408(b)(2) Disclosures for Related Parties

One of our concerns about disclosures by broker-dealers (and affiliated RIAs) is that they may not fully appreciate the concept of related parties under the 408(b)(2) regulation.

When a broker-dealer is a covered service provider and contracts with others to provide some of the services, the broker-dealer and those other parties are “related” for purposes of the regulation and its disclosure requirements. In those cases, the compensation of the related party (as opposed to the broker-dealer) must be disclosed if it is (1) transactional or (2) charged against the plan’s investments. In some cases, there may be other required disclosures.

The most obvious example of a related party disclosure occurs where the registered representatives of a broker-dealer are independent contractors. In that case, the registered representatives are considered to be subcontractors of the broker-dealer and their share of the commissions is considered to be transactional compensation. Thus, the grid or formula for sharing commissions with the representatives must be disclosed. (This is not required if the representatives are employees.)

Another, less obvious, example is when the broker-dealer is an introducing broker, and thus the arrangement includes a clearing broker-dealer. In that situation, the clearing broker-dealer appears to be a subcontractor of the introducing broker-dealer and its compensation is transactional. When transactional compensation is received by a subcontractor, the 408(b)(2) regulation requires, among other things, that the compensation of the subcontractor be disclosed.

A third—but slightly different—example is when a dual-registered broker-dealer offers an investment management platform. I have seen a number of situations where the RIA/BD charges a single fee and then compensates the investment managers selected by the ERISA plan fiduciaries out of its compensation. In those cases, there is not a direct contract between the investment managers and the ERISA plan. As a result, it appears that the investment managers are subcontractors of the broker-dealer/RIA. However, the compensation of the investment managers is not transactional and is not charged against the plan’s investments. Instead, it is paid as a service fee by the broker-dealer/RIA. Thus, it does not appear that a compensation disclosure is required by ERISA. However, the broker-dealer/RIA is delivering, under its covered service arrangement, a set of fiduciary services to ERISA plans, that is, the investment managers are a part of the “bundle” of the broker-dealer/RIA (since they do not have separate arrangements with the plan). In that case, it appears that, as a part of the broker-dealer/RIA’s service arrangement, fiduciary services are being delivered. If that is how the arrangement is structured, the broker-dealer/RIA will need to satisfy the status disclosures required by the 408(b)(2) regulation. That would mean, among other things, that a fiduciary status declaration is required.

My point is that this concept of “bundling” of services and the related party disclosures are not commonly understood. Because of that, they present a significant risk to broker-dealers.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

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