Path Toward a True Profession - The DOL s Conflict of Interest Rule and BICE s Impartial Conduct Standards

Transcription

1 Path Toward a True Profession - The DOL s Conflict of Interest Rule and BICE s Impartial Conduct Standards by Ron A. Rhoades, J.D., CFP Integrity. Objectivity. Loyalty. Knowledge. Expertise. Skill. Honesty. Truthfulness. We use such words to describe the desired attributes of financial planners. And all of these attributes are reflected in the U.S. Department of Labor s (DOL s) Conflict of Interest Final Rule, issued in April 2016, with the majority of its provisions effective on April 10, The DOL s fiduciary rule is elegant in its core provisions, yet fraught with danger for those who ignore its tough requirements when providing conflicted advice. Should the fiduciary rule survive judicial and political challenges, it promises to propel the financial planning community closer to status as a true profession with its foundation firmly rooted in the provision of objective advice and counsel. The DOL s fiduciary rule subjects nearly all providers of investment advice to ERISA-covered retirement plan accounts and IRA accounts to fiduciary standards of conduct. It preserves the tough sole interests fiduciary standard for fee-only advisers, as appropriate. Various class exemptions then seek to accommodate a variety of ways broker-dealers, insurance companies, and their representatives receive compensation from product manufacturers, primarily through the Best Interest Contract Exemption, or BICE, in which the best interests fiduciary standard is applied. BICE s Impartial Conduct Standards As the guidance issued by the DOL in its releases for the fiduciary rule and BICE inform us, the best interests fiduciary standard is not far removed from the nearly conflict-prohibited sole interests fiduciary standard (see the sidebar on page 25). Indeed, BICE s impartial conduct standards express the core

2 requirements of the fiduciary principle in some detail, leaving little room for creative interpretations. Under the express terms of ERISA, the DOL may not grant an exemption under this subsection unless [it] finds that such exemption is (1) administratively feasible; (2) in the interests of the plan and of its participants and beneficiaries; and (3) protective of the rights of participants and beneficiaries of such plan [emphasis added.] 1 In accommodating the desires of financial services firms diverse and sometimes conflicted methods of securing revenue from clients (including third-party compensation such as commissions, 12b-1 fees, and other forms of revenuesharing), the DOL stated: When fiduciaries have conflicts of interest, they will uniformly be expected to adhere to fiduciary norms and to make recommendations that are in their customer s best interests. 2 Hence, in crafting BICE and its impartial conduct standards, the DOL was constrained by the language of ERISA to ensure that the best interests of investors be protected. Reflective of the requirements of state common law (see the sidebar on page 26), the DOL requires under BICE that a financial institution and adviser act in the best interest of a retirement investor when they provide investment advice that reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution, or any Affiliate, Related Entity, or other party. 3 In discussing the specific requirement of acting in the best interest of a client, the DOL set forth, in its issuing releases, strong guidance for firms and their advisers. The DOL specifically noted that full disclosure is not a defense to

3 making an imprudent recommendation or favoring one s own interests at the Retirement Investor s expense. 4 The DOL also cited several decisions addressing the requirements when a conflict of interest is present, stating that the decisions [of the fiduciary] must be made with an eye single to the interests of the participants and beneficiaries. 5 Said differently, [t]he Adviser may not base his or her recommendations on the Adviser s own financial interest in the transaction. 6 The DOL then provided an illustration of the application of these requirements: [F]or example, an Adviser, in choosing between two investments, could not select an investment because it is better for the Adviser s or Financial Institution s bottom line, even though it is a worse choice for the Retirement Investor. 7 In essence, the client cannot be harmed by a firm s receipt of third-party compensation. Does this permit differential compensation to be received, in which a broker-dealer firm or insurance agency receives greater compensation for recommending one product over another? The DOL provided several examples of the application of BICE, including assetbased compensation that does not vary based upon the recommendation made and the use of fee-offsets to levelize compensation. The DOL also illustrated an example of a variation in compensation: The Financial Institution establishes a commission-based compensation schedule for Advisers in which all variation in commissions is eliminated for recommendations of investments within reasonably designed categories. The Financial Institution establishes supervisory mechanisms to protect against conflicts of interest created by the transaction-based model and takes special care to ensure that any differentials that are retained are based on neutral factors, such as the time or complexity of the work involved, and that the differentials do not incentivize Advisers to violate the Impartial Conduct Standards or operate to transmit firmlevel conflicts of interest to the Adviser (e.g., by increasing compensation based

4 on how much revenue or profits the investment products generate for the Financial Institution). 8 BICE has many other requirements. Given the increased likelihood of questionable fee structuring arising from the economic incentives resulting from conflicts of interest, BICE requires numerous disclosures to investors, a written contract between the financial institution and the retirement investor, in which fiduciary status is acknowledged and core fiduciary duties may not be disclaimed. BICE also requires firms to adopt anti-conflict policies and procedures, and to identify a person responsible for the oversight of advisers, the retention of records, and notification to the DOL. Additionally, and consistent with longstanding common law requirements, only reasonable compensation must be received. Cost of Compliance Although BICE s disclosure, contract, oversight, and notification requirements impose substantial requirements upon financial institutions and advisers, the impartial conduct standards remain the most significant obstacle for compliance in the situation where one product, or class of product, is recommended over another and where the financial institution receives greater compensation as a result. Given the substantial (and some would say overwhelming) academic research indicating that higher fees and costs associated with investment products lead to lower returns for investors (all other things being equal), 9 one could conclude that the only way for a firm to receive additional compensation and fulfill BICE s requirements is to offset any additional compensation against other fees the client pays. A high burden exists for a financial institution and an adviser to demonstrate that a higher-cost product is better for a client than a similar lowercost product. Some firms may conclude that BICE s requirements are too

5 burdensome and will mandate the use of levelized compensation arrangements such as a percentage of assets under management for advice provided on accounts covered by the DOL s fiduciary rule. BICE generally provides that financial institutions may receive additional revenue, but advisers may receive differential compensation only based upon the added time to explain a product with increased complexity or similar factors. This creates a dynamic whereby the interests of advisers and financial institutions are not always aligned; financial institutions may continue to wear two hats (fiduciary and non-fiduciary), while advisers are obligated to wear only the fiduciary hat. Some in the broker-dealer and insurance communities have opined that the increased liability resulting from violations of BICE in IRA accounts might be seen as just a cost of doing business. 10 And while firms generally possess the marketing prowess and mandatory arbitration requirement for complaints to overcome any reputational damage that may occur, damage to the adviser s reputation is not so easily mended. Advisers may likely depart firms that continue to seek differential compensation through higher-cost products in favor of firms that eschew conflicts of interests. Due Diligence Under the DOL s fiduciary rule, financial institutions and advisers possess substantial due diligence obligations as experts and fiduciaries, with respect to the formulation of investment strategies and the selection of specific investment products. Hence, another consequence of the DOL s fiduciary rule is that product manufacturers will increasingly compete on the merits of their products, rather than on the amounts paid to broker-dealer firms as revenue sharing. Advisers must up their game and ensure that applicable investment portfolios are designed and managed prudently and with a high degree of stewardship on the part of the adviser. Given the tests for reliability in determining the

6 admissibility of expert testimony, in that such evidence must be based upon generally accepted academic evidence, back-testing, or analysis undertaken with intellectual rigor 11, it is likely that speculative investment strategies will be abandoned in favor of the relatively few investment strategies supported by academic research. Otherwise, it would be difficult for an expert to opine that a given strategy was prudent. Additionally, the often-hidden transaction and opportunity costs of pooled investment vehicles will likely find their way into due diligence methodologies. IRA Rollovers Another consequence of BICE, applicable to all advisers, is that rollovers to IRAs will require checklists for the gathering of data and for undertaking the required cost/benefit analysis prior to recommending the IRA rollover. 12 Documentation of the analysis undertaken is required. Financial institutions will quickly discover that the provision of substantial personalized financial planning services can be a factor used to justify IRA rollovers. As a result, a rising demand for financial planners within brokerage firms will occur, either in support of other advisers or teams, or as a stand-alone comprehensive financial and investment adviser within the firm. The DOL s fiduciary rule will accelerate a decades-long move away from commission-based compensation toward AUM, retainer, and hourly fees. Even if the DOL s implementation of the rule is delayed or halted, fiduciary advice models will continue to gain market share, driven in part for consumer demand for truly objective advice, and in part by many advisers desire to provide advice on the same side of the table as their clients, rather than sell products in armslength relationships with customers.

7 All of this bodes well for the emerging profession of financial advice, for a true profession requires, as its very foundation, the provision of disinterested objective counsel and service to others. Other foundations for the financial planning profession continue to progress, such as the delineation of its core body of knowledge, a growing body of academic research that supports the daily work of advisers, educational and testing requirements, the establishment of stricter codes of ethics, and a commitment to serve the public interest. In the years to come, the DOL s Conflict of Interest Final Rule may come to be seen as not only transformational for the financial services industry, but also as one of the major steps along the path toward a true profession for all financial planners. Ron A. Rhoades, J.D., CFP, serves as director of the financial planning program at Western Kentucky University and as an assistant professor of finance with WKU s Gordon Ford College of Business. He is the author of the forthcoming book, The Fiduciary Duties of Financial Advisers: Practical Guidance for Adherence and Compliance. Endnotes U.S.C. 1108(a) (in pertinent part). 2. Best Interest Contract Exemption, 81 Fed. Reg. 21,007 (April 8, 2016). 3. Best Interest Contract Exemption, 81 Fed. Reg. 21,026 (April 8, 2016). 4. Best Interest Contract Exemption, 81 Fed. Reg. 21,028 (April 8, 2016). 5. Best Interest Contract Exemption, 81 Fed. Reg. 21,029, fn.53 (April 8, 2016). 6. Best Interest Contract Exemption, 81 Fed. Reg. 21,028 (April 8, 2016). 7. Best Interest Contract Exemption, 81 Fed. Reg. 21,027 (April 8, 2016). 8. Best Interest Contract Exemption, 81 Fed. Reg. 21,039 (April 8, 2016). 9. See Mutual Fund Fee Research by Edwin Weinstein, prepared in spring 2015 for the Ontario Securities Commission on behalf of the Canadian Securities Administrators.

8 10. See the April 18 WealthManagement.com article by David Armstrong, Fiduciary Rule Takes Center Stage in Nashville. 11. See, Expert Testimony and the Quest for Reliability: The Case for a Methodology Questionnaire, by Marta Chlistunoff published in the Texas Law Review, volume 94, See, generally, Best Interest Contract Exemption, 81 Fed. Reg. 21,079 (April 8, 2016), to be codified as 29 CFR Part 2550 Section II(h)(3)(i). Sidebar 1: "Sole Interest" vs. "Best Interest" The courts look to state common law when applying ERISA. And under state common law, the sole interest fiduciary standard of conduct is frequently applied to trustee-beneficiary relationships (with some exceptions that vary from jurisdiction to jurisdiction). The sole interest standard generally prohibits transactions between the trustee and the trust, even if the transaction is mutually beneficial. The best interests standard is somewhat more flexible; it permits transactions between a fiduciary and the assets under its, his, or her charge, but only if there is a mutual benefit to the fiduciary and the entrustor (client). At a minimum, the entrustor should not be harmed by any transaction that involves the fiduciary. (See, for example, the 2005 article Questioning the Trust Law Duty of Loyalty: Sole Interest or Best Interest? by John H. Langbein in The Yale Law Journal.) Sidebar 2: "Curing" a Breach of Fiduciary Obligation Under state common law s best interest fiduciary standard, a conflict of interest is strongly disfavored, but is permitted in certain instances. Indeed, a conflict of interest is a breach of one s fiduciary duty, but the assertion of a defense to the

9 breach can occur. In essence, the breach of the fiduciary obligation can be cured only by demonstrating that the clients best interests were not subordinated. Several steps are required for such a cure, including: (1) affirmative disclosure of the conflict of interest and all material facts regarding it; (2) ensuring the client understands the conflict (a burden placed on the adviser, not the client, recognizing that the duty to read when receiving advice from a fiduciary is somewhat abrogated, and that even with extensive counsel some clients may not be able to understand the material facts, the conflict of interest, and its ramifications); (3) the client s informed consent; and (4) that the transaction remain substantively fair to the client. And the courts take the view, properly so, that clients would never provide informed consent to be harmed.