Category Archives: prudent

Interesting Angles on the DOL’s Fiduciary Rule #98


broker-dealers, DOL, prudent, SEC

Regulation Best Interest: Consideration of Cost and Compensation

This is my 98th article about interesting observations concerning the Department of Labor’s fiduciary rule and the SEC’s “best interest” proposals.

The SEC’s Regulation Best Interest (Reg BI) proposes a number of major changes to the governance of broker-dealers. For example, it imposes a best interest standard of care on recommendations of securities transactions and it requires that material conflicts of interest involving financial incentives be eliminated or, alternatively, disclosed and mitigated. Based on the SEC’s examples of mitigation, it appears “real” mitigation is expected and not just existing practices with more disclosure.

There are other significant changes. For example, there is an increased focus on the costs and compensation related to recommended securities transactions and investment strategies. The SEC’s discussion explains that:

“[O]ur proposed interpretation of the Care Obligation would make the cost of the security or strategy, and any associated financial incentives, more important factors (of the many factors that should be considered) in understanding and analyzing whether to recommend a security or an investment strategy.” [Emphasis added.]

The SEC’s position is that both the costs of recommended securities or strategies and the associated compensation (that is, the financial incentives) will be more important factors than they have been in the past.

The SEC goes on to explain its position on costs:

“We preliminarily believe that, in order to meet its Care Obligation, when a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost of the security or strategy is justified (and thus nevertheless in the retail customer’s best interest) based on other factors (e.g., the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), in light of the retail customer’s investment profile.” [Emphasis added.]

In addition, the SEC explained its position on compensation:

“When a broker-dealer recommends a more remunerative security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker- dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile.”

The two quotes (which are together in a single paragraph in Reg BI) may appear to conflict with each other. However, they are consistent and coherent if they are interpreted as follows: a broker-dealer will need to justify recommending a higher-cost investment (over another reasonably available, but lower-cost alternative). However, if there are two similar investments (including costs), but one pays the broker-dealer (and the financial advisor), more than the other, and it is better for the investor, then it could be recommended under the best interest standard. The inverse of that, though, is that the higher cost (and higher compensating) alternative cannot be recommended unless there are different characteristics and features that justify the cost.

The SEC’s best interest will require that a broker-dealer be diligent, careful, skillful, and prudent—which suggests a process—and that the process result in an investment that is in the best interest of the investor, with a greater emphasis on cost and compensation.

For those of you who work with retirement plans, you will recognize that the process, and the factors to be considered, are similar to ERISA’s prudent process requirement.

The proposals under Reg BI are significant and will, if finalized, require changes in the operations, including supervision, of broker-dealers.

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 #97


DOL, fiduciary, General, prudent, registered investment advisers, SEC

Regulation Best Interest Recommendations by Broker-Dealers: Part 3

This is my 97th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last two articles—Part 1 and Part 2 on this topic, I discussed the fact that proposed Reg BI and its best interest standard of care for broker-dealers did not apply to all of the recommendations made by broker-dealers. The proposed best interest standard for broker-dealers will apply only to securities transactions recommended to “retail customers.” (Reg BI defines a “retail customer” as “a person, or the legal representative of such person, who . . . uses the recommendation primarily for personal, family, or household purposes.”) I compared that to the SEC’s Interpretation for RIAs, which applies to all advice to all clients. This article gives examples of how the proposals will differ when applied to common scenarios.

Based on the discussions in the Reg BI package, and on my conversations with securities lawyers, the definition of “retail customers” appears to refer to individuals, participants’ accounts in retirement plans, IRAs, custodianships, guardianships, and personal trusts. That’s not meant to be an exhaustive list, but it is meant to point out that it doesn’t appear to apply to business accounts or retirement plans. Frankly, I’m surprised that it doesn’t apply, at the very least, to small businesses and small plans.

Let me explain. Assume that Jim and Joan Smith, a married couple, have been working for a large company, Acme Corporation. However, they decide to leave Acme and to start up “Jim and Joan’s Bakery.” Fortunately, the bakery is successful and their cash flow is strong enough to start a retirement plan for the two of them, who are the only workers at the bakery. Knowing that the company will grow, their advisor (who works for a broker-dealer) recommends that they set up a 401(k) plan and recommends the investments. Those recommendations would not be covered by the Reg BI best interest standard of care.

At the same time, though, the advisor recommends that Jim and Joan take distributions from the Acme 401(k) plan and roll that money into IRAs. Both the rollover recommendation and the recommended IRA investments would be covered by the best interest standard.

Jim and Joan were also participants in the Acme pension plan. The advisor recommends that the pension benefits be withdrawn and rolled to IRAs. It appears that the withdrawal recommendation would not be subject to the best interest standard (because it does not require that Jim and Joan buy, sell or hold any securities), but the recommendations about investing in the rollover IRA would be.

The advisor helps Jim and Joan invest their accounts inside their new 401(k) plan. That would be covered by the best interest standard of care.

As the business becomes more successful, Jim and Joan set up personal accounts with the broker-dealer. Recommendations on those personal accounts would be subject to the best interest standard. But, if they had an account for their business, those recommendations would not be.

The business continues to grow and the advisor recommends that Jim and Joan set up a cash balance plan and assists them in the asset allocation and selection of investments for the plan. That would not be subject to the best interest standard of care.

With the continued success of the business, Joan and Jim decide to have children and the advisor helps them set up 529 accounts for the children’s education. The 529 investments would be subject to the best interest standard.

Confused? You should be. All of the advice in this article was to Jim and Joan. And, Jim and Joan have the same sophistication for evaluating each of the recommendations. Yet, because of the definition of “retail customer,” the duties owed by the advisor and the broker-dealer under the proposed Reg BI bounce around. Ask yourself . . . will the average investor understand which rules apply to which situation? I don’t think so. The burden shouldn’t be on the investor to understand these technical rules. Instead, the rules should be consistent and understandable.

Needless to say, this is my opinion. It doesn’t mean it is right; but it does mean that I’ve thought about it.

POSTSCRIPT: All of the recommendations in this article, when made by an investment adviser (RIA), are covered by the best interest standard. That’s straightforward, consistent and understandable.

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 #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 #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 #79


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

The Fiduciary Rule: Mistaken Beliefs (#4)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #77


BICE, DOL, fiduciary, General, prudent

The Fiduciary Rule: Mistaken Beliefs (#2)

This is my 77th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

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

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

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

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. (Emphasis added by me.)

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #76


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

Discretionary Management of IRAs: Prohibited Transaction Issues for RIAs

This is my 76th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

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

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

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

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

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

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

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

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

 

 

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