How the Fiduciary Rule Will Harm Fintech and Startups

Add startup entrepreneurs and Fintech innovators to the long list of potential victims of the Department of Labor’s pending fiduciary rule.

There is already bipartisan concern that many ordinary people far away from Wall Street will be harmed if the final fiduciary rule, likely to be released next week by the Labor Department (DOL), is not changed significantly from the proposed rule put forth last year. A letter from more than half of the Democrats in the House of Representatives – 96 to be exact – expressed concern that the rule, as proposed, “could have a disproportionate impact on lower or middle-income consumers.”

Independent insurance agents and small and midsize brokers in every corner of the country also say that the rule will devastate their businesses. And as I have reported previously in FORBES, the rule could even implicate financial broadcasters such as Dave Ramsey and Suze Orman who give financial guidance to individual callers on their shows.

The rule, which would sharply restrict types of investments in 401(k)s and individual retirement accounts (IRAs,) could also curtail investment in startups. Why? Because though not widely reported, IRAs have long been a significant source of startup investment from angel investors, venture capitalists, and often the entrepreneurs themselves.

The rule labels as “fiduciaries” a broad swath of financial professionals who service IRAs and 401(k)s – extending potentially even to appraisers and custodians who have virtually nothing to do with savers’ investment choices. It then mandates that these “fiduciaries” only advance a portfolio in the “best interest” of the savers they serve. Center-left economists Robert Litan and Hal Singer describe this “best interest” requirement as “a vague open‐ ended obligation with seemingly no bounds.” As a result, it will be almost inevitable that financial service providers will restrict choices of investment vehicles and strategies and look for a “safe harbor” of particular investments the government would bless. And that safe harbor will likely not include startups, even though a good number of IRAs have long invested in these new firms.

As Angel Capital Association Chairman David Verrill writes, “It has been legal to use a retirement account to invest into private stock since the 1970’s when IRAs were born.” Some big-name investors have done so in very successful ventures. As FORBES reported, venture capitalist Peter Thiel – the first outside investor in Facebook – invested in the early stages of the company’s growth partially through his self-directed IRA. Similarly, Max R. Levchin, who co-founded PayPal with Thiel in 1998, utilized his IRA to become one of the first private investors in the social media review site Yelp.

And now, Fintech, as well as liberalization of equity crowdfunding from the Jumpstart Our Business Startups (JOBS) Act, is beginning to bring this opportunity to everyday IRA holders. The popular peer-to-peer lending sites Prosper and Lending Club are partnering with IRA custodians so savers can purchase these interest-bearing loans as assets for their IRAs.

The 37-year-old IRA Services Trust, a Bay Area firm that has assisted well-heeled IRA holders in investing in Silicon Valley startups, is expanding into new options with its InvestNow platform to help average investors diversify their retirement accounts with some startups in their portfolios as well. Says Todd Yancey, chief strategy officer for the firm, “People may not have regular savings to invest in a startup if they have kids in college and other expenses, but they have the money to do so in their 401(k)s and IRAs.”

Are there risks? Yes. However, there is some risk with any investment, and the smartest investors seem willing to take this risk as part of a diversified portfolio. The expansion of IRA investment in startups also seems to be consistent with statement of President Obama when he signed the JOBS Act into law in April 2012. The president proclaimed at the signing ceremony, “For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”

Yet the fiduciary rule threaten to eviscerate the JOBS Act’s gains in freedom for ordinary investors. On top of that, it may even wipe out crucial funding from startups from investors the Securities and Exchange Commission has long recognized as having the wealth and sophistication to invest in startups. Incredibly, in mandating that financial professionals only facilitate investments in the “best interest” of savers they serve, the rule has no equivalent to the SEC’s exemption for “accredited investors” allowed to take more risks.

The proposed rule starts with the premise that most investors are stupid. As I note in my Competitive Enterprise Institute paper, “Fiduciary Rule for Dummies,” the DOL believes that even with improved disclosure, “savers are not smart enough to make what [the department] considers the correct investment decisions for their retirement.”

The rule explicitly proclaims that most individuals cannot “prudently manage retirement assets on their own,” and that they “generally cannot distinguish good advice, or even good investment results, from bad.” And unlike longstanding SEC rules, the fiduciary rule makes no apparent exception for investors who can prove their wealth or sophistication.

The SEC’s Regulation D designates “accredited investors” as those with more than $1 million in assets (not including personal residence), or who make more than $200,000 as an individual or $300,000 as a couple. These folks – including angel investors, venture capitalists, and private equity and hedge fund holders – can be sold private securities free from much of the red tape for public companies from laws such as Sarbanes-Oxley and Dodd-Frank. A bipartisan bill that passed the U.S. House of Representatives in February would also let non-wealthy folks who have demonstrated their investing proficiency become “accredited investors” as well.

But while Congress and the SEC have recently worked to expand the pool of investors available to startups, the DOL seems determined to radically shrink it. When it comes to the “best interest” mandate of the fiduciary rule, the DOL says through omission that no “accrediteds” need not apply. And “fiduciary” is defined so broadly as to even potentially include custodians and appraisers of self-directed IRAs, who measure value but in no way provide advice. This heightened liability could limit IRA service providers, which could in turn limit investment in startups and Fintech.

When the DOL proposed a similar rule in 2010, IRA custodians spoke out in opposition and the DOL withdrew the proposal one year later. Tom Anderson, board manager of Pensco Trust, a San Francisco-based IRA custodian that is now one of the leaders in offering crowdfunding options, wrote in comments to the DOL in 2011 that imposing a fiduciary standard “would result in higher costs and potentially fewer service providers to self-directed IRAs,” which “in turn, could result in fewer investment choices.” Anderson’s comments were written on behalf the Retirement Industry Trust Association, a trade group for custodians of self-directed IRAs.

To prevent undue harm to startups, Fintech, and many other potential victims, Congress must stop the DOL from “starting up” such a destructive rule.

Originally posted at Forbes.