Category Archives: Broker-Dealers

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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Interesting Angles on the DOL’s Fiduciary Rule #69

Compensation Risks for Broker-Dealers and RIAs

This is my 69th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

While the Best Interest Contract Exemption (BICE) is greatly simplified during the transition period, there is more than meets the eye, and broker-dealers and RIAs need to consider whether their practices for compensating advisors encourage advice to retirement investors that may not be in the best interest of those investors. Certain compensation practices are more risky than others. This article discuss some of the arrangements that pose the greatest risks.

As background, transition BICE requires that broker-dealers and RIAs adhere to the Impartial Conduct Standards when making investment recommendations to plans, participants, and IRA owners . . . where there is a conflict of interest. For this purpose, a prohibited conflict of interest exists where the firm or the individual advisor receives compensation from a third party (e.g., 12b-1 fees or insurance commissions) or where the compensation is received as a result of the recommendation (e.g., commissions on securities transactions). Transition BICE first applied on June 9, 2017, and based on recent DOL activity, it appears that it will continue to be the rule until June 30, 2019.

The Impartial Conduct Standards are: the best interest standard of care (basically ERISA’s prudent man rule and duty of loyalty); no more than reasonable compensation; and no materially misleading statements. However, the DOL has imposed one more requirement. In the notice of the extension of the transition rules (and, previously, in a set of FAQs), the DOL made clear that firms need to have policies, procedures and practices that ensure that advisors do not succumb to the allure of incentive compensation and give advice that is not in the best interest of the retirement investor in order to receive that compensation. (However, if the compensation is reasonable for the services rendered, it would be difficult, but not impossible, to argue that a violation had been committed.)

On a related matter, the DOL has said that, for advisors and their supervisory firms to receive the benefit of the DOL and IRS non-enforcement policies, the firms must make diligent and good faith efforts to comply with BICE. I worry that the failure to have policies, procedures and practices in place will cause the loss of protection under the non-enforcement policy.

Based on prior DOL statements and guidance, there are several types of compensation that appear to create greater risks. In those areas, firms are well-advised to have robust policies, procedures and supervision. Some of those are:

  • Recruitment compensation. The DOL has identified recruitment compensation practices that it believes create substantial incentive for advisors to make recommendations that are not in the best interest of retirement investors. Firms should familiarize themselves with that DOL guidance and design their programs accordingly.
  • Bonus arrangements. This is another area where firms should consider re-designing their compensation practices to avoid concerns identified by the DOL. For example, the DOL favors narrower increments to qualify for bonuses (or increased bonuses) and then favors that the bonuses for each of those narrower “steps” be correspondingly smaller so not to be an inappropriate incentive to give advice that favors the advisor over the retirement investors. Similarly, “waterfall” bonus arrangements are disfavored. (A waterfall arrangement is one where the increased bonus percent “waterfalls” back to cover all of the commissions for the year.)
  • Recommendations of plan distributions and rollovers. In the typical situation, the advisor will not earn anything if the participant doesn’t accept the recommendation, but the advisor will receive compensation (and, for a large rollover, perhaps significant compensation) if the retirement investor accepts the recommendation. The DOL has issued detailed guidance about what information it expects broker-dealers and RIAs to collect and examine before making recommendations to participants to take distributions and make rollovers. A firm’s policies and procedures–including supervision–should literally reflect (or even re-state) those requirements. This is not an area to take risk.

Those are just some examples . . . but now that the full exemptions are being delayed until 2019, broker-dealers and RIAs should revisit the DOL’s guidance and focus on developing compliant practices, particularly in the high risk areas.

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 #68

Recommendations of Distributions: The SEC Joins the Fray

This is my 68th 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.

In 2013, FINRA put its stake in the ground on recommendations of distributions and rollovers when it issued Regulatory Notice 13-45. The DOL has, with the development of its fiduciary regulation over the past few years—which became applicable on June 9 of this year—taken a similar, but more demanding position. However, the DOL’s guidance has more teeth than FINRA’s, because it is backed by a standard of care—the prudent man rule and duty of loyalty—and by the prohibited transaction rules in ERISA and the Internal Revenue Code. Recently, the SEC has joined the fray with the issuance of its ReTIRE initiative and its examination priorities over the past few years.

The SEC has completed the first phase of its ReTIRE initiative. This Angles article reports on the observations from the first phase and the current examination priorities.

Needless to say, recommendations and rollovers are issues of concern to the SEC and are, in fact, being examined. RIAs and broker-dealers who do not have well-developed practices and documentation for recommending rollovers and distributions may be surprised when the SEC raises those issues and faults their practices. However, my belief is that compliance with the DOL’s best interest standard of care (that is, the prudent man rule and the duty of loyalty) will satisfy the standard of care and conflicts of interest concerns of both the DOL and the SEC. As a result, broker-dealers and RIAs should focus on compliance with the DOL rules (especially in light of the SEC’s examination positions). Additionally, broker-dealers and RIAs should seriously consider affirmatively disclosing the conflicts of interest inherent in recommending distributions and rollovers.

Here is some additional information about the SEC examinations and their observations:

  • The SEC has conducted over 250 examinations under the ReTIRE initiative.
  • Specific areas of concern have been uncovered during the examinations. Those include:
  • Recommendations to investors/retirees of inappropriate share classes.
  • Misleading marketing materials regarding offerings and rollovers.
  • Lack of documentation to support the reasonableness of recommendations (including rollovers).
  • Vague or omitted disclosures related to fees, conflicts and services of affiliates.
  • Misleading touting of credentials.
  • Supervision and compliance breakdowns.

We expect that the SEC’s examinations will continue to focus on issues related to retirees and older investors, including distribution and rollover issues.

As an observation, in a recent SEC examination of a broker-dealer, the report specifically referenced practices which could violate FINRA Regulatory Notice 13-45. As a result, now is a good time for broker-dealers to review their practices, including advisor education, under 13-45, as well as the related policies, procedures and supervision.

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 #66

Concerns About 408(b)(2) Disclosures

This is my 66th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

Because of the change in the definition of fiduciary advice (which applied on June 9, 2017), all advisors to retirement plans need to review their prior 408(b)(2) disclosures to see if changes are necessary. That particularly applies to broker-dealers and life insurance brokers and agents.

The first level of review should be to determine whether their prior 408(b)(2) disclosures to ERISA retirement plans affirmatively stated that they were not fiduciaries to the plans that they served. If so, those broker-dealers, insurance brokers and agents need to send out new 408(b)(2) disclosures that affirmatively disclose their new-found fiduciary status (assuming that their advisors became fiduciaries under the new rule, which would ordinarily be the case). However, if the old disclosures were silent about fiduciary status or non-status, the prior disclosures would only need to be reviewed to determine if they adequately describe the services that would be considered to be fiduciary advice. Those services would include, for example, making investment recommendations, referring to other investment advisors or managers, or providing selective lists of investments. (Actually, the definition is much broader, and also includes suggestions of investments, investment policies, or investment strategies.)

Also, the review should include consideration of whether the 408(b)(2) statements adequately disclose compensation. I have been reviewing 408(b)(2) disclosures for a number of broker-dealers. As a part of that, I noticed that compensation was often described in ranges, sometimes very broad ranges. That reminded me of the language in the preamble to the 408(b)(2) regulation, which said:

“A few commenters also asked whether compensation or costs may be disclosed in ranges, for example by a range of possible basis points. The Department believes that disclosure of expected compensation in the form of known ranges can be a ‘‘reasonable’’ method for purposes of the final rule. However, such ranges must be reasonable under the circumstances surrounding the service and compensation arrangement at issue. To ensure that covered service providers communicate meaningful and understandable compensation information to responsible plan fiduciaries whenever possible, the Department cautions that more specific, rather than less specific, compensation information is preferred whenever it can be furnished without undue burden.” [Emphasis added.]

I leave it to the reader to decide whether the ranges in the following types of disclosures are narrow enough. Keep in mind, though, that the purpose of the 408(b)(2) disclosures is to allow the responsible plan fiduciaries to determine (i) whether the compensation paid to the advisor and affiliates is reasonable in light of the services being rendered, and (ii) the nature and extent of the conflicts of interest. With that in mind, do you think that the following types of disclosures are narrow enough to provide information that allows the plan fiduciaries to make those determinations?

  • For mutual funds, the broker-dealer may receive between 0% to 10% front-end commissions.
  • As ongoing trailing commissions, the compensation may range from 0% to 2% per year.
  • The compensation for managed accounts will not exceed 2.5% per year.

Since the test for evaluating those statements is one of “reasonableness,” each reader can form his or her own opinions. But, keep in mind the dual purpose of the disclosures. Then, think about whether the disclosures adequately inform the responsible plan fiduciaries, so that they can make prudent decisions on behalf of their plans and their participants.

Needless to say, I am concerned that some service providers may be making disclosures that don’t satisfy the standards. As a result, I suggest that broker-dealers, RIAs, and insurance agents and brokers review their disclosures to make sure that they are comfortable that the necessary information is being provided to plan fiduciaries.

Forewarned is 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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Interesting Angles on the DOL’s Fiduciary Rule #62

Is It Possible To Be An Advisor Without Being A Fiduciary?

This is my 62nd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

Under the new fiduciary definition (that applied on June 9), an investment “suggestion” is fiduciary advice. That includes suggestions about a range of issues, including investments, insurance products, investment strategies, other investment advisors and managers, IRA transfers, and plan distributions.

Because of the breadth of the definition, it is almost impossible to be an advisor to a plan without becoming a fiduciary. Under the old rules advisors would provide investment information that, at least arguably, was not fiduciary investment advice. However, under the new definition, where an advisor provides information about investments, it’s possible, perhaps even probable, that the advisor would reasonably be viewed as having suggested that the plan sponsor, participant or IRA owner choose the investments. Otherwise, why provide information about those specific investments . . . unless it was a suggestion that the retirement investor select one or more of them?

Let’s delve into that a little more deeply . . . in the context of a 401(k) plan. It is possible that for a new plan or for a plan changing recordkeepers, the recordkeeper would provide a list of investments in response to an RFI or RFP. If properly done, the list will not be fiduciary advice—because of a fiduciary exception for recordkeepers. In turn, if the advisor does not comment on the list, either favorably or unfavorably, the advisor would not be viewed as having provided fiduciary advice.

Then, at future meetings with the plan sponsor, the advisor or the recordkeeper could simply provide information about the existing investments. However, is it feasible that an advisor would not make comments about poorly performing investments which could be viewed as “suggestions” that they be removed? If those suggestions are made by an advisor, it could be fiduciary advice. Similarly, if an investment is removed, a plan sponsor needs to select a replacement investment. Who will provide the potential replacement investments to the plan sponsor? If the advisor does, that could be a suggestion, or fiduciary advice, that one of those replacement investments be used.

Alternatively, some broker-dealers may decide that their advisors can only use recordkeepers that include fiduciary advisers on their platforms. Those platform advisers would then recommend or select a plan’s investment line-up (and, in the future, would remove and replace investments, as appropriate). That might work. However, the recommendation of a third party fiduciary investment adviser or manager is also a fiduciary act. So, while the advisor would not be a fiduciary for the recommendation of investments, the advisor could be a fiduciary for “suggesting” that the plan sponsor use a fiduciary on the recordkeeper platform.

Unfortunately, these issues have not been tested in the courts or in FINRA arbitrations . . . so, it’s almost impossible to tell where the line will be drawn. As a result, broker-dealers and RIAs need to decide whether they will take the position that they are not fiduciaries—and be subject to risk, or whether they will take a conservative position and clearly be compliant.

While these rules apply to both ERISA retirement plans and IRAs, the issue is particularly acute for plans. That is because a service provider to plans must state, in its 408(b)(2) disclosures, whether it is serving as an ERISA fiduciary. If it is not, then it can remain silent on the issue. However, if the firm and its advisors will be acting as ERISA fiduciaries, that must be affirmatively stated in the 408(b)(2) disclosures. (Note that, during the transition period, recent DOL guidance permits the firm to describe its fiduciary services in the 408(b)(2) disclosures, but does not require that the firm specifically state that it is an ERISA fiduciary . . . with one exception. If a firm has previously said in its 408(b)(2) disclosures, that it was not acting as a fiduciary, that must be corrected by affirmatively saying that it is now acting as a fiduciary.)

The new rules have a number of unforeseen applications. With the likely delay of the applicability dates of the exemptions, including of the full and final Best Interest Contract Exemption, this is a good time to think about how these rules apply and what changes need to be made.

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 #57

DOL FAQs on 408(b)(2) Fiduciary Disclosures

This is my 57th article about interesting observations concerning the Department of Labor’s 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 Department of Labor has issued a new set of “Conflict of Interest FAQs (408(b)(2) Disclosure Transition Period, Recommendations to Increase Contributions and Plan Participation).”

This article discusses the DOL’s relief from the 408(b)(2) requirement that a “change” notice be given for advisers who became fiduciaries to ERISA-governed retirement plans because of the June 9th expansion of the definition of fiduciary advice.

Before getting into the details of the relief, let’s look at what the DOL’s FAQs did not do. If an adviser (or his or her supervisory entity) was a fiduciary, functional or acknowledged, before June 9th, but did not give a 408(b)(2) notice of fiduciary status, that is not covered. In other words, it is a violation that is not remedied by the Department of Labor’s guidance. If the adviser’s prior 408(b)(2) disclosures, or agreement, stated that the adviser (and his or her supervisory entity) is not a fiduciary, then relief is not provided and a disclosure must be given.

So, what does that leave?

The DOL’s relief applies where an adviser became a fiduciary solely because of the change of definition. But, the relief from disclosing the new fiduciary status only applies if “the covered service provider furnishes an accurate and complete description of the services that will be performed under the contract or arrangement with the plan, including the services that would make the covered service provider an investment fiduciary under the currently applicable Fiduciary Rule.”

In other words, the covered service provider (for example, a broker-dealer) must provide an accurate and complete description of its fiduciary services. For example, those services could be recommendations about the selection and monitoring of the investments in a 401(k) plan. My experience is that, few—if any—broker-dealers made that representation in their previous 408(b)(2) disclosures (since it would have resulted in fiduciary status under the old rules). As a result, it is likely that advisers, and their supervisory entities, will need, at the least, to give more detailed descriptions of their services in order to take advantage of the 408(b)(2) relief. Needless to say, that should be done as soon as possible. (Technically, the DOL FAQs say that these disclosures should be made “as soon as practicable after June 9, 2017, even if more than 60 days after June 9, 2017.”)

Even if those conditions are satisfied and, therefore, the relief is available, the requirement for the 408(b)(2) fiduciary notice is only delayed until the applicability date of the final exemptions (that is, the Best Interest Contract Exemption (BICE) and the Principal Transactions Exemption). If the fiduciary definition remains the same, or substantially similar, the pre-June 9th 408(b)(2) disclosures will need to be updated at that time to declare fiduciary status. However, there is at least an outside chance that the regulation will be modified to define some sales practices as non-fiduciary. Obviously, if that change is made, there would not be a need to disclose fiduciary status for those non-fiduciary sales practices.

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 #55

The DOL’s RFI and the Recommendation of Annuities

This is my 55th article about interesting observations concerning the Department of Labor’s 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 Department of Labor’s Request for Information (RFI) on the fiduciary rule and exemptions does a good job of focusing on the key issues for advisers and their financial institutions (e.g., broker-dealers and RIA firms). That is, the questions in the RFI cover most of the issues that prove to be compliance problems for our clients, in the sense that the requirements were difficult to satisfy or expensive to implement.

In addition, the RFI also highlights an issue for independent insurance agents, which is that, in the exemptions scheduled to apply on January 1, 2018, the sale of fixed indexed annuities to qualified accounts (e.g., plans and IRAs) is transferred from Prohibited Transaction Exemption 84-24 to the Best Interest Contract Exemption (BICE). That creates a difficult situation, because independent insurance agents will not be able to sell fixed indexed annuities under BICE, because BICE requires that a financial institution supervise the sale. I believe the DOL thought that insurance companies would serve as the supervisory entities (and, in a manner of speaking, as co-fiduciaries) for independent insurance agents who were appointed as agents for the insurance companies. However, insurance companies were not willing to do that. As a result, independent insurance agents will effectively be precluded from selling fixed indexed annuities. (Note that a number of insurance intermediaries have applied to the DOL for “financial institution” status under BICE. However, the DOL has not issued final guidance for the applicants.)

Fortunately for those agents, the 84-24 exemption was amended for the transition period to put fixed indexed annuities, along with variable annuities and fixed rate annuities, under the exemptive relief of 84-24. However, the final 84-24 exemption continues to say that fixed indexed annuities are not included in 84-24, but instead must be sold under BICE.

Because of those issues, the Department of Labor asked, in Question 17 of the RFI:

If the Department provided an exemption for insurance intermediaries to serve as Financial Institutions under the BIC Exemption, would this facilitate advice regarding all types of annuities? Would it facilitate advice to expand the scope of PTE 84–24 to cover all types of annuities after the end of the transition period on January 1, 2018? What are the relative advantages and disadvantages of these two exemption approaches (i.e., expanding the definition of Financial Institution or expanding the types of annuities covered under PTE 84–24)? To what extent would the ongoing availability of PTE 84–24 for specified annuity products, such as fixed indexed annuities, give these products a competitive advantage vis-a`-vis other products covered only by the BIC Exemption, such as mutual fund shares?

In effect, the DOL is asking questions about two alternatives. The first is whether “insurance intermediaries,” such as IMOs, should be allowed to serve as “financial institutions,” which would allow independent insurance agents to use the Best Interest Contract Exemption. Based on our representation of a number of IMOs and BGAs, many of those types of organizations would be willing to serve in the financial institution role, if that was available. If properly done, that solution would work.

The second question is whether to continue to include fixed indexed annuities, along with fixed rate and variable annuities, under the 84-24 exemption. In that case, independent insurance agents would not need a financial institution to supervise their activities. At the present time, the 84-24 rules are more restrictive on compensation and require greater disclosure of compensation than BICE. So, while that alternative is less burdensome in terms of the need for a financial institution, it is more demanding in terms of compensation disclosures.

It is likely that one or both of those solutions will be permitted when the rules are revised by the current leadership at the DOL. While the financial institution alternative is more burdensome and involves greater regulation, it could be favored by the DOL because of the financial institutions’ supervision of the independent insurance agents. On the other hand, if the DOL favors less regulation and burden, the 84-24 exemption will be expanded to include all forms of annuities. Only time will tell.

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 #53

The Fiduciary Rule and Discretionary Investment Management

This is my 53rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In recent conversations I have learned that many broker-dealers and RIAs do not understand how the prohibited transaction rules and exemptions (and, particularly, the Best Interest Contract Exemption) apply differently to discretionary accounts and non-discretionary accounts. This article discusses some of those differences.

One similarity, though, is that ERISA’s prudent man rule and duty of loyalty apply for both discretionary and non-discretionary advice to retirement plans and participants.

However, ERISA does not generally govern investment advice to IRAs. As a result, absent the need for a prohibited transaction exemption, advisers to IRAs will not be governed by fiduciary/best interest standard of care. For example, where an adviser (and his or her supervisory entity) provides discretionary or non-discretionary investment advice to an IRA on a “pure” level fee basis, the adviser and the entity are subject to the fiduciary standards under the securities laws, but are not covered by the new fiduciary rule. That is because, where an adviser is providing advice for a reasonable level fee, it is not a prohibited transaction. As a result, an exemption is not needed. (By the way, a “pure” level fee is compensation that does not vary based on the advisory decisions or recommendations and that is not paid by third parties, e.g., 12b-1 fees, insurance commissions, etc. Also, the fee must be level across all related and affiliated parties.)

However, where there is a financial conflict of interest for non-discretionary or discretionary investment advice to an IRA, a prohibited transaction results. That includes, for example, where the adviser or supervisory entity (or any affiliated or related party) receives compensation in addition to the level fee. Examples of those additional, and conflicted, payments are: 12b-1 fees; insurance commissions and trails; proprietary products; asset-based revenue sharing; and payments from custodians.

Where conflicted payments are received, and a prohibited transaction occurs, the adviser and the supervisory entity will need an exemption. If the adviser provides non-discretionary investment advice, the Best Interest Contract Exemption (BICE) is available, if its conditions are satisfied. BICE requires only that the adviser and the supervisory entity comply with the Impartial Conduct Standards during the transition period (the transition period is from June 9 to December 31, 2017, but will likely be extended). The Impartial Conduct Standards are that the adviser and entity adhere to the best interest standard of care, receive no more than reasonable compensation for their services, and make no materially misleading statements. The entity–-the broker-dealer or RIA firm-–also needs to have procedures and practices to ensure that the conflicts do not result in advice that is not in the best interest of the retirement investor.

However, BICE cannot be used for prohibited transactions that result from discretionary investment management. In fact, there are only a few exemptions for discretionary investment management, and none as broad as BICE. For example, there is an exemption for the use of proprietary mutual funds.

As a result, many—and perhaps most—financial conflicts (that is, prohibited transactions) that result from discretionary investment management decisions are absolutely prohibited, because there are not exemptions for the conflicted payments.

The moral of this story is that RIA firms and broker-dealers need to distinguish between discretionary investment management and non-discretionary investment advice. For the time being, at least, most conflicts of interest for nondiscretionary advisers are permissible, if the Impartial Conduct Standards are satisfied. However, for discretionary investment management, there are few exemptions and most financial conflicts will be prohibited without any available exemptions. To the extent that the prohibited transaction rules are being inadvertently violated for managed IRAs, now is the time to correct the errors.

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 #51

Recommendations to Transfer IRAs

This is my 51st article about interesting observations concerning the Department of Labor’s 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 new fiduciary regulation includes, among its definitions of fiduciary advice, a recommendation to an IRA owner to transfer the IRA from another firm. As a result, the recommendation, if accepted by the IRA owner, will automatically result in a prohibited transaction. That is because, if the recommendation is accepted and the IRA is transferred, the adviser will obviously make more money than if it were not. That is a financial conflict of interest that is a prohibited transaction under the Internal Revenue Code.

Fortunately, there is an exemption, or exception, called the Best Interest Contract Exemption (BICE). However, BICE comes with conditions . . . the adviser and his or her supervisory entity (typically a broker-dealer or RIA firm) must comply with the Impartial Conduct Standards. There are three Impartial Conduct Standards:

  • The adviser (and the supervisory entity) must adhere to the best interest standard of care (which includes the duties of prudence and loyalty).
  • Neither the adviser nor the supervisory entity can receive more than reasonable compensation.
  • The adviser and the supervisory entity must not make any materially misleading statements.

This article looks at the requirement to engage in a best interest process.

The first step of a best interest, or prudent process, is to determine the information that is “relevant” to making a decision that is “informed.” In other words, what would a person who is knowledgeable about such matters, and who is unbiased and loyal to the IRA owner, want to review in order to develop a recommendation? Unfortunately, there aren’t any specific guidelines in the fiduciary regulation or BICE. However, it seems reasonable to conclude that, at the least, the following would be required in most cases:

  • The investments, services and expenses in the current IRA.
  • The investments, services and expenses available in the IRA that the adviser will recommend.
  • The needs, objectives, risk tolerance and financial circumstances of the IRA owner.

In the typical case, that may be enough. However, in some cases, there may be special circumstances that would require considerations of additional factors.

Once those considerations have been identified, the next step is to gather the information; that documentation should be retained in retrievable fashion in the event of SEC or FINRA examinations, IRS audits, or private claims.

The next step is to analyze the information. For example, if the investments and the expenses are similar for both the current IRA and a new IRA, the key is to consider the services in light of the needs and circumstances of the IRA owner. With that in mind, in this new fiduciary world, advisers and their supervisory entities should focus on the services that they will provide to retirement money, such as Individual Retirement Accounts. Generally speaking, the investment of retirement money (at least, based on guidance from the Department of Labor) involves considerations of generally accepted investment theories—such as modern portfolio theory, and of prevailing investment industry standards. Ordinarily, that would include strategies such as asset allocation, diversification among and within asset classes, portfolio construction, and so on. Those are “services” that are consistent with the best interest standard of care and that could justify a prudent, or best interest, recommendation to transfer an IRA.

The considerations listed in this article are not exclusive. There are many other factors that could reasonably be considered in developing a recommendation to transfer an IRA. The key, though, is that the appropriate documentation be gathered, a thoughtful analysis be made, and the recommendation be prudent and loyal.

The best interest fiduciary process is a new way of looking at everyday transactions and making recommendations about those transactions. It’s important for advisers to realize that it’s not just a compliance issue; instead, it’s a process . . . a thoughtful, documented, best interest 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 #50

The Fourth Impartial Conduct Standard

This is my 50th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

When the Department of Labor announced that the fiduciary rule and the transition exemptions would apply on June 9, it also issued a non-enforcement policy and a set of Frequently Asked Questions (FAQs) and Answers. The FAQs are titled “Conflict of Interest FAQs (Transition Period).”

For the most part, the FAQs are benign and helpful. However, FAQ 6 raises some significant issues for broker-dealers and RIA firms. In relevant part, FAQ 6 states:

During the transition period, the Department expects financial institutions to adopt such policies and procedures as they reasonably conclude are necessary to ensure that advisers comply with the impartial conduct standards. During that period, however, the Department does not require firms and advisers to give their customers a warranty regarding their adoption of specific best interest policies and procedures, nor does it insist that they adhere to all of the specific provisions of Section IV of the BIC Exemption as a condition of compliance. Instead, financial institutions retain flexibility to choose precisely how to safeguard compliance with the impartial conduct standards, whether by tamping down conflicts of interest associated with adviser compensation, increased monitoring and surveillance of investment recommendations, or other approaches or combinations of approaches. For example, some firms have indicated that they intend to rely upon or build on existing regulatory compliance structures to monitor their advisers’ sales practices and recommendations, document the bases for those recommendations, and ensure that the impartial conduct standards are met (e.g., by subjecting transactions involving conflicts of interest to heightened scrutiny and surveillance).

As a general rule, the Best Interest Contract Exemption (BICE) requires only that broker-dealer and RIAs comply with the Impartial Conduct Standards. The Impartial Conduct Standards are:

  • The best interest standard of care.
  • No more than reasonable compensation.
  • No materially misleading statements.

However, the quoted language from FAQ 6 has the effect of adding a fourth requirement. It is that RIAs and broker-dealers, as financial institutions, adopt the policies and procedures “as they reasonably conclude are necessary to ensure that advisers comply with the Impartial Conduct Standards.”

That language should not be ignored. That is because, among other reasons, the non-enforcement policy requires that financial institutions, such as broker-dealers and RIAs, make a “diligent and good-faith” effort to comply with BICE. Since this additional requirement is imposed as a condition of BICE, it seems difficult to imagine that the non-enforcement policy would be available to a broker-dealer or RIA who did not adopt appropriate policies, procedures, practices and supervision.

Then, the question is, what is “appropriate”? The quoted language provides several alternatives. Those are:

  • Review and determine that existing policies, procedures and supervision is adequate for ensuring that the impartial conduct standards are met.
  • Review and revise existing policies, procedures and supervision, as needed.
  • Adjust adviser compensation to reduce and/or to otherwise manage the effects of conflicts of interest that arise from varying levels of compensation.
  • Heightened scrutiny, surveillance and supervision of transactions involving conflicts of interest.
  • Monitoring advisers’ sales practices and recommendations, including documenting the basis for recommendations.
  • A combination of the above and/or possibly other reasonable practices.

As I read this requirement, a good approach is for a financial institution to review its existing policies, procedures, compensation practices and supervision, and document why they will “ensure that advisers comply with the Impartial Conduct Standards.” No particular approach is required for doing that, but appropriate steps should be taken. (By the way, I specifically mention documentation of the decision because financial institutions may be required to demonstrate that they complied with this requirement. Also, under ERISA, the DOL has specifically stated that documentation is an integral part of a prudent process, and it appears likely that those requirements will apply to fiduciary services under BICE, as well.)

During the transition period, it is possible, perhaps even likely, that the DOL will accept any reasonable efforts to comply with this requirement. In other words, the DOL will probably apply a “reasonable efforts” standard, rather than a “strict compliance” standard. However, the attorneys who represent investors—most likely in arbitrations—will probably push for a higher standard. With that in mind, the broker-dealers and RIAs need to think about the policies, procedures, compensation practices and supervision that will appropriately manage the risk in that more demanding scenario.

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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