Broker-Dealer Regulation & Litigation Insights

The Fate of the Fiduciary Rule: What is Not Affected

While we won’t know until the end of the month whether the DOL fiduciary rule will survive beyond May 7, there are some activities that won’t be affected, regardless of what happens.

Let’s start by reviewing basics. A fiduciary under ERISA and the Internal Revenue Code (the “Code”) includes one who provides investment advice to an ERISA plan and/or IRA for a fee –an “advice fiduciary.” Before the new DOL fiduciary rule, a broker-dealer or RIA (referred to here as a “firm”) would be considered an advice fiduciary if a five-part test was satisfied: (1) its advisor provided advice for compensation about a security or other property, (2) on a regular basis, (3) pursuant to a mutual understanding, (4) that the advice would form a primary basis for the investor’s decision and (5) it was individualized based upon the investor’s particular needs. If the DOL’s new fiduciary rule does not survive, the five-part test will come back into effect.

Regardless of whether the DOL fiduciary rule or the five-part test applies, there are some things that will remain unchanged:

• Investment Management Services: Discretionary investment management for ERISA plans or IRAs is and will continue to be a fiduciary service. This is because under both ERISA and the Code, there is a definition of “fiduciary” separate and apart from an “advice fiduciary.” That definition says that a broker-dealer or RIA, or its representative, is a fiduciary when it has discretion over ERISA or IRA assets. This means that investment management services for ERISA plans are, and continue to be, subject to ERISA’s prudent man standard of care and duty of loyalty. Also, managing ERISA and/or IRA plan assets is, and will continue to be, subject to the fiduciary prohibited transaction rules in ERISA and the Code. Firms need to have policies, training and supervisory processes in place to ensure that advisors providing investment management services to ERISA plans and/or IRAs comply with these rules, even if the DOL fiduciary rule does not survive.

• Reasonable Compensation: Firms also need to make sure that compensation for services to ERISA plans or IRAs is reasonable, because unreasonable compensation is a prohibited transaction under both the Code and ERISA. This requirement applies to all service providers to plans, participants and IRAs, and to service providers who are not fiduciaries. Firms need to develop systems and data to determine reasonable compensation for different products and services and to manage advisor compensation practices.

• Rollover Recommendations by Fiduciary Advisors: Even if the DOL fiduciary rule does not survive, some rollover recommendations may still be fiduciary acts. Specifically, under a DOL advisory opinion, if an advisor (and the firm) is a plan fiduciary and its advisor recommends that a plan participant take a distribution and roll over to an IRA, the advisor will be a fiduciary for that purpose. As such, the advisor’s recommendation needs to satisfy the ERISA prudent man standard. Additionally, if the DOL fiduciary rule does not survive, there will not be a Best Interest Contract Exemption to “cure” the resulting prohibited transaction. If, on the other hand, the firm is not a fiduciary to the plan and the advisor recommends a rollover, it will not be a fiduciary act if the DOL fiduciary rule does not survive. Firms should examine their current rollover practices and determine what processes will need to be retained to address these issues.

• Ongoing Advisory Services: Providing ongoing investment advisory services to ERISA plans or IRAs based upon the particular needs of the retirement investor will continue to be a fiduciary act even if the DOL fiduciary rule is vacated. The reason is that under most advisory arrangements, the advisor is providing the advice on a regular basis and meeting the other elements of the five-part test. The firm should identify current arrangements that satisfy the five-part test and make sure there are policies and procedures in place to ensure compliance with the prohibited transaction rules and exemptions and, in the case of ERISA plan services, compliance with the prudent man rule and duty of loyalty.

While the possible demise of the DOL fiduciary rule will limit the scope of investment activities that are fiduciary in nature, there are still investment services that will be fiduciary and thus subject to the prohibited transaction requirements. As a result, firms should take steps now to identify those activities and take appropriate steps for compliance.

SEC Proposes Regulations to Reform Retail Investment Standards

The SEC has issued proposed rules seeking to clarify how investment professionals advise retail investors. The three-part proposal includes a requirement that brokers act in a customer’s best interest; interpretive guidance on the fiduciary duty applicable to investment advisers; and Form CRS, which mandates certain disclosures by broker-dealers and investment advisers to their clients. The SEC’s release of these proposed rules and guidance is only the beginning of what will likely be an active 90-day comment period. As the SEC Commissioners did repeatedly, we encourage interested parties to participate in the SEC’s comment letter process.

An alert that I co-authored analyzes significant parts of the proposal and offers thoughts on what to look out for as the SEC continues to address these issues.

Click here to read the alert

For additional information and discussion on these SEC proposals, below is a link to Drinker Biddle’s Inside the Beltway from the day after the SEC’s open meeting in which partners Fred Reish, Brad Campbell and I discuss the SEC’s proposals and their anticipated impacts.

Inside the Beltway Recording

SEC Open Meeting on Broker-Dealer and Investment Adviser Standards

On April 12, 2018, the Securities and Exchange Commission (SEC) announced an open meeting scheduled for April 18, 2018 at 3:30 p.m. (ET) to discuss standards applicable to broker-dealers and investment advisers in their dealings with retail investors. The subject matters scheduled to be covered are threefold:

Continue reading “SEC Open Meeting on Broker-Dealer and Investment Adviser Standards”

FINRA Seeks Comments on Proposed New Rule to Govern Outside Business Activities and Private Securities Activities of FINRA Member Associated Persons

If adopted, proposed new FINRA Rule 3290 will be significant for broker-dealers who allow their associated persons to engage in outside business activities (in particular in securities related fields – such as serving with/as a third-party investment adviser) and broker-dealer staff who engage in such activities. In general, the changes may make the lives of both such groups a bit easier.

FINRA Rule 3290 would be a replacement for both current FINRA Rule 3270 (Outside Business Activities (OBA) of Registered Persons) and current FINRA Rule 3280 (Private Securities Transactions of an Associated Person) for its member broker-dealers. As explained in Regulatory Notice 18-08, compliance with proposed FINRA Rule 3290 would involve only modest and mostly clarifying changes for most traditional “3270” activities. The impact on what are now “3280” activities could be more pronounced.

Probably of the greatest interest for many broker-dealers: proposed Rule 3290 would ease current requirements with respect to the investment advisory activities of their registered persons. Under Rule 3280, FINRA members must supervise and record on the members’ books and records the transactions resulting from a variety of outside “IA” activities of their associated persons. Under proposed Rule 3290, any IA activity conducted on behalf of a dually registered “BD/IA” or for an IA affiliate of a member would be excluded from the rule. Any IA activity conducted for a third-party, non-affiliated IA would constitute an “investment-related” activity under the rule – as a result, it would require that the registered person provide prior written notice of such activity, and the FINRA member would then be required to conduct a risk assessment and based on its assessment, to: (a) approve the registered person’s participation, (b) approve it subject to conditions or limitations, or (c) disapprove it. However, the proposed rule would not impose a general supervisory obligation over the IA activities and would not require the FINRA member to record on its books and records transactions resulting from such IA activities.

Under the proposed rule, if an activity is not “investment related,” the broker-dealer would effectively have no material obligations (other than receiving notice of the activities and recording the activity on the associated person’s Form U-4). If the activity is “investment-related,” then the broker-dealer would be required to perform a risk assessment. The proposed rule defines “investment-related” as “pertaining to securities, commodities, banking, insurance, or real estate (including, but not limited to, acting as or being associated with a broker-dealer, issuer, investment company, investment adviser, futures sponsor, bank, or savings association).”

The proposed rule would impose a supervisory obligation in two key situations:

-First, if a broker-dealer decides to impose its own conditions or limitations on a registered person’s participation in an investment-related activity, the broker-dealer would then be required to “reasonably” supervise the registered person’s compliance with those specific conditions or limitations. Actual supervision of the underlying activities would not be required.

-Second, to the extent that a broker-dealer approves a registered person’s participation in a proposed investment-related activity and such activity would require, “if not for the person’s association with a member, registration as a broker or dealer under the Exchange Act and the person is not so registered,” the activity would be deemed to be part of the broker-dealer’s own business. So, if an associated person could only legally engage in an “OBA” because the individual is associated with a FINRA member, the FINRA member approving that activity must treat the activity as its own in all respects. Accordingly, all applicable securities laws and regulations and FINRA rules, including supervision and recordkeeping, would apply to the FINRA member with respect to the approved activity.

Under this second situation, if the registered person is associated with more than one FINRA member, the individual FINRA members would be permitted to develop a formal allocation arrangement whereby at least one member agrees in writing with specificity to comply with all applicable securities laws and regulations and FINRA rules (including supervision and recordkeeping obligations) regarding the proposed activity.

As provided in summary as part of Regulatory Notice 18-08:

Selling Private Placements Away from Member	Subject to the proposed rule, potentially to the fullest extent – prior notice by the registered person and risk assessment by the member. If the member disapproves the activity, it has no further obligation. If the member approves the activity, the activity becomes part of the member’s business and must be supervised and recorded as such.
Activities at Third-Party IA	Subject to the proposed rule, but in an intermediate manner – prior notice by the registered person and risk assessment by the member because it is investment related and not excluded from the proposed rule, but the member is not required to supervise or keep records of the IA activities.
Non-Investment Related Work (e.g., car service, seasonal retail)	Subject to the proposed rule, but in a limited manner – a registered person must provide prior notice to the member, but the member is not required to perform a risk assessment of or supervise the activity.
Activities at Affiliates (e.g., IA, Insurance and Banking Affiliates)	Generally excluded from the proposed rule – the proposed rule excludes activities at affiliates, whether or not investment related, unless those activities would require registration as a broker or dealer if not for the person’s association with a member.
Personal Investments (e.g., Buying Away)	Excluded from the proposed rule, but potentially subject to other rules (e.g., FINRA Rule 3210) or firm-imposed notice requirements.

Bye-Bye Fiduciary Rule?

Should you say goodbye to the Fiduciary Rule? Maybe, but not just yet. The DOL has until the end of April to decide whether to let the 5th Circuit decision vacating the Fiduciary Rule stand or try to get it over-turned. If they do nothing, the ruling becomes effective May 7, and bye-bye Fiduciary Rule – the regulation re-defining fiduciary investment advice for plans and IRAs and the related prohibited transaction exemptions.

Many pundits say this is what will happen. But it’s possible that the DOL will either ask the court to reverse itself – this would mean the 15 judge panel agreeing to re-hear and re-decide the case – or try to get the Supreme Court (SCOTUS) to accept an appeal. SCOTUS doesn’t have to do that, so those who think the DOL won’t let this go are betting on the re-hearing request. While requests for rehearing are rarely granted, in this case there might be a better chance. The decision vacating the Fiduciary Rule was a split decision, with Chief Judge Carl E. Stewart dissenting in favor of the Rule.

Continue reading “Bye-Bye Fiduciary Rule?”

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”

Family Members as Investors in IRAs and Plans

Most of us want to help family members – especially with issues in our realm of experience. But helping family members with their IRAs creates a problem under the “prohibited transaction” rules of the Internal Revenue Code (the “Code”). (Similar issues arise in connection with retirement plan accounts under the ERISA rules, but as we discuss later, the consequences aren’t quite as severe. Thus, our focus in this article is on IRAs.)

In our experience, this problem is not well-known and will come as an unpleasant surprise to many. To help you make sense of this, we are getting a little deeper into the legal weeds than we usually do.

Continue reading “Family Members as Investors in IRAs and Plans”

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:

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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”