How Well Do You Know Your B/D?

Do you really know how your broker/dealer makes money? If not, it’s time to learn before a Department of Labor (DOL) investigator knocks on your door.

Plan sponsors and advisers should be well informed of broker/dealers’ compensation, particularly because of 408(b)(2) fee disclosure, which one source says is prompting more DOL investigations.

For example, 12b-1 fees a broker/dealer receives should be disclosed up front and used for specific purposes or they are prohibited transactions, and the recent disclosures developed by broker/dealers may not include all appropriate information. A 12b-1 fee is paid by a mutual fund out of fund assets to cover certain expenses. This is why it is vital for sponsors and advisers to research their broker/dealers and ask important questions regarding their compensation.

The DOL and the Securities and Exchange Commission (SEC) are cracking down on companies failing to fully disclose 12b-1 fees and revenue-sharing agreements. “The job just got a lot easier for these investigators [because of 408(b)(2)],” Jason Roberts, chief executive of Pension Resource Institute and managing partner at Roberts Elliott LLP, told PLANADVISER. With 408(b)(2) disclosure information, the DOL has essentially “thrown [sponsors] a bone” because the written disclosure makes it even easier to detect a problem.

Two such cases have come to light in the past several weeks: An investigation by the Department of Labor’s Employee Benefits Security Administration (EBSA) found that Glastonbury, Connecticut-based USI Advisors made investments in mutual funds on behalf of Employee Retirement Income Security Act (ERISA)-covered defined benefit plan clients and received 12b-1 fees from those funds. (See “USI Advisors Settles DOL Suit Over Fees.”)

USI Advisors failed to fully disclose the receipt of the 12b-1 fees, and failed to use those fees for the benefit of the plans either by directly crediting the amounts to the plans or by offsetting other fees the plans would be obligated to pay the company.   

On September 6, the SEC instituted a settled administrative proceeding against two Portland, Oregon-based investment advisory firms and their owner regarding the failure to disclose a revenue-sharing agreement and other potential conflicts of interest to clients.



The USI case created a sort of script for DOL investigators, so plan sponsors and advisers must ensure they know answers to key questions about their broker/dealers. “In my mind … this is not going to be the only case like that,” Roberts said, adding that he has seen an increase in investigations of broker/dealers and their registered representatives.

Under the new Consultant Advisor Project (CAP), for example, potential conflicts uncovered in a routine plan investigation are providing DOL investigators a gateway into the programs, products and policies used by broker/dealers, he added.

The scope of the DOL’s requests for documents and information is “quite broad,” Roberts said, and many stem from routine investigations of plan sponsors.

Roberts emphasized three questions plan advisers and sponsors must know the answer to with regard to their broker/dealers:

1. Do you service, as an ERISA fiduciary, any plans that transact through a broker/dealer?

2. If so, do you understand, and can you describe, all forms of compensation received by the broker/dealer (e.g. markups, bank or money market sweep revenue, revenue sharing, 12b-1 fees)?

3. Have all forms of broker/dealer compensation been disclosed in 408(b)(2) statements?

Plan sponsors who do not know the answer to these questions can be held personally liable, should an investigation arise, because not knowing this foundational information means the plan sponsor has failed to prudently select a provider and thus failed to comply with both 408(b)(2) and 404(a)(5) (participant fee disclosure).



Broker/Dealer Investigations  

The requests coming to broker/dealers are also exposing gaps in compliance and supervisory procedures that may result in ERISA violations, Roberts said. “Some of the firms that developed their disclosures internally or with the help of less-experienced ERISA counsel, for example, have failed to report the full extent and or sufficiently identify the source of direct and indirect compensation,” he added.

Prohibited transaction exemptions like PTE 86-128, which allows broker/dealers to make a reasonable profit on executing trades recommended by an affiliated investment advisory representative (IAR)/registered investment adviser (RIA), are often misunderstood or not considered, Roberts said.

While this PTE requires specific authorization for the ERISA-covered client and ongoing reporting, once properly explained, it tends to be the preferred method versus offsetting against the advisory fee or engaging in systemic prohibited transactions, he said.

A number of procedural safeguards are available to broker/dealers, but Roberts said they tend to be underutilized because many firms do not employ in-house ERISA legal or compliance experts. “To properly evaluate a broker/dealer’s exposure under ERISA, one needs to incorporate securities laws and regulations, and have a thorough understanding of the products that are sold or serviced,” he added.

If red flags are discovered that suggest gaps in a firm’s ERISA compliance, a DOL investigator may refer the matter to CAP and initiate an investigation of the broker/dealer, Roberts cautioned. “In my experience, few firms have policies for responding to DOL requests, which can result in incomplete productions,” he added.

If the DOL senses a “scramble” or lack of understanding by the broker/dealer personnel, they may look for things outside of the scope of the initial request, he said.