Category Archives: DOL

Interesting Angles on the DOL’s Fiduciary Rule #76


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

Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

This is my 76th 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 regulation defining fiduciary advice for plans, participants and IRAs applied on June 9, 2017. As a result, we now have some experience with the fiduciary regulation and the transition prohibited transaction exemptions. Based on that experience, there are some significant misunderstandings about how the rules work. This article discusses one of those.

If a broker-dealer or RIA firm receives prohibited (or “conflicted”) compensation from an IRA, the compensation may be permissible under the Best Interest Contract Exemption (BICE). During the transition period (until July 1, 2019), BICE only requires that fiduciary advisors (such as broker-dealers and RIAs, and their representatives) adhere to the Impartial Conduct Standards. There are three Impartial Conduct Standards. Those are:

  • The best interest standard of care (which is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty).
  • The compensation of the financial institution and the individual advisor is no more than a reasonable amount for the services rendered.
  • Neither the financial institution nor the advisor makes any materially misleading mis-statements.

There are two other considerations, though. The first is that BICE is an exemption to the prohibited transaction rules and, therefore, the burden of proof is on the financial institution (e.g., the RIA firm or broker-dealer). As a result, compliance with those three Impartial Conduct Standards should be documented in a retrievable form. The second is that the Department of Labor has said that financial institutions need to have policies, procedures and practices that ensure that their advisors are adhering to the Impartial Conduct Standards.

All in all, though, it is possible to comply with those requirements. Stated another way, the most burdensome requirements in BICE were delayed until July 1, 2019—and will likely be revised before those rules apply.

However, there is a caveat. That is, BICE only applies to non-discretionary investment advice. In other words, if the financial institution or its advisors have the responsibility or authority to make the decisions, or if they actually make the investment or transaction decisions, and there is a financial conflict of interest (that is, a prohibited transaction), BICE does not provide relief. To make matters even worse, there are very few exemptions for prohibited transactions resulting from discretionary decisions. Based on conversations with RIAs over the last few months, I have learned that many of them are not aware that, where they have financial conflicts (for example, 12b-1 fees or payments from custodians) for discretionary investment management for IRAs, there is usually not an exemption and the compensation is prohibited.

In other words, where advisors have discretion, the “cleanest” approach is “pure” level fee advice. Any payments or financial benefits from third parties (e.g., custodians, mutual funds, insurance companies) are prohibited. The DOL’s definition of “discretion” is very broad, for example, if the advisor selects the share class, and the investor does not approve that share class in advance, the advisor (and therefore the financial institution) has exercised discretion.

With that in mind, my advice is that RIAs and broker-dealers should consult with their ERISA attorneys to make sure that they understand these rules and are in compliance.

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 #75


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

The Fiduciary Rule: Mistaken Beliefs

This is my 75th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

In the past, there was a common belief among advisors that fiduciary status could be avoided by presenting a list of investments to plan sponsors. For example, an advisor might provide a list of three alternatives in each investment category (e.g., three alternatives for a large cap blend fund, three alternatives for a small cap fund, and so on). The belief was that, since the list did not “recommend” any particular investments, it could not be a fiduciary recommendation.

While that may (or may not) have been correct before June 9, it is not correct today. The presentation of a selective list will result in fiduciary status, implicating the prudent man rule, the duty of loyalty, and the fiduciary prohibited transactions.

To quote from the new fiduciary regulation:

“Providing a selective list of securities to a particular advice recipient as appropriate for that investor would be a recommendation as to the advisability of acquiring securities even if no recommendation is made with respect to any one security.”

While the practice of presenting selective lists was, at least in my experience, primarily for participant-directed plans, e.g., 401(k) plans, under the new definition, the presentation of selective lists of investments would also be fiduciary advice to individual retirement accounts and individual retirement annuities.

The “moral of the story” is that advisors and their supervisory entities (for example, broker-dealers and RIAs) need to realize that when they provide these types of lists, they will be making fiduciary recommendations. For recommendations to retirement plans, that means that the advisor must engage in a prudent process to evaluate the investments based on factors such as the expenses of the investments, the quality of investment management, the reasonableness of the compensation paid to the advisor from the investments (e.g., 12b-1 fees), and so on. From a risk management perspective, that process should be documented and retained in a retrievable form.

For recommendations to IRAs, if the advice is given by a “pure” level fee fiduciary, the advisor is not committing a prohibited transaction (that is, doesn’t have a financial conflict of interest), and the best interest standard of care does not apply to the advisor. A “pure” level fee advisor would typically be an RIA that charges a level advisory fee, does not receive any payments from the investments, and does not recommend any proprietary products.

However, where an advisor to an IRA receives payments from the investments or where the advisor can affect the level of his compensation based on the investments that are recommended, that would be a financial conflict of interest, which is a prohibited transaction under the Internal Revenue Code.

As a result, if an advisor presents a selective list of investments to the IRA owner, those would be viewed as fiduciary recommendations and any payments from the investments (such as 12b-1 fees) would be prohibited transactions. To avoid a violation, the advisor and the financial institution would need to satisfy the requirements of transition BICE. The most significant of those requirements is the best interest standard of care, which is a combination of ERISA’s prudent man rule and duty of loyalty. That standard of care is somewhat more demanding than the suitability and know-your-customer standards. Advisors and financial institutions need to understand these rules, so that they do not inadvertently fail to comply with them. Also, the burden of proof of compliance is on the financial institution; as a result, the best interest process should be documented.

The second “moral of the story” is that advisors should be familiar with the new rules, so that they don’t inadvertently fall into a compliance trap.

Forewarned and forearmed.

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #74


BICE, DOL, fiduciary, recordkeeper

One More Fiduciary Issue for Recordkeepers

This is my 74th 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 my last four posts, Angles 70 through 73, I discussed issues and opportunities for recordkeepers under the new fiduciary rule and the transition Best Interest Contract Exemption. This post covers a carve-out to the fiduciary definition that probably will not work—or, at least, won’t work effectively—for recordkeepers.

That carve-out to the fiduciary definition is one that allows recordkeepers to provide lists of the investments available on their platforms that satisfy certain criteria specified by the plan sponsor, for example, performance, expense ratios, volatility, etc. Specifically, that provision says that a recordkeeper does not become a fiduciary by:

Identifying investment alternatives that meet objective criteria specified by the plan fiduciary (e.g., stated parameters concerning expense ratios, size of fund, type of asset, or credit quality), provided that the person identifying the investment alternatives discloses in writing whether the person has a financial interest in any of the identified investment alternatives, and if so the precise nature of such interest; . . .”.

At first blush, that raises a practical question of whether plan sponsors who aren’t working with advisors have the ability to select appropriate criteria. Fortunately, the DOL permits recordkeepers to provide information to plan sponsors about generally accepted criteria. So, that hurdle can be cleared.

Similarly, in a FAQ, the DOL permits recordkeepers to use the criteria in an investment policy statement and provide the plan sponsor with the list that those criteria produce, without the recordkeeper becoming a fiduciary for that purpose.

In that regard, the FAQ states:

The recordkeeper would not be treated as making a recommendation for purposes of the Rule if it provided a list of all of the investment alternatives available on the platform that meet the requirements of the plan’s investment policy statement.

The recordkeeper must apply the criteria to all of the investments that are available on its platform and then report the results. As you might imagine, that could, depending on the criteria selected by the plan sponsor, be a list of just a few funds or a list of hundreds of funds.

Unfortunately, if the recordkeeper further winnows the list of investments produced by the application of the generally accepted criteria or the IPS criteria, the recordkeeper could become an investment fiduciary. In that regard, the DOL has said:

However, if the recordkeeper exercises discretion in narrowing the response to a selective list of investment alternatives, in the Department’s view, the communication could constitute an investment recommendation for purposes of the Rule if a reasonable person would view the communication as a recommendation that the fiduciary choose investments from the selective menu screened by the recordkeeper.

My view is that this carve-out may not be particularly helpful . . . because recordkeepers cannot provide selective lists without running the risk of becoming fiduciaries. As a result, recordkeepers that do not want to be fiduciaries are likely to provide investment line-ups to advisors through wholesalers (see Angles #72) and through responses to RFPs and RFIs as described in Angles #73.

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 #73


DOL, plan sponsors, prudent, recordkeeper

Recordkeeper Investment Support for Plan Sponsors

This is my 73rd 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 Angles article #70, I discussed three areas where the fiduciary rule is impacting recordkeepers. Those are: acceptance of fiduciary status; non-fiduciary investment services for advisors; and non-fiduciary investment services for plan sponsors. Angles articles #71 and #72 discussed the first two points. This article discusses the third.

In the past, recordkeepers often provided sample line-ups to start-up plans and to existing plans that were transferring to their recordkeeping platform. However, under the new fiduciary definition, a selective list of investments is considered to be fiduciary investment advice, which means that the recordkeeper would need to make prudent recommendations and would be subject to ERISA’s prohibited transaction rules (e.g., for any proprietary investments and revenue sharing). Fortunately, there is an exception in the fiduciary regulation; unfortunately, though, the scope of the exception is limited. Let me explain.

The DOL’s fiduciary regulation—which applied on June 9, 2017—expands the definition of fiduciary advice. However, it also includes “carve-outs,” or exceptions, from the fiduciary definition. One of those exceptions is that fiduciary advice does not include a line-up of investments that is provided:

“ . . . In response to a request for information, request for proposal, or similar solicitation by or on behalf of the plan, identifying a limited or sample set of investment alternatives based on only the size of the employer or plan, the current investment alternatives designated under the plan, or both, provided that the response is in writing and discloses whether the person identifying the limited or sample set of investment alternatives has a financial interest in any of the alternatives, and if so the precise nature of such interest; . . .”

As a result, a recordkeeper can provide a plan sponsor with a sample list of investments (for example, for a 401(k) plan) without becoming an investment advisor fiduciary. However, the investment line-up can only be based on the size of the employer or the size of the plan, the plan’s current investment alternatives (if it is an existing plan), or both. In other words, the line-up cannot be customized for the particular plan (by, e.g., taking into account other factions). If it is customized, that would be fiduciary investment advice.

In addition, the sample line-up must be:

  • In response to a request for information, request for proposal, or similar solicitation by or on behalf of the plan.
  • In a written form which discloses whether the recordkeeper has a financial interest in any of the investments in the line-up and, if so, the precise nature of the interests must be described. That would include any proprietary investments and any investments that pay revenue sharing to the recordkeeper.

The sample list is limited to line-ups that would generally be proposed for plans or employers of a particular size (or be based on the line-up of an existing plan) and, therefore, would be of limited value to many plans, this RFP/RFI exception will likely provide some value to small, start-up plans which are serviced by advisors with little or no 401(k) experience and to plans that do not have advisors.

However, where plans do have advisors (even if they have limited experience with plans), the better approach would probably be the wholesalers exception, which was discussed in a prior post, Angles article #72.

Interestingly, if a recordkeeper goes beyond the limits of the RFP/RFI exception (for example, customizes the investment line-up), the recordkeeper will be a fiduciary to the plan, which implicates both the fiduciary standard of care and the prohibited transaction rules. Since recordkeepers commonly receive revenue sharing from a plan’s investments and, therefore, engage in prohibited transactions, they would need to comply with the transition rules for the Best Interest Contract Exemption. Those rules are: adherence to the best interest standard of care; receipt of no more than reasonable compensation; and not making materially misleading statements. For the duration of the transition period (until July 1, 2019), those requirements do not appear to be insurmountable. As a result, some recordkeepers may decide to provide fiduciary investment advice to plan sponsors, rather than use the RFP/RFI carve-out. To this point in time, though, I haven’t seen a movement in that direction.

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 #71


BICE, DOL, fiduciary, recordkeeper

Recordkeepers and Financial Wellness Programs

This is my 71st article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In my last post, Angles #70, I highlighted the three types of work that we are doing for recordkeepers as a result of the DOL’s fiduciary regulation and exemptions. This post goes into more detail about the development of financial wellness programs and the acceptance by recordkeepers of fiduciary responsibility for some of the services.

As background, the goal of financial wellness programs is to provide help to participants in achieving their short-, intermediate-, and long-term financial objectives. Recordkeepers are uniquely suited to provide those services, because of the information they already possess and because of their call centers. The services most often provided cover advice about:

  • Contributions and benefit adequacy.
  • Repayment of indebtedness.
  • Budgeting and management of expenses.
  • Savings for unexpected expenses.
  • Investing their 401(k) accounts.
  • Roll-ins to the 401(k) plan.
  • Rollovers from the 401(k) plan.

Some of that advice is fiduciary and some is not. Let’s take a closer look at that.

Clearly, recommendations about repayment of indebtedness, budgeting and management of expenses, and the accumulation of savings for unexpected expenses is not fiduciary advice. However, the recommendations must be reasonable in light of the circumstances (under the laws of most states). In addition, advice about the level of deferrals to 401(k) plans is not fiduciary advice, so long as it is based on an objective standard. For example, financial wellness programs may recommend that, as a first step, participants defer at least enough to benefit from the full match offered by the employer. In addition, those programs typically recommend at some point in the process that participants defer enough to achieve benefit adequacy at retirement (for example, a 70% income replacement ratio).

On the other hand, investment advice for participants’ accounts and recommendations of roll-ins and rollovers, is fiduciary advice. Those types of recommendations will cause the recordkeeper to become a fiduciary for those purposes. As a result, recordkeepers will need to have prudent processes in place to develop and deliver the recommendations. In addition, where the recordkeeper, or an affiliate, would make more money if a participant agrees to the recommendation, the recordkeeper will need to comply with a prohibited transaction exemption. Usually, that will the Best Interest Contract Exemption, or BICE.

For example, if a recordkeeper recommends that a participant rolls in his or her money from another plan or an IRA, the recordkeeper will need to do a prudent analysis of the relevant facts and then make a prudent and loyal recommendation to the participant. While the DOL has not provided detailed guidance about roll-ins, a reasonable approach would be for the recordkeeper to gather information about the investments, services and expenses in the IRA or old plan; the same type of information about investments, services and expenses in the recordkeeper’s plan; and information about the needs, circumstances and preferences of the participant. (As a general rule, in order to provide prudent advice, a fiduciary must gather the information that a knowledgeable person would consider relevant to making the decision. However, we are left to speculate about the specific information that would be required for a roll-in recommendation.)

In any event, recordkeepers must gather the relevant information and make prudent and loyal recommendations where they provide fiduciary advice under a wellness program. In addition, where a recordkeeper would receive additional compensation if the recommendation is accepted by the participant, the recordkeeper would need to satisfy the conditions of BICE which, in addition to the best interest standard of care, would include a prohibition on compensation in excess of a reasonable amount and would prohibit any materially misleading statements. The recordkeeper should also have written policies and procedures, together with supervision, for the development and delivery of the fiduciary recommendations.

If those conditions are satisfied, recordkeepers could provide so-called “conflicted” advice. (In this context, “conflicted” means that advice that will cause the recordkeeper or an affiliate to receive additional compensation.)

Where the financial wellness program also includes discretionary investment management of participant accounts, the issues are more complex. That is because BICE does not provide an exemption for discretionary investment management. In that case, the recordkeeper will need to either utilize an independent third party investment manager for the discretionary services or will need to use another exception (for example, the Frost Advisory Opinion or Prohibited Transaction Exemption 77-4).

Having worked on programs that offer these services to participants—and, therefore, having given it some thought, I believe that these programs will provide valuable services to employees. The financial world is increasingly complex and young employees are often burdened by substantial student loans. As a result, there is a need for help with financial decisions.

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 #70


BICE, DOL, fiduciary, plan sponsors, prudent, recordkeeper, registered investment advisers

The Fiduciary Rule and Recordkeeper Services

This is my 70th 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.

Almost all of my Angles articles have been about the impact of the fiduciary rule on advisors—representatives of broker-dealers and RIAs. However, the fiduciary rule also affects recordkeepers and the services that they offer to plans and advisors. In that regard, most of the work that we are doing for recordkeepers falls into three categories:

  • Acceptance of fiduciary responsibility by recordkeepers for “financial wellness” of participants.
  • Providing investment services and support for advisors, without becoming a fiduciary.
  • Providing investment services and support for plan sponsors, without becoming a fiduciary.

The next few Angles articles will discuss these issues in detail. This article is just to introduce the topics.

Financial Wellness

Financial wellness combines a focus on benefit adequacy with basic budgeting and financial management. Typically, it covers advice on plan participation, amounts to defer, repayment of indebtedness, budgeting and management of regular expenses, basic savings, investment advice and management of participants’ accounts, roll-ins to plans, and rollovers from plans. The objective is to help employees with financial decision-making for the short, intermediate and long terms. Where the recommendations constitute fiduciary advice under ERISA and the Best Interest Contract Exemption, the recordkeepers are accepting fiduciary status.

Investment Assistance to Advisors

The fiduciary rule includes an exception for investment services provided to “independent fiduciaries with financial expertise,” or “IFFEs.” Those fiduciaries include broker-dealers, RIAs, banks and trust companies, and insurance companies. In turn, where those financial institutions are willing to serve as fiduciaries with their advisors, recordkeepers can provide investment recommendations to the advisors without becoming fiduciaries. That is because the financial institution and the advisors are considered to be independent and knowledgeable fiduciaries who can evaluate the recordkeeper recommendations on behalf of their plan, participant and IRA clients.

Investment Assistance to Plan Sponsors

While recordkeepers have great flexibility to provide investment advice to advisors (who qualify as IFFEs) without becoming fiduciaries, the same is not true for advice to plan sponsors. (The IFFE provision also applies to some larger plans.)

However, there are some exceptions of general application for providing investment information to plan sponsors. The most useable exception is for responding to requests for proposals (RFPs) and requests for information (RFIs). But, even that exception is limited. The investment list provided by the recordkeeper can only be based on the size of the employer or the size of the plan, or both. For existing plans, it could be based on the current investment line-up.

A Prediction About Future Directions

As a prediction, recordkeepers will increasingly take advantage of the IFFE carve-out. That means that they will be providing suggested investment line-ups to qualifying IFFE advisors. The advisor will then need to evaluate the line-up and decide whether to present it to the plan sponsor. If an advisor then gives that investment line-up to the plan sponsor, the law will treat it as the advisor’s fiduciary recommendation (and, therefore, not as a recommendation by the recordkeeper).

That is the only meaningful exception for individualized non-fiduciary investment recommendations by recordkeepers. The RFP/RFI exception will also help, but it provides, by definition, a generic list of investments.

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

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Interesting Angles on the DOL’s Fiduciary Rule #69


BICE, broker-dealers, DOL, registered investment advisers

Compensation Risks for Broker-Dealers and RIAs

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

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

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #68


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

Recommendations of Distributions: The SEC Joins the Fray

This is my 68th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

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

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

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

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

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

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

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #67


BICE, DOL, fiduciary, prudent, SEC

Fiduciary Rule: From the DOL to the SEC

This is my 67th 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.

It now seems certain that the DOL will extend the applicability date of the final exemptions to July 1, 2019, or thereabouts. In any event, it will be a long extension. As a practical matter, that means that the transition rules under the Best Interest Contract Exemption (BICE) and Prohibited Transaction Exemption 84-24 will be extended until June 30, 2019 . . . in other words, the transition rules will continue until the applicability of revised final exemptions.

The extended time will be used for the DOL and the Securities and Exchange Commission (SEC) to cooperate in the development of new fiduciary rules by the SEC (and perhaps changes to the DOL’s fiduciary regulation) and for revised exemptions to be issued by the DOL for BICE and 84-24.

However, that coordination will probably not produce rules as favorable as some expect nor as unfavorable as others anticipate. Let me explain that comment.

The DOL’s new fiduciary regulation—which became fully applicable on June 9 of this year—defines the recommendations that cause an advisor and his or her supervisory entity to be fiduciaries. For example, if an advisor recommends an investment, an investment manager, an investment strategy or policy, a withdrawal from an IRA or a distribution and rollover from a plan, that is already fiduciary advice.

Since that’s a regulation, the DOL can amend it. However, I doubt that any of those recommendations will be removed from the category of fiduciary advice. On the other hand, an amended regulation could expand the circumstances in which selling is allowed without becoming fiduciary advice (perhaps with enhanced disclosures of non-fiduciary status) and could require a more personalized recommendation, e.g., a recommendation that is individualized to a plan, participant or IRA owner. However, I doubt that the changes will substantially alter the current landscape.

The second fiduciary issue is the standard of care—the dual duties of prudence and loyalty. For advice to plans and participants, those duties are statutory. They cannot be changed by regulation. And, they cannot be changed by the SEC. Only Congress can amend the law (and this Congress seems to have a difficult time doing anything).

However, the statutory prudent man rule and duty of loyalty only apply to advice to ERISA plans and their participants. For IRAs, those duties (which are referred to as the “best interest standard of care”) are imposed by the exemptions, for example, BICE. (As an aside, that means that advisors and their firms only need to comply with the best interest standard of care for IRAs if they are committing prohibited transactions by, e.g., receiving variable compensation or third party compensation. So, for example, a level fee advisor to an IRA would not be committing a prohibited transaction and, therefore, would not need to comply with the conditions of an exemption, e.g., the best interest standard of care.) However, the DOL can amend exemptions. So, BICE and 84-24 could be changed to a standard other than the best interest standard of care. Having said that, though, there may not be significant changes. If you look at the best interest standard, it requires that the advisor and his or her firm act prudently and loyally. It’s possible that the SEC could adopt the ERISA rule as the standard for retail advice for broker-dealers and RIAs. In any event, it’s difficult to imagine a new SEC standard that is much different than prudence and loyalty.

With regard to disclosures for exemptions, it’s possible—perhaps even likely—that the DOL will follow the SEC’s lead. Before the DOL does that, though, it must make an independent finding that the SEC’s disclosures are adequately protective of the interests of plans, participants and IRA owners. In that regard, the DOL needs to consider the effectiveness of the disclosures, as well as the facts to be disclosed. Nonetheless, I believe that the SEC will be leader on disclosures and the DOL will make every effort to use the SEC disclosures as conditions of the prohibited transaction exemptions. That will be more than is required under the transition exemptions, but it will probably be significantly less than is required under the current versions of the final exemptions.

We are working with clients to develop their strategies and comments for the SEC. I expect to have additional insights as those develop.

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 #65


BICE, DOL, fiduciary, prohibited transaction, prudent

Unexpected Consequences of Fiduciary Rule

This is my 65th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The fiduciary and best interest standards of care, as well as the prohibited transaction rules, will impact advisors in some unexpected ways. That is particularly true of investment advice to IRAs. Here is an example.

When plan or IRA assets are held by a custodian, an advisor often has the ability to recommend either transaction-fee (TF) mutual funds or no-transaction fee (NTF) mutual funds. The recommendation of either TF or NTF funds is a fiduciary act for plan assets, and it will be a best interest act for IRA assets—if the advisor or his or her firm receives any payments beyond a stated advisory fee that is level. (In effect, the payments from the custodian “unlevelize” the advisory fee.)

For both the prudence and best interest standards of care (which are virtually identical), an advisor must consider whether it is prudent to recommend a TF fund or an NTF fund. The issue is that NTF funds typically have a higher expense ratio, while TF funds charge an initial transaction cost but usually have a lower expense ratio. As a general statement, NTF funds would be appropriate for short-term holdings, while TF funds would be more cost-effective for longer term holdings.

To further compound matters, there are also prohibited transaction issues. Some custodians pay money to advisors if the advisors select NTF funds (because, I assume, the custodians make more money on NTF funds). The Department of Labor would consider those payments to be prohibited transactions, since they result from an advisor’s recommendation and since they generate payments above and beyond the advisor’s stated level fee.

However, not all is lost. Under the Best Interest Contract Exemption (BICE), where an advisor receives additional compensation that is prohibited under these rules, the additional compensation is permissible, if the conditions of the exemption are met. One of the BICE conditions is that the total compensation cannot be more than a reasonable amount. Note that, for plan purposes, the additional compensation would need to be disclosed in the advisor’s 408(b)(2) disclosures. In addition, and for both plan and IRA assets, it is possible, perhaps even likely, that an assertion could be made that undisclosed compensation is impermissible (since, arguably, the advisor is setting its own compensation as a result of the nondisclosure). As a result, an advisor should disclose, at the beginning of the fiduciary relationship, all of the compensation which the advisor will or may receive.

However, there are two other conditions for BICE. The first is that the advisor cannot make any materially misleading statements about the transactions or the compensation. The second is that the advisor must adhere to the best interest standard of care. That standard of care includes deciding whether the prudent recommendation is to use TF or NTF funds. If those conditions are not satisfied, the additional compensation is impermissible, at least from the perspective of the Department of Labor.

To make matters even more complex, the Best Interest Contract Exemption only protects compensation resulting from non-discretionary advice. So, for example, if the advisor is the one who decides to use NTF funds, that decision amounts to discretion. In that case, BICE would not be available to permit the prohibited payments from the custodian.

Now that the final fiduciary rule applies (as of June 9, 2017), advisors need to review all of their sources of compensation directly or indirectly from “qualified” assets (that is, plans, participants or IRAs). The changes are more far-reaching than most people think.

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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