The legal standards for broker-dealer firms (BDs) and their representatives, particularly in the retirement market, continue to be in flux. BDs were among those most affected by the promulgation in 2016 of the Department of Labor (DOL) fiduciary rule under the Employee Retirement Income Security Act of 1974, as amended (ERISA), which undertook to switch their legal status in the retirement market from securities selling firms (sometimes as principals and sometimes as agents) to unconflicted fiduciary advisers. Thus, BDs are among those most affected by the vacatur of that rule. With the Securities and Exchange Commission (SEC) “best interest” standard of care proposal, however, the regulatory environment continues to evolve.
Consider the overlapping layers of regulation to which BDs would be subject in the retirement market if:
- Regulation BI and Form CRS (Client Relationship Summary), at least structurally, are adopted by the SEC as proposed; and
- By reason of the vacatur of the DOL rule, ERISA regulation reverts as expected to its pre-June 9, 2017 state.
These are both modestly speculative assumptions; the SEC proposal will no doubt be refined prior to any adoption and, other than what may be inferred from its non-enforcement policy, DOL has not yet taken a position on the effect of the vacatur, including whether sub-regulatory guidance rescinded in connection with the new rule was reinstated by the vacatur.
In such an event, however, there would be four bodies of nationally applicable regulation broadly imposing standards of conduct on BDs in the retirement space:
- The federal securities law administered by the SEC;
- The rules of the Financial Industry Regulatory Authority (FINRA);
- The prohibited transaction excise tax provision of the Internal Revenue Code (IRC); and
- The fiduciary standards and prohibited transaction rules of ERISA enforced by the DOL.
For present purposes, we leave aside the emerging state law changes to the standard of care for BDs, on the basis that those changes are not yet sufficiently developed.
Because each of these bodies of national regulation would undertake in varying yet cumulative ways to address conflicted interests on the part of BDs—recall that the FINRA suitability rule originated as a measure for managing compensation-related conflicts—in the aggregate they would form a deep and meaningful complex of protections for retirement investors.
- The SEC and FINRA standards would be in scope by reason of the status of the BD—as an SEC-registered BD and FINRA member—and apply on the basis of the nature of services provided, the type of investment under consideration, and the type of compensation received.
- The IRC and ERISA standards would be in scope by reason of the status of the customer—a retirement investor—and apply on the basis of the nature of services provided (in a manner that differs from that of the securities laws, and in particular whether the BD or representative is acting as a fiduciary under the reinstated ERISA five-part definition), the type of retirement customer (plan sponsor or other fiduciary, plan participant or beneficiary, or IRA owner), and the type of compensation received.
The following chart summarizes the applicability of these standards of conduct to common circumstances in which BDs provide more than execution services to retirement investors.
Assume, for example, that a BD representative (i) assists a 401(k) plan participant/retirement investor with the allocation of her account balance among non-proprietary mutual funds available through the plan’s self-directed brokerage window, in a manner that constitutes a recommendation under FINRA rules and fiduciary investment advice under the 5-part definition for purposes of the IRC and ERISA, and (ii) is compensated on a traditional commission basis for that assistance. In these circumstances, which exemplify the most heavily regulated fact pattern, the recommendation would need to comply with all of the following:
- The ERISA and IRC service provider “reasonable contract” exemption—notably, that the participant can terminate the arrangement on reasonably short notice without penalty and the commissions are no more than “reasonable compensation” for the services provided.
- The SEC anti-fraud standard—i.e., that the BD and its representative not make false or misleading statements about the recommended transaction.
- The FINRA duty of fair dealing—i.e., that the BD and its representative deal fairly with the retirement investor.
- The FINRA KYC standard—i.e., that the BD knows essential facts about the retirement investor to effectively service her account.
- The FINRA suitability standard—i.e., that the BD and its representative have a reasonable basis to believe that the recommendation is suitable for the retirement investor. This standard has three components:
- Reasonable-basis suitability, which requires the BD representative to have “a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. Reasonable diligence must provide the firm or associated person with an understanding of the potential risks and rewards of the recommended security or strategy”;
- Customer-specific suitability, which requires that the representative, based on the particular retirement investor’s investment profile, has “a reasonable basis to believe that the recommendation is suitable” for that investor based on her profile; and
- Quantitative suitability, which requires a representative with control over a retirement investor’s account to have “a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, is not excessive and unsuitable for the [retirement investor] when taken together in light of [her] investment profile”.4
- The Regulation BI standard of conduct—i.e., that the BD or the BD representative acts in the best interest of the retirement investor without placing the financial or other interest of the BD or BD representative ahead of her interest. Under the proposal, this standard would be satisfied if:
- At the time the recommendation is made, the BD or its representative reasonably discloses to the retirement investor, in writing, the material facts relating to the scope of the brokerage relationship, including all material conflicts of interest that are associated with the securities recommendation;
- In making the recommendation, the BD or its representative exercises reasonable care to ensure that the recommendation (i) could be in the best interest of at least some retail customers, (ii) is in the best interest of a particular retirement investor based on her investment profile, and (iii) is not excessive and is in the retirement investor’s best interest when taken together as a series of recommended transactions; and
- The BD establishes and maintains written policies and procedures to identify and disclose, or eliminate, material conflicts of interest associated with a recommendation. Firms are required to establish procedures to identify, disclose, and mitigate (or eliminate) material conflicts of interest arising from financial incentives associated with the recommendation.
- The ERISA fiduciary standard of conduct—i.e., that the representative discharges his duties to the retirement investor:
- “Solely in the interest” of the retirement investor;
- For the “exclusive purpose” of providing benefits to the retirement investor and defraying expenses;
- “With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man 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”; and
- “By diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.”5
- Because the commissions would be treated under the ERISA and IRC rules as raising prohibited conflicts for the BD representative as a fiduciary, compliance with an applicable prohibited transaction exemption approved by Congress or DOL (rather than disclosure and mitigation as such) would also be necessary. In these circumstances, the specifically applicable exemption is Prohibited Transaction Exemption (PTE) 75-1, Part II(2) for non-proprietary mutual fund transactions—which notably requires that:
- The BD customarily engages in principal transactions (in form, an anachronism from the 1970s that is still extant in the exemption); and
- The transaction is as favorable to the retirement investor as an arm’s-length transaction.
Alternatively, pursuant to DOL’s non-enforcement policy, the BD could rely on the transition relief in the vacated Best Interest Contract Exemption (BICE) until further guidance is issued6—i.e., that:
- The BD firm and representative provide an investment recommendation 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 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 firm, representative, affiliated or related parties, or any other person;
- The recommended transaction does not cause the BD, the BD representative, or affiliated or related parties to receive direct or indirect compensation in excess of “reasonable compensation”; and
- Statements by the BD and its representative to the retirement investor about “the recommended transaction, fees and compensation, Material Conflicts of Interest, and any other matter relevant to a Retirement Investor’s investment decisions, are not materially misleading at the time they are made.”7
By way of disclosures, the retirement investor would receive at a minimum a Client Relationship Summary (Form CRS) from the BD, and access to conflicts disclosures from the BD and selling compensation disclosures in mutual fund prospectuses.8
That is, restated cumulatively, the BD and BD representative would be subject to all the following responsibilities:
- ERISA/IRC service provider “reasonable contract” requirements
- ERISA/IRC transactional prohibited transaction rules and PTE conditions
- FINRA fair dealing standard
- Client Relationship Summary
- Regulation BI conflicts disclosure
- SEC duty not to make false or misleading statements
Duty of Loyalty
- ERISA “solely in the interest” and “exclusive purpose” standards
- ERISA/IRC conflict of interest prohibited transaction rules and PTE conditions
- Regulation BI conflicts mitigation standard
Standard of Care
- ERISA prudence and diversification standards
- Regulation BI “best interest” standard
- FINRA reasonable basis, customer-specific and quantitative suitability standards
- FINRA KYC standard
The “best interest” lily would be well and truly gilded.
- If comparable assistance was provided to an IRA owner, all the same regulatory requirements would apply other than the ERISA fiduciary standard.
- If instead the assistance was provided to a plan sponsor, the Regulation BI and Form CRS requirements would no longer apply, but the ERISA fiduciary standard would (assuming fiduciary investment advice), as would the ERISA § 408(b)(2) disclosure requirement (in lieu of Form CRS).
- And in the event the investments in question are not securities, the body of law regulating those investments would apply, rather than the securities laws.
- In the case of annuity products, standards of conduct under insurance law could apply rather than SEC or FINRA standards (in the case of fixed annuities) or in addition to SEC and FINRA standards (in the case of variable annuities).
- Thus, in the example above, if the mutual funds were being purchased through a variable annuity contract to secure longevity or other insurance guarantees, the BD representative’s recommendation would also need to satisfy the standards of conduct for variable annuity sales under FINRA rules or as applicable under state insurance law.
- If the retirement investor was a senior, additional “sales to seniors” protections would also come into play.