DOL Compliance for Broker-Dealers and RIAs: Investment Advice, 408(b)(2) and Fiduciary Status

There are three primary initiatives being introduced by the DOL that will significantly impact the way broker-dealers, RIAs and their representatives conduct their ERISA and IRA business.

Investment Advice: Plan Participants and IRAs

First, the DOL introduced it’s proposed regulation affecting the provision of investment advice to participants of self-directed individual account plans and IRAs on March 2, 2010. The regulation essentially sets forth two exemptions from the prohibited transaction rules of ERISA and the Internal Revenue Code (the “Code”) that prohibit investment advice fiduciaries from recommending investments that could increase their compensation or the compensation of an affiliate (e.g., broker-dealer, investment managers, etc.). The comment period will end on May 5, 2010, and the DOL is expected to finalize the regulation by October.

Registered representatives or investment advisory representatives who are affiliated with product manufacturers or other entities that may receive un-level compensation based upon the investments selected by participants may now provide investment advice so long as they meet the conditions of the exemption (e.g., level-compensation at the RIA and producer level, eligible arrangement, disclosures and annual audit; or certified computer model, disclosures and annual audit). The regulation is also expected to highlight the prohibited nature of existing conflicted advice arrangements. The latter is a primary concern for broker-dealers, as un-level 12b-1 fees coupled with ongoing advice (whether rendered inadvertently or otherwise), for example, will give rise to a prohibited transaction under both ERISA and the Code. Other potential areas of exposure may include choice of share classes in IRAs, revenue sharing arrangements, inadequate policies and procedures to detect and prevent prohibited transactions, gaps in errors and omissions coverage for fiduciary services, etc. While the advice regulation is not expected to be effective until 2011, we recommend that, at a minimum, affected firms begin to conduct risk assessments of current policies and begin formulating a strategy to ensure future compliance.

Fee Disclosure and Reasonable Contracts under ERISA 408(b)(2)

On March 3, 2010, the DOL has sent its interim final regulation amending ERISA section 408(b)(2). Under this regulation, it will be a prohibited transaction to contract for services that do not meet the criteria of the regulation. This regulation is expected to significantly affect broker-dealers, as for the first time, registered representatives will be required to execute written agreements with their plan sponsor clients. The agreements are required to contain: a description of the specific services to be provided (i.e., investment advice, plan design, participant education, etc.); a statement as to whether the services give rise to fiduciary status under ERISA and/or the Investment Advisers Act of 1940; disclosure of all direct and indirect compensation; disclosure of all potential and actual conflicts of interest; and policies and procedures designed to address such conflicts.

Given that many registered representatives receive ongoing compensation from investment providers in the form of un-level 12b-1 fees, for example, broker-dealers are at risk for potential prohibited transactions unless they can prove that their representatives are not providing investment advice at the plan or participant level. Additionally, ERISA requires plan sponsors to manage plan investments prudently. If they do not have the requisite expertise, they are required to hire it. Many plans look to registered representatives to recommend investments, and to the extent the new agreements are silent or expressly prohibit the rendering of investment advice, plan sponsors will be forced to look elsewhere for advice providers. Lastly, many plan sponsors will be surprised to learn the nature and extent of the compensation paid to their adviser out of the participants’ investments. Plan sponsors that thought they were, or in fact were, receiving investment advice from their representative will likely look to the representative to explain their value proposition in light of the perceived or actual reduction in services. We are working with many broker-dealers to develop and deploy strategies that will seek to retain and attract these arrangements by utilizing the services of remote advice providers while simultaneously creating programs to add value through participant education with a focus on retirement readiness and the tracking of participant success measurements.

Based upon this experience, as well as that in preparing our clients for the initial 408(b)(2) regulation, which was set to become effective in January 2009, we have found that many firms require significant time to adopt and implement the necessary operational and organizational changes. For example, we found that many BD/RIAs had problems identifying the accounts that would be subject to the regulation. In many cases, profit sharing plans, for example, were not coded as subject to ERISA and appeared to be individual brokerage or advisory accounts. This issue is problematic, as non-compliance with the written agreement, disclosure and delivery requirements will result in the arrangement being a prohibited transaction - and can lead to disgorgement, excise taxes, personal liability, etc.

With regard to disclosure, the regulation requires the service provider (brokers and advisers) to deliver a disclosure document along with the written agreement to the responsible plan fiduciary (the individual(s) having the authority to enter into agreements on behalf of the plan) sufficiently in advance such that he/she can determine whether the arrangement is reasonable - both with respect to compensation as well as conflicts of interest. We found that most firms had difficulty obtaining the information required to be disclosed (revenue sharing arrangements, proprietary products, affiliated parties in interest, etc.) - particularly broker-dealers, as there is no existing equivalent to the Form ADV Part II. Moreover, in addition to disclosing all potential and actual conflicts, the regulation requires the disclosures to specify the firm's procedures designed to address those conflicts. Identifying, implementing, communicating and testing such procedures is also time consuming and presented challenges for our clients.

In light of the foregoing and our belief that the regulations will be issued in roughly the same form as previously published, we recommend that firms begin formulating action plans to address the following issues:

1. Identifying all accounts that are subject to the regulations;

2. Determining the scope of services to be offered (i.e., fiduciary vs. non-fiduciary, investment advice vs. education);

3. Reconciling those services with existing errors and omissions coverage;

4. Conducting due diligence on and narrowing the list of "approved" service providers (recordkeepers, TPAs, etc.);

5. Examining compensation arrangements (for ERISA and IRA accounts), including solicitor and referral payments, and developing procedures to meet the level compensation requirements;

6. Implementing procedures to address "cross-selling" and capturing of IRA rollovers from qualified plans (an area in which the DOL has expressed concern and vowed to increase enforcement efforts); and

7. Considering solutions to outsource fiduciary services (plan and participant-level investment advice) and redefining value proposition in light of revised services (i.e., emphasis on retirement readiness, education, participation and contributions).

Expansion of the Definition of Fiduciary

The DOL has also announced its plan to introduce a proposal to redefine the test for fiduciary status under ERISA by July. While the goal of this initiative is to capture the activities of pension consultants (that traditionally services large plans), which may have escaped the definition in the past, it is expected to also capture the activities of registered representatives (that traditionally service the small plan market). While we have yet to see a draft of the proposal, we are working with our broker-dealer clients to anticipant and adapt to the expected challenges of a broader definition of fiduciary status.