Buyer Beware

Do you really know how your broker/dealer (B/D) makes money? If not, it may be 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, industry experts say, will feature prominently in DOL investigations.

For example, any 12b-1 fees a broker/dealer receives should be disclosed upfront as indirect compensation under the rule, and a failure to do so can result in a prohibited transaction. A 12b-1 fee is paid by a mutual fund out of fund assets to cover certain distribution expenses, and such fees are often used to compensate service providers. This is why it is vital for sponsors and advisers to research their broker/dealers and ask important ­questions regarding B/D compensation.

The 408(b)(2) disclosure adds a front-end compliance question for fiduciaries, says Bradford Campbell, counsel at Drinker Biddle & Reath LLP’s Employee Benefits and ­Executive Compensation Practice Group and former assistant secretary of Labor for the Employee Benefits Security Administration (EBSA). Before 408(b)(2), plan sponsors may not have known if their broker/dealers received 12b-1 fees, but now they will be held accountable for receiving the required information and then using it as part of their service provider selection and monitoring process, he says.

Depending on the relationship between the broker/dealer and adviser, the responsibility to disclose 12b-1 fees may be on the adviser even though he is not the one receiving them. “Who[ever] owes the duty to the plan to make the disclosure can depend on the relationship between the adviser, the broker/dealer and the plan,” says Campbell. “We’ve had questions from some of our service provider clients regarding the application of the related-party rules.”

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)],” says Jason Roberts, chief executive of the Pension Resource Institute and managing partner at Roberts Elliott LLP in Los Angeles. With 408(b)(2) disclosure information, he says, the DOL has essentially “thrown [sponsors] a bone” because the written disclosure makes it even easier to detect a problem.

Two such cases have recently come to light: An investigation by 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 (DB) plan clients and received 12b-1 fees from those funds.

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

And, on September 6, 2012, 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’ compensation. “In my mind, this is not going to be the only case like that,” Roberts says, adding that he has seen an increase in ­investigations of broker/dealers and their registered representatives.

Under the new Consultant/Adviser 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, Roberts says. The CAP focuses on the receipt of improper or undisclosed compensation by employee benefit plan consultants and other investment advisers.

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

Three Key Questions

Roberts emphasizes three questions that plan advisers and sponsors must be able to answer in regard to broker/dealers:

1) Do you service, as an ERISA ^­fiduciary, any plans that transact through a broker/dealer? If so, you must pay attention to the next two questions.

 2) 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 and 12b-1 fees)?

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

Plan sponsors unable to answer these questions can be held personally liable should an investigation arise, because ignorance of this foundational information means the sponsor has failed to select a provider prudently and thus failed to comply with both 408(b)(2) and 404(a)(5), or participant fee disclosure.

The requests coming to broker/dealers are also exposing gaps in compliance and supervisory ­procedures that may result in ERISA violations, Roberts says. “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 says.

Prohibited-transaction ­exemptions (PTEs) such as PTE 86-128, which allows broker/dealers to make a reasonable profit on executing trades recommended by an affiliated investment advisory representative (IAR) or registered investment adviser (RIA), are often misunderstood or overlooked, Roberts says.

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 says.

A number of procedural safeguards are available to broker/dealers, but Roberts says they tend to be underutilized because many firms have no 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 says.

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

If the DOL senses a “scramble” or lack of understanding by the broker/dealer personnel, it may also look for violations outside the scope of the initial request, Roberts says.