Category Archives: prohibited transaction

Best Interest Standard of Care for Advisors #39


best interest, DOL, fiduciary, investment adviser, IRA, prohibited transaction, reg BI, rollovers
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Investment Adviser Considerations: The Department of Labor’s Prohibited Transaction Exemption and Its Impact on Recommendations to Plans, Participants and IRAs (Part 4)

On December 18, 2020, the DOL issued its final prohibited transaction exemption (PTE) that will allow conflicted compensation resulting from nondiscretionary fiduciary investment advice. The PTE is titled “Improving Investment Advice for Workers & Retirees.” The citation is Prohibited Transaction Exemption 2020-02. (https://www.govinfo.gov/content/pkg/FR-2019-07-12/pdf/2019-12208.pdf) The exemption became effective on February 16, 2021.

The exemption and the associated expansion of the definition of fiduciary advice will have the greatest impact on recommendations by investment advisers and broker-dealers (1) to retirement plan participants to take rollovers to IRAs with the advisors, and (2) to IRA owners about how to invest in their IRAs. My last article, Best Interest #38, discussed the impact on investment advisers who recommend rollovers. This article covers the impact on investment advisers for their services to IRAs and related conflicts of interest.

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Best Interest Standard of Care for Advisors #38


best interest, broker-dealers, DOL, fiduciary, investment adviser, IRA, prohibited transaction, reg BI, rollovers
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The Department of Labor’s Proposed Prohibited Transaction Exemption and Its Impact on Recommendations to Plans, Participants and IRAs (Part 3): Investment Adviser Considerations

On December 18, 2020, the DOL issued its final prohibited transaction exemption (PTE) that will allow conflicted compensation resulting from nondiscretionary fiduciary investment advice. The PTE is titled “Improving Investment Advice for Workers & Retirees.”  The citation is Prohibited Transaction Exemption 2020-02. The exemption is effective February 16, 2021.

The exemption and the associated expansion of the definition of fiduciary advice will have the greatest impact on recommendations by investment advisers and broker-dealers (1) to retirement plan participants about rollovers, and (2) to IRA owners about how to invest in their IRAs. This article focuses on the impact on investment advisers who recommend rollovers.

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Best Interest Standard of Care for Advisors #37


best interest, broker-dealers, DOL, fiduciary, investment adviser, IRA, prohibited transaction, reg BI, rollovers
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The Department of Labor’s Proposed Prohibited Transaction Exemption and its Impact on Recommendations to Plans, Participants and IRAs (Part 2)

On July 7, 2020, the DOL issued a proposed prohibited transaction exemption (PTE) that would allow conflicted recommendations resulting from nondiscretionary fiduciary investment advice. The proposal is titled “Improving Investment Advice for Workers & Retirees.” And, as my last post, #36 (Part 1), explained, the DOL said that it is re-interpreting part of the definition of fiduciary advice to include many more recommendations, and especially rollover recommendations.

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Best Interest Standard of Care for Advisors #36


best interest, broker-dealers, DOL, fiduciary, investment adviser, IRA, prohibited transaction, reg BI, rollovers

The Department of Labor’s Proposed Prohibited Transaction Exemption and its Impact on Recommendations to Plans, Participants and IRAs (Part 1)

 On July 7, 2020 the DOL issued a proposed prohibited transaction exemption (PTE) that would allow conflicted recommendations resulting from nondiscretionary fiduciary investment advice. The proposal is titled “Improving Investment Advice for Workers & Retirees.” As background, an exemption is an exception to the prohibited transaction rules, but the exception is only available if its conditions are satisfied…and there are conditions.

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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 #85


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

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

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

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

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

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

1. Who is a fiduciary?

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

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

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

2. What is the fiduciary standard of care?

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

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

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

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

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

This is the area of greatest differences among the regulators.

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

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

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

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

We live in interesting times.

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

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Interesting Angles on the DOL’s Fiduciary Rule #84


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

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

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

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

It means a lot . . . in some cases.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #83


DOL, General, prohibited transaction, SEC

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

This is my 83rd article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

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

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

Let’s look at each of those issues.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #81


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

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

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

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

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

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

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

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

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

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

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

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

 

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