Category Archives: Registered Investment Advisers

Best Interest Standard of Care for Advisors #7

What Does Best Interest Mean . . . In the Real World? (Part 4)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the seventh of the series about the Best Interest Standard of Care.

In my last three posts (Best Interest Standard of Care for Advisors #4 and #5 and #6), I discuss the Best Interest standard of care and its practical application. This article discusses a novel approach for compliance with the fiduciary standard for the selection of investments for 401(k) plans. All the more interesting, the approach was part of an opinion of the U.S. First Circuit Court of Appeals.

In October 2018, the First Circuit considered an appeal of a 401(k) case where Putnam Investments, and its fiduciaries, were the defendants. At one point, the defendants argued that, if the court found fiduciary liability under the facts of the case, it would discourage employers from adopting 401(k) plans. The Court of Appeals responded by saying:

“While Putnam warns of putative ERISA plans foregone for fear of litigation risk, it points to no evidence that employers in, for example, the Fourth, Fifth, and Eighth Circuits [which found that similar facts could result in liability], are less likely to adopt ERISA plans.”

The opinion went on to describe a “safe harbor” from fiduciary liability:

“Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these acts are not matters concerning which ERISA fiduciaries should cry ‘wolf.’”

I think it goes without saying that the court’s language was gratuitous . . . and it is a bit disturbing for judges to give investment advice.

Nonetheless, there is a point to be made. That is, at least from this Court’s perspective, the starting point is to consider index funds. Then, plan fiduciaries should seek to identify other funds, including actively managed funds, that can reasonably be expected to match or outperform the index funds. (Note that I say index funds, rather than indexes. That’s because an index fund, subject to its expense ratio, is the investable version of an index.)

In some ways, this is not different from what is commonly done. Based on my participation as a lawyer in plan committee meetings, the investment reports that advisors give to plan committees typically compare the plans’ mutual funds to appropriate indices. And, if there is sustained underperformance vis-a-vis the index, the advisors usually recommend that a fund be removed.

However, it is more complicated than that. For example, other factors can be considered, such as volatility. A less volatile investment may be more appropriate for a retirement plan and particularly for a plan covering employees who aren’t experienced investors. Also, a particular index may not be an appropriate benchmark for certain mutual funds.

In the final analysis, the issue is whether a plan committee engaged in a prudent process to select the investments; it is not whether the process predicted the best future outcome. Nonetheless, the process must have an intended outcome, and it is not unreasonable to conclude that one objective of the process is to select investments that are anticipated to outperform a comparable index fund.

Advisors and plan sponsors shouldn’t be fearful of selecting actively managed funds where there is a reasonable basis to believe that the performance of those funds will, over time, equal or exceed that of comparable index funds. So long as the process is prudent, the fiduciaries will have satisfied their legal responsibilities.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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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Best Interest Standard of Care for Advisors #5

What Does Best Interest Mean . . . In the Real World? (Part 2)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fifth of the series about the Best Interest Standard of Care.

My last article, Best Interest Standard of Care for Advisors #4, discussed different definitions of a “best interest” standard of care. The point of that article is that, while there may be slight differences in the wording, the rules converge to require that an advisor (and the advisor’s supervisory entity) act with care, skill, diligence and prudence to make recommendations that are in the best interest of the investor. This article discusses how the standard applies to specific circumstances.

As background, there are three parts to any best interest standard. The first is that the advisor engage in a process–carefully, skillfully, diligently and prudently–to develop the recommendation. That process is measured by an objective standard . . . what are the relevant factors that a knowledgeable professional advisor would consider and how would that hypothetical advisor evaluate those factors. The second is that the advisor act with loyalty to the investor. The advisor cannot put his interests ahead of the investor’s. The third is that the recommendation appropriately consider the investor’s profile (e.g., the needs and circumstances of the investor).

Let’s focus on the first part–the process and the relevant factors.

In its proposed Regulation Best Interest (Reg BI), the SEC said that its best interest standard for broker-dealers elevates (as compared to the suitability standard) the importance of costs. That is consistent with the fiduciary standard in ERISA’s prudent man rule. And, in my opinion, it is consistent with the fiduciary standard for registered investment advisers (RIAs). In other words, the new best interest “world” is placing greater emphasis on costs as a “relevant” factor for determining whether a recommendation satisfies that standard. Obviously, the requirement is that costs (and the impact of those costs on an investor’s returns), among other things, must be objectively and prudently considered (and given appropriate weight).

Using mutual funds as an example, that means that advisors need to make sure that the expense ratios of recommended mutual funds are reasonable. For example, the best interest standard would generally require that an advisor recommend the lowest cost share class of a mutual fund that is available to the advisor and the investor. Depending on the circumstances, that could mean a particular share class for one investor, but a different share class of the same mutual fund for another investor (for example, if a share class requires a threshold investment amount).

Here’s another example of the consideration of costs in a best interest process for different investors.

If a retail (e.g., IRA) investor’s time horizon is for the long term, e.g., for retirement investing, and therefore it is contemplated that the mutual fund could be held for decades, it is likely to be cheaper to use A shares with a front end load (as opposed to C shares). However, if an investor’s time horizon for holding a fund is short term, it will likely be less expensive to hold a C share. A “best interest” analysis requires that an advisor consider the investor’s needs and circumstances in determining which recommendation would result in a lower cost to the investor based on, among other things, the holding period. This point is not limited to considerations of A shares versus C shares. The issue is bigger than that—and involves careful consideration of costs, considering the alternatives, based on an investor’s needs, circumstances, investment horizon and other relevant factors.

Similarly, where an advisor is managing an account for an investor, it may or may not be in their investor’s best interest to choose NTF (No Transaction Fee) mutual funds. In that case, if the investor’s anticipated holding period is short term, the NTF funds will likely produce a lower cost and, therefore, may be in the best interest of the investor. However, if the investor anticipates holding the mutual funds for the long term, it would ordinarily be more cost-effective to pay a transaction fee, in exchange for a lower expense ratio.

Those are examples of how a “best interest” advisor would consider the “relevant” factors in developing a recommendation.

That’s it for this article . . . but my next post will discuss other best interest considerations.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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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Best Interest Standard of Care for Advisors #4

What Does “Best Interest” Mean? (Part 1)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fourth of the series about the Best Interest Standard of Care.

“Best Interest” has become part of the American lexicon . . . as an aspirational goal or a demanding standard—depending on the point of view. But, what does best interest mean? It may mean different things to different people . . . and perhaps even to different regulators. However, I believe that most people would agree on the definition in this article.

As I read the guidance issued by the Department of Labor (DOL), the Securities and Exchange Commission (SEC), and New York State, there are actually two different best interests. The first is a standard of care and the second is a duty of loyalty. Of the two, the duty of loyalty is the easiest to define because, in all of the guidance it boils down to a requirement that an advisor cannot put his interest ahead of the investor’s.

The best interest duty of care is more complicated. The only agency that has offered a full definition is the DOL in its vacated Best Interest Contract Exemption. That definition was:

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. [Emphasis added.]

 The SEC provided a partial definition in its proposed Regulation Best Interest, but the definition is, to a degree, circular:

 The best interest obligation . . . shall be satisfied if: The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:… Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; . . . [Emphasis added.]

 New York State has adopted a best interest regulation for insurance and annuity products:

 The producer, or insurer where no producer is involved, acts in the best interest of the consumer when . . . the producer’s or insurer’s recommendation to the consumer reflects the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use under the circumstances then prevailing.

If you look closely at the DOL’s best interest standard, you can see that it has three parts. The first is the requirement for a prudent process, that is, that the advisor act carefully, skillfully, diligently and prudently as a knowledgeable professional to develop the recommendation. The second is that the recommendation be based on the needs and circumstances of the investor, which in the case of ERISA, is the plan or participant. The third is a requirement that the advisor be loyal to the investor and not place his interest ahead of the investor’s.

The duty of care in the SEC’s proposed Reg BI and the New York standard also requires that an advisor exercise care, skill, diligence and prudence in developing a recommendation for an investor or, in the case of New York, an insured.

Because of the identical language in all three rules—the requirement to act with care, skill, diligence and prudence, it is likely that the three standards of care will be interpreted similarly. Since ERISA has a developed history through litigation and regulatory guidance, it would likely be the primary source for interpreting and applying that standard. Looking at the ERISA history, a careful, skillful, diligent and prudent advisor would engage in a thoughtful process to gather the information relevant to making a decision (that is, information that would be material to a knowledgeable person) and would then evaluate that information in light of the needs and circumstances of the investor. That process would be measured by the objective standard of a knowledgeable professional.

Stated differently, it appears that these best interest standards require that advisors engage in a thoughtful, professional process to obtain and evaluate the information needed to make a recommendation that is in the best interest of the investor. ERISA calls that a prudent process.

In a nutshell, the best interest standards are more demanding than the current suitability standards. That is particularly true of the weight to be given to costs and compensation. The SEC made that point in its discussion in Regulation Best Interest. However, I believe that it also increases the responsibility of advisors to consider the quality of the products and services being recommended, for example, the quality of the mutual fund managers and the financial stability of insurance companies.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

 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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Best Interest Standard of Care for Advisors #3

SEC Best Interests . . . When? And What About the DOL

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the third of the series about the Best Interest Standard of Care.

The Regulatory Agendas for the SEC and DOL were recently issued. Both have plans for guidance by September of 2019, but the anticipated timing of the guidance has, by and large, been misinterpreted. To understand what I mean, read on.

The SEC’s Agenda said that Final Action on the Regulation Best Interest proposal for broker-dealers and the Interpretation of Standard of Conduct for investment advisers would be “09/00/2019.”

Similarly, the Department of Labor Agenda said that there would be a final rule on the “Fiduciary Rule and Prohibited Transaction Exemptions” with the date of “09/00/2019.”

Let’s start with the dates. For those inclined towards conspiracy theories, it was interpreted to mean that the DOL and SEC were conspiring to issue combined and comprehensive new fiduciary/best interest rules. But, that doesn’t make any sense. While the two regulators are certainly communicating with each other, that doesn’t mean that there is behind-the-scenes plotting and planning.

Another interpretation was that the SEC and DOL were both going to issue guidance in September 2019. But that’s not right either. This is the short term agenda for the government fiscal year that ends in September, 2019. The September dates just mean that both regulators are planning on getting out their guidance during the upcoming government fiscal year.

Here’s my bet on what the dates will really be. Based on meetings with the SEC, it appears that Reg BI and the RIA Interpretation are moving along towards completion. That probably means that the final rules will be completed near the end of the first quarter or early in the second quarter of 2019. There will then be a delayed implementation date. That could be January 1, 2020, or even later, e.g., one year after the final rule is published.

As a word of warning, though, the SEC takes the position that most of the guidance in the RIA Interpretation reflects the Commission’s view of the current requirements for RIAs. There are only three true proposals in the Interpretation and none of those deal with the standard of care.

What about the DOL? I believe that the DOL’s guidance will be sequential rather than concurrent. By that I mean that the DOL’s guidance will probably be, to a large degree, based on the SEC’s final rules. As a result, their guidance will follow the SEC’s, rather than being released at the same time.

I think the DOL guidance will, at the least, include a new class exemption to cover prohibited transactions resulting from nondiscretionary fiduciary investment advice. It would replace the joint DOL/IRS non-enforcement policy (Field Assistance Bulletin 2018-02). My best guess is that it would include, as some of its conditions, compliance with parts of Reg BI and perhaps even the RIA Interpretation. But, I think that it will also include the Impartial Conduct Standards, that is, adhering to the DOL’s best interest standard, receiving no more than reasonable compensation, and making no materially misleading statements.

It’s less clear what the DOL plans to do about the fiduciary rule. There may be nothing. On the other hand, there may be some tinkering, for example, saying that a fiduciary under the securities law is also a fiduciary under ERISA. That would obviously cover RIAs. However, I don’t see any possibility that the Department would re-propose the vacated Fiduciary Rule or anything close to it.

Caveat: The future in unknowable. The educated guesses in this article are just that . . . “guesses.” But they are educated by experience and information. Don’t take them to the bank, but don’t toss them out either.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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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Moving from Angles to Bests

Now that I have completed 100 articles about interesting Angles on birth –and death–of the DOL’s Fiduciary Rule, and the birth of an SEC best interest standard for broker-dealers and RIAs, I am going to start on a new series. The new series, rather than being titled “Angles,” will be called “The Bests.”

So, from now on, my articles—maybe the next 100—will focus on two “bests”—the SEC’s best interest standard and best practices for advisors and plan sponsors.

I figure that the SEC’s best interest rules will be developed and implemented over the next year or two, giving me a wealth of materials for new articles. But, I don’t want to be limited to that. I think that it’s important to talk about best practices for retirement plans and retiree investing and withdrawing, with a focus on helping participants to and through retirement—accumulation and decumulation.

With this introduction of the new series, the articles will begin after the Labor Day break.

Enjoy the dog days of summer . . . family vacations, baseball games and barbeques!

Fred Reish

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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 #100

Investment Advisers and the SEC’s Interpretation of Their Duties: Part II

This is my 100th article about interesting observations—or “angles”—concerning the Department of Labor’s Fiduciary Rule and the SEC’s “best interest” proposals.

Part I of this post discussed the application of the SEC’s best interest standard to recommendations to participants to take distributions and rollover to IRAs. It also discussed the apparent requirement for a thoughtful and professional process to develop the recommendation. However, it reserved for this post, Part II, the factors to be considered in that process.

The RIA Interpretation lists a number of factors to consider in the best interest process. However, most of them apply to investment recommendations, rather than advice about distributions. But a few are helpful. For example, the costs of investments and services and consideration of the investor profile are relevant factors.

Under Reg BI, though, the SEC is a little more helpful. For example, Reg BI says that an advisor should engage in a careful, skillful, diligent and prudent process. Reg BI also refers to FINRA Regulatory Notice 13-45 in several places. That Regulatory Notice requires that the information about the important factors (see below) be gathered and considered in light of the investor profile. While the Regulatory Notice says that the rollover recommendation must be suitable in light of these factors, the RIA Interpretation and Reg BI add that the recommendation must be in the “best interest” of the participant and that the interests of advisors and their firms cannot supersede those of the participant.

Although vacated by the 5th Circuit, the DOL’s Best interest Contract Exemption (BICE) described a prudent process, using language similar to the SEC’s proposed Reg BI . . . care, skill, prudence and diligence. In addition, the DOL’s BICE also said that information needed to be gathered about the relevant factors and those factors should be evaluated in light of the needs and circumstances of the participant. In other words, the SEC’s proposals and the DOL’s vacated rule are remarkably similar on rollover recommendations.

In sum, I think that it’s fair to say that, in order for the SEC’s best interest standard to be satisfied, an advisor (of a broker-dealer or an RIA) must engage in a process where the advisor gathers, and carefully and professionally considers, the relevant information. That process would need to satisfy the best interest and loyalty standards.

But, what are the relevant factors? The leading guidance on that question is found in FINRA Regulatory Notice 13-45 and the DOL’s vacated BICE (including a FAQ issued by the DOL). Boiled down to the essence, those materials say that advisors must consider, at the least, the investments, services and expenses in the plan; the investments, services and expenses for the proposed rollover IRA; and information about the participant (for example, financial objectives, needs, and risk tolerance). It would also be permissible to consider other factors, such as participant preferences, outside assets, other family investments, and so on.

While BICE has been vacated, it likely reflects the DOL’s current thinking about a prudent process and, as a result, could be applied by the DOL to situations where fiduciary advisors make recommendations of distributions and rollovers. (See DOL Advisory Opinion 2005-23A.) Also, since the DOL has the most experience with plan distributions, FINRA and the SEC may defer to the DOL’s thinking in this area. And, while the FINRA Regulatory Notice only covers recommendations by broker-dealers and their advisors, I doubt that the standard for RIAs would be lower than the standard for broker-dealers.

As a result, investment advisers should develop processes for gathering and considering information about the investments (and fees, costs and services) available to the participant in the plan, and compare them to similar information for a proposed IRA, in light of the investment profile of the participant.

And, keep in mind, as I mentioned in Part I of this article, the SEC’s Interpretation RIA reflects current SEC thinking. This is not something to be put off for the future.

NOTE: This article discusses rollover recommendations to participants in participant directed plans. The issues for “pooled” plans are different. In particular, the analysis for defined benefit plans can be more complex.

NOTE: While the DOL’s vacated Fiduciary Rule would have applied to private sector, ERISA-governed retirement plans, the SEC’s guidance applies to participants in all plans, including government plans.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

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 #99

Investment Advisers and the SEC’s Interpretation of Their Duties: Part I

This is my 99th article about interesting observations concerning the Department of Labor’s (DOL) Fiduciary Rule and the SEC’s “best interest” proposals.

The SEC labeled its interpretation of the standard of care for RIAs (the “RIA Interpretation”) as a proposal. However, in that proposal, the SEC explained that the RIA Interpretation was based on the SEC’s current understanding of the duties of investment advisers. More specifically, the SEC described the RIA Interpretation as reaffirming and clarifying the RIA fiduciary rule: “. . . we believe it would be appropriate and beneficial to address in one release and reaffirm—and in some cases clarify—certain aspects of the fiduciary duty that an investment adviser owes to its clients under section 206 of the Advisers Act.”

As a result, investment advisers should treat the RIA Interpretation as governing guidance and should make sure that they are complying with the duties explained in the RIA Interpretation.

This article discusses some of those duties and compares them to the DOL’s vacated fiduciary rule and the SEC’s proposed Regulation Best Interest (“Reg BI”) for broker-dealers.

The RIA Interpretation says that all advice to all clients is fiduciary advice and, therefore, subject to the RIA duty of care and duty of loyalty. (There are several duties of care, but this article focuses on the best interest standard of care. There is also a duty of loyalty, which, for example, covers the disclosure requirements for RIAs.) To juxtapose the RIA duties with Reg BI, broker-dealers also have a best interest standard of care, but only for recommendations to “retail customers” about securities or strategies involving securities. Other recommendations by broker-dealers are not covered by the best interest standard.

With regard to the DOL, when the 5th Circuit Court of Appeals vacated the Fiduciary Rule, the old fiduciary regulation was revived. That regulation imposes a 5-part test for fiduciary status. (Note that the 5-part test only applies to non-discretionary investment advice. Whenever an advisor has discretion over assets in a plan, a participant’s accounts or an IRA, the advisor is automatically a fiduciary under a separate part of the regulation. And the DOL’s definition of discretion is very broad.) One of the 5 “parts” is that the advice must be given on a “regular basis,” meaning that a one-time recommendation would not cause a person to be a fiduciary. As a practical matter, the 5-part test is usually satisfied by the services typically offered by investment advisers to plans, participants’ accounts and IRAs. In addition, it is a functional test. As a result, where representatives of broker-dealers regularly make recommendations to those qualified accounts (and satisfy the other 4 parts), representatives and broker-dealers will be fiduciaries, even if they do not think they are.

To understand how those rules operate, let’s look at several scenarios involving recommendations of plan distributions and rollovers.

Under the DOL’s 5-part test, an advisor who recommends a distribution and rollover would not ordinarily be a fiduciary. However, there is an exception. Where the advisor is a fiduciary to a plan, and makes a recommendation to a participant in that plan to take a distribution and roll over to an IRA with the advisor, the DOL will consider the advisor (either a broker-dealer or RIA) to be a fiduciary for that purpose. See DOL Advisory Opinion 2005-23A.

The DOL’s position applies to all types of ERISA-governed plans, including 401(k)s, 403(b)s, cash balance plans, profit sharing plans and pension plans. (While most private sector plans are covered by ERISA, government plans are not. In addition, some private sector plans are not, for example, one-person plans and most church plans.)

With regard to RIAs, the SEC said, in its RIA Interpretation, that recommendations of plan distributions and rollovers would be fiduciary advice, subject to the best interest standard of care. Since the SEC RIA Interpretation applies to all recommendations to all clients, an investment adviser would be held to the best interest standard of care for distribution and rollover recommendations to all plans (even if not ERISA covered), including 401(k)s, 403(b)s, cash balance plans, pension plans and profit sharing plans.

Under the proposed Reg BI, a broker-dealer’s rollover recommendation to a participant in a participant-directed plan would also be subject to the best interest standard of care. That is because the recommendation to take a distribution necessarily includes a recommendation to liquidate the investments inside the participant’s account. In other words, it is a securities recommendation. However, it appears to me that a recommendation to take a distribution from a cash balance or pension plan would not involve a securities recommendation and, therefore, would not be subject to the best interest standard. Similarly, a recommendation to take a distribution from a “pooled” defined contribution plan, such as a profit sharing plan, may not involve a securities recommendation, since the participant does not have any authority to determine which investments are sold to finance the distribution.

In both cases—RIAs and broker-dealers, the recommendation about how to invest the money in the rollover IRA would be covered by the SEC’s best interest standard. (However, while RIAs would have an ongoing duty to monitor the account, broker-dealers do not. The duty to monitor could be modified by the agreement. For example, RIAs can contract to not monitor, while broker-dealers can agree to monitor.)

Now that we know which rollover recommendations are subject to the best interest standard, there are two remaining questions. The first is, what is the best interest standard? The second is, what does the best interest standard require for distribution recommendations?

Those two questions will be answered in Part II of this Angles.

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 #97

Regulation Best Interest Recommendations by Broker-Dealers: Part 3

This is my 97th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last two articles—Part 1 and Part 2 on this topic, I discussed the fact that proposed Reg BI and its best interest standard of care for broker-dealers did not apply to all of the recommendations made by broker-dealers. The proposed best interest standard for broker-dealers will apply only to securities transactions recommended to “retail customers.” (Reg BI defines a “retail customer” as “a person, or the legal representative of such person, who . . . uses the recommendation primarily for personal, family, or household purposes.”) I compared that to the SEC’s Interpretation for RIAs, which applies to all advice to all clients. This article gives examples of how the proposals will differ when applied to common scenarios.

Based on the discussions in the Reg BI package, and on my conversations with securities lawyers, the definition of “retail customers” appears to refer to individuals, participants’ accounts in retirement plans, IRAs, custodianships, guardianships, and personal trusts. That’s not meant to be an exhaustive list, but it is meant to point out that it doesn’t appear to apply to business accounts or retirement plans. Frankly, I’m surprised that it doesn’t apply, at the very least, to small businesses and small plans.

Let me explain. Assume that Jim and Joan Smith, a married couple, have been working for a large company, Acme Corporation. However, they decide to leave Acme and to start up “Jim and Joan’s Bakery.” Fortunately, the bakery is successful and their cash flow is strong enough to start a retirement plan for the two of them, who are the only workers at the bakery. Knowing that the company will grow, their advisor (who works for a broker-dealer) recommends that they set up a 401(k) plan and recommends the investments. Those recommendations would not be covered by the Reg BI best interest standard of care.

At the same time, though, the advisor recommends that Jim and Joan take distributions from the Acme 401(k) plan and roll that money into IRAs. Both the rollover recommendation and the recommended IRA investments would be covered by the best interest standard.

Jim and Joan were also participants in the Acme pension plan. The advisor recommends that the pension benefits be withdrawn and rolled to IRAs. It appears that the withdrawal recommendation would not be subject to the best interest standard (because it does not require that Jim and Joan buy, sell or hold any securities), but the recommendations about investing in the rollover IRA would be.

The advisor helps Jim and Joan invest their accounts inside their new 401(k) plan. That would be covered by the best interest standard of care.

As the business becomes more successful, Jim and Joan set up personal accounts with the broker-dealer. Recommendations on those personal accounts would be subject to the best interest standard. But, if they had an account for their business, those recommendations would not be.

The business continues to grow and the advisor recommends that Jim and Joan set up a cash balance plan and assists them in the asset allocation and selection of investments for the plan. That would not be subject to the best interest standard of care.

With the continued success of the business, Joan and Jim decide to have children and the advisor helps them set up 529 accounts for the children’s education. The 529 investments would be subject to the best interest standard.

Confused? You should be. All of the advice in this article was to Jim and Joan. And, Jim and Joan have the same sophistication for evaluating each of the recommendations. Yet, because of the definition of “retail customer,” the duties owed by the advisor and the broker-dealer under the proposed Reg BI bounce around. Ask yourself . . . will the average investor understand which rules apply to which situation? I don’t think so. The burden shouldn’t be on the investor to understand these technical rules. Instead, the rules should be consistent and understandable.

Needless to say, this is my opinion. It doesn’t mean it is right; but it does mean that I’ve thought about it.

POSTSCRIPT: All of the recommendations in this article, when made by an investment adviser (RIA), are covered by the best interest standard. That’s straightforward, consistent and understandable.

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 #96

Regulation Best Interest Recommendations by Broker-Dealers: Part 2

This is my 96th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last post, I compared the proposed best interest standard of care for broker-dealers—the SEC’s Regulation Best Interest (“Reg BI”), and the SEC’s proposed Interpretation Regarding Standard of Conduct for Investment Advisers (“RIA Interpretation”). In that article, I focused on the types of recommendations that implicated the best interest standard of care. For broker-dealers, the best interest standard only applied to recommendations of securities transactions and securities strategies. However, for RIAs the best interest standard applies to all advice and recommendations.

This article focuses on the advice recipients, that is, which investors will be protected by the best interest standard of care if the advice is given by a broker-dealer or, alternatively, if the advice is given by an RIA. Part 3 of this series gives examples of how the proposals apply to investors.

Focusing on the recipients of the advice, Reg BI’s standard of care would only protect “retail customers”:

“A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making recommendations of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, . . . .” [Emphasis added.]

Reg BI defines “retail customer” as:

“A person or the legal representative of such person, who . . .[u]ses the recommendation primarily for personal, family, or household purposes.”

Based on my reading of the SEC proposal, and on my conversations with securities lawyers, a “retail customer” includes individual investors, family and personal trusts, IRA owners, and plan participants. However, it does not include businesses, retirement plans, and tax-exempt organizations. Unfortunately, the SEC did not explain why they excluded some of those investors, who may be relatively unsophisticated. For example, if a small business owner has a 401(k) plan, advice about the business owner’s personal account would be protected by the best interest standard of care; advice about the investments in the plan would not be; advice to the owner about investing his participant account would be; and advice about investing the corporate account would not be.

It seems difficult to imagine that the small business owner—who has the same level of sophistication regardless of which account he or she is investing—would understand that the protections under the securities laws varied depending on which “hat” the business owner was wearing. This will, undoubtedly, lead to confusion.

On the other hand, in its RIA Interpretation, the SEC explains: “An investment adviser has a fiduciary duty to all of its clients, whether or not the client is a retail investor,” and “This obligation to provide advice that is suitable and in the best interest applies not just to potential investments, but to all the investment advice provides to clients . . . .”

In other words, the best interest duties of investment advisers are much broader than the proposed rule for broker-dealers. Looking at the example above, an investment adviser has a best interest duty to the small business owner when recommending investments for the business; investments for a retirement plan; personal investments; and investments in a participant account in the retirement plan. In addition to the material differences in the range of recommendations and recipients, an investment adviser also has a duty to monitor the investment recommendations (unless there is a contractual agreement that the adviser will not). However, a broker-dealer’s best interest obligation ends when a recommendation is made; that is, there isn’t an obligation to monitor.

This article is not intended to favor either RIAs or broker-dealers, but instead is to explain the SEC’s proposals. Each reader of this column can decide whether the benefits and burdens of the proposals favor one business model or the other. Also, I should point out that Reg BI is just a proposal. On the other hand, while the RIA Interpretation is labeled as a proposal, it is a compilation, or interpretation, of the SEC’s position on the rules regulating investment advisers.

In my next post, Part 3, I will expand on the examples in this article.

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 #94

SEC Proposed Reg BI and Recommendations of Rollovers (Part 3)

This is my 94th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

Part 1 of this series discussed the provisions in the SEC’s proposed Regulation Best Interest that would impose a best interest standard of care for rollover recommendations by broker-dealers and their registered representatives. (More specifically, the standard applies if the rollover recommendation involves securities transactions—which would ordinarily be the case for participant-directed plans.) Part 2 described some of the considerations for developing a best interest recommendation process.

This article—Part 3—describes the proposed requirement to “mitigate” the conflict of interest inherent in a rollover recommendation.

Since a broker-dealer and its representative would not, in most cases, receive any compensation if a participant does not roll over, there is, to use the SEC’s language, a material conflict of interest involving financial incentives. In that regard, Reg BI says that a broker-dealer must disclose and mitigate or, alternatively, eliminate the financial incentive conflict of interest. (This article refers to broker-dealers, but that includes the registered representative, or advisor.)

Of course, it’s impossible to eliminate the conflict, since—if the money stays in the plan—the broker-dealer will not earn anything. But if the money is rolled over, the broker-dealer will receive compensation from the rollover IRA. As a result, the only practical choice would be to disclose and mitigate. While the SEC does not give an example of mitigation of the conflict in the context of a rollover recommendation, the SEC does cite FINRA Regulatory Notice 13-45 on several occasions. RN 13-45, in turn, requires that a broker-dealer and its representatives make a reasonable inquiry about the participant’s plan account. After all, how can a recommendation be made in a manner that is careful, skillful, diligent and prudent (the Reg BI requirements) if the broker-dealer does not have any information about the investments that it is recommending be sold? (Since participant-directed plans such as 401(k) plans typically only distribute cash, a rollover recommendation inherently incudes a recommendation to sell the investments in the participant’s account.)

RN 13-45 requires an analysis of, among other things, the investments, services and expenses in the plan. For those of you who have studied the DOL’s Best Interest Contract Exemption, you will recognize those as the three primary factors listed by the DOL for consideration in making a fiduciary rollover recommendation. In other words, proposed Reg BI (including the references to RN 13-45) and the Best Interest Contract Exemption are remarkably similar.

Where does that leave us?

Bottom line, the best “mitigation” appears to be a process that ensures that the recommendation is in the best interest of, and loyal to, the participant.

That means that broker-dealers are in essentially the same position as they were under BICE. They need to gather and evaluate appropriate information about the investments, services and expenses (among other things) in the plan; the investments, services and expenses (among other things) in the proposed IRA arrangement; and the needs, circumstances, risk tolerance, and preferences of the participant.

Broker-dealers need to develop a process for doing that, together with policies and procedures, training and supervision. That process should produce a reasonable and informed recommendation in the best interest of the investor.

Similar requirements are imposed on RIAs. That will be the subject of a future post.

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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