Before the Labor Department formally delayed the full implementation of the fiduciary rule in November of 2017, regulators were sending clear signals that clean shares of mutual funds would play a prominent role in revisions to the regulation.
A FAQ issued in May 2017 by the agency noted the emerging prospect of broker-dealers and fund managers using clean shares as way to comply with the Obama-era regulation, which was written in an attempt to protect investors by reducing conflicts of interest in mutual fund recommendations.
“Such an approach is a potentially powerful means of reducing conflicts of interest with respect to mutual fund recommendations,” Labor wrote in the FAQ.
When the Department ultimately delayed the rule by 18 months, it based its reasoning, in significant part, on product innovations such as clean shares, and the additional time industry would need to address the “logistical obstacles” of implementing a new share class industry-wide.
“The delay provides firms with additional time to address these issues and successfully launch products that benefit investors,” wrote Labor when it issued the delay of the rule.
Clean shares of mutual funds unbundle the fees and commissions brokers and advisors are paid on investment products. Other share classes embed varying levels of compensation in the cost of funds, raising potential conflicts of interest by incentivizing recommendations based on the level of compensation, and not on the prudence of the investment.
In January 2017, the Securities and Exchange Commission issued an interpretive letter in response to inquiries from the Capital Group, owner of American Funds, an action that was widely viewed as paving the way for clean shares.
As the Trump administration undertook a review of the rule, ordered by the president, a consensus in industry soon after followed: The Labor Department would streamline the regulation criticized by stakeholders as overly burdensome by crafting a new clean share exemption.
A Solution in Search of a Problem?
But that outcome is now much less certain. For all of the promise initially seen in clean shares, some of industry’s most influential players have since raised concerns to Labor and the SEC over conditioning an exemption on clean shares.
And a decision in the 5th Circuit Court of Appeals vacating the fiduciary rule has raised the prospect that the Trump administration will cease revising a rule that a court has said is defunct.
“It is still possible DOL could issue a streamlined clean share exemption, but I’d have to guess that if the fiduciary rule dies, DOL will move on to other priorities,” said Kevin Walsh, an attorney with the Groom Law Group.
“Without the fiduciary rule, clean shares are a solution in search of a problem,” added Walsh.
Even before Labor delayed full implementation of the rule, stakeholders were cautioning regulators of the potential negative unintended consequences of an exemption conditioned on clean shares.
In an August 2017 comment letter to Labor, Vanguard asked the Department to craft new streamlined exemptions to the rule that protect investors from conflicts of interest.
But a clean share exemption would not be flexible enough, and could have the effect of stifling future product innovations by overly favoring clean shares, Vanguard said.
“It is imperative that streamlined exemptions be based on principles and general characteristics of products and services that protect retirement investors and promote innovation, rather than limiting available relief to particular types of products that exist, or are being contemplated,” the firm said. “The Department should not limit future streamlined exemptions to specific investment products.”
More recently, Vanguard raised the same concern in a comment letter to the SEC. A spokesperson for Vanguard said the firm would not comment beyond the issues raised in letters to regulators.
Aron Szapiro, director of policy research at Morningstar, has been a prominent advocate of clean shares as a way to mitigate conflicts with investment recommendations.
But he too said there are “very legitimate concerns” that an exemption to a fiduciary standard based on clean shares could stifle future product innovation.
“There’s no question in my mind that DOL has peeled back the onion on this and found it to be much more complicated,” Szapiro told BenefitsPRO.
The Capital Group, which initiated the momentum behind clean shares when it sought clarification from the SEC, supported the prospect of a clean share exemption in its comments to Labor.
But the firm also cautioned Labor, and later the SEC, that other compensation models should be protected.
“While we believe that clean shares will play an important role in preserving commissionable investment advice, we do not think it should be the only option available for recommending mutual funds on a commissionable basis,” the firm wrote in its comments to Labor, noting that Class A shares of mutual funds, which come with embedded broker compensation, can be beneficial to investors. The Capital Group would not comment for this story.
Exemption or Not, Momentum Continues for Unbundled Investments
Even if Labor were to stop revising the fiduciary rule, the agency will of course still retain its jurisdiction under the Employee Retirement Income Security Act. It could also be expected to issue new exemptions relative to a uniform fiduciary standard that emerges from the SEC.
“DOL is still the primary regulator in the retirement plan space and the regulator who has authority to grant exemptions in the IRA space,” said Kevin Walsh.
“After the SEC issues its proposal, stakeholders will want to know whether DOL is willing to issue an exemption providing prohibited transaction relief for entities that comply with the SEC’s rule. DOL’s answer to that question could even play a role in determining whether stakeholders support the SEC’s proposal,” added Walsh.
If an SEC rule, or subsequent Labor exemptions, are not based on clean shares, the innovation is still likely to find legs in the market, said Szapiro.
“The SEC’s standard may not directly embrace clean shares, but then, neither did the DOL’s fiduciary rule. When regulators focus on conflicts of interest, clean shares become a potential way to mitigate conflicts, and we could see a renewed interest in them,” he said.
“There has been a lot of interest in moving past traditional share classes with loads and 12b-1 fees,” added Szapiro, noting trends in the defined contribution market. “I think we will continue to see industry move away from traditional share classes toward share classes that unbundle certain fees. However, whether they will fully unbundle these fees or partially unbundle them remains to be seen.”
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