'Reg BI' and Dual Registrants

Art by Tim Bower

ADVISER QUESTION: I am a “dual-hatted” adviser—i.e., a registrant broker/dealer (B/D)/registered investment adviser (RIA). I primarily act as an investment adviser representative (IAR). When acting as an IAR, I can recommend mutual funds to investors that will pay 12b-1 fees to my broker/dealer, and I am paid 80% of those fees personally. How will the SEC [Securities and Exchange Commission]’s proposed Regulation Best Interest affect that arrangement?

ANSWER: It depends, and we need to consider some additional facts to answer that question.

First, we need to consider whether the investor is a qualified plan or an individual retirement account (IRA). With regard to advice to qualified plans and IRAs, the payment of 12b-1 fees in addition to an advisory fee would be a prohibited transaction if the adviser is an investment advice fiduciary. This is because under both the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC), the adviser may not use his fiduciary authority to cause himself or an affiliate—i.e., the broker/dealer—to receive compensation from a third party, here, the mutual fund.

It is likely that an IAR who provides ongoing advisory services to a qualified plan or an IRA is a fiduciary subject to this prohibited transaction rule. Note, though, that the Department of Labor (DOL) and IRS have issued a temporary nonenforcement policy for prohibited transactions resulting from nondiscretionary investment advice. But there are strings. The adviser must adhere to the DOL’s impartial conduct standards, including the best interest standard of care, which is a combination of the prudent man rule and the duty of loyalty.

It appears that the proposed Regulation Best Interest, or Reg BI, rule—which applies to IRAs but not plans—is similar, if not identical, to the DOL’s best interest standard. Both require that the adviser act with diligence, care, skill and prudence to make recommendations that are based on the needs and circumstances of the investor. That said, Reg BI will not change these results.
Also keep in mind that the temporary nonenforcement policy applies only to nondiscretionary advice. If you have discretion over the investments, that policy is not available and the receipt of the 12b-1 fees is prohibited.

For other types of accounts of retail investors, Reg BI would permit higher compensating mutual funds to be recommended, if the conflicts are disclosed and mitigated. However, the issue is more complicated than it initially appears. The SEC explains that the Reg BI best interest obligation “would make the cost of the security or strategy, and any associated financial incentives, more important factors (of the many factors that should be considered) in understanding and analyzing whether to recommend a security or an investment strategy.”

In other words, cost is a more important factor under the best interest standard than it is under the suitability rules. In explaining the best interest process for evaluating costs, the SEC says the adviser will need to justify recommending a higher-cost investment fund over another, lower-cost alternative that is reasonably available. To do this, the SEC points out that the adviser will need to consider relevant factors about the investment funds under consideration such as each fund’s investment objectives, characteristics—including any special or unusual features—liquidity, risks, potential benefits, volatility and likely performance in a variety of market and economic conditions.

Under this process, the Reg BI best interest standard would require that the adviser recommend the lowest-cost share class of a mutual fund that is available to the investor. In other words, it would be a violation of the Reg BI best interest duty to recommend a more expensive share class of a mutual fund that pays more to the broker/dealer and adviser.

There is a similar issue for different mutual funds that are reasonably similar. It would be a breach of the best interest duty to recommend the more expensive of those funds, unless there were characteristics or other factors that justified the difference in cost.

In the final analysis, under Reg BI, an adviser will need to make best interest recommendations to retail investors.

Fred Reish is chair of the financial services ERISA practice at law firm Drinker Biddle & Reath LLP. A nationally recognized expert in employee benefits law, Reish has written four books and many articles on ERISA, pension plan disputes and audits by the IRS and Department of Labor. Joan Neri is counsel in the firm’s financial services ERISA practice, where she focuses on all aspects of ERISA compliance affecting registered investment advisers and other plan service providers.