Category Archives: DOL

Interesting Angles on the DOL’s Fiduciary Rule #86


DOL, fiduciary, prudent

The Fiduciary Rule: What’s Next (Part 2)?

This is my 86th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This is the second of my four-part series on the critical questions raised by the 5th Circuit Court of Appeals decision to “vacate,” or throw out, the Fiduciary Rule. My last post, Angles #85, introduced the questions:

  • Who is a fiduciary?
  • What is the fiduciary standard of care?
  • How will conflicts of interest be treated under the new rules?

This post discusses the first question: “Who is a fiduciary?”

Assuming that the 5th Circuit Court of Appeals decision is the final word, the old 5-part fiduciary test will automatically be reinstated. That means that, in order for an advisor to be a fiduciary, all 5 requirements in the regulation must be satisfied. (Keep in mind, though, that this only applies to non-discretionary investment advice. Where an advisor has discretion, the advisor is a fiduciary under a different rule.) The 5-part test is that the advisor must:

  • Make investment or insurance recommendations for compensation;
  • Provide the advice on a regular basis;
  • Have a mutual understanding with the retirement investor that:
    • The advice will serve as a primary basis for investment decisions; and
    • The advice will be individualized and based on the particular needs of the retirement investor.

The definition covers investment and insurance advice to “retirement investors,” in other words, to plans, participants and IRA owners.

Let’s look at each of the 5 parts of the definition.

With regard to the first requirement—recommendations for compensation, it appears that virtually all recommendations to retirement investors would satisfy that requirement, if the advisor (or his supervisory entity, e.g., broker-dealer or RIA) will receive compensation, directly or indirectly, when the recommendation is accepted.

The second requirement—that the advice be given on a regular basis—is a more interesting issue and will vary from case to case. Let me explain. Where an advisor regularly meets with a retirement investor and updates the advice (e.g., asset allocation or investments), it is likely that the requirement is satisfied. That would apply, for example, to an advisor for a 401(k) plan who meets with a plan sponsor on a quarterly or annual basis. Similarly, it might apply where an advisor recommends an individual variable annuity or individual fixed indexed annuity to an IRA owner, with the contemplation that they will meet periodically to review the investments, indexes, etc. However, it would not apply to a one-time sale, where the advisor sells an investment or insurance product and does not provide any ongoing advice.

The third requirement is that there be a mutual understanding, arrangement or agreement, between the retirement investor and the advisor that the advice satisfies the 4th and 5th requirements (below). While some people believe that refers to a subjective understanding in the minds of the advisor and the investor, the DOL will probably use the standard of what a reasonable third party would conclude based on the communications between the advisor and the investor.

The fourth requirement is that the recommendations be understood to be a primary basis for making investment or insurance decisions. It is frequently described incorrectly as “the” primary basis. However, if you look at the wording of the regulation (and if you look back into the history of the regulation), the recommendation simply has to be one of the primary bases. In other words, it doesn’t have to be the sole, or even the predominant, basis for making decisions. As a result, it seems like this condition would usually be satisfied, because recommendations are typically made for the purpose of being seriously considered by an investor.

The last requirement is that there is a mutual understanding that the advice is individualized and based on the particular needs of the retirement investor. While the expectation, and perhaps the understanding in most cases, is that investment recommendation is designed for the particular investor, there are cases where communications about investments may not be fiduciary advice. For example, if a broker-dealer has a list of preferred mutual funds or stocks, the list would likely be viewed as generic and, therefore, as not being intended for any particular investor. However, if that list was narrowed by an advisor and then presented to an investor, that would probably tip the scales in the other direction.

The moral to this story is that, even if the 5th Circuit decision becomes the final word on the fiduciary rule, many—if not most—advisors to retirement plans will still be fiduciaries.

On the other hand, it may make a difference for IRAs. For example, RIAs may generally be fiduciaries, even in the IRA world, because they provide investment services on a regular—or ongoing—basis and there is usually an understanding that the advice is individualized. In addition, many RIAs provide discretionary investment management services for IRAs, which is automatically fiduciary advice.

However, insurance agents and representatives of broker-dealers may, in some cases, make recommendations on an isolated basis, and there may be an understanding that it is a sale, where the advisor will not be providing continuous services. But, where an insurance agent or a representative of a broker-dealer satisfies the 5-part test, the agent/advisor will be a fiduciary.

The fiduciary standard of care will be discussed in the next article, Angles #87.

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

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Interesting Angles on the DOL’s Fiduciary Rule #85


BICE, broker-dealers, DOL, FINRA, prohibited transaction, registered investment advisers, SEC

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

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

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

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

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

1. Who is a fiduciary?

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

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

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

2. What is the fiduciary standard of care?

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

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

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

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

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

This is the area of greatest differences among the regulators.

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

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

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

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

We live in interesting times.

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

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Interesting Angles on the DOL’s Fiduciary Rule #84


BICE, broker-dealers, DOL, fiduciary, plan sponsors, prohibited transaction, prudent

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

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

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

It means a lot . . . in some cases.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #83


DOL, General, prohibited transaction, SEC

Part 2 of Undisclosed (and Disclosed) 12b-1 Fees

This is my 83rd 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 last week’s post (Angles #82) I discussed the fiduciary and prohibited transaction rules that should be considered in light of the SEC’s “Share Class Selection Disclosure Initiative” (“SCSDI”). As a refresher, the SCSD Initiative is a self-correction and self-reporting program where RIAs can identify, correct and report failures to adequately disclose the receipt of 12b-1 fees in addition to their advisory fees. My article discussed the consequences under the DOL’s guidance for the receipt of 12b-1 fees—on top of advisory fees—for both non-discretionary investment advice and discretionary investment management, where the results are quite different.

This article builds on that. The topics for this article:

  • When will, or could, a recommendation of a higher-cost share class (and, therefore, a more expensive investment) satisfy the best interest standard of care (that is, the prudent person rule and the duty of loyalty)?
  • What kind of disclosure of 12b-1 fees would be adequate under the fiduciary rule?

Let’s look at each of those issues.

When will, or could, a recommendation of a higher-cost share class (and, therefore, a more expensive investment) satisfy the best interest standard of care (that is, the prudent person rule and the duty of loyalty)?

As a general principle, a fiduciary adviser should not recommend or select investments that are more expensive than reasonable and necessary. That is one of the considerations under the prudent man rule and under the duty of loyalty. On the other hand, investment advisers are entitled to receive reasonable compensation for their services.

A fiduciary adviser could recommend mutual funds that pay 12b-1 fees as long as the total compensation to the adviser and the firm does not exceed a reasonable amount and as long as the cost of the investment (e.g., expense ratio) is not unreasonably high. (This assumes that there is adequate disclosure of the 12b-1 fees.) So, for example, if an adviser recommends a mutual fund that has a 1% expense ratio, and 25 basis points is paid as 12b-1 fees, the reasonableness of the cost for the mutual fund should be the net expense ratio, or .75%. The adviser needs to determine whether that cost is appropriate and reasonable for the particular qualified account.

On the other hand, if the payment of the 12b-1 fee to the adviser’s firm—when added to the advisory fee—results in excess (or “unreasonable”) compensation for the services, the compensation would not be justifiable and it could mean that the cost (or expense ratio) of the mutual fund was unreasonably expensive (since the cost of the 12b-1 fee was not justified). The former is a prohibited transaction and the latter is a fiduciary breach.

In a nutshell, the prudent man rule and duty of loyalty require an evaluation of the cost of the investment (e.g., mutual fund). However, that analysis is connected at the hip to the reasonableness of the adviser’s compensation.

What kind of disclosure of 12b-1 fees would be adequate under the fiduciary rule?

While the Department of Labor (“DOL”) hasn’t issued any specific guidance on this subject, it has issued guidance about disclosures of compensation in other situations. For example, the DOL’s 408(b)(2) regulation requires that service providers disclose their compensation to plan fiduciaries. While 408(b)(2) applies only to compensation for plan services, it may help understand the expectations for other fee disclosures under the fiduciary rule.

Simply stated, the 408(b)(2) guidance is that the retirement plan fiduciaries must be provided with adequate information to make two determinations. Those are:

  • Whether the compensation of an adviser and the firm is reasonable relative to the services provided.
  • Whether, and to what extent, an adviser and the firm have conflicts of interest.

With that understanding, it seems reasonable to think that the expectation of the fiduciary rule is that the disclosures would enable an investor to calculate a relatively accurate estimate of the compensation paid. For example, it would be risky to say that the adviser or his firm “may” receive 12b-1 fees. The question is, would a reasonable person be able to approximate the total compensation based on that information. Another example would be where the disclosure is that the firm will, in addition to the advisory fee, receive 12b-1 fees in the range of -0-% to 1.00%. Again, the issue is whether the investor can reasonably calculate the total compensation when provided with that information.

A significant risk is that, where the disclosures are inadequate, the adviser and the firm are receiving compensation that was not approved—and that the DOL and IRS would take the position that the payment was a prohibited transaction.

These rules—and particularly, the prohibited transaction rules—are complex and, if not understood, can result in significant problems.

However, once understood—and with appropriate disclosures and agreements—compliance is not conceptually difficult.

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 #82


BICE, DOL, fiduciary, FINRA, registered investment advisers, SEC

Undisclosed (and Disclosed) 12b-1 Fees: The Different Views of the SEC and DOL

This is my 82nd 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.

On February 12, 2018, the SEC announced a remedial program called the “Share Class Selection Disclosure Initiative” (“SCSDI”). Simply stated, the temporary program says that investment advisers who have received undisclosed 12b-1 fees can correct and self-report. In that case, the SEC staff will not recommend financial penalties. However, if an investment adviser does not correct and self-report and the SEC later examines the adviser and discovers those undisclosed payments, the staff will likely be more aggressive about recommending penalties (because the advisers were given the opportunity to self-correct, but failed to do so).

If you would like to know more about that program, here is a link to an article written by two of my firm’s securities lawyers, Jim Lundy and Mary Hansen.

The purpose of this post is not to describe the SEC program, but instead to discuss the same issue from the perspective of the Fiduciary Rule and the prohibited transaction exemptions (and, in particular, the Best Interest Contract Exemption, BICE). This article focuses on investment advice and management for IRAs, rather than retirement plans. However, the principles are the same.

So . . . what are the consequences under the Fiduciary Rule (which became applicable on June 9, 2017) for advisory services to IRAs, where an investment adviser receives undisclosed 12b-1 fees? (By the way, the Fiduciary Rule also applies to advice by financial advisors and insurance agents and brokers. In that regard, it is of broader application than the SEC rules.)

To analyze the issues, the advice needs to be considered in two scenarios. The first is where a fiduciary adviser is providing non-discretionary investment advice; the second is where the fiduciary adviser is managing the account with discretion.

Where a fiduciary adviser has discretion, that is, where the adviser is actually managing the account, the adviser can only receive his stated fee. Stated slightly differently, the adviser cannot receive anything in addition to the advisory fee that results from the adviser’s investment decisions. BICE does not provide an exemption, or exception, for discretionary investment management; BICE only applies to non-discretionary investment advice.

And, to further complicate matters, the Fiduciary Rule prohibits the receipt of additional 12b-1 fees for discretionary investment management regardless of whether those fees are disclosed or not.

How can an adviser remedy the situation? The answer is that, to the extent that a discretionary fiduciary adviser receives additional payments (e.g., 12b-1 fees), the adviser must either offset those payments against the advisory fee—on a dollar-for-dollar basis—or must pay the 12b-1 fees over into the IRA.

As a result, the Fiduciary Rule is more demanding for discretionary investment management than the SEC rules are.

What about non-discretionary investment advice to IRAs?

Prior to June 9, 2017, the receipt of any additional payments for non-discretionary investment advice would have been treated the same as the receipt of additional payments for discretionary investment management (that is, the retention of those payments would have been prohibited). However, on June 9 the “transition” version of BICE became applicable. Under transition BICE, a fiduciary adviser can receive compensation in addition to the advisory fee so long as the adviser’s total compensation is reasonable (and so long as the firm, that is, the RIA or broker-dealer has policies, procedures and practices that ensure that the additional compensation does not incent the fiduciary adviser to make recommendations that are not in the best interest of the retirement investor).

Unfortunately, that second requirement—the policies, procedures and practices—is not well defined. Almost any additional compensation could be viewed as a potential incentive for a fiduciary adviser to increase his or her compensation. However, I believe that, if attention is paid to the subject, and if the people designing the policies, procedures and practices understand the rules, compliant programs can be developed.

But that assumes that the additional compensation was disclosed, which is different than the SEC’s SCSD Initiative. The SEC’s remedial program was designed to provide correction and reporting of the failure to disclose the receipt of additional 12b-1 fees. In that case, I believe that the DOL would take the same position as the SEC. That is, I believe that the DOL would take the position that, if the retirement investor (that is, the IRA owner) had not authorized the payment of the additional 12b-1 fees, the fiduciary adviser was setting his own compensation without the approval of the IRA owner and, therefore, the receipt of those payments was a prohibited transaction for which BICE did not provide relief.

Viewed in that way, the DOL Fiduciary Rule for non-discretionary advice is similar to the SEC’s, but still more demanding. For example, even if the additional 12b-1 fees were disclosed, the Fiduciary Rule and BICE require that the total compensation be reasonable. And, if not disclosed, there is a good chance that the Fiduciary Rule and BICE would be interpreted in a way that results in the 12b-1 fees being prohibited transactions.

Where do we end up? First, fully disclosed compensation, if reasonable, is permissible under the Fiduciary Rule and the exemptions for non-discretionary investment advice. Second, the receipt of additional amounts, such as 12b-1 fees, is prohibited where the adviser has discretion to manage the account, even if the total compensation is reasonable.

In this brave new world of the Fiduciary Rule, it’s important to understand the differences between the rules of the SEC, FINRA and the DOL. That is particularly true for advisory services to IRAs, since my experience is that many advisers to IRAs have little, if any, understanding of the new Fiduciary Rule and exemptions.

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

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Interesting Angles on the DOL’s Fiduciary Rule #81


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

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

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

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

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

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

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

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

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

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

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

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #80


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #79


BICE, broker-dealers, DOL, fiduciary, FINRA, prudent, registered investment advisers, SEC

The Fiduciary Rule: Mistaken Beliefs (#4)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #78


broker-dealers, DOL, fiduciary, General, prohibited transaction, registered investment advisers

The Fiduciary Rule: Mistaken Beliefs (#3)

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

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

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

In fact, the DOL has explained that:

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

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

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

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

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

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

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

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #77


BICE, DOL, fiduciary, General, prudent

The Fiduciary Rule: Mistaken Beliefs (#2)

This is my 77th 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 DOL’s fiduciary regulation and the transition Best Interest Contract Exemption (BICE) first applied on June 9, 2017. In other words, the recommendations made by broker-dealers and RIAs, and their representatives, have been governed by those rules for more than six months. While the requirements of the fiduciary standard of care and transition BICE are fairly straightforward—at least for advisors who understand the fiduciary concept, I am hearing about misunderstandings of those requirements. Angles #75 was my first post about mistaken beliefs; this article continues that theme by examining whether the best interest standard mandates the selection of the “best investment.”

To focus on BICE, when an advisor gives conflicted advice to IRAs, plans or participants, the advisor must adhere to the Impartial Conduct Standards. In that case the advisor must:

  • Adhere to the best interest standard of care.
  • Receive no more than reasonable compensation.
  • Make no materially misleading statements.

The best interest standard of care is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty. More literally, BICE defines the best interest standard as:

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 by me.)

While the full meaning of that language may not be obvious on its face, there is a substantial amount of guidance, through court cases and DOL opinions, about its meaning. It means, first and foremost, that an advisor must engage in a prudent process to develop a recommendation. And, the process must be done carefully and skillfully at the level of a person who is knowledgeable about the particular issues (for example, asset allocation, selection of investments, insurance products, etc.).

However, some people are saying that the best interest standard means that an advisor must recommend the best possible investment. That is incorrect. In fact, the DOL has specifically stated that, even if it were possible to select the best possible investment, that is not the requirement.

Instead, the requirement is that advisors act prudently when selecting investments . . . and prudence is defined by the quality of the process used by the advisor. So, for example, where an advisor uses reputable software to evaluate the investments and to develop an appropriate asset allocation, the use of that software would be part of a prudent process and would document that the advisor was complying with the rules.

Perhaps people are confusing the best interest standard with “best practice.” But, those are different things.

Having said that, there is certainly nothing wrong with an advisor doing more than is legally needed in an effort to prudently select investments.

The best interest standard—while more demanding than the suitability standard—is not as burdensome or difficult as some people believe. Instead, it requires a thoughtful and diligent process implemented by a knowledgeable advisor. Since these rules are designed to protect retirement money, that doesn’t seem like an unreasonable standard.

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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