The Proposed Best Interest Contract Exemption: Part 2

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: The Proposed Best Interest Contract Exemption: Part 2 Law360, New York (July 27, 2015, 11:29 AM ET) -- This article is part two of a three-part series exploring the operational challenges that broker-dealers could encounter if the U.S. Department of Labor s proposed best interest contract exemption (proposal or BIC exemption)[1] is adopted in the form proposed. Part one followed Alice through the looking glass[2] into a world that has adopted the BIC exemption as proposed, and compared the proposal s fee and cost disclosure requirements to those currently applicable to broker-dealers. This article continues the journey on the other side of the looking glass and focuses on the construction of a retirement investment platform, including investment selection and compensation arrangements, that would meet the proposal s requirements. Maintenance of Investment Platform Susan Krawczyk Broker-dealer guidance acknowledges that broker-dealers may maintain a "menu" or platform of investments (e.g., a mutual fund, variable annuity, exchange traded fund or real estate investment trust, herein, products or investment products ), but does not require that a broker-dealer do so, nor does it prescribe any standards for the composition of an investment menu or platform. Thus, broker-dealers have considerable latitude in selecting the investments they offer or make available to their clients. Broker-dealers can limit their platforms to proprietary products (those products issued or sponsored by affiliates) or to limited product lines, such as mutual funds and variable insurance contracts. Indeed, under the terms of their Financial Industry Regulatory Authority membership agreements, broker-dealers may be permitted to engage in only limited lines of business. Moreover, broker-dealers routinely consider a number of operational and economic factors when vetting an investment product for their platforms, such as the wholesaling support and ease of doing business with the investment product sponsor, as well as the overall compensation arrangements, including broker training and education support and assistance. In comparison, the proposal effectively requires a financial institution to maintain an investment menu for retirement investors that will provide a "range," such as a menu or platform, of assets that is broad enough to enable its advisers to make recommendations with respect to all of the asset classes reasonably necessary to serve the best interests (discussed below) of the retirement investor

2 suggesting that a financial institution should seek out investments to round out its platform if its range of assets is not sufficiently broad. [3] In this context, the proposal lists 13 different types of assets: bank deposits, certificates of deposits, registered investment companies, bank collective funds, insurance company separate accounts, exchange-traded real estate investment trusts ("REITs"), exchange-traded funds, U.S. Securities and Exchange Commission-registered corporate bonds, governmental agency debt securities, U.S. Department of Treasury securities, insurance and annuity contracts, guaranteed investment contracts and equity securities that are traded on a securities exchange.[4] Asset is defined in the BIC exemption as a synonym for investment product, and the proposal uses the term investment option interchangeably with asset. It is uncertain, though, whether the DOL intended to require a financial institution to provide a broad array of different types of investment products, or instead intended to refer to classes of their underlying investments, such as equities, fixed income, cash equivalents, commodities or real estate. The proposal expresses the view that an adviser should be able to make recommendations with respect to all of the asset classes reasonably necessary to serve the best interests of the retirement investor.[5] According to the proposal, the DOL decided to limit the applicability of the BIC exemption to common investments that are relatively transparent and liquid, and have a ready market price. Of note, the covered assets include investment products that can be purchased only in the context of a securities offering (e.g., registered investment companies and insurance company separate accounts), as well as those that are traded on an exchange (exchange-traded REITs, exchange-traded funds and equity securities). Also, the covered assets do not include nontraded REITs, business development companies, nontraded direct participation programs or privately offered investments. If a financial institution limits the assets on its platform for retirement investors based on whether the assets are proprietary products, generate third-party payments (defined to include sales charges, Section 12b-1 fees and other payments by a third party) or for other reasons, the financial institution could still rely on the BIC exemption, but only if four conditions are met: (1) the financial institution makes a specific written finding that the limitations so imposed do not prevent the adviser from providing advice that is in the best interest of the retirement investor; (2) any compensation received in connection with an asset is reasonable in relation to the value of the specific services provided to the retirement investor in exchange for the payment and not in excess of the services fair market value; (3) before an investment recommendation is given, the retirement investor is given written notice of the limits placed on the assets; and (4) the adviser notifies the retirement investor if the adviser (notably, not the financial institution) does not recommend a sufficiently broad range of assets to meet the retirement investor s needs.[6] The proposal does not elaborate on the circumstances surrounding the giving of the notice, such as whether it could be included in the customer account agreement (to be discussed in part three of this series) or with the point-of-sale asset cost information (discussed in part one of this series). Investment Selection Review Process Broker-dealer regulatory guidance relating to the selection of investments to be offered to customers generally appears in the context of FINRA notices discussing best practices for reviewing new products and complex products. This guidance generally encourages broker-dealers to adopt written policies and procedures for their new product review process, and to consider numerous factors, such as product complexity, costs, risks, broker training, tax and operational requirements in determining whether or

3 not to approve or condition the product for sale by their brokers. This guidance recognizes that a broker-dealer could approve a particular investment only for certain types of accounts (e.g., those with a speculative investment objective), or for offering by only certain qualified brokers (e.g., seasoned brokers). In comparison, the proposal appears to contemplate that assets would be selected as potential investments for retirement investors only if the financial institution makes the determination that the investment will serve the best interest of the retirement investor. Best interest, in turn, is defined as investment advice that is reflective of care, skill, prudence and diligence under circumstances then prevailing that a prudent person would exercise based on investment objectives, risk tolerance, financial circumstances and needs of the retirement investor, without regard to the financial or other interests of the adviser, financial institution, affiliate, related entity or other party.[7] This description of best interest appears to outline the factors for determining whether an investment should be selected for a retirement investment platform. While at first it might appear that a broker-dealer could use its new product review process to select investments for its retirement investment platform, the factors considered in that process may not fully align with the considerations identified in the best interest definition. For example, existing new product review procedures may include minimum compensation requirements, and such requirements might be deemed inconsistent with the best interest definition in the BIC exemption. Standards for Broker-Dealer Compensation The federal securities laws, FINRA rules and, to some extent, state securities rules impose fair and reasonable standards and in certain cases explicit limits on broker-dealer compensation. These standards appear in FINRA rules governing member firm participation in public securities offerings, as well as rules governing fair prices, commissions and markups for securities transactions. Moreover, in the context of securities offerings (as noted above, several of the assets can be purchased only in a securities offering), broker-dealer compensation is typically paid by or negotiated with the issuer, rather than the investor, and is evaluated with reference in part to the services provided to the issuer in carrying out the distribution of the securities offering. Further, the securities may be available for purchase only through those broker-dealers that are members of the selling group or syndicate for the offering. In comparison, the contractual impartial conduct standards mandated by the BIC exemption would prohibit the recommendation of an asset that provides for total compensation to be received by the financial institution, adviser, affiliates and related entities that would exceed reasonable compensation for total services provided to the retirement investor.[8] ( Affiliate includes control affiliates and any corporation or partnership in which an adviser is an officer, director or employee or in which the adviser is a partner; it thus could include a broker s outside business activity. Related entity is defined as an entity other than an affiliate in which the adviser or financial institution has an interest which may affect the exercise of its best judgment as a fiduciary.[9] A related entity could include a broker s outside business activity.) Also, if the financial institution offers a limited range of retirement investments, the compensation received by the financial institution must be reasonable in relation to the value of the specific services provided to the retirement investor in exchange for the payments and not in excess of the services fair market value.[10] The proposal does not outline any factors indicative of reasonable or excessive compensation, nor does it elaborate on what would be considered services provided to the retirement

4 investor, or the difference between total services and specific services provided to the retirement investor. More importantly, there is no suggestion that compensation deemed to be reasonable for purposes of standards applied under FINRA rules would be considered reasonable for purposes of the BIC exemption. Adviser Compensation With a few exceptions, broker-dealer rules generally do not impose standards on compensation for brokers. The exceptions include provisions in FINRA rules for certain public securities offerings imposing restrictions on brokers receipt of noncash compensation. These restrictions generally require any noncash incentive arrangements to use total production and equal weighting concepts, which FINRA believes will limit the impact of noncash sales incentives at point of sale. Existing rules do not prohibit cash incentives or bonuses, but FINRA has identified this practice as a potential conflict of interest that firms should manage. Also, since the 1995 publication of the report of the SEC-appointed Committee on Compensation Practices, sometimes referred to as the Tully Report, broker-dealers have been encouraged to use compensation schedules for their brokers that level out compensation for proprietary and nonproprietary products (e.g., same percentage of gross dealer concession, or GDC). In comparison, the contractual warranties mandated by the proposal (to be discussed in part three) would prohibit the use of quotas, appraisals, bonuses, awards, differential compensation or incentives if they would tend to encourage advisers to make recommendations not in the best interest of a retirement investor.[11] The proposal notes several examples of compensation structures that would comply with the warranty, such as a level-fee structure in which compensation for advisers would not vary based on the particular investment product recommended, asset-based compensation and fee offsets. (Notably, the proposal does not refer to the FINRA noncash compensation rules or total production/equal weighting concepts as a way to satisfy the requirement.) The proposal also notes that the form or amount of compensation would not matter if an adviser makes recommendations in accordance with an unbiased computer model created by an independent third party. While the proposal does not explicitly require a financial institution to adopt policies and procedures relating to adviser compensation (the reference to policies and procedures is expressed in the context of material conflicts of interest), the proposal presumes that a financial institution will have them, and identifies the following measures as components of effective policies and procedures relating to an adviser s compensation : avoiding compensation thresholds that enable an adviser to increase his or her compensation disproportionately through an incremental increase in sales; monitoring adviser activity when approaching compensation thresholds, such as higher payout percentages, back-end bonuses or participation in a recognition club, such as a president s club; refraining from providing higher compensation or other rewards for the sale of proprietary products or products for which the firm has entered into revenue-sharing arrangements; and stringently monitoring recommendations around key liquidity events in the investor s life cycle where the recommendation is particularly significant.[12] In light of this guidance, a broker-dealer might decide to exclude transactions in retirement investor accounts from incentive or bonus programs offered to its brokers in order to comply with the warranty. Doing so, though, could run afoul of total production requirements imposed by FINRA rules for noncash incentive compensation, absent relief or clarification from FINRA. Part three will discuss conflicts of interest, customer account agreements, recommendations and other

5 compliance elements of the proposal. By Susan Krawczyk, Sutherland Asbill & Brennan LLP Susan Krawczyk is a partner in Sutherland Asbill & Brennan's Washington, D.C., office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] Proposed Best Interest Contract Exemption, 80 Fed. Reg et seq. (April 20, 2015) (DOL Release). [2] Lewis Carroll (Charles Lutwidge Dodgson), Through the Looking-Glass: And What Alice Found There (London. MacMillan & Co. 1871). [3] Section IV(a) of the proposed BIC exemption. [4] Section VIII(c) of the proposed BIC exemption. [5] DOL Release at [6] Section IV(b) of the proposed BIC exemption. [7] Section II(c) of the proposed BIC exemption. [8] Section II(c)(2) of the proposed BIC exemption. [9] Section VIII of the proposed BIC exemption. [10] Section IV(b) of the proposed BIC exemption. [11] Section II(c)(4) of the proposed BIC exemption. [12] DOL Release at All Content , Portfolio Media, Inc.