Category Archives: FINRA

Interesting Angles on the DOL’s Fiduciary Rule #85

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

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

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

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

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

1. Who is a fiduciary?

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

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

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

2. What is the fiduciary standard of care?

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

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

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

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

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

This is the area of greatest differences among the regulators.

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

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

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

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

We live in interesting times.

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


Interesting Angles on the DOL’s Fiduciary Rule #82

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.


Interesting Angles on the DOL’s Fiduciary Rule #79

The Fiduciary Rule: Mistaken Beliefs (#4)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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




FINRA 2018 Annual Regulatory and Examination Priorities Letter Makes No Mention of a Fiduciary Duty for Brokers

FINRA released its 2018 Annual Regulatory and Examination Priorities Letter (Priorities Letter) on January 8, 2018. While FINRA advises that it can change its priorities in response to circumstances, the purpose of the Priorities Letter is to permit broker-dealers to plan their compliance, supervisory and risk management programs and to prepare for FINRA examinations. Therefore, this Priorities Letter is significant both in what it says and in what it has chosen not to say including failing to discuss FINRA’s views regarding a “fiduciary standard.”

My colleagues, Sandy Grannum, Jim Lundy, Jamie Helman, and I wrote a post about this issue for the Broker-Dealer Regulation & Litigation Insights blog. Read more here.