Category Archives: Broker-Dealers

Interesting Angles on the DOL’s Fiduciary Rule #91

Parallels Between the SEC Regulation Best Interest and the DOL Best Interest Contract Exemption (Part 2)

This is my 91st article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws—including the SEC’s “best interest” proposals.

This article continues my discussion of the similarities between the SEC’s proposed Regulation Best Interest (Reg BI) for broker-dealers and the DOL’s Best Interest Contract Exemption (BICE).

In addition to the standard of care (best interest and loyalty), Reg BI also has enhanced protections for conflicts of interest. Interestingly, they closely parallel the DOL’s conditions in BICE. For example, Reg BI proposes to require that material conflicts of interest involving financial incentives be eliminated or, alternatively, be disclosed and mitigated. The key word is “mitigated.” While the SEC guidance refers to “financial incentives” and the DOL refers to “compensation,” the outcome is much the same. ERISA and the Internal Revenue Code prohibit compensation that results from fiduciary recommendations, where the compensation is paid by a third party (for example, insurance commissions or 12b-1 fees) or where the compensation is variable, based on the recommendations (for example, commissions on securities transactions). Those types of payments are, in the view of the SEC, “material conflicts of interest involving financial incentives.”

In BICE, the DOL said that fiduciary advisors (which could include broker-dealers and their representatives) needed to have policies, procedures and practices in place to ensure that the compensation did not incent advisors to make recommendations that were not in the best interest of retirement investors. Similarly, the SEC says that broker-dealers must eliminate, or disclose and mitigate, conflicts of interest that involve financial incentives. As examples of “mitigation,” the SEC and DOL both gave the following:

  • Within a particular investment category, compensation could be levelized. For example, the initial compensation and trailing compensation for all mutual fund sales could be set at the same level. As a hypothetical, that might be a 3% initial commission (or load) on all mutual funds, with a uniform 25 basis point trailing 12b-1 fee.
  • Among investment categories, a broker-dealer might base differences in compensation on “neutral” factors. For example, if it took twice as much work to explain and sell a variable annuity contract, that would be a neutral factor that would justify twice as much compensation for the sale of an individual variable annuity. Hypothetically, if reasonable and level compensation for mutual fund sales was 3%, then in my hypothetical, first-year compensation of 6% could be justified for the sale of a variable annuity.

Keep in mind, though, that those are just examples about how the mitigation requirement could be satisfied. If the SEC’s Reg BI is finalized in its current form, broker-dealers will need to implement those policies or adopt other practices that are reasonably designed to mitigate the impact of material conflicts of interest arising from financial incentives associated with investment recommendations. (More technically, the SEC proposes that Reg BI would apply to recommendations of securities transactions and investment strategies that involve investment transactions.) Based on the examples used by the SEC, it appears that the Commission is serious about mitigation of the incentive effect of those payments.

As this article suggests, in order to fully appreciate the SEC’s Reg BI, broker-dealers need to understand the development and history of the DOL’s BICE. There are remarkable parallels. In fact, it would be difficult to understand some concepts, such as neutral factors, without having worked on BICE compliance issues.

However, it also means that broker-dealers who are in substantial compliance with the final BICE requirements–as opposed to the transition rules–have already substantially satisfied the SEC’s proposed rules. That’s good news. It means that the hard work put in by those firms, and the costs involved, will have been worth it. It also means that, for broker-dealers who were not close to being in compliance with full BICE, practices and compensation arrangements developed by others can be used to develop compliant practices for the SEC guidance.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #90

Parallels Between the SEC Regulation Best Interest and the DOL Best Interest Contract Exemption (Part 1)

This is my 90th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The SEC’s proposed Regulation Best Interest (“Reg BI”) is remarkable in its similarities to the DOL’s vacated Best Interest Contract Exemption (“BICE”). This article describes some of those similarities. Keep in mind as you read this that Reg BI applies to securities recommendations, while BICE would have covered any investment or insurance recommendation by a fiduciary advisor.

Reg BI, if finalized, will require that broker-dealers and their representatives act in the “best interest” of “retail customers,” which includes IRA owners and participants. The DOL’s BICE also would have required that fiduciary advisors (including broker-dealers and their representatives) act in the “best interest” of participants and IRA owners. A major difference is that the SEC proposal covers all retail customers, while the DOL’s BICE would have covered “qualified accounts”—which includes only plans, participants and IRA owners. (I should note that Reg BI says that it covers recommendations to “legal representatives” of retail customers. That reference could include the trustees and plan committees for retirement plans. However, it’s not clear.)

Also, Reg BI is similar to BICE in that it covers recommendations to participants to take distributions from retirement plans and roll over to IRAs. Reg BI only applies where securities recommendations are made. But it appears to be the position of both the SEC and FINRA that a recommendation to take a distribution from a 401(k) plan implicitly includes a recommendation to liquidate the investments in the participant’s account, which would be a securities transaction. (I will get into more detail about recommendations to participants to take distributions and roll over to IRAs in a future article.)

In addition, both Reg BI and BICE include a duty of loyalty for recommended securities transactions. While the wording in the two pieces of guidance is slightly different, the outcome is the same . . . broker-dealers and their representatives cannot prioritize their own interests ahead of the interests of investors.

While some people refer to the new standard of care as being “suitability plus” or “enhanced suitability,” I see it differently. Based on my reading of the guidance and on comments by SEC commissioners, the suitability standard is incorporated into the new Best Interest Standard of Care, rather than the other way around. As a result, it might be better referred to as “transactional best interest.”

Unfortunately, the SEC proposal does not fully define the Best Interest Standard of Care. However, it does say that broker-dealers and their representatives have to act with “diligence, care, skill, and prudence,” which was also in the DOL’s Best Interest Standard of Care. (As an aside, the requirement to act diligently, carefully, skillfully, and prudently suggests the need for a process—similar to ERISA’s prudent man rule.) The proposed Reg BI goes on to say that its duty of care is based on the principles in the DOL’s Best Interest Standard of Care. To me, that means that a starting point for understanding the Reg BI requirements is to look at the DOL’s Best Interest Standard of Care which says that:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

If you read that closely, it easily divides into three categories: a prudent person rule; a know-your-customer requirement; and a duty of loyalty. The preamble to the proposed Reg BI discusses those three principles as being key elements of its standards.

However, while the proposal would require best interest for recommendations of securities transactions, it would not mandate a duty to monitor. That is significantly different from the role of an investment adviser (RIA), where best interest monitoring is generally expected.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #85

The Fiduciary Rule: What’s Next (Part 1)?

This is my 85th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

By now, it’s common knowledge that the 5th Circuit Court of Appeals has thrown out the fiduciary rule. That includes the regulation expanding the definition of fiduciary advice and the related prohibited transaction exemptions, for example, the Best Interest Contract Exemption (BICE). At the same time, the SEC is working on a new “best interest” standard of care, and the DOL is working on amending the fiduciary regulation and related exemptions.

That raises the critical questions . . . where are we now and where are we going?

Let’s start by looking at the issues that the DOL and SEC need to address. Subsequent posts will cover each of these points in more detail.

1. Who is a fiduciary?

This is the threshold question. The 5th Circuit’s opinion said that a fiduciary relationship is one of “trust and confidence” which, in the Court’s opinion, was not typical of arrangements with brokers. Instead, the Court focused on the “mutuality” and “regular basis” parts of the old fiduciary definition (which is discussed in the next Angles, #86).

While not certain, it is possible that the Department of Labor will propose a new regulation, which expands on the old definition and which focuses on the elements of trust and confidence, as well as other criteria.

Meanwhile, the SEC has an entirely different approach. The DOL approach is “functional,” that is, it is based on conduct—if you act in a way that satisfies the fiduciary definition, you are a fiduciary regardless of your registration as a representative of a broker-dealer or RIA. By contrast, the SEC has, at least in the past, regarded representatives of RIAs and broker-dealers as providing different levels of advisory services (e.g., primary versus incidental) and, as a result, as being subject to different standards of care. A critical question for the SEC is whether RIAs and broker-dealers will have the same standard of care.

2. What is the fiduciary standard of care?

The fiduciary standard of care for advice to plans and participants is the prudent man rule and the duty of loyalty. That is based on the ERISA statute and cannot be changed by regulation. (But, of course, this assumes that an advisor is a fiduciary.)

The FINRA “standard of care” for broker-dealers is suitability.

RIAs are fiduciaries under a Supreme Court decision. However, there isn’t any formal definition of that standard of care. The SEC staff has taken the position that the suitability standard applies and that investment advisors must disclose all material information to their clients to permit them to make informed decisions about transactions and their advisory relationship. In addition, from time to time, the SEC applies a “reasonable basis” standard to RIAs.

 (Out of fairness to both broker-dealers and RIAs, the requirements are greater than those described. However, this is a short article, so I am using general descriptions.)

3. How will conflicts of interest be treated under the new rules?

This is the area of greatest differences among the regulators.

 Tax-qualified, ERISA-governed retirement plans are subject to the prohibited transaction rules in ERISA and the Internal Revenue Code. (Those rules are virtually identical in both statutes.) However, only the Code applies to IRAs.

Under both ERISA and the Code, financial conflicts of interest are prohibited. Generally speaking, the conflicts relate to compensation paid to financial institutions, individual advisors or any affiliates. In other words, it’s prohibited for fiduciary advisors and their firms to receive conflicted compensation. However, the DOL has the authority to issue exceptions (called “exemptions”) to the prohibited transaction rules. The most helpful exemption—the Best Interest Contract Exemption (BICE)—was thrown out by the 5th Circuit. As a result, in many cases conflicted compensation for fiduciary advice will be prohibited—if the 5th Circuit decision is the final word. However, it’s likely that the DOL will issue new exemptions—with conditions.

Both the SEC and FINRA generally rely on disclosures to mitigate conflicts. In other words, if adequately disclosed, it is permissible to have financial conflicts of interest for SEC and FINRA regulated advisors.

That describes the general lay of the land. My next few posts will deal with each of those three points.

We live in interesting times.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #84

What Does the 5th Circuit Decision Mean for Rollover Recommendations?

This is my 84th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The 5th Circuit Court of Appeals has “vacated” the DOL’s fiduciary rule and exemptions. What does that mean for recommendations to participants that they take plan distributions and rollover to IRAs?

It means a lot . . . in some cases.

But before discussing that, it’s important to note that the decision isn’t applicable yet. At the earliest, it will take effect on May 7. However, if the DOL contests that decision and the courts “stay”–or block—it as the hearings and appeals take place, it may not apply for a year or more . . . or it may be overturned. So, the only thing we know is that we don’t know whether advisors are governed by the new fiduciary rule–the one the court vacated–or if the “old” pre-June 9, 2017 rules apply. Unfortunately, when it comes to recommendations of plan distributions and rollovers, those two sets of rules are different in significant ways.

Let’s look at the post-June 8, or “new,” rules–the ones that the 5th Circuit considered. Under those rules, a recommendation to take a plan distribution and rollover is a fiduciary act and must be based on a prudent analysis of the participant’s needs and a comparison of the plan and the IRA. Also, it’s a prohibited transaction if the advisor makes more money if the recommendation is accepted by the participant, that is, if the money is rolled to an IRA with the advisor. Fortunately, there is an exemption–the transition Best Interest Contract Exemption, BICE. Unfortunately, it’s hard to comply with BICE.

But, what if the new rules (including BICE) are thrown out? Under the old rules, a recommendation to a participant to take a distribution and rollover was not, in most cases, a fiduciary recommendation. As a result, it was not subject to the prudent man and loyalty requirements, and it was not a prohibited transaction. (Note, though, both FINRA and the SEC view that advice as a securities recommendation subject to their jurisdiction. See, e.g., Regulatory Notice 13-45.)

However, it the advisor was a fiduciary to the plan, a recommendation to rollover would be a fiduciary act. See DOL Advisory Opinion 2005-23A. Of course, that implicates the fiduciary standard of care–prudence and loyalty. It also is a prohibited transaction if the fiduciary recommendation causes the advisor (or the advisor’s firm) to earn more from the IRA than it did from the plan. For example, if the advisor is a fiduciary to the plan and the compensation from the plan is 25 basis points a year, but the compensation from the IRA will be 100 basis points per year, that’s a prohibited transaction. Unfortunately, there isn’t an old rule exemption . . . meaning there’s no way around the prohibition.

To make matters worse, many broker-dealers have allowed their advisors to be fiduciaries to the plans they work with . . . so the number of fiduciary advisors to plans is much greater than it was before June 9 of last year. And some of those advisors had counted on rollovers as part of the bargain for their services to the plans.

To further compound matters, I suspect that the attention given to fiduciary services in recent years means that more advisors are fiduciaries whether they declare that status or not. That’s because the old rule had a functional definition that will be satisfied in many cases. Two provisions in the old rule are that the advice must be given regularly and there has to be a mutual understanding that the advice will be a primary basis for the plan sponsor to make investment decisions. Since most advisors now meet with plan sponsors at least once a year, the “regularly” requirement appears to be satisfied. And, it’s possible that a disinterested reasonable third party would view the materials and statements by the advisor are a primary basis for investment decisions. In that case, the second prong may also be satisfied. (Some people think that the mutuality is about an explicit understanding between an advisor and a plan sponsor. The DOL, though, would probably take the position that the test should be what a reasonable third party would think of the interactions.)

What does this mean? What should advisors and their firms do?

Until this plays out, advisors and their firms need to satisfy two conflicting rules. Of course, that’s impossible.

If the new rules are followed, rollover recommendations must be prudent and loyal. The benefit of that burden, though, is that BICE would be available. That’s not a bad result under the transition rules for BICE.

But, if the old rules are followed, many advisors will not be fiduciaries . . . and therefore won’t need an exemption. However, for those advisors who are fiduciaries to plans, recommendations to rollover will be fiduciary acts and likely prohibited transactions–without relief. Perhaps they could use education, rather than make recommendations.

Unfortunately, though, until the legal “dust” settles, in the sense of a resolution of the litigation, we won’t know which rules apply.

More practically, I suspect that many advisors and their firms will continue under the new rules until the situation clears up. That could be as early as late April, or it could be delayed until the Supreme Court rules–if the case gets that far, perhaps more than a year from now.

If that wasn’t complicated enough, it’s likely that the DOL will come out with a new proposed rule and exemptions in the second half of this year. If I had to guess, I would say that these revised rules will still say that a recommendation to take a distribution and roll over was still a fiduciary act. The interesting part would be what the new exemption will require.

Bottom line . . . get legal advice; this is risky.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #81

The Fiduciary Rule Prohibits Commissions . . . or Not (Myth #6)

This is my 81st article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is another in my series of articles about myths concerning the Fiduciary Rule. The myth for this post is the oft-repeated statement that the Fiduciary Rule prohibits the payment of commissions.

Before getting into the explanation, though, I should give you some background information. Under the prohibited transaction rules in ERISA, a fiduciary advisor cannot make a recommendation that causes a payment from a third party (for example, a 12b-1 fee or an insurance commission) or that directly increases the advisor’s compensation (for example, a commission on a securities transaction). While those ERISA prohibited transactions only apply to retirement plans, there are virtually identical rules under the Internal Revenue Code–which apply to both qualified retirement plans and IRAs.

However, those prohibited transactions apply to advisors who are fiduciaries. As a result, the prohibitions were not a problem for non-fiduciary advisors prior to the June 9, 2017 expansion of the definition of fiduciary. With that new Fiduciary Rule, almost every advisor to retirement plans or IRAs is now a fiduciary. That includes financial advisors of broker-dealers, investment advisors with RIAs, and insurance agents and brokers.

Now that advisors are usually fiduciaries, ERISA and the Internal Revenue Code prohibit the receipt (i) of payments from third parties and (ii) of compensation that varies with the recommended investments or insurance products. If that were the end of the story, then it would not be a myth to say that commissions are prohibited by the Fiduciary Rule. But, it’s not the end of the story. On June 9, 2017, the “transition” version of the Best Interest Contract Exemption (BICE) also came into effect. Under transition BICE, there is only one explicit restriction on compensation. That is that advisors and their financial institutions can receive no more than reasonable compensation for their services. In other words, and as a general rule, the BIC exemption permits the payment of reasonable compensation in virtually all forms. As the DOL said in its preamble to the BIC exemption: “[T]he Department confirms that this exemption provides relief for commissions paid directly by the plan or IRA, as well as commissions, trailing commissions, sales loads, 12b-1 fees, revenue sharing payments, and other payments by investment product manufacturers or other third parties to Advisers and Financial Institutions.”

But . . . there is still more to this story.

The Department of Labor has also said, on several occasions, that it expects financial institutions (such as broker-dealers and RIAs) to have policies, procedures and practices that ensure that the form of compensation does not cause advisors to recommend investments that are not in the best interest of the retirement investors. As a result, financial institutions should develop policies, procedures and practices for those purposes. That could include reducing the differences between levels of commissions, close supervision of certain types of transactions, and/or specifying the process by which recommendations are to be developed. In other words, the development of those policies, procedures and practices needs to be done thoughtfully. There is no “one-size-fits-all” solution that will satisfy the requirements for all types of transactions. For example, it is difficult to imagine a single policy that would cover issues as diverse as recruitment bonuses, recommendations to participants to roll over, and sales contests.

I am concerned that some broker-dealers, banks and RIAs may be underestimating the importance of well-developed policies for each of the types of potential conflicts of interest that could impact advice to plans, participants and IRA owners.

Note: The BIC exemption only provides relief for nondiscretionary investment advice. This article does not apply to arrangements for discretionary investment management.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #80

Is the New Fiduciary Rule Enforceable During the Transition Period? (Myth #5)

This is my 80th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is another in my series of articles about myths concerning the Fiduciary Rule. This article deals with the “myth” that the fiduciary rule will not be enforced during the transition period. As the word “myth” suggests, that’s not correct.

As background, the Department of Labor said that it will not, under appropriate circumstances, enforce the requirements of the fiduciary regulation and prohibited transaction exemptions (and, particularly, the Best Interest Contract Exemption [BICE]):

Accordingly, during the phased implementation period from June 9, 2017 to July 1, 2019, the Department will not pursue claims against fiduciaries who are working diligently and in good faith to comply with the Fiduciary Rule and applicable provisions of the PTEs [Prohibited Transaction Exemptions] or treat those fiduciaries as being in violation of the Fiduciary Rule and PTEs.”

The IRS has agreed to abide by that non-enforcement policy.

At first blush, that could be interpreted to be a free pass for compliance until the transition period ends on July 1, 2019. However, it would be a mistake to read it that way. The DOL went on to say:

At the same time, however, the Department emphasizes, as it has in the past, that firms and advisers should work “diligently and good faith to comply” with their fiduciary obligation during the Transition Period. The “basic fiduciary norms and standards of fair dealings” are still required of fiduciaries during the Transition Period (citations omitted).

As a result, we know that there is a “line in the sand” and crossing that line could result in DOL enforcement. However, we don’t know quite where the line is. Elsewhere, though, the DOL has said that it expects financial institutions (for example, broker-dealers and RIA firms) to develop policies, procedures and practices which are designed to ensure that advisors do not succumb to conflicts of interest and do not make recommendations that are not in the best interest of retirement investors. As a result, it would be poor risk management for broker-dealers and RIAs to provide investment advice to plans, participants and IRAs (“retirement investors”) without having adopted appropriate policies, procedures and practices . . . and then supervising compliance with those policies, procedures and practices. Stated slightly differently, there is a risk that the failure to take those steps could result in the DOL finding that a broker-dealer or RIA had not worked “diligently and in good faith” to comply with the fiduciary rule and the PTEs.

So, the first lesson is that the non-enforcement policy does not give a free pass during the transition period. Instead, there are expectations about good faith efforts to comply with the Impartial Conduct Standards and about the adoption and application of policies, procedures and practices to mitigate the effects of conflicts of interest and incentive compensation.

A second enforcement risk is that private claims by investors can be made under the fiduciary rule and the prohibited transaction exemptions. It is clear that, for advice to plans and participants (which would include, for example, recommendations of rollovers), there is a private right of action under ERISA. In other words, for advice to plans and participants, ERISA’s remedial provisions apply even during the transition period. As a result, while DOL and IRS enforcement may be limited, private claims can be filed on behalf of fiduciaries and participants.

The issue is somewhat more complex for claims of fiduciary breaches and failures to satisfy the PT exemptions for IRAs. However, it is likely that claimant’s attorneys will be asserting fiduciary claims with creative theories. For example, if an advisor with a broker-dealer engages in a prohibited transaction (that is, receives compensation from a third party, such as a mutual fund, or otherwise makes recommendations that affect the level of his or her compensation), the broker-dealer and advisor would need the benefit of a prohibited transaction exemption—probably BICE. That creates a Hobson’s choice. If the broker-dealer defends itself by saying that it was not claiming the benefit of the BIC exemption (and, therefore, was not bound by the Impartial Conduct Standards, including the best interest standard of care), that defense is effectively an admission of the commission of a prohibited transaction. On the other hand, if the broker-dealer responds by claiming the benefit of the exemption, the broker-dealer is agreeing that it is bound by the Impartial Conduct Standards. While neither of those may be explicit claims available to claimants, those choices can put financial institutions and their advisors in difficult positions.

Finally, there may be claims by state regulators. For example, the State of Massachusetts recently filed a claim against a broker-dealer on the basis that it violated its policies and procedures concerning sales contests. Those policies and procedures were developed as a result of the DOL’s Fiduciary Rule and prohibited transaction exemptions. In other words, the claim was not that the broker-dealer violated the Impartial Conduct Standards, but instead it violated its own policies and procedures, which were developed in order to comply with the those Standards. (By the way, individual investors and their attorneys could also assert claims on that basis.)

What does this mean? It means that the fiduciary “waters” are treacherous. It means that advisors and their financial institutions should re-double their efforts to provide documented advice that is in the best interest of retirement investors. The easiest way to avoid difficulties is to comply with the new rules.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #79

The Fiduciary Rule: Mistaken Beliefs (#4)

This is my 79th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This post continues my series on myths about the fiduciary rule and prohibited transaction exemptions. This article focuses on the issue of “reasonable compensation” for RIAs, broker-dealers and their advisors for their services to retirement plans and IRAs (“qualified accounts”), and what, if any, changes will be made to that requirement. The myth is that the SEC will draft rules that eliminate the reasonable compensation rule. That is incorrect. The reasonable compensation limitation on advisors and their supervisory entities is here to stay.

This article explains why the reasonable compensation limits are here to stay and what advisors and their supervisory entities need to do to comply with those rules.

The fiduciary regulation is currently in effect. It first applied on June 9, 2017. And, it applied in full force. That is, while there are transition versions of the prohibited transaction exemptions, the fiduciary regulation was not modified to be a transition version.

The effect of the fiduciary regulation is to broadly expand the definition of who is a fiduciary. Because of the regulation, virtually anyone who makes an investment or insurance recommendation to a plan, a participant, or an IRA owner, is a fiduciary.

The conflict of interest exceptions (called “exemptions”), on the other hand, only partially applied on June 9th. The most important exemption—the Best Interest Contract Exemption, or BICE—requires only that advisors and their supervisory entities adhere to the Impartial Conduct Standards. Those standards are:

  • The best interest standard of care, which is, in its essence, the prudent person rule and the duty of loyalty.
  • No materially misleading statements.
  • No more than reasonable compensation for the individual advisor and the entity.

However, even if the reasonable compensation condition in BICE is removed from the exemption, that will not mean that advisers and their supervisory entities can ignore that limit. And, even if the SEC or FINRA do not impose a reasonable compensation limitation, that will not change the rule. Why is that?

The reasonable compensation limit is found in both the Internal Revenue Code and ERISA. In other words, it is a statutory requirement. Neither the DOL, the SEC nor FINRA can issue a rule that overrides a statute.

But, what if the definition of fiduciary is changed and an advisor is no longer a fiduciary? That doesn’t matter either. The reasonable compensation limitation in the Code and ERISA applies to all service providers, regardless of whether they are fiduciaries.

With that background, the essential question is, how do advisors and their financial institutions determine the reasonableness of their fees? Before I answer that question, though, I want to explain two threshold issues. The first is the definition of compensation and the second is the definition of reasonableness.

ERISA and the Code use “compensation” to cover all payments, monetary and non-monetary, that are compensatory. A compensatory payment is one which is partially or entirely, directly or indirectly, attributable to an investment or insurance recommendation. The DOL uses a “but for” test to determine if a payment is compensation, that is, would the broker-dealer or RIA firm have received the payment “but for” the investment recommendations. If the payment is partially or entirely, directly or indirectly, attributable to investment recommendations, it is compensatory.

With regard to “reasonableness,” the DOL explains that the reasonableness of compensation is determined by the services provided by the advisor. In effect, the marketplace defines “reasonable” because, in most cases, the ordinary and customary compensation for the services associated with particular transactions is reasonable.

More specifically, the DOL explained in its preamble to BICE:

The reasonableness of the fees depends on the particular facts and circumstances at the time of the recommendation. Several factors inform whether compensation is reasonable including, inter alia, the market pricing of service(s) provided and the underlying asset(s), the scope of monitoring, and the complexity of the product. No single factor is dispositive in determining whether compensation is reasonable; the essential question is whether the charges are reasonable in relation to what the investor receives.

Now, let’s turn to the steps that advisors and their supervisory entities should take to determine whether the compensation for a particular type of investment transaction is reasonable. Financial institutions and advisors need to obtain information about the marketplace pricing for various types of transactions. For example, what is the range of customary compensation for individual variable annuities? What is customary for referrals to third party asset managers? What is customary for mutual funds? And so on.

While it may be possible for financial institutions to collect that information on their own (and to update it periodically . . . perhaps annually), the more practical and cost-effective answer is to work with a benchmarking service that obtains and updates that information. Of course, advisors and financial institutions should investigate the experience and quality of the benchmarking service, and the integrity and timeliness of its data.

Keep in mind that the reasonable compensation limits are in the prohibited transaction rules. As a result, the burden of proof is on the financial institution, and not on the retirement investor. In other words, it’s important to have market data and to develop compensation policies that are consistent with the data. Since it is likely that the levels of reasonable compensation will change over time, that information should be updated at reasonable intervals.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #78

The Fiduciary Rule: Mistaken Beliefs (#3)

This is my 78th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The fiduciary regulation has been in effect since June of last year — a period of over six months. As you might expect, we are seeing mistakes and misunderstandings about activities that can result in fiduciary status for advisors. This article covers one of those.

The myth for this Angles is that broker-dealers and RIAs, and their advisors, must only recommend the lowest cost investments, for example, mutual funds with the lowest expense ratios. That is not correct.

In fact, the DOL has explained that:

“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” [81 Fed. Reg. 21002, at page 21030 (April 8, 2016)]

As indicated in that quote, and as explained elsewhere by the Department of Labor and several courts, an advisor’s fiduciary responsibility is to recommend investments with reasonable expenses . . . or, in a more specific context, to recommend mutual funds with expense ratios within the range of reasonableness for the particular plan and the type of fund.

For advisors with broker-dealers, the expense ratio of mutual funds typically includes a cost component and a compensation component (that is, compensation for the advisor). Assume, for example, that the expense ratio of a mutual fund is 100 basis points and that it includes a 12b-1 fee of 25 basis points. Viewed in terms of cost and compensation, the true cost of the mutual fund is 75 basis points and the cost of the advisor’s compensation is 25 basis points. In order to perform a proper analysis of cost of the investment, that distinction must be made.

Once the “true cost” is determined, that should be used as the expense ratio of the mutual fund for purpose of the fiduciary analysis of whether the cost of the investment is reasonable. (Note that, the reasonableness of the cost of an investment is a fiduciary issue measured by the best interest standard of care; however, the reasonableness of the compensation of the firm and the advisor is a prohibited transaction issue.)

A second step in the fiduciary analysis of cost is the determination of whether or not the appropriate share class is being recommended (including, for example, whether waivers are available). Generally speaking, the lowest cost available share class should be recommended. However, keep in mind that I am referring to the lowest “net cost” share class. In other words, the advisor’s compensation (for example, the 12b-1 fee) should be deducted to determine the true cost and then should be compared to the net cost of the other share classes of the same mutual fund.

Once an investment’s cost has been appropriately determined, and the appropriate share class has been determined, that information should be compared to similar data for other mutual funds in the same investment category. Again, though, the requirement is not that the lowest-cost investment be recommended. Instead, it is that the cost be reasonable relative to the value provided. On a practical level, that means that there is a range of reasonableness for a given type of investment. The risk is in recommending an investment that is clearly more expensive than what is typically charged for that type of investment.

Since a broker-dealer, RIA and advisor are fiduciaries for this purpose, the process used for the selection of investments and the determination of the reasonableness of cost should produce documentation that can be retained and retrieved. In other words, firms and advisors should be in a position to prove that they engaged in a prudent process.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #76

Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

This is my 76th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The regulation defining fiduciary advice for plans, participants and IRAs applied on June 9, 2017. As a result, we now have some experience with the fiduciary regulation and the transition prohibited transaction exemptions. Based on that experience, there are some significant misunderstandings about how the rules work. This article discusses one of those.

If a broker-dealer or RIA firm receives prohibited (or “conflicted”) compensation from an IRA, the compensation may be permissible under the Best Interest Contract Exemption (BICE). During the transition period (until July 1, 2019), BICE only requires that fiduciary advisors (such as broker-dealers and RIAs, and their representatives) adhere to the Impartial Conduct Standards. There are three Impartial Conduct Standards. Those are:

  • The best interest standard of care (which is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty).
  • The compensation of the financial institution and the individual advisor is no more than a reasonable amount for the services rendered.
  • Neither the financial institution nor the advisor makes any materially misleading mis-statements.

There are two other considerations, though. The first is that BICE is an exemption to the prohibited transaction rules and, therefore, the burden of proof is on the financial institution (e.g., the RIA firm or broker-dealer). As a result, compliance with those three Impartial Conduct Standards should be documented in a retrievable form. The second is that the Department of Labor has said that financial institutions need to have policies, procedures and practices that ensure that their advisors are adhering to the Impartial Conduct Standards.

All in all, though, it is possible to comply with those requirements. Stated another way, the most burdensome requirements in BICE were delayed until July 1, 2019—and will likely be revised before those rules apply.

However, there is a caveat. That is, BICE only applies to non-discretionary investment advice. In other words, if the financial institution or its advisors have the responsibility or authority to make the decisions, or if they actually make the investment or transaction decisions, and there is a financial conflict of interest (that is, a prohibited transaction), BICE does not provide relief. To make matters even worse, there are very few exemptions for prohibited transactions resulting from discretionary decisions. Based on conversations with RIAs over the last few months, I have learned that many of them are not aware that, where they have financial conflicts (for example, 12b-1 fees or payments from custodians) for discretionary investment management for IRAs, there is usually not an exemption and the compensation is prohibited.

In other words, where advisors have discretion, the “cleanest” approach is “pure” level fee advice. Any payments or financial benefits from third parties (e.g., custodians, mutual funds, insurance companies) are prohibited. The DOL’s definition of “discretion” is very broad, for example, if the advisor selects the share class, and the investor does not approve that share class in advance, the advisor (and therefore the financial institution) has exercised discretion.

With that in mind, my advice is that RIAs and broker-dealers should consult with their ERISA attorneys to make sure that they understand these rules and are in compliance.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #75

The Fiduciary Rule: Mistaken Beliefs

This is my 75th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The fiduciary regulation has been in effect since June of last year — a period of over six months. As you might expect, we are seeing mistakes and misunderstandings about activities that can result in fiduciary status for advisors. This article covers one of those.

In the past, there was a common belief among advisors that fiduciary status could be avoided by presenting a list of investments to plan sponsors. For example, an advisor might provide a list of three alternatives in each investment category (e.g., three alternatives for a large cap blend fund, three alternatives for a small cap fund, and so on). The belief was that, since the list did not “recommend” any particular investments, it could not be a fiduciary recommendation.

While that may (or may not) have been correct before June 9, it is not correct today. The presentation of a selective list will result in fiduciary status, implicating the prudent man rule, the duty of loyalty, and the fiduciary prohibited transactions.

To quote from the new fiduciary regulation:

“Providing a selective list of securities to a particular advice recipient as appropriate for that investor would be a recommendation as to the advisability of acquiring securities even if no recommendation is made with respect to any one security.”

While the practice of presenting selective lists was, at least in my experience, primarily for participant-directed plans, e.g., 401(k) plans, under the new definition, the presentation of selective lists of investments would also be fiduciary advice to individual retirement accounts and individual retirement annuities.

The “moral of the story” is that advisors and their supervisory entities (for example, broker-dealers and RIAs) need to realize that when they provide these types of lists, they will be making fiduciary recommendations. For recommendations to retirement plans, that means that the advisor must engage in a prudent process to evaluate the investments based on factors such as the expenses of the investments, the quality of investment management, the reasonableness of the compensation paid to the advisor from the investments (e.g., 12b-1 fees), and so on. From a risk management perspective, that process should be documented and retained in a retrievable form.

For recommendations to IRAs, if the advice is given by a “pure” level fee fiduciary, the advisor is not committing a prohibited transaction (that is, doesn’t have a financial conflict of interest), and the best interest standard of care does not apply to the advisor. A “pure” level fee advisor would typically be an RIA that charges a level advisory fee, does not receive any payments from the investments, and does not recommend any proprietary products.

However, where an advisor to an IRA receives payments from the investments or where the advisor can affect the level of his compensation based on the investments that are recommended, that would be a financial conflict of interest, which is a prohibited transaction under the Internal Revenue Code.

As a result, if an advisor presents a selective list of investments to the IRA owner, those would be viewed as fiduciary recommendations and any payments from the investments (such as 12b-1 fees) would be prohibited transactions. To avoid a violation, the advisor and the financial institution would need to satisfy the requirements of transition BICE. The most significant of those requirements is the best interest standard of care, which is a combination of ERISA’s prudent man rule and duty of loyalty. That standard of care is somewhat more demanding than the suitability and know-your-customer standards. Advisors and financial institutions need to understand these rules, so that they do not inadvertently fail to comply with them. Also, the burden of proof of compliance is on the financial institution; as a result, the best interest process should be documented.

The second “moral of the story” is that advisors should be familiar with the new rules, so that they don’t inadvertently fall into a compliance trap.

Forewarned and forearmed.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

 

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