The Financial Choice Act And The Pushback On Fiduciary Duties

• Posted on: May 8 2017

On April 26, 2017, the House Financial Services Committee (the “Committee”) held a hearing, entitled “A Legislative Proposal to Create Hope and Opportunity for Investors, Consumers, and Entrepreneurs.” (Here.) The purpose of the hearing, which lasted over three hours, was to examine the discussion draft of the “Financial CHOICE Act of 2017” (“CHOICE Act 2.0”), which was introduced by Committee Chairman Jeb Hensarling on April 19, 2017. (Discussed here.) The CHOICE Act 2.0 seeks to repeal and make fundamental changes to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), as well as other financial regulatory laws.

On May 4, 2017, the Committee voted to send the CHOICE Act 2.0 to the full House for a vote. (Here.)

Last week, this Blog discussed the proposed change to the SEC Whistleblower program included in the Choice Act 2.0 (here); namely, that relators who are non-criminally culpable participants (deemed “co-conspirators” under the discussion draft) in the alleged violation are ineligible to receive a reward for their information. In this installment, this Blog will address the proposed bill’s effort to protect fiduciaries from challenges by those whose interests they are charged with protecting.

DOL Fiduciary Rule

In May of last year, this Blog wrote about the Department of Labor’s (“DOL” or “Department”) fiduciary rule (“Fiduciary Rule”), which requires financial advisors to put their clients’ interests first when making investment recommendations for retirement accounts, such as 401(k)s and IRAs. (Here.) The rule, designed to prevent conflicts of interest, had strong support from the Obama administration and investor advocates who argued that inappropriate recommendations cost retirement investors $17 billion a year.

On February 3, 2017, President Trump signed a memorandum directing the DOL to determine whether the Fiduciary Rule should be revised or rescinded. (Discussed here.) The memorandum directed the DOL to delay the implementation date of the rule by 180 days. Pursuant to that direction, on March 10, 2017, the DOL filed a notice proposing to delay the start of the Fiduciary Rule from April 10 to June 9, 2017. (Here.) After a 15-day public comment period, the DOL sent its delay notice to the Office of Management and Budget for review. (Here.)

Following the OMB’s review, the DOL publicly released an official 60-day delay to the effective date of the Fiduciary Rule.

Although the DOL has been tasked with reviewing the desirability of, and necessity for, the rule, if enacted into law before June 9, the CHOICE Act 2.0 will effectively take that decision away from the Department.

Under the previous version of the CHOICE Act, the DOL was prohibited from issuing a fiduciary duty rule until 60 days after the Securities and Exchange Commission (“SEC”) issues a rule.  In that regard, the act would have blocked the Fiduciary Rule from becoming effective until 60 days after the SEC initiates a fiduciary rule governing the standards of conduct for brokers when providing personalized investment advice about securities to a retail customer. The CHOICE Act 2.0 abandons the 60-day time limit, instead requiring the DOL to issue a fiduciary rule that is “substantially similar” to the SEC’s rule.  Since the SEC has not issued a fiduciary duty rule, the CHOICE Act 2.0 effectively prevents the Fiduciary Rule from becoming effective.

Fiduciary Duty Under Section 36(b) of The Investment Company Act of 1940

The Investment Company Act of 1940 (“ICA”) regulates investment companies, including mutual funds. See Jones v. Harris Assocs. L.P., 559 U.S. 335, 338 (2010). “Congress adopted the [ICA] because of its concern with the potential for abuse inherent in the structure of investment companies.” Id. at 339 (citing Daily Income Fund, Inc. v. Fox, 464 U.S. 523, 536 (1984)). The ICA provides various safeguards for shareholders in response to the risk of abuse, including limitations on affiliations of fund directors with investment advisors and a requirement that fees for advisors be approved by the directors and shareholders of the funds. Id. In 1970, Congress amended the ICA to “strengthen the ‘cornerstone’ of the Act’s efforts to check conflicts of interest, [and ensure] the independence of mutual fund boards of directors, which negotiate and scrutinize advisor compensation.” Id. (citation omitted). In that regard, the ICA includes a broad provision empowering the SEC to bring actions in a federal district court to seek civil penalties or injunctive relief against individuals or entities that violate the ICA. 15 U.S.C. § 80a-41(d)-(e).

In creating Section 36(b), Congress imposed a fiduciary duty on investment advisors with respect to the receipt of compensation for services. Section 36(b) provides shareholders with a private right of action to enforce this obligation. Section 36(b) does not, however, give plaintiffs the right to sue for alleged breaches of general fiduciary duties.

Case law makes clear that a breach may be shown only where the fee charged is “so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” Jones, 559 U.S. at 346. The court’s function is to use “the range of fees that might result from arm’s-length bargaining as the benchmark for reviewing challenged fees” and “identify the outer bounds of arm’s length bargaining.” Id. In applying this standard, courts consider the following factors: (1) the nature and quality of the services provided to the fund and shareholders; (2) the profitability of the fund to the adviser; (3) any “fall-out financial benefits,” those collateral benefits that accrue to the adviser because of its relationship with the mutual fund; (4) comparative fee structure (meaning a comparison of the fees with those paid by similar funds); and (5) the independence, expertise, care and conscientiousness of the board in evaluating adviser compensation. Id. at 1426, n.5 (citing Gartenberg v. Merrill Lynch Asset Mgmt., Inc., 694 F.2d 923, 929-32 (2d Cir. 1982)). These factors are non-exclusive. Therefore, courts are to consider “all relevant circumstances.” Gartenberg, 694 F.2d at 929); see also Sivolella v. AXA Equitable Life, Civ. A. No. 11-cv-4194 (PGS)(DEA), 2016 WL 4487857, at *4 (D.N.J. Aug. 25, 2016) (“The Court weighs all of the evidence presented and the gravity of each factor to adjudicate the case.”) (citation omitted).

Plaintiffs have the burden of proving a breach of fiduciary duty under Section 36(b).  Jones, 559 U.S. at 340 (internal citations omitted); 15 U.S.C. § 80a-35(b). This means that plaintiffs must meet the burden of proving their case by a preponderance of the evidence. Kasilag v. Hartford Inv. Fin’l Servs., LLC, 2:11-cv-01083, at *7 (D.N.J. Feb. 28, 2017).

The CHOICE Act 2.0 seeks to change the foregoing by requiring private plaintiffs to state their claim with particularity and prove it by clear and convincing evidence. By imposing these requirements, the CHOICE Act 2.0 seeks to treat the ICA’s breach of fiduciary duty claim like a fraud claim. Under the Federal Rules of Civil Procedure, fraud claims must be pled with particularity. Most states require the plaintiff to prove fraud with clear and convincing evidence, rather than a preponderance of the evidence generally applicable to civil claims. Some jurisdictions also apply the higher pleading standard to breach of fiduciary claims, in effect treating them as fraud claims. By imposing a heightened pleading standard and burden of proof, the CHOICE Act 2.0 will make it even more difficult for a plaintiff to sustain breach of fiduciary duty claims against officers, directors or other specified fiduciaries of the investment company.

Tagged with: Fiduciary Duty, Securities, Securities Arbitration