Category Archives: registered investment advisers

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 #78


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

The Fiduciary Rule: Mistaken Beliefs (#3)

This is my 78th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

The myth for this Angles is that broker-dealers and RIAs, and their advisors, must only recommend the lowest cost investments, for example, mutual funds with the lowest expense ratios. That is not correct.

In fact, the DOL has explained that:

“Consistent with the Department’s prior interpretations of this standard [the reasonable compensation standard], the Department confirms that an Adviser and Financial Institution do not have to recommend the transaction that is the lowest cost or that generates the lowest fees without regard to other relevant factors.” [81 Fed. Reg. 21002, at page 21030 (April 8, 2016)]

As indicated in that quote, and as explained elsewhere by the Department of Labor and several courts, an advisor’s fiduciary responsibility is to recommend investments with reasonable expenses . . . or, in a more specific context, to recommend mutual funds with expense ratios within the range of reasonableness for the particular plan and the type of fund.

For advisors with broker-dealers, the expense ratio of mutual funds typically includes a cost component and a compensation component (that is, compensation for the advisor). Assume, for example, that the expense ratio of a mutual fund is 100 basis points and that it includes a 12b-1 fee of 25 basis points. Viewed in terms of cost and compensation, the true cost of the mutual fund is 75 basis points and the cost of the advisor’s compensation is 25 basis points. In order to perform a proper analysis of cost of the investment, that distinction must be made.

Once the “true cost” is determined, that should be used as the expense ratio of the mutual fund for purpose of the fiduciary analysis of whether the cost of the investment is reasonable. (Note that, the reasonableness of the cost of an investment is a fiduciary issue measured by the best interest standard of care; however, the reasonableness of the compensation of the firm and the advisor is a prohibited transaction issue.)

A second step in the fiduciary analysis of cost is the determination of whether or not the appropriate share class is being recommended (including, for example, whether waivers are available). Generally speaking, the lowest cost available share class should be recommended. However, keep in mind that I am referring to the lowest “net cost” share class. In other words, the advisor’s compensation (for example, the 12b-1 fee) should be deducted to determine the true cost and then should be compared to the net cost of the other share classes of the same mutual fund.

Once an investment’s cost has been appropriately determined, and the appropriate share class has been determined, that information should be compared to similar data for other mutual funds in the same investment category. Again, though, the requirement is not that the lowest-cost investment be recommended. Instead, it is that the cost be reasonable relative to the value provided. On a practical level, that means that there is a range of reasonableness for a given type of investment. The risk is in recommending an investment that is clearly more expensive than what is typically charged for that type of investment.

Since a broker-dealer, RIA and advisor are fiduciaries for this purpose, the process used for the selection of investments and the determination of the reasonableness of cost should produce documentation that can be retained and retrieved. In other words, firms and advisors should be in a position to prove that they engaged in a prudent process.

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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Interesting Angles on the DOL’s Fiduciary Rule #75


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

The Fiduciary Rule: Mistaken Beliefs

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

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

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

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

To quote from the new fiduciary regulation:

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

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

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

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

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

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

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

Forewarned and forearmed.

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

 

 

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Interesting Angles on the DOL’s Fiduciary Rule #70


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

The Fiduciary Rule and Recordkeeper Services

This is my 70th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

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

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

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

Financial Wellness

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

Investment Assistance to Advisors

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

Investment Assistance to Plan Sponsors

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

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

A Prediction About Future Directions

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #69


BICE, broker-dealers, DOL, registered investment advisers

Compensation Risks for Broker-Dealers and RIAs

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

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

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

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

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

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

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

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

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

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Interesting Angles on the DOL’s Fiduciary Rule #68


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

Recommendations of Distributions: The SEC Joins the Fray

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

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

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

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

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

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

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

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

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

 

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Interesting Angles on the DOL’s Fiduciary Rule #66


408(b)(2), broker-dealers, fiduciary, prudent, registered investment advisers, service providers

Concerns About 408(b)(2) Disclosures

This is my 66th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

Because of the change in the definition of fiduciary advice (which applied on June 9, 2017), all advisors to retirement plans need to review their prior 408(b)(2) disclosures to see if changes are necessary. That particularly applies to broker-dealers and life insurance brokers and agents.

The first level of review should be to determine whether their prior 408(b)(2) disclosures to ERISA retirement plans affirmatively stated that they were not fiduciaries to the plans that they served. If so, those broker-dealers, insurance brokers and agents need to send out new 408(b)(2) disclosures that affirmatively disclose their new-found fiduciary status (assuming that their advisors became fiduciaries under the new rule, which would ordinarily be the case). However, if the old disclosures were silent about fiduciary status or non-status, the prior disclosures would only need to be reviewed to determine if they adequately describe the services that would be considered to be fiduciary advice. Those services would include, for example, making investment recommendations, referring to other investment advisors or managers, or providing selective lists of investments. (Actually, the definition is much broader, and also includes suggestions of investments, investment policies, or investment strategies.)

Also, the review should include consideration of whether the 408(b)(2) statements adequately disclose compensation. I have been reviewing 408(b)(2) disclosures for a number of broker-dealers. As a part of that, I noticed that compensation was often described in ranges, sometimes very broad ranges. That reminded me of the language in the preamble to the 408(b)(2) regulation, which said:

“A few commenters also asked whether compensation or costs may be disclosed in ranges, for example by a range of possible basis points. The Department believes that disclosure of expected compensation in the form of known ranges can be a ‘‘reasonable’’ method for purposes of the final rule. However, such ranges must be reasonable under the circumstances surrounding the service and compensation arrangement at issue. To ensure that covered service providers communicate meaningful and understandable compensation information to responsible plan fiduciaries whenever possible, the Department cautions that more specific, rather than less specific, compensation information is preferred whenever it can be furnished without undue burden.” [Emphasis added.]

I leave it to the reader to decide whether the ranges in the following types of disclosures are narrow enough. Keep in mind, though, that the purpose of the 408(b)(2) disclosures is to allow the responsible plan fiduciaries to determine (i) whether the compensation paid to the advisor and affiliates is reasonable in light of the services being rendered, and (ii) the nature and extent of the conflicts of interest. With that in mind, do you think that the following types of disclosures are narrow enough to provide information that allows the plan fiduciaries to make those determinations?

  • For mutual funds, the broker-dealer may receive between 0% to 10% front-end commissions.
  • As ongoing trailing commissions, the compensation may range from 0% to 2% per year.
  • The compensation for managed accounts will not exceed 2.5% per year.

Since the test for evaluating those statements is one of “reasonableness,” each reader can form his or her own opinions. But, keep in mind the dual purpose of the disclosures. Then, think about whether the disclosures adequately inform the responsible plan fiduciaries, so that they can make prudent decisions on behalf of their plans and their participants.

Needless to say, I am concerned that some service providers may be making disclosures that don’t satisfy the standards. As a result, I suggest that broker-dealers, RIAs, and insurance agents and brokers review their disclosures to make sure that they are comfortable that the necessary information is being provided to plan fiduciaries.

Forewarned is forearmed.

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

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Interesting Angles on the DOL’s Fiduciary Rule #55


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

The DOL’s RFI and the Recommendation of Annuities

This is my 55th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor’s Request for Information (RFI) on the fiduciary rule and exemptions does a good job of focusing on the key issues for advisers and their financial institutions (e.g., broker-dealers and RIA firms). That is, the questions in the RFI cover most of the issues that prove to be compliance problems for our clients, in the sense that the requirements were difficult to satisfy or expensive to implement.

In addition, the RFI also highlights an issue for independent insurance agents, which is that, in the exemptions scheduled to apply on January 1, 2018, the sale of fixed indexed annuities to qualified accounts (e.g., plans and IRAs) is transferred from Prohibited Transaction Exemption 84-24 to the Best Interest Contract Exemption (BICE). That creates a difficult situation, because independent insurance agents will not be able to sell fixed indexed annuities under BICE, because BICE requires that a financial institution supervise the sale. I believe the DOL thought that insurance companies would serve as the supervisory entities (and, in a manner of speaking, as co-fiduciaries) for independent insurance agents who were appointed as agents for the insurance companies. However, insurance companies were not willing to do that. As a result, independent insurance agents will effectively be precluded from selling fixed indexed annuities. (Note that a number of insurance intermediaries have applied to the DOL for “financial institution” status under BICE. However, the DOL has not issued final guidance for the applicants.)

Fortunately for those agents, the 84-24 exemption was amended for the transition period to put fixed indexed annuities, along with variable annuities and fixed rate annuities, under the exemptive relief of 84-24. However, the final 84-24 exemption continues to say that fixed indexed annuities are not included in 84-24, but instead must be sold under BICE.

Because of those issues, the Department of Labor asked, in Question 17 of the RFI:

If the Department provided an exemption for insurance intermediaries to serve as Financial Institutions under the BIC Exemption, would this facilitate advice regarding all types of annuities? Would it facilitate advice to expand the scope of PTE 84–24 to cover all types of annuities after the end of the transition period on January 1, 2018? What are the relative advantages and disadvantages of these two exemption approaches (i.e., expanding the definition of Financial Institution or expanding the types of annuities covered under PTE 84–24)? To what extent would the ongoing availability of PTE 84–24 for specified annuity products, such as fixed indexed annuities, give these products a competitive advantage vis-a`-vis other products covered only by the BIC Exemption, such as mutual fund shares?

In effect, the DOL is asking questions about two alternatives. The first is whether “insurance intermediaries,” such as IMOs, should be allowed to serve as “financial institutions,” which would allow independent insurance agents to use the Best Interest Contract Exemption. Based on our representation of a number of IMOs and BGAs, many of those types of organizations would be willing to serve in the financial institution role, if that was available. If properly done, that solution would work.

The second question is whether to continue to include fixed indexed annuities, along with fixed rate and variable annuities, under the 84-24 exemption. In that case, independent insurance agents would not need a financial institution to supervise their activities. At the present time, the 84-24 rules are more restrictive on compensation and require greater disclosure of compensation than BICE. So, while that alternative is less burdensome in terms of the need for a financial institution, it is more demanding in terms of compensation disclosures.

It is likely that one or both of those solutions will be permitted when the rules are revised by the current leadership at the DOL. While the financial institution alternative is more burdensome and involves greater regulation, it could be favored by the DOL because of the financial institutions’ supervision of the independent insurance agents. On the other hand, if the DOL favors less regulation and burden, the 84-24 exemption will be expanded to include all forms of annuities. Only time will tell.

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 #50


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

The Fourth Impartial Conduct Standard

This is my 50th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

When the Department of Labor announced that the fiduciary rule and the transition exemptions would apply on June 9, it also issued a non-enforcement policy and a set of Frequently Asked Questions (FAQs) and Answers. The FAQs are titled “Conflict of Interest FAQs (Transition Period).”

For the most part, the FAQs are benign and helpful. However, FAQ 6 raises some significant issues for broker-dealers and RIA firms. In relevant part, FAQ 6 states:

During the transition period, the Department expects financial institutions to adopt such policies and procedures as they reasonably conclude are necessary to ensure that advisers comply with the impartial conduct standards. During that period, however, the Department does not require firms and advisers to give their customers a warranty regarding their adoption of specific best interest policies and procedures, nor does it insist that they adhere to all of the specific provisions of Section IV of the BIC Exemption as a condition of compliance. Instead, financial institutions retain flexibility to choose precisely how to safeguard compliance with the impartial conduct standards, whether by tamping down conflicts of interest associated with adviser compensation, increased monitoring and surveillance of investment recommendations, or other approaches or combinations of approaches. For example, some firms have indicated that they intend to rely upon or build on existing regulatory compliance structures to monitor their advisers’ sales practices and recommendations, document the bases for those recommendations, and ensure that the impartial conduct standards are met (e.g., by subjecting transactions involving conflicts of interest to heightened scrutiny and surveillance).

As a general rule, the Best Interest Contract Exemption (BICE) requires only that broker-dealer and RIAs comply with the Impartial Conduct Standards. The Impartial Conduct Standards are:

  • The best interest standard of care.
  • No more than reasonable compensation.
  • No materially misleading statements.

However, the quoted language from FAQ 6 has the effect of adding a fourth requirement. It is that RIAs and broker-dealers, as financial institutions, adopt the policies and procedures “as they reasonably conclude are necessary to ensure that advisers comply with the Impartial Conduct Standards.”

That language should not be ignored. That is because, among other reasons, the non-enforcement policy requires that financial institutions, such as broker-dealers and RIAs, make a “diligent and good-faith” effort to comply with BICE. Since this additional requirement is imposed as a condition of BICE, it seems difficult to imagine that the non-enforcement policy would be available to a broker-dealer or RIA who did not adopt appropriate policies, procedures, practices and supervision.

Then, the question is, what is “appropriate”? The quoted language provides several alternatives. Those are:

  • Review and determine that existing policies, procedures and supervision is adequate for ensuring that the impartial conduct standards are met.
  • Review and revise existing policies, procedures and supervision, as needed.
  • Adjust adviser compensation to reduce and/or to otherwise manage the effects of conflicts of interest that arise from varying levels of compensation.
  • Heightened scrutiny, surveillance and supervision of transactions involving conflicts of interest.
  • Monitoring advisers’ sales practices and recommendations, including documenting the basis for recommendations.
  • A combination of the above and/or possibly other reasonable practices.

As I read this requirement, a good approach is for a financial institution to review its existing policies, procedures, compensation practices and supervision, and document why they will “ensure that advisers comply with the Impartial Conduct Standards.” No particular approach is required for doing that, but appropriate steps should be taken. (By the way, I specifically mention documentation of the decision because financial institutions may be required to demonstrate that they complied with this requirement. Also, under ERISA, the DOL has specifically stated that documentation is an integral part of a prudent process, and it appears likely that those requirements will apply to fiduciary services under BICE, as well.)

During the transition period, it is possible, perhaps even likely, that the DOL will accept any reasonable efforts to comply with this requirement. In other words, the DOL will probably apply a “reasonable efforts” standard, rather than a “strict compliance” standard. However, the attorneys who represent investors—most likely in arbitrations—will probably push for a higher standard. With that in mind, the broker-dealers and RIAs need to think about the policies, procedures, compensation practices and supervision that will appropriately manage the risk in that more demanding scenario.

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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