In our first post on this topic, we discussed the existing rules that apply to rollover recommendations by broker-dealers and RIAs. This discussion included the ERISA guidance that remains after the 5th Circuit’s decision vacating the Fiduciary Rule, as well as FINRA’s Regulatory Notice 13-45. In this post, we focus on the SEC’s best interest proposals for broker-dealers and RIAs and where that may take firms in the future. In our next, and final, post in this series, we’ll talk about how to make a compliant rollover recommendation.
(As a reminder, by “rollover” recommendation, we mean a recommendation to a retirement plan participant to take a distribution of his or her account and roll it over to an IRA being advised by the broker-dealer or RIA.)
Application to Broker-Dealers
In April, the SEC released its proposed Regulation Best Interest (“Reg BI”). The SEC indicates that broker-dealers will (if and when Reg BI is finalized) have an obligation to act in the best interest of their clients when making securities recommendations. (Keep in mind that broker-dealers are already subject to FINRA Notice 13-45, discussed in Part 1. While Notice 13-45 does not impose a “best interest” standard when a broker-dealer makes a rollover recommendation, it does require an in-depth assessment of differences in costs, investments and services between the plan and IRA.)
Reg BI applies only to retail customers. This means that advice to plans and institutional investors would not be covered, but the SEC makes clear that the best interest standard will apply to “investment” recommendations to individual participants, including rollover recommendations. This refers to participants in participant-directed plans, such as 401(k) and 403(b) plans.
To understand how Reg BI applies, let’s start with the fact that it would govern recommendations of “securities transactions.” But is a rollover recommendation a securities transaction? According to the SEC, it is: they explain that “[s]ecurities transactions may also include recommendations to roll over or transfer assets from one type of account to another, such as recommendations to roll over or transfer assets in [a participant-directed plan] account to an IRA.”
The SEC also references FINRA Notice 13-45 in Reg BI, as well as the FINRA suitability requirements, explaining (in footnote 155) that “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.” Since almost all plans will only distribute cash, a rollover recommendation involves an implicit recommendation of a securities transaction.
But Reg BI goes beyond suitability. The SEC also says that a rollover recommendation involves a material conflict of interest. This is because a broker-dealer will earn commissions or other fees as a result of the recommendation, whereas “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.” (See footnote 204.) The SEC goes on to say that broker-dealers have an obligation to mitigate the financial conflict. One obvious way to mitigate would be not to receive compensation from the IRA, but that is not realistic. Thus, in the rollover context, we think firms will likely need to adopt a robust process for ensuring that the recommendation is in the customer’s best interest.
Reg BI imposes both best interest and suitability standards of care on rollover recommendations by broker-dealers. This requires care, skill, prudence and diligence in making recommendations and includes a duty of loyalty. The suitability and best interest standards apply to recommendations about the re-investment of distributed money in the IRA.
Application to RIAs
In April, the SEC also released its proposed interpretation of the fiduciary obligation of RIAs under the Investment Advisers Act. Unlike Reg BI, which contains proposed rules that require additional action to become applicable, the RIA interpretation is the SEC’s view of existing rules. This suggests that RIAs should be looking to comply with the interpretation now.
In the context of a rollover recommendation by an RIA, the best interest standard would apply to any type of plan – not just participant-directed plans – because recommendations to all clients are covered by the RIA fiduciary standard. An RIA’s recommendation about the investments in the rollover IRA would be covered by the best interest standard.
Where does this leave us? For a broker-dealer, the Notice 13-45 requirements apply and, if it becomes final, the Reg BI best interest requirement – including the duty of loyalty and avoidance or mitigation of material financial conflicts – would apply to retail customer recommendations. For RIAs, the SEC’s best interest standard applies to all of their rollover recommendations to participants in all types of plans, as well as to IRAs.
In our next post, we’ll discuss how to apply the best interest standard to rollover recommendations.