AdvisorNews - February, 2017

B.I.C.E.: Financial Advisors Beware

by Ron A. Rhoades, JD, CFP®, 1/9/17

As of the date of this writing, the future of the DOL “Fiduciary Rule” remains unclear. Judicial challenges remain, and the Trump administration has not yet expressed its view on whether the rule will be repealed (and how long that will take). Many broker-dealer and dual registrant firms have already spent millions to comply with the rule – but are they choosing the right path for compliance?

Some broker-dealer firms – both wirehouses and IBDs – will choose not to use the DOL’s Best Interests Contract Exemption (B.I.C.E.) and will move their clients (to the extent not grandfathered) to fee-based accounts. Yet, other broker-dealer firms have (e.g., Merrill Lynch, etc.) will embrace B.I.C.E., which contains a proverbial minefield of traps for both firms and their financial advisors.

What does this mean for financial advisors in those firms that utilize B.I.C.E.? Here are my insights and legal analysis. I question why any financial advisor would want to use B.I.C.E., given the likelihood of significant reputational damage that would result for the advisor.

The U.S. Department of Labor issued its final “Conflict of Interest” (“C.O.I.”) regulation in April 2016, with the effective date of its core provisions on April 10, 2017. Under the C.O.I. regulation, fiduciary status is imposed on nearly everyone providing investment recommendations to ERISA-covered plan sponsors and plan participants, as well as to owners of IRA accounts, Keogh plan accounts and health savings accounts. While prohibited transaction exemptions (PTEs) (including the B.I.C.E.) permit the receipt of third-party compensation, as a practical matter firms – and their advisors – should transition to fee-based accounts. Anything less will result in significant reputational risk to advisors, as well as substantially increased litigation risk to both firms and advisors.

The 237 words of the impartial conduct standards

B.I.C.E. permits commissions, 12b-1 fees and other third-party compensation to be paid to broker-dealer firms. Much attention has been focused on the voluminous disclosures required under B.I.C.E.; some firms may wrongly believe that they can conduct “business as usual” simply by providing these disclosures. However, the core of the DOL’s rules are found in the 237 words that comprise the Impartial Conduct Standards. These standards impose strict fiduciary duties of loyalty and due care upon firms and advisors, require the receipt of only reasonable compensation, and prohibit misleading statements. And, these Impartial Conduct Standards also apply to recommendations of proprietary funds, principal trades and fixed-index annuities.

B.I.C.E. imposes upon both firms and their advisors an extremely strong fiduciary duty of “loyalty” that cannot be disclaimed by the firm or advisor, nor waived by the client

Under B.I.C.E. and its Impartial Conduct Standards, recommendations must be given to clients “without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.”[1] “[F]or example, an advisor, in choosing between two investments, could not select an investment because it is better for the advisor’s or financial institution’s bottom line ….”[2] Moreover, neither the firm nor advisor may seek to limit its liability by disclaiming their core fiduciary duty or loyalty, nor may the firm seek to have the client waive the fiduciary duties owed to the client.[3]

The DOL’s strong fiduciary duty of due care is further rooted in the “prudent investor rule,” which includes the duty to not waste the client’s assets

The Impartial Conduct Standards also incorporate, as part of a firm’s and advisor’s fiduciary duty of due care, the tough “prudent investor rule” (PIR).[4] The PIR has a decades-long history of interpretation, as it is the core of a trustee’s duty to manage investment under trust law, and it is codified in most states as a version of the Uniform Prudent Investor Act. The PIR requires the advisor to manage risk across the investor’s portfolio, and to consider the risk and return objectives of the portfolio in making decisions. The duties to diversify investments and to avoid idiosyncratic risk are emphasized, in keeping with the findings of modern portfolio theory.

Additionally, under the PIR, the firm and advisor possess a duty that avoids waste. In other words, there exists a duty to minimize the costs incurred by the client when determining which investment products to select. “[F]iduciaries … ordinarily have a duty to seek … the lowest level of risk and cost for a particular level of expected return.”[5] In the particular context of mutual funds and other pooled investment vehicles, advisors must pay “special attention” to “sales charges, compensation, and other costs” and should “make careful overall cost comparisons, particularly among similar products of a specific type being considered for a … portfolio.”[6] Put simply, “[w]asting [clients’] money is imprudent.”[7]

The PIR’s duties to avoid idiosyncratic risk and to avoid waste of the client’s assets bring into doubt the efficacy of several programs already announced by certain firms. For example, an IRA platform for smaller clients consisting only of individual stocks and bonds may render it impossible for an advisor to minimize idiosyncratic risk.

The PIR also poses huge challenges to the use of expensive funds and annuity products, where less expensive alternatives are available. For example, a broker-dealer platform or program in which the financial advisor is confined to the use of higher-cost mutual funds or variable annuities would likely run afoul of the fiduciary’s duty to avoid waste of the client assets, especially where similar lower-cost investments were available in the marketplace. While the use of very-low-total-cost index funds and index ETFs is not explicitly required by the rule, their utilization is certainly implicitly favored and should be viewed as one step that could be taken along the path toward risk reduction for the firm and its advisors.

Academic research has not ruled out the utilization of all active management strategies. However, the research is compelling that high-cost actively managed funds should be avoided by advisors operating under the fiduciary duty of prudence, given the consistent inverse relationship between investment product fees and investor returns. Further research on the ability of very-low-cost actively managed funds to beat appropriately chosen benchmarks is desired, as the current research is insufficient to either support or undermine their utilization.

When providing advice to an account under the DOL Rules, it is far more likely that the entire relationship will be deemed to be one of trust and confidence, applying state common law

In private litigation and arbitration, firms and advisors are normally sued not only for breach of contract, but also under state common law for breach of fiduciary duty. In such proceedings broker-dealer firms and their advisors usually deny the existence of fiduciary status. However, when the prudent investor rule is imposed upon one portion of a client’s portfolio, other portions of the portfolio should also be managed prudently given the fiduciary’s duty to consider the client’s other investments and assets.[8]

When fiduciary duties are applicable contractually under B.I.C.E. for the management of IRA accounts, then it more likely that common law fiduciary status will be found to exist for the entirety of the advisor’s relationship with the client – including but not limited to the IRA account and other brokerage and investment advisory accounts upon which advice is provided. In other words, a court or arbitrator is more likely to find that a relationship of trust and confidence exists for non-qualified accounts when fiduciary duties are already imposed upon qualified accounts managed by the advisor.

Under state common law, the receipt of additional compensation by a firm or advisor is a breach of fiduciary duty, which requires proof that the client is not harmed

Given the higher likelihood of fiduciary status under state common law, methods to comply with state common law fiduciary duties should be reviewed.

The preferred method of complying with one’s fiduciary duty of loyalty under state common law is to seek, in advance of any investment recommendations, the client’s agreement to a reasonable “level fee” arrangement (i.e., the fee is independent of the product sold to the client). Such fee structures include asset-under-management fees, annual fixed fees, project-based fixed fees, hourly fees, subscription fees, and combinations thereof. After securing the client’s agreement on fees, the advisor should not recommend any investment product that would provide the advisor with additional compensation, absent an agreement to offset other fees the advisor receives. This is because, under state common law, a “fiduciary who receives compensation from an entity whose investment products the fiduciary recommends presumptively breaches the duty of loyalty … [T]he common law … tolerates authorized conflicts of interests, provided that the [advisor] acts fairly and in good faith in pursuit of the beneficiary’s best interest.”[9]

Once the burden of proof and/or persuasion shifts from the client to the firm and advisor, proof must be offered that the client was not harmed by the receipt of the additional compensation by the firm. As discussed below, given that additional compensation is paid by product providers from product fees, and that higher product fees on average lead to lower returns for investors, especially over the long term, this is a difficult burden of proof to meet.

The “careful scrutiny” of additional fees received by a firm under B.I.C.E.

Unlike ERISA’s statutory “sole interests” fiduciary standard (where conflicts of interest are prohibited), under B.I.C.E.’s “best interests” standard a conflict of interest is permitted to exist. Yet, when additional fees are received by a firm then the conduct of the firm and advisor “will be subject to especially careful scrutiny.”[10]

The DOL’s Impartial Conduct Standards do permit “differential compensation” between “reasonably designed investment categories” to financial advisors based upon “neutral factors” tied to the services delivered to the client.[11] The DOL provided the example that a difference in compensation to the advisor could be based upon the “time and analysis necessary to provide prudent advice with respect to different types of investments.”[12]

Self-dealing and the receipt of additional fees from product providers: the impact of the prudent investor rule and academic research

As indicated above, the receipt by of third-party compensation is likely to be closely scrutinized under B.I.C.E. This is especially true when additional compensation is received by a broker-dealer firm, such as through 12b-1 fees, payment for shelf space and other forms of revenue sharing and/or marketing reimbursements, as this amounts to a form of self-dealing.

If additional fees and costs are received from the recommendation of a particular investment, such additional compensation is necessarily derived from the product’s costs. And here’s the rub … the academic research is strong and compelling – higher product fees and costs result, on average, in lower returns for investors.[13]

Hence, under B.I.C.E. the test for receipt of additional compensation is a tough one. “[A]n 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.”[14] Furthermore, under B.I.C.E. “full disclosure is not a defense to making an imprudent recommendation or favoring one’s own interests at the Retirement Investor’s expense.”[15]

“Commissions are better for investors?” Not so fast!

Some financial advisors might argue that mutual fund A share classes are better for investors, as the client does not need to pay ongoing fees – just an upfront commission. Leaving aside for a minute that most class A shares still impose a 0.25% or less annual 12b-1 fee, the impact of the sales commission is often understated.

A 5.75% sales charge requires a mutual fund to earn a 1.20% greater annual return (assuming a hypothetical 10% level return of the fund), if the fund is held for five years. If held for 10 years, the impact of the sales charge falls to 0.59% annually. If held for 15 years, the impact falls to 0.43%. But, here’s the rub – according to the Investment Company Institute the average holding period for stock mutual funds is only four years, and for bond mutual funds only three years. With these average holding periods a 5.75% sales charge translates into an annual fee well above 1.2% a year.

In addition, the application of Modern Portfolio Theory often leads to the need to rebalance a client’s investment portfolio. And, if the financial advisor just deals with mutual fund A share classes, it may very well occur that the advisor would recommend that some of the shares of a fund purchased by a client just a few months or few years before would need to be sold for rebalancing purposes. In essence, commission-based compensation is inconsistent with the application of Modern Portfolio Theory.

Some financial advisors will still argue that breakpoint discounts on mutual fund A share class commissions will significantly lower the commissions paid. Yet, in hundreds and hundreds of investment portfolios I’ve reviewed, implemented by brokers, nearly 90% of them appeared to be structured to avoid breakpoint discounts by spreading out investments among funds from different fund companies. Under a fiduciary standard the level of scrutiny intensifies, and it would be hard for brokers to justify such a practice given the prudent investor rule’s duty to avoid the waste of client assets. Financial advisors who operate under a fiduciary standard will have to justify any action that negates breakpoint discounts; given the existence of the conflict of interest in connection with breakpoint discounts, the burden of proof and persuasion falls upon the financial advisor, not the client. Subjective “good faith” is insufficient to meet this burden, as the actions of the financial advisor are judged under an objective standard.

Lastly, the comparison of “sales commission” to “1% annual fee” is often comparing apples to oranges. When a mutual fund A share class is sold, the broker has no duty to continue to monitor the portfolio. (However, several courts have found that, in situations when trailing compensation exists and continued advice is provided to the investor, fiduciary status existed under state common law, which included an ongoing duty.[16]) In contrast, investment advisors who charge 1% annual fees often provide a large amount of ongoing financial planning and investment advice. And, of course, many investment advisors charge less than 1%, particularly on larger accounts.

Relying on 12b-1 fees? Don’t!

In 2010 the U.S. Securities and Exchange Commission (SEC) held hearings on whether 12b-1 fees should be continued. While no action was taken by the SEC at that time, since then various SEC officials have indicated that 12b-1 fees remain under review.

Even before the enactment of Rule 12b-1 the SEC had generally opposed the use of fund assets for the purpose of financing the distribution of mutual fund shares, noting that "existing shareholders of a fund often derive little or no benefit from the sale of new shares."[17] Given the substantial evidence that investors fail to understand 12b-1 fees, their uncompetitive nature (as they generally cannot be negotiated), and the indefinite continuation of 12b-1 fees in many instances even if the client no longer desires ongoing investment advice, it is likely that 12b-1 fees will be repealed at some future date.

The manner of compensation is much more suspect than the amount of compensation

The DOL’s Impartial Conduct Standards set forth the existing requirement that the both the firm and advisor receive no more than “reasonable compensation.”[18] As a result of this standard, firms will likely benchmark their services and fees against those of other firms in order to ensure that the total fees paid by the client to the firm are not excessive.[19] Yet, as Tim Hauser, the Deputy Assistant Secretary for Program Operations of EBSA at the DOL, explained at a conference in the Fall of 2016, it is very difficult for a plaintiff’s attorney or an agency to prevail on allegations of unreasonable compensation.[20] The courts generally defer to the parties to negotiate fees, provided the negotiation occurs in an arms’-length bargaining and not as a result of self-dealing by a fiduciary, in order that courts not get involved in rate-setting.[21]

B.I.C.E. can result in a misalignment of the interests of the firm and those of its advisors, for the firm can receive more compensation while the advisor’s compensation generally must not vary

Under B.I.C.E. the firm may receive additional compensation from the recommendation of particular products, but the firm must adopt policies and procedures to ensure that individual advisors do not receive differential compensation, bonuses, or awards “to the extent they are intended to or would reasonably be expected to cause Advisers to make recommendations that are not in the Best Interest of the Retirement Investor.”[22] In other words, while firms can receive additional compensation for the recommendation of certain products, the advisor must not receive any portion of such additional compensation. The distinction between compensation received by the firm, versus those received by the advisor, results in a significant disconnect between the interests of the firm and the interests of the advisor.

It is possible under B.I.C.E. to pay advisors additional compensation when a more complex product, that requires additional time to explain, is provided to a client. But plaintiff’s attorneys will likely question advisors on the additional time spent to understand more complex products (which time, in theory, would be allocated among many clients), and to explain the more complex product to a specific client. These plaintiff’s attorneys will likely assert that the amount of additional compensation provided to the advisor could easily become an improper incentive to the advisor under B.I.C.E., given the relatively small amount of additional time spent by the advisor with each individual client.

Over time, the economic incentives present will result in pressures placed upon advisors by their firms to not act in the best interests of the client

Where financial products are recommended, due to the vast asymmetry of information between a financial firm and its clients, incentives exist for the firm to pass off low-quality goods as higher-quality ones.[23] Over time, such economic incentives tend to distort a fiduciary’s judgment, as has often been recognized by the courts.

For example, the U.S. Supreme Court, in discussing conflicts of interest, stated: “The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them ....”[24] And, as the U.S. Supreme Court stated 170 years ago, the law “acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.”[25]

As an eloquent Tennessee jurist put it before the Civil War, the doctrine that conflicts of interest should be avoided “has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, ‘Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that ‘a man cannot serve two masters.’”[26]

B.I.C.E. effectively limits the ability of individual advisors to receive additional compensation. But under B.I.C.E. firms will still possess the economic incentive to encourage their advisors to promote to clients investment products that pay the firm (but not the advisor) additional compensation. Advisors working in firms that utilize B.I.C.E. must confront the substantial likelihood that their own interests will not align with those of their firms.

The reputational risk for the individual advisor is far greater than that of the typical firm

The single most important asset a financial advisor possesses is her or his personal reputation. Damage to the advisor’s reputation is the greatest risk individual advisors face today. Such risk is realized should client complaints, usually triggered by the presence of conflicts of interest, lead to resolutions that mandate disclosures of settlements or arbitration awards to current clients of the advisor as well as to future potential clients.

Yet, for the larger financial services firm, reputational risk is far less consequential. Those firms can more easily mask transgressions via nondisclosure agreements with claimants during settlements, mandatory arbitration of individual claims and voluminous documents that are seldom read by clients. Moreover, a firm’s reputation is more easily repaired via marketing and promotion, explaining away past transgressions as due to “rogue advisors” who are no longer with the firm, and the inevitable passage of time that dims consumer’s memories.

B.I.C.E. requires voluminous, client-repulsive disclosures

Although much research has revealed the ineffectiveness of disclosures due to various behavioral biases consumers possess, fiduciary duties generally impose the burden upon individual advisors to ensure that their clients understand when a conflict of interest is present, as well as understand the consequences of such conflict of interest.[27] Hence, advisors who practice under B.I.C.E. will be confronted with an affirmative duty to ensure client understanding of disclosures that are both voluminous and onerous.

In the competition for clients, firms that use fee-based accounts will possess a huge marketing advantage over firms that utilize B.I.C.E.

Over the next several years many advisors will see a lot of “money in motion.” Triggered by changing fee and compensation structures, enhanced disclosures and the consumer press, clients will increasingly review their relationship with their current advisor and seek out second opinions.

As the distinctions between firms that utilize B.I.C.E. and those that don’t become known, the consumer press will steer their readers to firms that don’t use B.I.C.E. for IRA accounts. Additionally, savvy fee-only firms already provide questionnaires and checklists for prospective clients to utilize when shopping for new advisors. These questionnaires highlight the benefits of compensation structures that are more aligned with client interests.

As studies have demonstrated, the vast majority of consumers prefer fee-based compensation over commissions. Over the past two decades, more and more accounts have transitioned from commission-based to fee-based in reaction to consumer preferences. The DOL’s COI rule only accelerates this trend; fee-based accounts will rise from perhaps 40% of accounts today to 60% or greater within a short time.

B.I.C.E. is unlikely to survive the next decade

In other nations, such as Australia, New Zealand, and England, regulation has progressed much further, in that commissions paid to financial advisors for investment management services are largely banned. While these developments have not yet reached U.S. shores, they are an indication of future policy changes that may occur.

More important, however, will be the adverse result of firms using B.I.C.E. Some firms may see the increased cost of doing business under B.I.C.E. – primarily in the form of increased litigation costs – as just a “cost of doing business.” As abuses take place, the DOL may well re-evaluate whether B.I.C.E. is an effective solution. Should the courts set aside the DOL’s prohibition on the inclusion of clauses in client agreements that negate the ability of the client to participate in class actions, the DOL may become more concerned that B.I.C.E.’s remaining enforcement mechanisms are insufficient to deter bad conduct. As a result, a future administration may seek to sunset B.I.C.E. and require all financial advisors to utilize level-fee compensation methods.

Avoiding B.I.C.E. is the “right thing to do”

Finally, the most compelling reason to embrace “level-fee” compensation and to avoid B.I.C.E. is simply this – to serve the client in the best manner possible. Firms that embrace level fees, and eschew the receipt of product-based compensation, will truly act as representatives of the client.

Larger firms will use the collective purchasing power of their advisors and clients to squeeze asset manager’s compensation, in order to boost the returns their clients enjoy. These firms may also require annuity and other product manufacturers to create better and more transparent products.

As a result, products will compete – not on the basis of the amount of revenue sharing provided to the product’s distributors – but rather on the basis of each product’s individual merits. The real impact of the DOL’s Conflict of Interest Rule and its exemptions will be upon asset managers. Some financial advisors merely need to adjust the manner by which they receive their compensation.

In conclusion, here is my message to financial advisors (i.e., dual registrants and registered representatives): B.I.C.E. is a minefield that will generate a huge number of explosions. Don’t be around when the minefield starts to erupt. Rather, avoid B.I.C.E. and use a level-fee methodology. It’s the right thing to do – for the firm, its clients and especially for you, the financial advisor.

Ron A. Rhoades, JD, CFP® serves as director of the financial planning program for Western Kentucky University’s Gordon Ford College of Business. He is an assistant professor – finance, an attorney, an investment advisor and a frequent writer on the fiduciary standard as applied to financial services. A frequent speaker at national and regional conferences, he also serves as a consultant to firms on the application of the DOL Conflict of Interest Rules, fiduciary law and related issues. This article represents his views only, and not those of any institution, firm or organization with whom he may be associated. This article is believed to be correct at the time it is written; subsequent laws, regulations, and/or developments regarding the interpretation or enforcement of ERISA, the I.R.C., and DOL regulations should be consulted. Please direct all questions and requests via email:

[1] “The phrase ‘without regard to’ is a concise expression of ERISA’s duty of loyalty, as expressed in section 404(a)(1)(A) of ERISA and applied in the context of advice.” 81 Fed.Reg. 21,026 (April 8, 2016).

[2] 81 Fed.Reg. 21,027 (April 8, 2016).

[3] “Section II(f)(1) prohibits all exculpatory provisions disclaiming or otherwise limiting liability of the Adviser or Financial Institution for a violation of the [B.I.C.E.] contract's terms, and Section II(g)(5) prohibits Financial Institutions and Adviser from purporting to disclaim any responsibility or liability for any responsibility, obligation, or duty under Title I of ERISA to the extent the disclaimer would be prohibited by Section 410 of ERISA.” 81 Fed.Reg. 21,042 (April 8, 2016).

[4] “[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.’” 81 Fed.Reg. 21,053 (April 8, 2016).

[5] Restatement (Third) of Trusts § 90 cmt. f(1), at 308; see id. § 88 cmt. a, at 256 (trustee has “a duty to be cost-conscious”).

[6] Restatement (Third) of Trusts § 90 cmt. m, at 332.

[7] Uniform Prudent Investor Act § 7 & cmt., 7B U.L.A. 37 (2006).

[8] While the U.S. Department of Labor does not possess the ability to impose fiduciary standards on non-ERISA, non-IRA accounts, prudent investor rule experts Max M. Schanzenbach and Robert H. Sitkoff rightfully conclude that “proper diversification requires an assessment of the portfolio as a whole, including the other assets of the investor.” Schanzenbach, Max M. and Sitkoff, Robert H., Financial Adviser Can't Overlook the Prudent Investor Rule (August 1, 2016). Journal of Financial Planning (August 2016).

[9] Schanzenbach, Max M. and Sitkoff, Robert H., Fiduciary Financial AdviserAdvisors and the Incoherence of a 'High-Quality Low-Fee' Safe Harbor (September 16, 2015). Northwestern Law & Econ Research Paper No. 15-18. Available at, citing see Restatement (Third) of Trusts § 78 cmt. c(2); Jesse Dukeminier & Robert H. Sitkoff, Wills, Trusts, and Estates 591, 593 (9th ed. 2013).

[10] See Restatement (Third) of Trusts § 37 cmt. f(1); see also Dukeminier & Sitkoff, supra note 9, at 593.

[11] 81 Fed. Reg. 21,036 (Apr. 8, 2016).

[12] Id.

[13] For a list of academic articles, please see Rhoades, Scholarly Financial Blog, “Part 3: Professional and Other Fees Matter” (Jan. 1, 2016), located at

[14] 81 Fed. Reg. 21,027 (Apr. 8, 2016). However, “[d]ifferential compensation between categories of investments could be permissible as long as the compensation structure and lines between categories were drawn based on neutral factors that were not tied to the Financial Institution’s own conflicts of interest, such as the time or complexity of the advisory work, rather than on promoting sales of the most lucrative products.” Id. at 21,037.

[15] 81 Fed. Reg. 21,028 (Apr. 8, 2016).

[16] See, e.g., Western Reserve Life Assurance Company of Ohio vs. Graben, No. 2-05-328-CV (Tex. App. 6/28/2007) (Tex. App., 2007). (A dual registrant crossed the line in "holding out" as a financial advisor, and in stating that ongoing advice would be provided, and other representations, and in so doing the dual registrant, who sold a variable annuity, and was found to have formed a relationship of trust and confidence with the customers to which fiduciary status attached. The court stated: "Obviously, when a person such as Hutton is acting as a financial advisor, that role extends well beyond a simple arms'-length business transaction. An unsophisticated investor is necessarily entrusting his funds to one who is representing that he will place the funds in a suitable investment and manage the funds appropriately for the benefit of his investor/entrustor. The relationship goes well beyond a traditional arms'-length business transaction that provides 'mutual benefit' for both parties.") See also, e.g., Johnson v. John Hancock Funds, No. M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006) (in a case involving sale of Class B mutual fund shares, the court stated: “If the transaction is non-discretionary and at arm's length, i.e., a simple order to buy or sell a particular stock, the relationship does not give rise to general fiduciary duties. However, if the client has requested the broker or advisor to provide investment advice or has given the broker discretion to select his or her investments, the broker or advisor assumes broad fiduciary obligations that extend beyond the individual transactions.) … When a stock broker or financial advisor is providing financial or investment advice, he or she is required to exercise the utmost good faith, loyalty, and honesty toward the client.”

[17] See Bearing of Distribution Expenses by Mutual Funds: Statutory Interpretation, Investment Company Act Release No. 9915 (Aug. 31, 1977) [42 FR 44810 (Sept. 7, 1977)] (quoting SEC, Future Structure of the Securities Markets (Feb. 2, 1972) [37 FR 5286 (Mar. 14, 1972)]).

[18] 81 Fed. Reg. 21,007 (Apr. 8, 2016). As stated by the DOL, “ERISA section 408(b)(2) and Code section 4975(d)(2) require that services arrangements involving plans and IRAs result in no more than reasonable compensation to the service provider. Accordingly, Advisors and Financial Institutions – as service providers – have long been subject to this requirement, regardless of their fiduciary status.” Id. at 21,029.

[19] “[T]he 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.” 81 Fed. Reg. 21,029 (Apr. 8, 2016).

[20] Paraphrasing Tim Hauser, speaking with the author during a session entitled “Deconstructing the DOL Fiduciary Rule,” where both Tim Hauser and the author were panelists, at the Financial Planning Association’s BE Conference, September 16, 2016.

[21] See, e.g. Brock v. Robbins, 830 F.2d 640 (7th Cir. 1987).

[22] 81 Fed. Reg. 21, 033 (Apr. 8, 2016). Under B.I.C.E. both the firm and the advisor possess a fiduciary duty of loyalty to the client. While the fiduciary duty of the advisor to the firm still exists, the duty to the client is paramount. In other words, there is an “ordering” of the fiduciary duties, and any duty of loyalty owed by the advisor to the advisor’s firm is subservient to the primary duty of loyalty owed to the client.

[23] See, e.g., Akerlof, George, "The Market for Lemons: Quality Uncertainty and the Market Mechanism" (1970).

[24] SEC v. Capital Gains Research Bureau, 375 U.S. at 196 (citing United States v. Mississippi Valley Generating Co., 364 U.S. 520 (1961)); id. at 196 n.50

[25] Michoud v. Girod, 45 U.S. 503 555 (1846). The U.S. Supreme Court also stated in that decision: “if persons having a confidential character were permitted to avail themselves of any knowledge acquired in that capacity, they might be induced to conceal their information and not to exercise it for the benefit of the persons relying upon their integrity. The characters are inconsistent. Emptor emit quam minimo potest, venditor vendit quam maximo potest.” [The buyer buys for as little as possible; the vendor sells for as much as possible.] Id. at 554.

[26] Tisdale v. Tisdale, 2 Sneed 596 (Tenn. 1855).

[27] Study on Investment Adviser and Broker-Dealers (As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, by the Staff of the U.S. Securities and Exchange Commission (Jan. 2011).


In DOL/Post-DOL Fiduciary World, RIAs Need to Re-Differentiate


Originally published in Think Advisor, November 29, 2016

The election of Donald Trump means that finance will get a new wave of deregulation that will (almost certainly) sweep away the DOL fiduciary rule. The watchword for RIAs in this new world: re-differentiation. But let’s first review how we got to this new world.

First, An Historic October for Fiduciaries

October was historic for brokers and advice. As many as 49,200 brokers from five BDs “automatically” became fiduciaries to retirement investors effective next year. Brokers from Morgan Stanley (16,000), Ameriprise (2,700), LPL (14,000), Raymond James (3,500), and Edward Jones (13,000) will offer retirement advice in brokerage accounts under the DOL rule BICE starting in April, according to firm announcements. (This is the start; more firms are certain to follow.)

In contrast, Merrill Lynch and Commonwealth Financial announced they would drop or limit the availability of brokerage accounts in retirement advice to comply with the DOL rule. Merrill revved up its marketing with full-page newspaper ads headlined, “We’re committed to your best interest. Not the status quo.” Merrill explains, “It means when you sit at the table with your Merrill Lynch advisor or invest with us online, you can be sure you are getting guidance [emphasis added] that is in your best interest …. We believe we are honoring the spirit of the new rules – not looking for ways to get around them.”

The challenge for fiduciaries is daunting. Tens of thousands of new fiduciary brokers will soon fly the fiduciary flag, as Merrill tells the country that the thundering herd will give all its customers – retirement and nonretirement accounts alike – ‘best interest’ treatment. The implications of these developments have barely been discussed in the advisory industry.

Tens of thousands of new fiduciary brokers will soon fly the fiduciary flag, as Merrill tells the country that the thundering herd will give all its customers – retirement and nonretirement accounts alike – ‘best interest’ treatment.

One exception. Schwab CEO Walt Bettinger took the bull by the horns at its 2016 IMPACT conference (in October). His message: fiduciaries must differentiate what they do. The great challenge is “To re-differentiate ourselves” from those “Wanting to look and act and to appear” to be like us. Merrill’s branding serves as a keen reminder of the relevance of Bettinger’s message.

Second, an Historic November for Fiduciaries

The November presidential election has clear consequences for the DOL rule. “Historic” October was then overshadowed by the election. Advisors to the president-elect openly say they wish to repeal the rule. Though a rule repeal is neither quick nor easy, a number of possible tactics can be applied to postpone, undermine or eventually repeal the rule. The DOL rule is now on life support.

Meanwhile, BDs are preparing for the DOL rule. New platforms, policies and procedures are under construction in c-suites around the country. Some are transforming the fee-based best interest world. Others will keep commissions. These changes are significant and costly. The central question is how firms will implement these policies absent the DOL rule. The answer is unclear. There is no certainty as to implementation.

There is, however, much “certainty” that, irrespective regulations, firms will communicate their fidelity to customers’ best interests. Merrill has already started. Minor edits to its current communications on the DOL rule will suffice to meet its branding objectives in a world without the DOL rule.

Third, a New Era of More Subtle Confusion

For 20 years fiduciary advisors, regulators and researchers have documented, discussed and bemoaned how investors don’t understand that brokerage sales and product recommendations differ from fiduciary advice. From this perspective, confusion has defined the fiduciary discussion. Is it possible investor confusion could get worse?

With the elimination or dilution of the DOL rule and BICE (and deregulatory winds preventing SEC fiduciary rulemaking), industry voices will reach further. Some voices will be responsible. However, other influential voices will simply suggest fidelity to stringent standards, but lack sufficient policies and procedures to truly implement them. SIFMA and FINRA will communicate their concept of ‘best interest.’ Yet prior writings suggest their idea of ‘best interest’ simply does not comport with common law or trust law standards.

Schwab’s Bettinger frames the challenge for fiduciary advisors – “re-differentiating” from those who “appear” to be fiduciaries – with lessons in mind. One such lesson is that advisors need to better counter clever ads with credible actions. This is a lesson that United Capital boss Joe Duran says the finance industry should take from the election. That is: the system is “broken” and the industry is “tone deaf” to criticisms and “American voters have said it’s time their interests come first.”

This lesson drives the Institute for the Fiduciary Standard’s Best Practices, which are crafted to raise standards and understanding of what fiduciaries do. The Best Practices affirmation program lets advisors show investors how fiduciary conduct differs from brokerage sales practices. Industry research suggests that the impact of following these practices can be more than clarifying what advice means. It suggests these practices can increase client trust and enhance advisor /client relationships.

“Re-differentiation” should be the ‘best practice’ of any advisor in the DOL/post-DOL fiduciary world that lies ahead.





Best Interest Contract Exemption: Hedging Against the Possibility of Changes to the Department of Labor Fiduciary Rules

Larry Goldbrum | Thursday, December 15, 2016

The fate of the Department of Labor (DOL) fiduciary rules is clouded in uncertainty because of the presidential election win by Donald Trump. The new rules will become applicable — or as a practical matter, effective — on April 10, 2017. However, Mr. Trump will become President on January 20, 2017, and there are many who believe that the incoming administration will repeal, modify or delay the new rules. Without a clear statement from Mr. Trump, most industry professionals advise the regulated community to proceed as if the rule will apply as originally expected on April 10. But are there ways to minimize certain compliance costs under the Best Interest Contract (BIC) exemption while the uncertainty is sorted out?

The short answer is yes. Fortunately, the DOL staggered the applicability dates of many of the more onerous provisions of the BIC exemption in the final rules. The more cumbersome requirements are not applicable until January 1, 2018. Consequently, investment fiduciaries could focus their compliance efforts on the April requirements and defer compliance with the others until April when more may be known about the fate of the rules and who will lead the Employee Benefits Security Administration.

BIC Exemption Requirements Applicable on April 10, 2017

  • Best Interest Standard - The financial institution and advisor must act in the best interest of the plan, participant or investor.
  • Reasonable Compensation - The financial institution, its affiliates and the advisor must receive no more than reasonable compensation.
  • No Misleading Statements - The financial institution and the advisor must not make any materially misleading statements.
  • Abbreviated Disclosures – The financial institution must furnish certain abbreviated transition period disclosures . Notably, a written contract that may otherwise be required is not needed during the transition period.
  •  BIC Exemption Officer - The financial institution must designate a BIC exemption compliance officer.
  • Records and Access - The financial institution must maintain records that enable a determination that the conditions of the exemption have been met, and such records must be reasonably available for examination by the DOL, IRS, plan fiduciaries, participants and certain other parties.

BIC Exemption Requirements Applicable on January 1, 2018

  • Full Disclosures and Contracts - All BIC exemption disclosures must be furnished and the written contract requirements (in the case of IRAs and other non-ERISA plans) must be satisfied, including the required warranties.
  • Web Disclosures - In addition to the disclosure and written contract requirements noted directly above, the financial institution must make certain additional web and transaction-based disclosures are published.
  • Policies and Procedures - The financial institution must have certain documentation, and written policies and procedures in place.
  • DOL Notice - The financial institution must notify the DOL of its intent to rely on the BIC exemption prior to receiving compensation.

As noted above, the January 1, 2018 requirements are among the most complex and potentially costly to implement. The additional time to comply originally provided by the DOL gives financial institutions the opportunity to prioritize their compliance efforts.


Why the new fiduciary rules spells opportunity for RIAs

By Skip Schweiss

December 27 2016, 1:43pm EST

The Department of Labor's new fiduciary rule has inspired plenty of doom-and-gloom predictions from critics who warn that industry profits will suffer and small investors will lose their access to financial advice.

But for RIAs, it’s becoming clear the new rules may actually present significant growth opportunities.

When the new rule takes effect next April, the DoL will extend to IRAs the kind of best interest protections that have long governed 401(k)s and other workplace-sponsored retirement plans. The new rule also makes advice about rolling workplace retirement assets into an IRA as investment advice subject to best interest protections.

These changes, which come as tens of millions of retiring baby boomers face the decision of what they will do with their retirement plan nest eggs, could result in some important benefits for RIAs. Among them:

• Recent regulatory changes favor RIAs.

Fee-disclosure regulations finalized in 2012, combined with the new DoL conflicts rule, strengthen the wind in the sails of RIAs looking to compete in a $5 trillion marketplace, while creating a higher hurdle for commissioned brokers to advise retirement plans.

• RIAs can attract a greater share of 401(k) plan business.

We believe there is enormous, untapped opportunity for RIAs to advise 401(k) and other workplace retirement plans. Fewer than 10% of RIAs are actively involved in the retirement plan space, according to Cerulli & Associates. When you consider that some plans have tens of millions of dollars, with new money coming in with every paycheck, what’s not to like?

• RIAs can capture more IRA rollovers from 401(k) clients.

The DoL rule not only provides a clearer path for advising retirement plans, but also for advising employees on how to roll assets into IRAs managed by your firm when they leave an employer. If you can justify and document why a rollover is in their best interest, you have a better chance of providing a long-term experience for that client.

• Advisers can gain other business from plan participants.

If an RIA advises the workplace plan of an employee, and is able to retain that relationship when the individual leaves the employer, that RIA has a greater opportunity to discuss and, possibly, oversee assets outside the retirement account.

• Deeper relationships create a competitive advantage.

By developing a broader, more holistic relationship with retirement plan participants, RIAs can create a moat around the client that competitors will find more challenging to break through.

There are also potential challenges for RIAs, however.

Many commissioned brokers, for example, likely will continue serving retirement investors through a best interest contract exemption established under the new DoL rule. Discretionary RIAs have no need for such an exemption, but that important distinction may be lost on most investors.

IRA rollovers, meanwhile, will require some more work.

Before advising a retiree to roll over a 401(k) plan to an IRA account their firm would manage, RIAs will need to compare the investor’s current fund lineup, costs, services and other factors with their own offerings and then determine whether a rollover is truly in the investor’s best interest. And they must fully document that assessment.

Even so, RIAs providing comprehensive financial planning services would still have an advantage in this new world:

• RIAs can be the better choice for the retirement investor.

Compared with the typical workplace plan, RIAs can offer more education and investment services. They also tend to offer access to a wider menu of funds through their custodian.

• More talent and clients shifting to the RIA channel.

RIAs may also benefit from increased movement of broker teams to the RIA world. There have been reports the new DoL rule is prompting more commissioned brokers to break away from their firms to become independent RIAs, creating an opportunity for RIA firms to grow by acquiring firms or tucking in breakaways.

• Consolidation opportunities.

By the same token, smaller RIA firms buckling under the weight of regulation may decide to sell. These firms can become acquisition targets that help other RIAs grow.

Ultimately, the DoL is trying to do the right thing by mandating stronger protections for the millions of Americans responsible for managing their own retirement savings outside the workplace protections of ERISA.

And that’s why I believe that over time, the DoL rule can spell opportunity for RIAs, a group of professionals that have been putting their clients’ interests first for decades under the Investment Advisers Act of 1940.


Breaking Down the 3 Key Elements of the DOL Fiduciary Rule

Whether an advisor is subject to the rule depends on these definitions of 'fiduciary,' 'investment advice,' and 'compensation.'

W. Scott Simon, 01/05/2017

The Conflict of Interest Rule (Rule) promulgated by the U.S. Department of Labor on April 8, 2016, pertains to only one "kind" of the three kinds of fiduciaries described in section 3(21) of the Employee Retirement Income Security Act of 1974 (ERISA), which can be thought of as "Fiduciary Central." That one kind of fiduciary--an ERISA section 3(21)(A)(ii) fiduciary--is a non-discretionary advice-giver.

All three elements described in section 3(21)(A)(ii)--1) a fiduciary 2) that renders (non-discretionary) investment advice 3) for compensation--must be present in order for the Rule to apply to an advisor communicating with a plan participant or an IRA owner.

Element 1: Fiduciary

The Rule broadens the class of entities--which it defines as "Financial Institutions"--that will bear the "fiduciary" moniker come April 10. These include registered investment advisors, broker/dealers, banks, and insurance companies. This definition also includes any employees, contractors, agents, representatives, affiliates, or related entities of a given Financial Institution.

Element 2: Investment Advice

The Rule also broadens the definition of "investment advice." More precisely, "retirement investment advice" that's rendered to 1) participants in ERISA plans such as 401(k) plans, profit-sharing plans, money purchase pension plans, and defined benefit plans, as well as 2) owners of IRAs and participants in non-ERISA plans. Note that the Rule does not pertain to investment advice rendered to those investing in taxable accounts and non-retirement accounts. That retail environment remains within the purview of the SEC.

Determining whether an advisor has rendered "retirement investment advice" in a given situation requires posing a threshold question: Has the advisor made a "recommendation" as defined by the Rule? If there's no recommendation, then there's no investment advice, and since, as noted, investment advice is one of the three elements of ERISA section 3(21)(A)(ii), an advisor's communication will not make it a fiduciary subject to the Rule.

So how does the Rule define a "recommendation"?

A "recommendation" is a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion (some have termed this a "call to action") that a recipient of the investment advice should engage in, or refrain from taking, a particular course of action. (A "recipient of investment advice" is defined as a plan, plan fiduciary or plan participant or beneficiary, IRA or IRA owner.)

The following four kinds of communication are each defined by the Rule as a "recommendation":

1. The advisability of acquiring, holding, disposing of, or exchanging investment property;

2. How investment property should be invested after the property is rolled over, transferred, or distributed from a plan or IRA;

3. The management of investment property, including recommendations on investment policies, strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, or types of investment account arrangements (e.g., brokerage account vs. advisory account); or

4. Whether, in what amount, in what form, or to what destination a rollover, transfer, or distribution from a plan or IRA should be made.

Note that the test of whether a particular communication rises to the level of a "recommendation" is whether a reasonable person--not the recipient of the advice--will view the communication as being a recommendation.

The more individually tailored the communication is to the specific recipient of the advice, the more likely it will be judged to be a recommendation.

A series of actions may comprise a recommendation in the aggregate; it's possible, though, that if viewed individually, they would not.

It doesn't matter if a communication is initiated by a human being or a computer software program such as a robo-advisor.

An advisor's "hire me" communication in a marketing scenario will not be deemed a recommendation; that's true, though, if an advisor describes only its services and fees. If the advisor adds to that description by, for example, suggesting to an IRA owner that a particular product, investment, or platform should be used, then that leaves the realm of a "hire me" communication and enters that of a recommendation.

An advisor's suggestion to select other persons to provide advice is a recommendation.

When an advisor provides a Rule-defined recommendation, it rises to the level of "investment advice" but only when the advisor delivers it in one of the three following contexts:

1. By representing or acknowledging that it's acting as a fiduciary under ERISA or the Internal Revenue Code in rendering investment advice; or

2. By rendering investment advice with a written (or unwritten) understanding that it's based on particular investment needs of a specific advice recipient(s); or

3. By directing investment advice to a specific advice recipient(s) about the advisability of a particular investment decision or recommendation.

Element 3: Compensation

We're still not out of the woods yet. In fact, no fiduciary investment advice will be deemed to be rendered if no fee or other compensation is given in exchange for it. So it's important to see how the Rule broadens the definition of "fee or other compensation":

> Any explicit fee or compensation for the advice received by a person (or an affiliate) from any source; or

> Any fee or compensation received from any source in connection with, or as a result of, the recommended purchase or sale of a security or the provision of investment advice services.

Examples of fees or compensation include--but are not limited to--commissions, loads, finder's fees, revenue-sharing payments, shareholder servicing fees, marketing or distribution fees, underwriting compensation, payments to brokerage firms in return for shelf space, recruitment compensation paid in connection with transfers of accounts to a registered representative's new broker-dealer firm, gifts and gratuities, and expense reimbursements.

A fee or compensation is paid "in connection with, or as a result of" investment advice if the fee or compensation would not have been paid but for the recommended transaction or advisory service, or if eligibility for, or the amount of, the fee or compensation is based in whole or in part on the transaction or service.

An Analytical Framework to Determine If an Advisor Is Subject to the Rule

In order for an advisor to become subject to the Rule in a given situation, as noted, it must be a fiduciary providing investment advice for compensation (ERISA section 3(21)(A)(ii)). Here's an analytical framework that can be used to go about determining that:

Is any one of four different kinds of communication deemed a "recommendation?" If not, an advisor is not subject to the Rule.

If so, is the recommendation delivered by the advisor in one of three different contexts? If not, an advisor is not subject to the Rule.

If so, is the recommendation deemed "investment advice?" If not, an advisor is not subject to the Rule.

If so, is the investment advice rendered in exchange for "a fee or other compensation?" If not, an advisor is not subject to the Rule.

If so, "fiduciary" status is conferred on the advisor.

Wait, not so fast. If the recommendation is a safe harbor exception/exclusion designated in the Rule, it's not considered investment advice. And if there's no investment advice, one of the three elements of ERISA section 3(21)(A)(ii) is lacking. In that case, the Rule will not apply to an advisor.