The Private Equity for Families Blog

Hasty Rulemaking Will Alter Employment Relationships

I am stunned by the rapid fire set of initiatives by the Labor Department under the leadership of the ambitious Thomas Perez. In the last six months he has called for changes in the minimum wage, the level of pay that will exempt an employee from overtime and the imposition of a fiduciary standard on stockbrokers and insurance agents. The last initiative is going to change forever how individuals interact with financial advisers and, ultimately, will spawn thousands of class action lawsuits.

I always thought the mission of the Labor Department was to promote jobs and create fairness in the workplace. Its website states its mission as follows:

OUR MISSION: To foster, promote, and develop the welfare of the wage earners, job seekers, and retirees of the United States; improve working conditions; advance opportunities for profitable employment; and assure work-related benefits and rights.

Employers Will Respond

In the private equity world sponsors understand their responsibility to all stakeholders including the exempt and nonexempt men and women who work for our portfolio companies. We understand that there is a war for talent and good employees have choices in the marketplace. A number of our portfolio companies provide good jobs with fair benefits to people who earn less than $15.00 per hour. Given the historic low turnover among our workers, you begin to assume that these workers like and need their job. However, if you have 100 workers earning $13.00 per hour in California or New York, you now have 100 employees making $15.00 per hour on account of new minimum wage rules adopted by those states. That is a pay increase of 15.38% and, more importantly, a dollar increase in labor expense of $400,000 based on a 2000 hour annual work plan.

Without corresponding productivity increases, any employer who is trying to make his budget will immediately think about cutting $400,000 of labor expense. That means right away 13 workers may lose their job just to break even. In addition, every employer who cannot relocate from high minimum wage states will also begin to ask about robots and factory automation to replace people. For the 87 workers who remain this is a pyrrhic victory as short sighted as the ambition of a politician on the move. The 87 are now at risk of being replaced by systems or having the employer relocate to lower wage states or countries.

How can this trend promote the welfare of the wage earner in the United States?

Similarly, how can an immediate mandated increase in the population of people who are paid overtime end well? The service economy has millions of workers who are considered exempt from overtime by virtue of making more than $23,400 per year. If you raise that rate from $23,400 to $50,000 what will most employers do to meet their budget? They will have to make sure that the new nonexempt people work less than 40 hours. If they cannot, they will have to lower base wages to make up for the new overtime. In reality, employers do not lower wages. They fire workers instead. They will also have to find people replacements like automation, robots or low wage outsourcing to handle the additional labor expense of overtime and double-time. Predictably, labor expense will seek equilibrium. More importantly, because this is a national standard, employers will be encouraged by the Labor Department to outsource to lower labor rate countries like Mexico.

How does this foster, promote and develop the welfare of the wage earner?

Turning Boy Scouts into Navy Seals

Finally, Mr. Perez has decided that stockbrokers and insurance agents should be fiduciaries. Wex Legal Dictionary defines fiduciary duty as “a legal duty to act solely in another party’s interests”.  As recently as May 22, 2015 The United States Supreme Court in the case of Tibble v. Addison affirmed that an ERISA fiduciary duty has a “continuing duty of some kind to monitor investments and remove imprudent ones. “According to the USA Today in an Article by Sam Powell on April 6 any person — be they a broker, registered investment adviser or insurance agent — paid to give advice to a plan sponsor (an employer with a retirement plan, for instance), plan participant or IRA owner is a now considered fiduciary. The new rule would also apply to advisers who help workers decide whether to roll over their money from an employer-sponsored retirement plan, such as a 401(k) or 403(b), to an IRA.”

No one can argue that there are many cases of abuse where an owner of an IRA or a plan participant in an employer sponsored 401k plan has received self-interested advice by a commission based salesman. As owners of companies with employer sponsored plans we are mindful of the conflict of interest and seek the best, unbiased advice for our employees and their retirement nest eggs. However, this new rule may boomerang and actually impose almost absolute liability for investment performance on many good firms that provide solid, unbiased advice that subsequently goes bad. Had this rule been in effect in 2008, there would be countless class action lawsuits still standing in 2016 where plan participants, rightly or wrongly, charge breach of fiduciary duty for loss of investment. We will have to see whether the Department of Labor can become an interested party in those lawsuits and whether the tort industry will have new opportunities for class actions. All I know from my legal training is that this is the highest standard of care at law or in equity. It dwarfs the concept of negligence or misdeeds and Mr. Perez is imposing it on an industry that has historically operated on self-interest and has virtually no training in this almost impossible duty of care. It is like asking a Boy Scout troop to become Navy Seals overnight.

The Wolf Pack Is Assembling

Many of the best small advisory firms may conclude they, in essence, are guaranteeing an investment result. The stakes are large because $14 trillion is estimated as being held in accounts that would be subject to the new rules. My prediction is that important middle class jobs will be lost as good investment advisors exit the field. Instead of the commissioned salesman, a majority of whom are now providing good (but self-interested) advice,  the owner of a 401k may find his retirement fortunes will ride exclusively with the Department of Labor and a law firm with a 30% commission whose advertisements appear on the side of a city bus.  I have also heard that the new rules will allow states to compete with the private sector in providing this advice. However, the states will be exempt from the fiduciary standard and also exempt from many SEC safeguards. That $14 trillion may just be too juicy to pass up if you are a state with a budget deficit?

The rush for presidential legacy and Mr. Perez’s political ambition may be destroying one of the great private sector job creators left in the United States. This is also the greatest gift to the mass tort industry since asbestos. By the way I heard my first plaintiff lawyer commercial this morning urging me to hire them to straighten out the “crooked” stockbrokers. The wolf pack is assembling.

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Rob McCreary

Rob McCreary has more than 40 years of transactional experience as an attorney, investment banker and private equity fund manager, and has spent his career in building entrepreneurial organizations with successful track records Founder and chairman of CapitalWorks, he is responsible for developing and maintaining senior relationships with investors and portfolio governance.

This blog represents the views of Rob McCreary and do not reflect those of CapitalWorks or its employees. This blog is not intended as investment advice. Any discussion of a specific security is for illustrative purposes only and should not be relied upon as indicative of such security’s current or future value. Readers should consult with their own financial advisors before making an investment decision.

Private Equity for Families Blog | CapitalWorks Private Equity Cleveland Ohio

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