Category Archives: fiduciary

Interesting Angles on the DOL’s Fiduciary Rule #94


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

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

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

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

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

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

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

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

Where does that leave us?

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

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

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

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

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #93


BICE, broker-dealers, DOL, fiduciary, FINRA, SEC

SEC Proposed Reg BI and Recommendations of Rollovers (Part 2)

This is my 93rd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

In my last post, I described the similarities between the SEC proposed Regulation Best Interest (Reg BI) and the DOL’s Fiduciary Rule (and especially the Best Interest Contract Exemption [BICE]) regarding recommendations to participants to take distributions and roll over into IRAs. The similarities include a best interest standard of care and the treatment of conflicts of interest. This article discusses the requirement of the best interest standard of care in Reg BI and compares it to the standard of care in BICE (and the requirements of FINRA Regulatory Notice 13-45). My next article—Part 3—will cover the conflict of interest issues.

In its discussion of recommendations about distributions and rollovers in proposed Reg BI, the SEC says that, where the recommendation involves a securities transaction, the best interest standard of care will apply to broker-dealers. The SEC goes on to describe the best interest standard of care as requiring care, skill, prudence and diligence and making a recommendation that is in the best interest of, loyal to, the participant.

With regard to the question of whether a recommendation to take a distribution and roll over is a securities transaction, the SEC refers to FINRA Regulatory Notice 13-45. The SEC guidance and that Regulatory Notice, in combination, point out that, in the typical recommendation to a 401(k) participant, there are two securities transactions. The first transaction is the liquidation of the investments in a participant’s account, since a distribution cannot ordinarily be made without first selling the investments in the account. (In other words, a recommendation to take a distribution usually inherently includes a recommendation to sell the investments in the participant’s account.) The second transaction is in the rollover IRA, where a new investment recommendation will be made. As a result, distribution and rollover recommendations to 401(k) and 403(b) participants will ordinarily involve two securities transactions and both will be subject to the proposed best interest standard of care.

However, the SEC does not discuss the process and analysis required to make a best interest recommendation of a distribution. As discussed above, though, the SEC makes a number of references to Regulatory Notice 13-45. That notice goes into some detail that the information needed to evaluate whether a rollover recommendation would be suitable. It seems safe to assume that, at the least, the same information would be required for a best interest recommendation.

In its Regulatory Notice, FINRA points to a number of factors to be considered, including the investments, services, and fees and expenses in the plan. A broker-dealer will need to gather information in order to evaluate those factors . . . and then compare them to the services, expenses, and investments in the proposed rollover IRA. That analysis must be done in light of the financial needs, circumstances and preferences of the participant.

While it is easy to say that plan information is needed, it is hard to find that information.

How do I know that? It is because those are the same factors that the DOL said were primary considerations for making a best interest recommendation under BICE.

The DOL, SEC and FINRA have converged to agree on the important factors that need to be considered to make a rollover recommendation. However, it’s proven to be difficult to gather information about plan investments, expenses and services. Fortunately, though, the DOL did offer guidance for situations where it was not possible to find the information. I assume that the SEC and FINRA will share the alternative approach provided by the DOL, which was described in a set of FAQs. Broadly stated, the DOL permits use of “alternative data” where a participant cannot find, or does not want to use, the primary plan data.

Also, I should point out that there continues to be an education alternative, which is that a broker-dealer can provide distribution and rollover education, rather than making recommendations. However, it’s important that the education be unbiased and relatively complete. Otherwise, it could be viewed as a disguised recommendation.

In my next post, I will discuss the conflict of interest issues where distribution and rollover recommendations are made.

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 #92


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

SEC Proposed Reg BI and Recommendations of Rollovers (Part 1)

This is my 92nd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions and the SEC’s “best interest” proposals.

On April 18, 2018, the SEC released three proposals for comment—Regulation Best Interest (“Reg BI”) for broker-dealers, an Interpretation about the Standard of Conduct for RIAs (“RIA Interpretation”), and a CRS—Customer/Client Relationship Summary for both broker-dealers and RIAs. That was the beginning of a lengthy process, and the outcome is uncertain. However, if these rules are finalized, the impact on the securities industry and investors will be significant.

My first reaction is that Reg BI, which imposes a best interest standard of care on broker-dealers, is strikingly similar to the DOL’s Best Interest Contract Exemption (BICE). There are major differences—for example, the SEC proposal does not create a private right of action for investors, and some of the disclosure requirements are eliminated. However, once you get beyond the differences, the similarities are striking.

Let’s discuss the SEC’s Best Interest standard for broker-dealers in the context of recommendations of plan distributions and rollovers.

First, the SEC acknowledges that a rollover recommendation involves an inherent conflict of interest. In footnote 204 the SEC states: “For example, firms and their registered representatives that recommend an investor roll over plan assets to an IRA may earn commissions or other fees as a result, while a recommendation that a retail investor leave his plan assets with his old employer or roll the assets to a plan sponsored by a new employer likely results in little or no compensation for a firm or a registered representative.”

On pages 82 and 83 of the Reg BI package, the SEC explains that “Securities transactions may also include recommendations to rollover or transfer assets from one type of account to another, such as recommendations to roll over or transfer assets in an ERISA account to an IRA.”

The significance of rollovers being classified as “securities transactions” is that the proposed best interest standard of care applies to recommendations of securities transactions. That is, a recommendation to a participant to take a distribution from his or her 401(k) plan and roll over to an IRA is, in effect, a recommendation that the participant sell the mutual funds in his or her account and rollover the cash proceeds.

In fact, the rollover process involves two securities transactions. In footnote 155, the SEC explains: “A recommendation concerning the type of retirement account in which a customer should hold his retirement investments typically involves a recommended securities transaction, and thus is subject to FINRA suitability obligations. For example, a firm may recommend that an investor sell his plan assets and roll over their cash proceeds into an IRA. Recommendations to sell securities in the plan or to purchase securities for a newly-opened IRA are subject to FINRA’s suitability obligations. See FINRA Regulatory Notice 13-45.”

In addition to the existing suitability obligation, Reg BI would impose a best interest standard of care, including a duty of loyalty, such that the recommendation to sell the investments in the plan (for example, a 401(k) plan) would be subject to both suitability and best interest. The suitability and best interest standards would also apply to recommendations about the re-investment of distributed money in an IRA.

That raises a question about how a best interest recommendation of a distribution and rollover should be made. What steps should be followed? That will be the subject of my next article.

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

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Interesting Angles on the DOL’s Fiduciary Rule #91


BICE, broker-dealers, DOL, fiduciary, SEC

Parallels Between the SEC Regulation Best Interest and the DOL Best Interest Contract Exemption (Part 2)

This is my 91st 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—including the SEC’s “best interest” proposals.

This article continues my discussion of the similarities between the SEC’s proposed Regulation Best Interest (Reg BI) for broker-dealers and the DOL’s Best Interest Contract Exemption (BICE).

In addition to the standard of care (best interest and loyalty), Reg BI also has enhanced protections for conflicts of interest. Interestingly, they closely parallel the DOL’s conditions in BICE. For example, Reg BI proposes to require that material conflicts of interest involving financial incentives be eliminated or, alternatively, be disclosed and mitigated. The key word is “mitigated.” While the SEC guidance refers to “financial incentives” and the DOL refers to “compensation,” the outcome is much the same. ERISA and the Internal Revenue Code prohibit compensation that results from fiduciary recommendations, where the compensation is paid by a third party (for example, insurance commissions or 12b-1 fees) or where the compensation is variable, based on the recommendations (for example, commissions on securities transactions). Those types of payments are, in the view of the SEC, “material conflicts of interest involving financial incentives.”

In BICE, the DOL said that fiduciary advisors (which could include broker-dealers and their representatives) needed to have policies, procedures and practices in place to ensure that the compensation did not incent advisors to make recommendations that were not in the best interest of retirement investors. Similarly, the SEC says that broker-dealers must eliminate, or disclose and mitigate, conflicts of interest that involve financial incentives. As examples of “mitigation,” the SEC and DOL both gave the following:

  • Within a particular investment category, compensation could be levelized. For example, the initial compensation and trailing compensation for all mutual fund sales could be set at the same level. As a hypothetical, that might be a 3% initial commission (or load) on all mutual funds, with a uniform 25 basis point trailing 12b-1 fee.
  • Among investment categories, a broker-dealer might base differences in compensation on “neutral” factors. For example, if it took twice as much work to explain and sell a variable annuity contract, that would be a neutral factor that would justify twice as much compensation for the sale of an individual variable annuity. Hypothetically, if reasonable and level compensation for mutual fund sales was 3%, then in my hypothetical, first-year compensation of 6% could be justified for the sale of a variable annuity.

Keep in mind, though, that those are just examples about how the mitigation requirement could be satisfied. If the SEC’s Reg BI is finalized in its current form, broker-dealers will need to implement those policies or adopt other practices that are reasonably designed to mitigate the impact of material conflicts of interest arising from financial incentives associated with investment recommendations. (More technically, the SEC proposes that Reg BI would apply to recommendations of securities transactions and investment strategies that involve investment transactions.) Based on the examples used by the SEC, it appears that the Commission is serious about mitigation of the incentive effect of those payments.

As this article suggests, in order to fully appreciate the SEC’s Reg BI, broker-dealers need to understand the development and history of the DOL’s BICE. There are remarkable parallels. In fact, it would be difficult to understand some concepts, such as neutral factors, without having worked on BICE compliance issues.

However, it also means that broker-dealers who are in substantial compliance with the final BICE requirements–as opposed to the transition rules–have already substantially satisfied the SEC’s proposed rules. That’s good news. It means that the hard work put in by those firms, and the costs involved, will have been worth it. It also means that, for broker-dealers who were not close to being in compliance with full BICE, practices and compensation arrangements developed by others can be used to develop compliant practices for the SEC guidance.

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 #90


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

Parallels Between the SEC Regulation Best Interest and the DOL Best Interest Contract Exemption (Part 1)

This is my 90th 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 SEC’s proposed Regulation Best Interest (“Reg BI”) is remarkable in its similarities to the DOL’s vacated Best Interest Contract Exemption (“BICE”). This article describes some of those similarities. Keep in mind as you read this that Reg BI applies to securities recommendations, while BICE would have covered any investment or insurance recommendation by a fiduciary advisor.

Reg BI, if finalized, will require that broker-dealers and their representatives act in the “best interest” of “retail customers,” which includes IRA owners and participants. The DOL’s BICE also would have required that fiduciary advisors (including broker-dealers and their representatives) act in the “best interest” of participants and IRA owners. A major difference is that the SEC proposal covers all retail customers, while the DOL’s BICE would have covered “qualified accounts”—which includes only plans, participants and IRA owners. (I should note that Reg BI says that it covers recommendations to “legal representatives” of retail customers. That reference could include the trustees and plan committees for retirement plans. However, it’s not clear.)

Also, Reg BI is similar to BICE in that it covers recommendations to participants to take distributions from retirement plans and roll over to IRAs. Reg BI only applies where securities recommendations are made. But it appears to be the position of both the SEC and FINRA that a recommendation to take a distribution from a 401(k) plan implicitly includes a recommendation to liquidate the investments in the participant’s account, which would be a securities transaction. (I will get into more detail about recommendations to participants to take distributions and roll over to IRAs in a future article.)

In addition, both Reg BI and BICE include a duty of loyalty for recommended securities transactions. While the wording in the two pieces of guidance is slightly different, the outcome is the same . . . broker-dealers and their representatives cannot prioritize their own interests ahead of the interests of investors.

While some people refer to the new standard of care as being “suitability plus” or “enhanced suitability,” I see it differently. Based on my reading of the guidance and on comments by SEC commissioners, the suitability standard is incorporated into the new Best Interest Standard of Care, rather than the other way around. As a result, it might be better referred to as “transactional best interest.”

Unfortunately, the SEC proposal does not fully define the Best Interest Standard of Care. However, it does say that broker-dealers and their representatives have to act with “diligence, care, skill, and prudence,” which was also in the DOL’s Best Interest Standard of Care. (As an aside, the requirement to act diligently, carefully, skillfully, and prudently suggests the need for a process—similar to ERISA’s prudent man rule.) The proposed Reg BI goes on to say that its duty of care is based on the principles in the DOL’s Best Interest Standard of Care. To me, that means that a starting point for understanding the Reg BI requirements is to look at the DOL’s Best Interest Standard of Care which says that:

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.

If you read that closely, it easily divides into three categories: a prudent person rule; a know-your-customer requirement; and a duty of loyalty. The preamble to the proposed Reg BI discusses those three principles as being key elements of its standards.

However, while the proposal would require best interest for recommendations of securities transactions, it would not mandate a duty to monitor. That is significantly different from the role of an investment adviser (RIA), where best interest monitoring is generally expected.

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 #89


BICE, DOL, fiduciary, prohibited transaction, recordkeeper, SEC

The 5th Circuit Decision, Prohibited Transactions, and New Non-Enforcement Policies

This is my 89th 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 Monday, May 7th, the Department of Labor and the Internal Revenue Service issued non-enforcement policies for prohibited transactions that resulted from the 5th Circuit Court of Appeals vacating the Fiduciary Rule. While it is well-understood that the 5th Circuit threw out the expanded definition of fiduciary advice, it is not as well known that the 5th Circuit also vacated the exemptions that were associated with the fiduciary regulation. As a result of the loss of the exemptions, including the Best Interest Contract Exemption (BICE), many advisors (including their broker-dealers and RIAs) have inadvertently engaged in prohibited transactions during the time since the Fiduciary Rule first applied on June 9, 2017. As a result, relief was needed. This article discusses the guidance from the DOL and IRS, as well as some of the implications.

As background, when the expanded definition of fiduciary advice became applicable on June 9th, that meant that almost any person providing investment, insurance, or rollover advice to ERISA retirement plans, participants or IRA owners was a fiduciary. As a result, two fiduciary prohibited transaction rules come into play. Two types of compensation are prohibited by both the Code and ERISA. Generally stated, the first prohibited transaction is the receipt of compensation by a fiduciary advisor (and/or the supervisory entity) from third parties. Broadly stated, “third parties” includes anyone other than the plan, plan sponsor, participant, participant’s account, IRA or IRA owner. As a result, it would include common payments such as 12b-1 fees, insurance commissions, payments from custodians and recordkeepers, and so on. The second fiduciary prohibited transaction is commonly referred to as “variable” compensation. More specifically, it is compensation received directly as a result of an investment recommendation. The most obvious example is a commission on a securities transaction, where each recommendation can generate compensation for the advisor. It would also include situations where, for example, a level fee advisor recommended mutual funds that pay 12b-1 fees in addition to the advisory fee.

The compensation resulting received by a fiduciary advisor because of those recommended transactions is prohibited. That compensation can only be retained by a fiduciary advisor (and his or her supervisory entity) if there is an exemption and if the conditions of the exemption are satisfied.

BICE fulfilled that role for most types of transactions. However, when the 5th Circuit Court of Appeals vacated the Fiduciary Rule, it also vacated the exemptions, including BICE.

As a result, there have been an unimaginable number of prohibited transactions committed during the period from June 9th to date. In addition, there would be absolute prohibitions on those types of compensation in the future. Obviously, that doesn’t work.

As a side note, these prohibitions apply only to fiduciary advisors. When the Fiduciary Rule was vacated, some advice that would have been fiduciary advice will not result in fiduciary status. For example, the recommendation of a fixed rate annuity as an individual retirement annuity (or IRA) could be one-time advice. In that case, the commission would not be prohibited compensation, either retroactively or prospectively.

However, in many other cases, the advice would, either under the vacated new rule or the old fiduciary definition, be fiduciary advice. For example, common practices of many investment advisors and RIAs would satisfy the 5-part test. In addition, where advisors with broker-dealers have ongoing relationships of trust and confidence with continuing customers, they could satisfy the 5-part test, depending on the facts and circumstances.

With that background, let’s turn to the non-enforcement policies. The DOL non-enforcement policy applies to fiduciary advice to ERISA-governed retirement plans and to participants in those plans. The policy is that the DOL will not enforce inadvertent prohibited transactions that occurred because fiduciary advisors complied with the transition rules in BICE (and other exemptions associated with the Fiduciary Rule by satisfying the Impartial Conduct Standards). However, that is only partial relief. That is because ERISA also provides for private rights of action by plan fiduciaries. As a result, fiduciary advisors need the additional protection of a prohibited transaction exemption. While that exemption does not exist now, the DOL is likely to remedy that. See the discussion below.

The IRS non-enforcement policy applies to both IRAs (and similar vehicles) and tax-qualified plans. In this case, the relief for IRAs is virtually complete, since only the IRS can enforce violations of the Code.

The non-enforcement policy requires that a fiduciary advisor (and the supervisory entity) comply with the Impartial Conduct Standards (which are, in effect, the conditions in the transition rules for BICE). The ICS includes the best interest standard of care.

The DOL also suggested that it is working on a proposed and temporary exemption that will be retroactive to June 9th of last year and that will be prospective—until there is a final exemption. However, it will likely take a few months before the DOL can draft and propose the exemption. Then, there will be a comment period and the final exemption would be issued later . . . perhaps much later. The delay in the final exemption is because, in all likelihood, the DOL will want to incorporate the provisions of the SEC’s proposed Regulation Best Interest. However, it is highly unlikely that the DOL would incorporate those conditions without seeing the final SEC Regulation.

That’s why the Department will issue the new exemption both as proposed and temporary relief. A “temporary” exemption is effective while the proposed regulation is being reviewed and finalized. This relief is needed. It will, for the time being, allow business to go forward while the SEC and the DOL work on their 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 #87


BICE, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers, SEC

The Fiduciary Rule: What’s Next (Part 3)?

This is my 87th 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 third 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. The first article, Angles #85, discusses the three critical questions for the SEC and DOL to answer. The second article, Angles #86, discussed the first critical question, “Who is a fiduciary?”

This post covers the second critical question, “What is the fiduciary standard of care?”

For purposes of advice to retirement plans and participants, that’s an easy answer. It’s ERISA’s prudent man rule and duty of loyalty. That standard is statutory and, as a result, it cannot be modified by rule or regulation—by the DOL or SEC.

There is a large amount of guidance, both from the DOL and the courts, on how to comply with the standard. For example, a fiduciary advisor must engage in a prudent process—at the level of a hypothetical, knowledgeable person—taking into account that the purpose of the investments is to provide retirement benefits. That means that an advisor must consider the “relevant” factors for making a prudent recommendation. You might call that a “duty to investigate,” and then to evaluate. Courts have also said that fiduciaries must use generally accepted investment theories and prevailing investment industry standards (e.g., for asset allocation and selection of investments).

But, of course, those standards only apply if an advisor is a fiduciary. Fiduciary status was discussed in Angles #86.

The issue is more complex for fiduciary advice to IRAs. Where an advisor to an IRA owner does not engage in prohibited transactions—for example, charges a reasonable level fee (and the advisor, supervisory entity and all affiliated and relates parties do not receive anything in addition to that fee), there is not a prohibited transaction. As a result, neither the IRS nor the DOL have a basis for further regulating the advisor. On the other hand, where an advisor (or the supervisory entity, or any affiliated or related party) receives conflicted compensation, that would be a prohibited transaction and an exemption would be needed. Generally speaking, there are two forms of conflicted compensation. The first, and most common, is any payment from a third party (for example, a 12b-1 fee from a mutual fund or a commission from an insurance company). The second form of conflicted compensation is sometimes referred to as “variable” compensation (for example, a commission on each recommended transaction in a brokerage account).

Before the 5th Circuit decision, the primary exemption for those conflicts was BICE (the Best Interest Contract Exemption). That exemption permitted conflicted compensation if the advisor and the supervisory entity (e.g., a broker-dealer) adhered to the best interest standard of care (and other Impartial Conduct Standards). However, the 5th Circuit Court of Appeals threw out BICE, as well as the fiduciary regulation. After that decision, there are only a few exemptions for conflicted advice—and they are very limited.

However, the DOL will likely issue a new exemption to replace BICE, and will impose conditions. It remains to be seen what those will be. But, it’s possible that some standard of care would be imposed, perhaps the new standard that the SEC is working on—and it’s almost certain that disclosures will be required.

One thing that is certain is that the limitation for reasonable compensation will be a requirement of the exemption. It’s a statutory provision in both the Code and ERISA.

At this point, it’s impossible to know what the SEC’s new standard of care will be. There are important questions to be answered. For example, will the standard be the same for RIAs and broker-dealers when investment advice is given to retail investors, such as IRA owners? While uncertain, it is possible that a duty of loyalty will be applied to both types of advisors. And, since RIAs are already fiduciaries under the securities laws, it’s hard to imagine that a lower standard of care would be required for RIAs.

On the other hand, there is some discussion that the SEC might develop an “enhanced” suitability standard for broker-dealers. While that sounds interesting on paper, it’s more difficult to imagine what it would be. For example, the DOL has said that, if a recommendation is not suitable, it would not be prudent. However, the DOL went on to say that, if a recommendation is suitable, that doesn’t necessarily mean that it’s prudent. So, the question is, will the SEC draw a line between those two standards and, if so, where will that line be?

On a related point, and as a guess, I don’t believe the DOL or the SEC will say that the new standards can be enforced by retail investors. In other words, it is likely that the standards will only be enforceable by regulators. While that may be the outcome for the case for IRAs and other retail accounts, ERISA allows for private claims for violations of its provisions, and those statutory rights cannot be taken away by rules or regulations. As a result, advice to plans and participants will be enforceable as private claims.

Since the SEC’s proposed guidance will be issued in the near future, we will know the answers soon enough.

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 #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 #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 #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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