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Let the Fiduciary Wrestling Match Begin--Again

The DOL and SEC should both take notice of a long-standing judicial reluctance to 'dumb down' fiduciary standards.

W. Scott Simon, 04/07/2011

Have a comment, insight, or burning opinion on this article? Make your feelings known in the comments section at the end of the article.

Item 1: Back when yours truly was a young pup politico-in-training in Washington, D.C., our gaggle of (unpaid) interns and (low-paid) employees would descend after work on receptions hosted by trade association lobbyists held in various congressional hearing rooms on Capitol Hill. Those receptions always featured good food, which we eagerly turned into our dinner, given our impecunious condition. We weren't exactly feeding at the public trough--the food was paid for by the lobbyists--but I sometimes grimace at the thought of all the deductions taken for that food, which, of course, reduced the taxes that would have otherwise flowed to the national treasury. We all agreed that one lobbying group stood head and shoulders above all others in the taste and quality (and therefore expense) of the food that it served at its receptions. For me, one food that this group served was, by far, head and shoulders above all others: baby lamb chops. Folks, I love lamb, and those chops were truly in a class by themselves. I couldn't get enough of them. Think Dan Aykroyd in Trading Places as the inebriated Santa Claus at the office Christmas party where he attempts to stuff an entire salmon into the pocket of his red suit. I'd like to say that I didn't actually smuggle out any of those sublime lamb chops in my pockets, but I must confess it's certainly possible that I did.

Item 2: Footnote 44 of my book, The Prudent Investor Act: A Guide to Understanding, reads, in part: "An SEC Release entitled 'Certain Broker-Dealers Deemed Not To Be Investment Advisers' [i.e., the Merrill Lynch Rule] proposes that financial consultants employed by major brokerage firms such as Merrill Lynch [who receive asset-based advisory fees] be exempt from registration under the Investment Advisers Act of 1940. This would allow such consultants to avoid the more stringent legal and professional obligations that are otherwise imposed on a 'Registered Investment Adviser...' The Financial Planning Association...has been vociferous in opposing this exemption. Rather than opposing the exemption, perhaps the FPA should embrace it and turn it into a marketing opportunity for its...RIA membership. In a highly competitive environment, RIAs may want to emphasize that they have to meet stringent standards of fiduciary conduct while advisors at large brokerage firms don't." (The Merrill Lynch Rule was struck down by the U.S. Court of Appeals for the District of Columbia Circuit in 2007.)

More on these two items in next month's column.

A fiduciary wrestling match is now taking place between those doing business in the qualified retirement plan marketplace, and the Department of Labor (DOL) as well as the Securities and Exchange Commission (SEC). On Jan. 21, the staff of the SEC issued two reports as required by the Dodd-Frank Act, one of which examined whether broker/dealers (B/D) should be subjected to the "best interest" fiduciary standard of conduct under the Investment Advisers Act of 1940 ('40 Act) when providing personalized investment advice about securities to their retail customers. (One commentator--Ron Rhoades--is precise in pointing out that Congress never, via the Dodd-Frank Act, authorized the SEC staff to study whether B/Ds should be subjected to a "uniform" or "harmonized" fiduciary standard of conduct. Rather, the study topic assigned was whether B/Ds should be subjected, when dealing with the retail accounts of their customers, to the best interest fiduciary standard of conduct under the '40 Act.)

The conduct of RIAs and their investment adviser representatives is governed legally by the '40 Act, which requires them to adhere to a best interest fiduciary standard of conduct. The SEC is the regulatory body governing larger RIAs, while state securities administrators oversee smaller RIAs. The conduct of B/Ds, in contrast, is governed legally by the Securities Exchange Act of 1934 ('34 Act). Under rules adopted by the Financial Industry Regulatory Authority (FINRA), the self-regulatory organization (SRO) for B/Ds, B/Ds and their registered representatives must adhere to a number of specific rules including those relating to suitability. Both RIAs and B/Ds may also be subject to fiduciary duties arising under state common law, which generally applies broad fiduciary duties of care and loyalty upon those providing financial and investment advice when they're in a relationship of trust and confidence with their clients.

In addition to the study issued by the SEC staff in January, the Department of Labor (DOL) proposed a new regulation in 2010 that changes the definition of "fiduciary advice" and, in so doing, changes the definition of a "fiduciary" under section 3(21) of the Employee Retirement Income Security Act (ERISA) with respect to qualified retirement plans such as 401(k) plans. ERISA generally imposes the "sole interest" fiduciary standard of conduct and also applies "prohibited transaction" rules, any one of which doesn't apply when a specific exemption has been granted to it by the DOL.

A lot of ink has been spilled over the years discussing the many ins and outs of the varying standards of fiduciary conduct and whether (or how) non-fiduciaries such as B/Ds, insurance agents and benefits brokers could (or should) be governed by any of these standards when interacting in certain ways with qualified retirement plans. It's plain to see, though, from the DOL's proposed regulation that the battle has already been fought--and lost--by those who are advocates of providing qualified retirement plans with truly impartial fiduciary investment advice. As under the existing regulation, non-fiduciaries under the proposed regulation will be permitted to have meaningful interactions with ERISA-governed retirement plans despite the inherent conflicts in the suitability standard (or no standard) they are required to adhere to and the resultant business model they follow. A one-page document issued as a "Fact Sheet" by the DOL's Employee Benefits Security Administration (EBSA) on March 30 succinctly clarifies this. It's time well spent to review an edited portion of it.

The EBSA March 30 Fact Sheet

Definition of the Term "Fiduciary"
The Employee Retirement Income Security Act (ERISA) requires plan fiduciaries to act prudently and solely in the interest of the plan's participants and beneficiaries, prohibits self-dealing, and provides judicial remedies when violations of these standards cause harm to plans. In enacting ERISA, Congress recognized that the security of America's employee benefit plans depends on their fiduciaries. The Employee Benefits Security Administration (EBSA) has proposed a rule to recast an existing regulation to better reflect relationships between investment advisers and their employee benefit clients.

-- EBSA is responsible for administering and enforcing the fiduciary, reporting, and disclosure provisions of Title I of ERISA.
-- ...ERISA defines a plan fiduciary to include anyone who gives investment advice for a fee or other compensation with respect to any moneys or other property of a plan, or has any authority or responsibility to do so.
--In 1975, the Department issued a 5-part regulatory test for "investment advice" that gave a very narrow meaning to this term. Under the regulation, before a person can be held to ERISA's fiduciary standards with respect to their advice, they must (1) make recommendations on investing in, purchasing or selling securities or other property, or give advice as to their value (2) on a regular basis (3) pursuant to a mutual understanding that the advice (4) will serve as a primary basis for investment decisions, and (5) will be individualized to the particular needs of the plan. An investment adviser is not treated as a fiduciary unless each of the five elements of this test is satisfied for each instance of advice.

--...EBSA believes it is time to re-examine the types of advisory relationships that give rise to fiduciary duties and to update the rigid 1975 regulation so that plan fiduciaries, participants and IRA holders receive the impartiality they expect when they rely on their adviser's expertise.

Overview of Proposed Rule
A person gives fiduciary investment advice if, for a direct or indirect fee, he or she ...

Provides the requisite type of advice:

--Recommendations on investing in, purchasing, holding, or selling securities; or
--Recommendations as to the management of securities or other property;

And meets one of the following conditions:

--Represents to a plan, participant or beneficiary that the individual is acting as an ERISA fiduciary;
--Is already an ERISA fiduciary to the plan by virtue of having any control over the management or disposition of plan assets, or by having discretionary authority over the administration of the plan;
--Is an investment adviser under the Investment Advisers Act of 1940; or
--Provides the advice pursuant to an agreement or understanding that the advice may be considered in connection with investment or management decisions with respect to plan assets and will be individualized to the needs of the plan.

Limitations recognizing that certain activities should not result in fiduciary status:

--Persons who do not represent themselves to be ERISA fiduciaries, and who make it clear to the plan that they are acting for a purchaser/seller on the opposite side of the transaction from the plan rather than providing impartial advice...
--Persons who market investment option platforms to 401(k) plan fiduciaries on a non-individualized basis and disclose in writing that they are not providing impartial advice..PAGEBREAK.

Some Observations About the EBSA March 30 Fact Sheet

--It's useful to note at the outset that the DOL is responsible for administering and enforcing the fiduciary provisions of the great "sole interest" and "exclusive purpose" rules of ERISA section 404(a) found in Title I, the heart and soul of ERISA.

--The EBSA seeks, as a goal of its proposed rule, to ensure that retirement plan fiduciaries and participants receive impartial investment advice from their advisors. Yet the delivery of impartial advice within a product-sales-driven business model followed by B/Ds is very difficult at best. Commissions in themselves, while not prohibited under fiduciary law, create an inherent conflict of interest. When commissions can "vary"--that is, when an advisor can receive higher compensation for the sale of one product vis-à-vis another product--the conflict of interest rises to such a level that challenges to the conduct of the advisor become inevitable. In addition, the broad array of variable compensation received by B/Ds and their affiliates from product manufacturers--payment for shelf space, 12b-1 fees, and soft dollar payments (i.e., artificially higher commissions paid in exchange for "research")--all create additional hurdles that are unlikely to be overcome when applying the sole interest standard of conduct as well as the various prohibited transaction rules of ERISA. The problem of "proprietary" products is even more challenging. In a time when there are thousands upon thousands of mutual funds and ETFs, how is it possible for a broker to say with a straight face that the relatively few funds manufactured by his or her firm (or an affiliate) are better than the many others--often available at far lower total fees and costs--which are available in the marketplace?

--The duty to monitor is a core function of a fiduciary that provides ongoing investment advisory services. B/Ds and others that are compensated through a transactional-based sales model are not trained to think of providing service after the sale of a product. In a transactional relationship, B/Ds make money from trades, not through ongoing services or through a monitoring duty. (I was once an expert witness in a case involving an insurance agent; he literally could not comprehend the concept of having any ongoing duty to a customer after the sale of a product.)

--Despite all the talk from B/Ds that the fiduciary standard of conduct must adapt to today's (i.e., their) business environment, it seems, instead, that we should insist that business practices actually conform to the law. Many judges over the centuries have refused to permit enactment of "particular exceptions" to the fiduciary standard of conduct. The DOL and SEC should both take notice of this long-standing reluctance to "dumb down" fiduciary standards. In addition, it's unwise in this day and age to compromise the protections of investors on behalf of financially and politically powerful segments of the retirement plan marketplace unwilling to place the needs of plan participants (and their beneficiaries) first. As I've said often in this column, B/Ds and their brethren just don't want to be fiduciaries and--so far--they have had the financial and political muscle to back that up, which unfortunately has subjected millions of plan participants (and their beneficiaries) to the bad effects of their business practices.

--Attempting to bootstrap the B/D business model--one based on product sales and "arms-length" relationships--into the fiduciary model--one based on the provision of ongoing advice in a trusted advisor-client relationship--is like trying to fit a square peg into a round hole. We can only hope that DOL/EBSA will recognize such inherent difficulties and not attempt to reconcile these fundamentally incompatible kinds of relationships by weakening the applicable fiduciary standard of conduct found in the '40 Act and in ERISA.

More observations will be offered about the EBSA March 30 Fact Sheet in next month's column.

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W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing.

Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals.

For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.

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