of the economy that Congress had entrusted to the oversight of other regulators; and circumvented provisions in the Dodd-Frank Act by adopting regulations that Congress prohibited the SEC from adopting.
Although it did not decide the issues, the Fifth Circuit also raised two critically important considerations concerning the current state of administrative law. First, bound though it was to follow precedent, the court observed that considerable controversy has arisen over the propriety of Chevron deference. This observation is a reminder that the U.S. Supreme Court may soon be asked to reconsider whether its deference rule improperly abdicates judicial responsibility to interpret the law to the executive branch. Second, without deciding its “precise status,” the court acknowledged the emergence of a “major questions” doctrine that might provide an exception to the ordinary rule of deference when an agency regulates in areas of “deep economic and political significant.”
Commentators are bound to have plenty to say about the effect of the Fifth Circuit’s decision on investment regulation, but what is far more important is that the decision thoroughly and convincingly reinforces the separation of powers and the limited authority of administrative agencies. It makes clear that regulators may not rewrite the boundaries of their own jurisdiction by compelling the public’s agreement to give them more power. One supposes that many supporters of the Fiduciary Rule have spent a fair bit of time since the last presidential election questioning the wisdom of expansive executive power. It will be telling to see whether they acknowledge that the Fifth Circuit’s decision is a victory for the liberties secured by faithful enforcement of Congress’s and the Constitution’s restrictions on executive authority.
Where will we go from here? Some may ask if the Fifth Circuit’s decision marks a conflict with a Tenth Circuit ruling, issued days earlier, that upheld some aspects the Fiduciary Rule. It does not. The Tenth Circuit addressed a narrow challenge to the Rule’s regulation of products called “fixed indexed annuities.” Although the Tenth Circuit rejected that challenge, it made clear that it was not addressing, and was not asked to address, two threshold issues that are fundamental to the validity of the Fiduciary Rule: namely, whether the Labor Department had the authority to adopt the Rule, and whether the Rule’s definition of “fiduciary” was lawful. By contrast, the Fifth Circuit squarely addressed those questions, answered both in the negative, and held that those answers required the Rule to be vacated. Because the Fifth Circuit vacated the Rule on grounds the Tenth Circuit did not consider, the two decisions are not in conflict. And when Fifth Circuit’s judgment takes effect (which should occur on or before May 7, based on the current schedule), the Fiduciary Rule will be vacated everywhere.
Many will ask whether the Labor Department will seek further review of the Fifth Circuit’s decision. Early reports suggest it will not, and it plainly should not. Apart from being legally correct, the decision is aligned with the current Administration’s policies. It eliminates an extraordinarily controversial and burdensome regulation that would have imposed tens of billions of dollars in compliance costs. It rejects a regulatory tactic that threatened to erase the lines of responsibility among federal agencies. It also clears the way for the new leadership in the Labor Department to focus on its own priorities.
Even unabashed proponents of government overreach will recognize that the Fifth Circuit’s decision is not the worst conceivable outcome for them. As the Fifth Circuit observed, this case implicates broader questions about the propriety of judicial deference to agencies. Although the Fifth Circuit was bound to apply the Chevron framework, the Supreme Court is not, and further review very well could lead to much greater limitations on agency power. Moreover, the Fiduciary Rule was bad policy. Investment professionals are already subject to sweeping regulation, and the SEC is currently examining that regulation at Congress’s direction. The Labor Department does not have substantial expertise in the regulation of investment activity, and its foray into this field drove many major companies out of segments of the retirement investment market. The Rule would have multiplied regulatory burdens while reducing investment options. The time has come to move on, allow the SEC to continue its work, and recognize that the cause of liberty is advanced whenever limitations on government power are properly and faithfully applied.
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Jason J. Mendro is a litigation partner in the Washington, D.C. office of Gibson, Dunn & Crutcher LLP. Gibson Dunn represents plaintiffs challenging the Fiduciary Rule, including the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association, the Financial Services Institute, the Financial Services Roundtable, the Insured Retirement Institute, and other leading trade associations.