Category Archives: broker-dealers

The Presidential Election: Now What?


BICE, broker-dealers, DOL, fiduciary, registered investment advisers

One of the consequences of the presidential election is that the future of the fiduciary rule (and the exemptions) is uncertain. What does that mean to advisers . . . regardless of whether they are representatives of RIAs or broker-dealers, or for that matter, if they are independent insurance agents?

The answer is that nobody knows. However, this article outlines the most likely alternatives. Those are:

  1. The rule will be killed by regulation or legislation.
  2. The rule will be implemented “as is.”
  3. The rule and the exemptions will be modified.

Only the second alternative (the “as is” option) could realistically be implemented by the current deadline of April 10. But, that’s the alternative that is, in my opinion, the least likely to happen. While it is low probability, it is high risk in the sense that broker-dealers and RIAs must be in compliance by April 10 if it happens. As a result, broker-dealers, RIA firms and IMOs need to continue working on complying with the new rules until they hear otherwise.

For either of the other two alternatives to play out in a thoughtful way, the applicability date of the rule will need to be delayed. That would be the first step of the process. If I had to guess, the delay would be until either December 31, 2017 or April 10, 2018.

Assuming there is a delay, I think that it would be a close call as to whether the rule would be killed or re-written. My gut feeling is that the fiduciary rule will be retained, but modified.

I say that for a few reasons. First, the fiduciary rule wasn’t the source of the greatest objections to the DOL’s guidance. Instead, that was the Best Interest Contract Exemption (BICE). Secondly, there is an argument that a rule that requires that retirement money be invested in the best interest of the investor is not, in and of itself, objectionable. In fact, many people may like that approach. Third, because of the ongoing retirement of baby boomers, many of whom are unsophisticated investors, and the rollover of their money to IRAs, there may be a perceived need to protect retirees.

On the other hand, the contrary arguments are that (1) the current system is working well and doesn’t need to be changed (and that therefore additional regulation would increase costs, without a corresponding benefit); and (2) the regulation of securities transactions should be in the hands of the Securities and Exchange Commission (SEC), and not the DOL. (One weakness with that latter argument is that insurance products, such as fixed rate annuities and fixed indexed annuities, are also sold to plans and IRAs, and the SEC doesn’t have the jurisdiction to regulate those products.)

If the SEC were to take the leadership in defining the fiduciary duty of care, there would be a uniform fiduciary definition that would apply to plans, IRAs and “non-qualified” accounts. While the conflict of interest rules for fiduciary advice to non-qualified accounts could be handled largely through disclosure, that is not the case for retirement plans and IRAs, because of the prohibited transaction rules in ERISA and the Internal Revenue Code.

To contemplate a worst case scenario, the SEC could develop a uniform fiduciary standard of care, but fiduciary advice and recommendations that involve conflicts of interest will still be prohibited by ERISA and the Internal Revenue Code. In that case, the Best Interest Contract Exemption would be revoked, and there would not be any generally available exemption for commissions, 12b-1 fees, etc. Obviously, that won’t work. As a result, BICE can’t just be withdrawn. It needs to be improved. (Of course, Congress could pass a bill that would create an exemption based on disclosures alone, but that would take time. Also, the regulatory process, with input from comments and meetings between the private sector and the regulators, is better at producing detailed guidance.)

So, while the outcome is not predictable, my “best guess” is that we will end up with a rule similar to the DOL’s fiduciary standard of care and that there will be modified exemptions that are based more on disclosures and less on prohibitions.

Stay tuned.

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 #26


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, service providers

Reasonable Compensation for IRAs: When and How Long?

This is my twenty-sixth article about interesting observations concerning the fiduciary rule and exemptions.

This article is a little different than most of my previous posts. However, it is equally as important. To get to the point, I am writing this article about reasonable compensation for advice to IRAs because of a common misunderstanding about the requirement.

In the last month or two, I have seen a number of articles and heard several comments to the effect that it will be difficult to determine reasonable compensation for IRAs because the rule is so new. Stated a little differently, the point is that the reasonable compensation requirement for IRAs will first become effective on April 10, 2017. That is not correct.

Section 4975(c)(1)(C) provides that the “furnishing of . . . services . . . between a plan and a disqualified person” is a prohibited transaction. However, section 4975(d)(2) permits, as an exception to that general prohibition, “any contract, or reasonable arrangement, made with a disqualified person for . . . services necessary for the establishment or operation of a plan, if no more than reasonable compensation is paid therefor.” (Section 4975(e)(2) defines a “disqualified” person as “a person providing services to the plan.” Then, 4975(e)(1)(B) defines a “plan” as “an individual retirement account.” And, (C) includes “an individual retirement annuity.”)

In other words, the reasonable compensation limitation is not new. It’s been with us for decades.

But, if that’s the case, why hasn’t there been more discussion and, in the bigger picture, more enforcement of the rule? There are two reasons. The first is that, by and large, the rule has been ignored. How is that possible? That’s because only the Internal Revenue Service can enforce the rule, but it hasn’t. In this case, the 15% excise tax under section 4975 would be enforced against the service provider, that is, the adviser. But, if the rule has been in effect for years without much publicity, why is there so much discussion now?

The answer is that the Department of Labor has, in conjunction with the fiduciary rule, issued two exemptions—84-24 for life insurance policies and fixed rate annuities, and the Best Interest Contract Exemption (BICE) for any and all investments that can be sold to plans and IRAs. Both of those exemptions—which are needed where prohibited compensation results from the investment or insurance recommendation—limit the adviser’s compensation for recommended investments and insurance products to be no more than a reasonable amount. In the case of BICE, for example, the Financial Institution (e.g., the broker-dealer) must agree that its compensation and the adviser’s compensation for their services will not exceed a reasonable amount. IRA and plan investors will be able to pursue breach of contract claims for excess compensation.

So, while the law limiting the compensation of advisers (and Financial Institutions) is not new, the enforcement mechanism will be.

While the new rules seem burdensome, I believe that a variety of services will be developed to assist Financial Institutions in determining reasonable compensation for different levels of services related to different types of products.

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 #24


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

The Meaning of Differential Compensation Based on Neutral Factors

This is my twenty-fourth article covering interesting observations about the fiduciary rule and exemptions.

The DOL’s fiduciary “package” consists of a regulation that expands the definition of advice and exemptions, or exceptions, from the prohibited transaction (PT) rules. If a recommendation by a fiduciary adviser does not constitute a PT (e.g., does not affect the adviser’s compensation, or that of an affiliate, and does not cause a payment from a third party), no exemption is needed. However, if the fiduciary recommendation causes a PT, an exemption must be used – and most often that will be BICE – the Best Interest Contract Exemption. Therein lies the rub . . . the compensation of the financial institution (e.g., the broker-dealer) and the adviser are regulated by BICE.

Under BICE, the compensation of broker-dealers can be “variable,” but must be “reasonable.” In other words, a broker-dealer can receive different payments from different product providers (e.g., mutual funds), so long as the total compensation received by the broker-dealer is reasonable relative to the services provided to the particular plan, participant or IRA owner.

The rules for compensating advisers are similar because the compensation of the adviser also must be reasonable (relative to the services that the adviser is providing to the plan, participant or IRA owner in the first year and in succeeding years). But, from that point on, the rules are different.

The starting point for understanding the other rules for adviser compensation is to determine “reasonably designed investment categories.” A reasonably designed investment category is an investment product or service that, when properly analyzed, should produce a certain level of compensation for the adviser’s services. For example, non-discretionary investment advice about mutual funds probably involves a different set of services and complexity than investment advice about individual variable annuities. In that sense, each could be called a reasonably designed investment category.

The next step is to understand that, within a particular investment category, the adviser’s compensation must be level. For example, where an adviser is providing non-discretionary advisory services concerning mutual funds, the adviser’s compensation must be level regardless of which mutual funds are recommended or how much those mutual funds pay the broker-dealer. In that way, the adviser will be “financially agnostic” as to which funds are recommended and will, at least in theory, only be interested in recommending the funds that are the best for the qualified investor (e.g., reasonable priced and of good quality). Similarly, if another investment category covers individual variable annuities, the adviser will be paid the same regardless of the particular annuity contract, insurance company, or imbedded mutual funds. That is, the adviser’s compensation will be the same across all variable annuity contracts, regardless of which one is recommended.

But, what if some categories require more work or services than other categories? For example, what if it takes more work to recommend and service an individual variable annuity than to provide non-discretionary investment advice about mutual funds? In that case, the Department of Labor says that it is permissible to pay differential compensation among reasonably designed investment categories, so long as the differences are based on neutral factors. So, for example, if the amount of work, the complexity of the product, and so on, means that the services for a variable annuity are twice as valuable, the adviser could earn twice as much for recommending an individual variable annuity and assisting with the selection of the embedded investments. On the other hand, if the services for the variable annuity were only 50% more difficult each year thereafter, then the adviser could be compensated 50% more than the annual fee that could be paid for a qualified account with mutual funds.

The key to understanding these concepts is to realize that the “neutral factors” differential compensation is not a dollar amount. Instead, it is a ratio established, for both the first and each subsequent year, between the different categories of investments. Where the relative compensation to the adviser for different reasonably designed investment categories could vary according to those ratios, compensation must still be reasonable.

So, as described in this article, an individual adviser’s compensation must be “reasonable,” “level” within an investment category, and “neutral” in differences between investment categories.

It is going to be difficult and time-consuming for the financial services community to adjust to these changes. And, the deadline is April 10 (with an extension for some purposes until January 1, 2018).

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 #3


BICE, broker-dealers, DOL

This is my third article about the interesting observations “hidden” in the preambles to the fiduciary regulation and the exemptions.

Under the Best Interest Contract Exemption (BICE), the “financial institution” (e.g., a broker-dealer) cannot pay a fiduciary adviser (e.g., a financial adviser) incentive compensation that would encourage an adviser to make investment or insurance recommendations that are not in the best interest of a retirement investor. Needless to say, that requirement is highly disruptive to broker-dealers and insurance companies, since they often compensate advisers through commission payments (which are, by definition, incentive compensation).

But, the DOL’s concern about the impact of incentive compensation goes beyond payments to advisers. In the preamble to BICE, the DOL says the following about payments to managers and supervisors:

“As noted above, Financial Institutions also must pay attention to the incentives of branch managers and supervisors, and how the incentives potentially impact Adviser recommendations. Certainly, Financial Institutions must not provide incentives to branch managers or other supervisors that are intended to, or would reasonably be expected to cause such entities, in turn, to incentivize Advisers to make recommendations that do not meet the Best Interest standard. Financial Institutions, therefore, should not compensate branch managers and other supervisors, or award bonuses or trips to such entities based on sales of certain investments, if such awards could not be made directly to Advisers under the standards set forth in this exemption.”

As this indicates, the new rules will impact almost every aspect of the sales of investments and insurance products to plans . . . and especially to IRAs.

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #1


broker-dealers, DOL, fiduciary, prudent, registered investment advisers

While you have probably read articles that summarize the DOL’s final fiduciary rule and exemptions—and perhaps even articles that discuss specific aspects of the rules, there are a number of interesting observations “hidden” in the preambles to the regulation and exemptions.

In many cases, those comments are so focused on limited issues or complex that they are beyond the scope of the initial articles, speeches and webcasts. As a result, I will be writing several articles about those “nuggets.” This is the first of those articles.

In the preamble to the Best Interest Contract Exemption (BICE), the DOL noted that a fiduciary adviser and his or her financial institution (e.g., RIA firm or broker-dealer) could contractually limit the duty to monitor. But then the DOL went on to say:

“Further, when determining the extent of the monitoring to be provided, as disclosed in the contract pursuant to Section II(e) of the exemption, such Financial Institutions should carefully consider whether certain investments can be prudently recommended to the individual Retirement Investor, in the first place, without a mechanism in place for the ongoing monitoring of the investment. This is particularly a concern with respect to investments that possess unusual complexity and risk, and that are likely to require further guidance to protect the investor’s interests. Without an accompanying agreement to monitor certain recommended investments, or at least a recommendation that the Retirement Investor arrange for ongoing monitoring, the Adviser may be unable to satisfy the exemption’s Best Interest obligation with respect to such investments. Similarly, the added cost of monitoring such investments should be considered by the Adviser and Financial Institution in determining whether the recommended investments are in the Retirement Investor’s Best Interest.”

In other words, if an adviser isn’t going to have a duty to monitor the investments, don’t recommend investments that retirement investors lack the capacity to properly monitor.

It’s not clear where that line will ultimately be drawn – for example, does it refer to the particular investor or the average investor? As a result, some caution is warranted.

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Investment Advice to Plans Under the DOL’s Fiduciary Rules


broker-dealers, DOL, registered investment advisers

As I work with broker-dealers and RIA firms, certain patterns are developing in their efforts to satisfy the requirements of the DOL’s fiduciary rule and the exemptions.

This article looks at some of those “solutions” and comments on the areas where there is some agreement . . . or at least a majority opinion.

The DOL’s rule will, when finalized, regulate investment advice to plans and participants, investment advice to IRAs, and recommendations about distributions from plans and IRAs.

In this post, I look at the decision being made about advice to plans.

Interestingly, it appears that the changes will impact plans much less than IRAs and rollovers. The plan solutions fall into two categories. The first is that RIAs and broker-dealers will provide level-fee investment advice to plans. In some of those cases, a broker-dealer may need to act under its RIA registration. The level fee will be accomplished, by and large, either through expense recapture accounts or by payment from plan assets.

Note that, for purposes of this article, the words “level fee” actually refer to a “levelized” fee. For example, the broker-dealer or RIA could charge a flat fee (in terms of basis points or dollars) to the plan and be paid by the plan. Or, the broker-dealer or RIA could receive additional payments (for example, insurance commissions or 12b-1 fees) and either offset those against the flat fee or pay those amounts over into the plan. Both of those have the effect of “levelizing” compensation. But, it’s not enough to just do it. There needs to be an agreement to offset or pay over.

A second common solution is that advisers will be required to work with providers who have third-party 3(21) nondiscretionary and/or 3(38) discretionary investment advisers on their platforms. For example, representatives of a broker-dealer would be required to recommend that plan sponsors use the platform’s third-party fiduciary adviser to select and monitor the plan investments. In that way, an adviser and the broker-dealer will not be fiduciaries for purposes of selecting the investments. Note, though, that under the fiduciary rule, a recommendation of a fiduciary adviser (e.g., the 3(21) or 3(38) platform adviser) is, in its own right, fiduciary advice.

That’s a quick update for now. As this article suggests, these circumstances and decisions are evolving. So, keep tuned.

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The Year of the Fiduciary Rule


broker-dealers, DOL, fiduciary, registered investment advisers

2016 promises to be the year of the fiduciary . . . the fiduciary rule, that is.

It now seems certain that we will have a final fiduciary rule in effect by the end of 2016.

What will that mean? It will re-write the rules for investment advice and sales to retirement plans and IRAs. The impact will vary, depending upon whether the person making the recommendation is an RIA, a broker-dealer, or an insurance agent or broker.

For example, for RIAs, the greatest impact will be on investment advisers who recommend retirement plan distributions and rollovers and those who receive additional fees (for example, 12b-1 fees) from their IRA investors. On the other hand, advisers of broker-dealers will need to make significant changes in disclosures and compensation practices across the board (that is, for recommendations to plans and IRAs, and recommendations about distributions and rollovers).

Interestingly, the impact on retirement plan sales and advice may be less than is commonly expected. However, the impact on advice and sales to IRAs will be nothing short of revolutionary. Similarly, the “capturing” of IRA rollovers, through recommendations to participants to take distributions, will be dramatically affected.

We will be writing articles about all of that after the final rules are issued. That is likely to occur in the April/May/June timeframe.

One more comment: Much of the attention has been focused on the prohibited transaction exemptions, and particularly the Best Interest Contract Exemption (BICE). However, in my opinion, there has not been enough attention given to the fiduciary standard of care. For example, if an insurance agent recommends an annuity contract, both the financial stability of the insurance company and the provisions of the annuity contract need to be evaluated and a prudence determination must be made. I haven’t seen much said about that. Similarly, the recommendation of mutual funds to IRAs would need to take into account issues such as the quality of the investment management, the prudence of the amount allocated to that asset class or investment category, the reasonableness of the expense ratios, and so on. I think that, once these consequences are fully appreciated, the nature of investment and insurance advice given to IRAs will be materially changed.

That’s it for now. There will be much more in the future.

 

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Providing Compliant Services


broker-dealers, DOL, registered investment advisers

The increasing regulation of 401(k) distributions and rollovers to IRAs continues to be a subject of great interest to my clients . . . and a considerable amount of work for me. One of the benefits of concentrated work in that area has been an enhanced appreciation of the difficulty of broker-dealers, provider call centers, and RIAs in providing compliant services . . . from a practical perspective.

For example, viewed academically, it is possible to put together a compliant rollover program under FINRA’s guidance in Regulatory Notice 13-45. At the least, that would involve written materials and discussions about the seven factors listed in the guidance. The written materials would be provided to participants to both educate them and to support compliance and supervision. The conversations would be structured to provide a reasonable basis for developing a suitable recommendation, based on the individual needs and circumstances of the participant.

On a practical level, it is feasible for a financial adviser or an investment adviser to engage in that process . . . for a participant with a large account balance. However, that is only a small part of the real world of 401(k) participants. Many of the conversations are with participants with small account balances and, for a provider’s call center, are of limited duration. As a result, the compliance procedures and “scripts” for participants with small account balances are often more difficult to develop than for the individualized treatment that can be financially justified for wealthier participants.

Nonetheless, the regulators—FINRA, the SEC and the DOL—now expect broker-dealers and RIAs to have compliant procedures for “capturing” IRA rollovers. Based on my experience, this is not an easy job. I recommend that, at the least, your procedures incorporate unbiased and relatively thorough educational materials that are given to all participants who are eligible for distributions and a process that solicits the most important information about the needs and circumstances of the participants. Without that kind of approach (or something similar to it), it will be difficult to formulate a suitable or prudent distribution and rollover recommendation.

The FINRA guidance, and the SEC and FINRA 2014 Examination Priorities List, are posted under the “external resources” page on my blog at http://fredreish.wpengine.com/external-resources-2/.

 

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Responsible Plan Fiduciaries and Disclosure Issues


408(b)(2), broker-dealers, fiduciary, plan sponsors, recordkeeper, registered investment advisers, service providers

The 408(b)(2) regulation requires that its service, status and compensation disclosures be made to “responsible plan fiduciaries” or “RPFs.” In the rush to make the 408(b)(2) disclosures, most recordkeepers, broker-dealers and RIAs sent their disclosure documents to their primary contact at the plan sponsor. In at least some of those cases, the primary contact was not the RPF. As a result, we added language to our clients’ disclosures to the effect that, if the recipient was not the RPF, the written disclosure should immediately be forwarded to the RPF.

The regulation defines RPF as “a fiduciary with authority to cause the covered plan to enter into, or extend or renew, the contract or arrangement.” In other words, it is the person or committee who has the power to hire and fire the particular service provider, e.g., the broker-dealer, recordkeeper or RIA.

Because of the work involved in making mass disclosures, any inadvertent errors in properly identifying the RFPs may be excusable. However, going forward, it may not be. Because of that, all future agreements, account opening forms, and so on, with ERISA plans should specify that the person signing on behalf of the plan is the RPF. Furthermore, we recommend that service providers obtain the email address and other contact information for the RPFs (and that they contractually require plan fiduciaries to inform them of any changes of the RPFs).

We do that for two reasons. First, as covered service providers bring in new plan clients, the documents need to be executed by the RPFs and the disclosures need to be delivered to the RPFs. Second, the information is also needed for existing clients. Fiduciaries who have already received disclosures, they will need to be provided “change” disclosures in the future within 60 days of any changes. And, it is likely that more requirements will be imposed on service providers in the future and, therefore, providers will need to have an efficient and effective way of communicating with the RPFs.

Now is the time to put these new procedures in place.

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Fiduciary Advice and 12b-1 Fees


broker-dealers, DOL, fiduciary, prohibited transaction, registered investment advisers, service providers

The DOL recently settled a case for $1,265,608.70 with a firm that provided investment advice to retirement plans. Based on the DOL’s press release, the firm served as a fiduciary investment adviser to ERISA plans and recommended investments in mutual funds. In addition to the firm’s advisory fee, it also received 12b-1 fees.

Based on the press release, it appears that the DOL asserted two claims. The first is that the receipt of additional fees (which could include both 12b-1 fees and some forms of revenue sharing) is a violation of the prohibited transaction rules in section 406(b) of ERISA.

The second theory appears to be that, where a fiduciary adviser receives undisclosed compensation, the adviser has, in effect, set its own compensation (to the extent of the undisclosed payments). In the past, the DOL has successfully taken the position that, by receiving undisclosed compensation, a service provider has become the fiduciary for the purpose of setting its own compensation and has used its fiduciary status for its own benefit.

In any event, RIAs and broker-dealers need to be particularly conscious of undisclosed payments and/or payments in addition to an advisory fee. In recent years, the DOL has gained a greater understanding of RIA and broker-dealer compensation and is actively investigating both.

I have reviewed the 408(b)(2) disclosures of a number of broker-dealers. In a few cases, the broker-dealers specifically state that, where they were serving as fiduciary advisers, they were also receiving additional compensation (e.g., revenue sharing). Those disclosures raise issues about prohibited transactions.

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