In a perfect world, all investors with qualified retirement accounts would have unfettered access to reasonably compensated fiduciary advisors offering non-conflicted advice on all investment options available in the market today.
And no one would get sued.
“That would be the best imaginable outcome,” says Michael Wong, a senior equity analyst for Morningstar Research Services. “The best circumstance would be the fiduciary rule goes through, everyone uses the BIC (best interest contract exemption), and there are no class action lawsuits.”
Unfortunately, few in the industry expect that to be the case if the Labor Department’s fiduciary rule is implemented as written, not the least of whom is Wong.
Wong was the lead Morningstar analyst behind recently published estimates of class-action settlements the financial services industry can expect to pay under the rule, assuming it goes into effect with the private right-of-action provision intact.
In the long term, industry can expect to pay between $70 million and $150 million in annual class-action settlements. In the near term, the numbers are likely to be higher, said Wong.
The BIC Exemption’s private right-of-action provision prohibits institutions from writing class-action exclusions into the contracts advisors will have to use to earn commission-based and variable compensation on investment recommendations.
“The DOL would prefer that every firm would be able to comply with the BIC Exemption without material conflicts,” said Wong.
“But it would be hard to deny there will be some class action law suits lodged against wealth management firms if the rule is implemented as is,” he added.
The first attempt at estimating class-action costs
For years, the most powerful opponents of the rule have argued its private right-of-action provision will open the floodgates to a new body of vague, complex, potentially meritless and ultimately expensive litigation. The costs of defending those claims will be baked into the price of investment services and passed on to retirement savers.
While industry has deployed that argument in lawsuits against the rule and in the court of public opinion, stakeholders have been reluctant to estimate litigation costs under the private right of action.
So, too, was the Labor Department in its rulemaking process. Regulators did request supplemental litigation estimates from stakeholders before finalizing the rule, but industry was unable to provide a number due to “the extreme uncertainties surrounding litigation risk,” according to a comment letter from the Financial Services Institute, a trade group appealing a decision to uphold the rule in a Texas federal court.
Ultimately, the Labor Department did not factor the cost of class-action lawsuits into its cost estimates to comply with the rule.
Morningstar has lent its stamp of approval to Labor’s regulatory impact analysis, which says the rule will cost industry $5 billion in upfront compliance costs and $1.5 billion in ongoing costs.
But Labor’s estimate of compliance costs for individual large financial firms is low, says Morningstar. Compliance will cost some broker-dealers four times the $7.4 million in average annual costs estimated by the Department.
Adding in the cost of class-action settlements throws a further wrench in Labor’s cost estimates. For Stifel Financial, a relatively small broker-dealer among publicly owned firms, factoring higher estimates of class-action settlements brings the firm’s annual compliance costs to 15 times the $1.8 million in ongoing costs estimated by the Labor Department, according to Morningstar.
While settlements add to the rule’s impact beyond what the Labor Department accounted for in its regulatory analysis supporting the rule, Wong does not think it will be open season for class actions if institutions choose to work with the BIC Exemption.
“The rule’s private right of action is about protecting against having bad systems in place, and not guaranteeing that there won’t be a bad apple or two,” said Wong.
Satisfying numerosity requirements in order to get courts to certify class-action claims will handicap plaintiffs’ attorneys’ ability to create a class from the actions of one rogue advisor, thinks Wong.
Morningstar’s report concludes that firms will be incentivized to adhere to prudent policies protecting investors’ best interests in order to avoid the cost of class actions.
“The threat of a class action is about moving industry away from systemic conflicts,” added Wong.
How Morningstar gets its numbers
Quantifying class-action litigation under the rule is speculative business, admits Wong, who is confident his assumptions are reasonable.
It’s also a necessary exercise, given the rule’s impact on industry, public policy, and investors in public markets.
He applied four methods to weighing class-action costs, using data on restitution paid in individual arbitration claims since 2011; assessments from Labor’s analysis of premium increases for Errors and Omissions insurance under the rule; data on disgorgements paid by plan sponsors resulting from investigations by the Employee Benefits Security Administration; and estimates based on settlements of lawsuits against defined contribution plans.
Wong said the preferred method is using data from monetary recoveries from EBSA investigations, which produces the $70 million to $150 million estimate.
Basing predictions off private-action settlements against large 401(k) plans is not as efficient a method, though Wong expects some stakeholders will be tempted to use those settlements to overstate the potential for class-action costs under the fiduciary rule. Estimates based on 401(k) class-action settlements produce much higher numbers.
Wild cards in Morningstar’s estimates
Basing estimates off existing regulatory requirements is inherently problematic, says Jason Roberts, CEO of the Pension Resource Institute.
“The new requirements for exemptions under the rule are so revolutionary that using arbitration and litigation numbers under the status quo is likely not a good proxy,” thinks Roberts, who said he is nonetheless supportive of efforts to factor litigation expenses under the rule.
“Defined contribution plans and IRAs are inherently different animals,” added Roberts. “The recent litigation with 401(k) plans isn’t necessarily going to translate to IRA litigation under the rule. It’s extremely difficult to predict class action activity.”
What is safe to estimate, according to Roberts, is that firms using the BIC Exemption will have a higher bar to overcome defending individual investor claims in arbitration hearings.
“I don’t want to downplay the impact of having a written agreement in arbitration,” he said. “Rest assured, the BIC Exemption will be exhibit A. It’s an increased burden for financial firms, but I still don’t think it's easy to quantify or forecast what that will cost industry.”
Even meritless class actions cost money to defend
Wong said Morningstar’s estimates do not account for attorneys’ fees.
That fact, in part, explains why even the $150 million estimate seems low, says Carol McClarnon, a Washington, D.C.-based ERISA attorney with Eversheds Sutherland.
“Class actions can be very expensive to defend, just to get to the motion to dismiss a meritless claim,” said McClarnon.
“The problem with trying to project litigation costs is we are dealing with a whole new regulatory structure that’s never been litigated or interpreted before, where providers were not fiduciaries before the rule,” she added. “I see a lot of uncertainty as to how litigation will play out, but it will certainly be brought.”
If the rule is implemented as written, McClarnon expects considerable resources will be committed in litigation just to work through the rule’s meaning, even when there is no obvious harm to investors. “There would be no real benefit to plan participants or IRA investors in that.”
Theoretically, firms that apply the BIC Exemption should be protected if they have documented efforts to comply with the contract.
But monitoring distribution channels for conflicted advice will present a real challenge, and potential liability.
“The plaintiffs’ bar can be very creative,” said McClarnon. “We’ll just have to respond to what they come up with.”