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

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

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

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

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

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

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

Where does that leave us?

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

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

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

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

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

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

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