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Guidance to Prevent Non-Line Supervisory Liability

In light of the supervisory standards applicable to compliance officers and in-house attorneys with broker-dealer and investment management firms, these individuals and firms need to appreciate and manage the risks of supervisory liability being applied to them due to the violative conduct of business personnel.  In an article titled “Compliance and Legal Officer Guidelines To Prevent Non-Line Supervisory Liability” my colleague Carrie DeLange and I analyzed the “Gutfreund Standard” and the SEC’s more recent guidance from a Division of Trading and Markets “FAQ,” and other statutes and rules, and provide guidance for compliance officers and in-house attorneys with broker-dealer and investment management firms to best manage these situations. Continue reading “Guidance to Prevent Non-Line Supervisory Liability”

SEC Announces Share Class Selection Disclosure Initiative

Last week, the SEC announced a “Share Class Selection Disclosure Initiative” being led by the Asset Management Unit of the Division of Enforcement. This initiative warrants close examination for investment advisers who regularly recommend different mutual fund share classes for their clients and by their affiliated broker-dealers. This effort continues the SEC’s focus on 12b-1 fees, and provides the SEC with a vehicle to efficiently bring enforcement actions against those firms who have failed to properly disclose conflicts related to those fees. FINRA has not yet issued any related, formal pronouncements. Until FINRA issues guidance, affiliated broker-dealers concerned with how to handle any 12b-1 fee issues that they may have will need to consider FINRA’s “extraordinary cooperation” guidance. Continue reading “SEC Announces Share Class Selection Disclosure Initiative”

Fiduciary Rule Myths

MYTH:  “Advisors must recommend the best available investment.”

We recently pointed out that under the DOL fiduciary rule, it’s a myth that advisors have to recommend the lowest cost investment. They don’t.

Here’s another myth about investment recommendations that isn’t true: advisors have to recommend the best investment to their customers. Presumably, this comes up because of the Impartial Conduct Standards in the Best Interest Contract Exemption (BICE). One of the requirements in those Standards is that a recommendation be in the best interest of the customer. This best interest requirement may lead some to think that advisors have to meet an essentially impossible standard. As with a lowest-cost recommendation, however, a mandate to recommend the best investment is a myth…it just isn’t true. Even the DOL has said so:

Continue reading “Fiduciary Rule Myths”

SEC’s 2018 Exam Priorities – Worth the Wait

The SEC’s Office of Compliance Inspections and Examinations (OCIE) released its 2018 National Exam Program Examination Priorities on February 7, 2018 (“2018 Priorities Letter”). While issued later than in years past and almost a month to the day after the publication of the priorities letter from the Financial Industry Regulatory Authority (FINRA), OCIE deserves credit for the increased transparency and guidance provided in the 2018 Priorities Letter. By way of perspective, OCIE’s sixth publication of its examination priorities more than doubled the amount of information provided in last year’s edition. This improved transparency is consistent with the public statements of OCIE’s Director. Despite the greater detail, there appears to be one glaring omission: OCIE does not discuss how the anticipated rulemaking by the Commission regarding the development of a fiduciary standard may impact its priorities. However, upon further consideration and recalling that OCIE’s primary mission is to conduct examinations to assess compliance with the current securities laws, we realize it would have been premature for OCIE to discuss views on some yet-to-be formulated SEC fiduciary standard. That said, OCIE is clearly prioritizing the protection of retail investors even more than in years past, which is consistent with the SEC Chairman’s public statements about prioritizing the protection of “Main Street” investors. While the SEC Chairman has made these issues a “Main” priority, the SEC’s heightened focus regarding retail and retirement investors has been strengthening significantly since the Retirement-Targeted Industry Reviews and Examinations (ReTIRE) Initiative announced a few years ago and through the SEC’s announcement this past autumn of the Retail Strategy Task Force. Thus, OCIE leads into the 2018 Priorities Letter in the second and third sentences by opening with: “…we will continue to prioritize our commitment to protect retail investors, including seniors and those saving for retirement. We will especially be looking closely at products and services offered to retail investors, as well as the disclosures they receive about those investments.” This focus is similar to the focuses emphasized by FINRA in its recent priorities letter. Continue reading “SEC’s 2018 Exam Priorities – Worth the Wait”

Reasonable Compensation

In a previous post , we debunked the myth that the Fiduciary Rule requires advisors to recommend the lowest-cost investments. In this post, we discuss what is required when it comes to fees and compensation – that they not exceed a “reasonable” level.

Broker-dealers and advisors who rely on the Best Interest Contract Exemption (BICE) need to comply with the Impartial Conduct Standards. These include three requirements: (1) recommendations to plan and IRA investors must be in the “best interest” of the customer, (2) communications with customers must not include materially misleading statements, and (3) the firm’s and advisor’s compensation must be reasonable. If any of these is not met, they have engaged in a non-exempt prohibited transaction.

The reasonable compensation requirement is more than a condition imposed by the DOL. The requirement is statutory. That is, it is imposed under ERISA for employer-sponsored plans. It is imposed under the Code for all service arrangements with both plans and IRAs. The reasonable compensation limit applies to service providers regardless of whether or not they are fiduciaries.

This means two things. First, the requirement is not going away. Because it is embedded in the statutes, it can only be repealed by Congress – not the DOL, the SEC or any state rule – and this is not likely. While the DOL will undoubtedly make changes to BICE and other exemptions during the current transition period, firms and advisors cannot expect the reasonable compensation requirement to go away, or even be changed. Second, it applies to all service relationships. Even for level-fee advice arrangements – which do not have to satisfy BICE or any other similar exemption, compensation must be reasonable.

Reasonable compensation defined
What does “reasonable” mean? The requirement is that compensation be reasonable in relation to the services and benefits being provided. As the DOL explains in the BICE preamble:

At bottom, the standard simply requires that compensation not be excessive, as measured by the market value of the particular services, rights, and benefits the (advisor) and Financial Institution are delivering to the Retirement Investor.

For compensation to be reasonable, it is not necessary to recommend a product that pays the least compensation. It is not necessary that compensation be below average. It just cannot rise to a level that is excessive in relation to the services and benefits provided.

Note that the reasonableness requirement applies to the compensation received by the broker-dealer and to the amount passed on by the firm to the advisor. If, for example, a firm receives an excessive level of commissions for recommending a product, this would violate the standard even if the advisor’s “share” of the commission were within industry norms.

Value of services
The BICE preamble also makes clear that all services and benefits provided can be taken into account – not just the advice services – in determining if compensation is reasonable. The DOL offers the following example:

In the case of a charge for an annuity or insurance contract that covers both the provision of services and the purchase of the guarantees and financial benefits provided under the contract, it is appropriate to consider the value of the guarantees and benefits in assessing the reasonableness of the arrangement, as well as the value of the services.

In other words, the value of the services may be enhanced by the complexities and services associated with a product, and those can be considered in determining whether the compensation is reasonable.

Factors in determining reasonableness
How is “reasonableness” determined? While the requirement is imposed by law, the standard itself is an industry, or market standard. Per the DOL, there are “several” factors involved. They include, but are not necessarily limited to, the:

  •  market pricing for similar services and products
  •  scope of monitoring, if any
  •  complexity of the product

To help determine market standards for compensation, broker-dealers use benchmarking or similar services. In fact, the DOL has said that firms may want to seek “impartial reviews” of their fee structures. At the same time, firms should recognize that “reasonable” and “customary” do not necessarily mean the same thing. That is, in limited circumstances, the markets may not provide competitive pricing. However, where markets are transparent and competitive, the benchmarking information should properly define reasonable compensation.

Finally, firms may wish to consider “re-benchmarking” their compensation structures at reasonable intervals – what is reasonable this year might not be reasonable next year.

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

FINRA released its 2018 Annual Regulatory and Examination Priorities Letter (Priorities Letter) on January 8, 2018. While FINRA advises that it can change its priorities in response to circumstances, the purpose of the Priorities Letter is to permit broker-dealers to plan their compliance, supervisory and risk management programs and to prepare for FINRA examinations. Therefore, this Priorities Letter is significant both in what it says and in what it has chosen not to say including failing to discuss FINRA’s views regarding a “fiduciary standard.”
Continue reading “FINRA 2018 Annual Regulatory and Examination Priorities Letter Makes No Mention of a Fiduciary Duty for Brokers”

Fiduciary Rule Myths

MYTH:  “Advisors must recommend the lowest cost investment.”

This post discusses what broker-dealers and their advisors need to do to manage the risks in providing investment recommendations to plans and IRAs. In order to manage those risks, though, broker-dealers and advisors need to understand what the rules require. To do that, we need to debunk some “myths” about the rules. Continue reading “Fiduciary Rule Myths”

The U.S. Supreme Court Hears Argument on Whether State Courts Have Jurisdiction Over Large Securities Class Actions in Light of the Securities Litigation Uniform Standards Act of 1998

Generally when broker-dealers are subject to court jurisdiction, that jurisdiction, based either on diversity or subject matter, places the dispute in federal courts. However, that has not necessarily been the case in class actions. The issue of state versus federal court jurisdiction was argued before the U.S. Supreme Court on November 28, 2017. The Supreme Court heard oral arguments in Cyan, Inc. v. Beaver County Employees Retirement Fund regarding whether states had jurisdiction over “covered class actions” that allege violations of the Securities Act of 1933 (the “33 Act”). Specifically, the Court considered whether an amendment to the 33 Act—the Securities Litigation Uniform Standards Act of 1998 (SLUSA)—precluded states from hearing the vast majority of 33 Act claims. The Court tangled with both sides over Congress’ intent in passing SLUSA and the text of SLUSA, which Justice Alito referred to as “gibberish.”

Continue reading “The U.S. Supreme Court Hears Argument on Whether State Courts Have Jurisdiction Over Large Securities Class Actions in Light of the Securities Litigation Uniform Standards Act of 1998”

FINRA’S First Ever Public Release of Exam Findings: Top 6 Observations for Improving Compliance

As part of the Financial Industry Regulatory Authority’s (FINRA) efforts to protect investors, FINRA regularly conducts examinations of its broker-dealer members. Despite requests to release the reports to assist other FINRA members in improving their compliance with securities rules and regulations, FINRA has traditionally kept the reports private. That all changed this month.

On December 6, FINRA released a Summary Report of several observations from recent examinations. FINRA selected key issues based on their “potential impact on investors and markets or the frequency with which they occur.” The Summary Report will help FINRA members address potential areas of concern and improve their compliance and supervisory programs prior to their own examinations.

The Summary Report provides observations in 11 exam areas, and the notable ones include:

Continue reading “FINRA’S First Ever Public Release of Exam Findings: Top 6 Observations for Improving Compliance”