Author Archives: Jonathan Levy, J.D.

Department of Labor Fiduciary Rule, End of the World or No Big Deal*

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Jonathan Levy, J.D.

Unless you have been living in a cave, you have probably heard that on April 6, 2016, the Department of Labor (“DOL”) announced that investment professionals that provide investment services to IRA’s and other employer-sponsored retirement plans will be subject to fiduciary duties.  This event has been described as the coming of the apocalypse by the brokerage industry, or about time by investment advisers because these folks have always been subject to fiduciary duties.

Suitability vs Fiduciary

Prior to the effectiveness of the DOL’s action, investment professionals that provide advice to IRAs are not subject to ERISA’s prohibited transaction rules.  This means that broker-dealers and their registered representatives are subject to a suitability standard under FINRA rules.  Suitability essentially requires that the investment professional have a reasonable basis to believe that a recommended investment strategy is suitable for a client based on information available to the investment professional through reasonable diligence.  A fiduciary standard generally requires that the investment professional put the client’s interests first, act with utmost good faith, provide full and fair disclosure of material facts, avoid misleading clients, and disclose conflicts of interest.

Conflicted Advice

The DOL claims that investment firms not subject to a fiduciary standard steer IRA clients into investment products that have higher fees and lower returns.  The DOL alleges that these conflicts of interest cost $17 billion a year, and result in a 100 basis point lower annual average return.  The DOL claims that $1.7 trillion of IRA assets are invested in products that provide payments to investment professionals that generate conflicts of interest.  What the DOL is focused on are traditional securities brokerage commissions, revenue sharing with plan administrators, front-end loads, 12b-1 fees and other payments to brokerage firms for IRA asset management.

Best Interest Contract Exception

In response to the very loud complaints and political influence from the brokerage industry, the DOL adopted a special exception for fees to broker-dealers.  Under the Best Interest Contract Exemption or BICE, brokers can advise IRAs and receive revenue sharing, 12b-1 fees, brokerage commissions and even sell proprietary products managed by the broker, if the broker-dealer commits to putting client’s interests first, adopts certain anti-conflict of interest policies and procedures, and discloses conflicts that could affect the broker’s judgment as a fiduciary.

IRA Beneficiaries Can Bring Claims; Effectiveness

Finally, the new DOL rules permit IRA and other retirement plan beneficiaries to bring private causes of action or claims against investment professionals that violate the new rules.

Because these rules will require significant and expensive changes in the documentation and compliance policies of many large broker-dealers and their registered representatives, there is a long period of time before the rules take effect.  The new fiduciary standard is scheduled to take effect in approximately one year, and the BICE provisions will go into effect in January 2018.  But stay tuned, the brokerage industry is still complaining, and Congress has threatened to act against the rules.  Certain players in the brokerage industry have also threatened to try to block the new rules in court.

Why the Big Fuss?

What is the big fight really about?  As usual for big policy debates, it is about money, lots and lots of money.  With the baby boomer generation retiring there is a lot of retirement money to be managed in IRAs.  According to the Investment Company Institute’s 2015 Fact Book, as of the end of 2014, employer-sponsored retirement plan assets in the United States were approximately $24.7 trillion.  Of that sum, $14.2 trillion consisted of defined contribution and IRA assets, with the remainder in defined benefit plans.  Over the past fifteen years, the total assets in retirement plans have increased significantly, and the share of assets in defined contribution and IRAs has continued to grow as defined benefit plans continue to shrink.  IRA assets have grown from $4.7 trillion to $7.4 trillion in the past seven years, with mutual funds by far the largest asset class of IRA assets.  For the next 14 years, approximately 10,000 baby boomers will turn 65 every day.  There is a lot of money to be made on investment management of those assets  and therefore a lot of stakeholders are fighting about these new rules.  To be continued….

 

* Jonathan Levy is a securities lawyer at Lindquist & Vennum LLP, and is a member of the Board of Directors of the Minnesota CFA Society.

SEC Examination 2014 Priorities

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What Compliance Officers Should Expect from SEC Exams in 2014

If there is one thing that keeps compliance officers up at night, it is that dreaded message from the SEC, “We have decided to conduct an examination of your firm, and please do not treat this as an adversarial proceeding, rather we are here trying to learn about your firm, and we are here to help.” Hardly comforting given the many recent referrals from Enforcement, and the fact that Enforcement lawyers now routinely accompany SEC examiners to on-site inspections.

Recently, the SEC published its 2014 Examination Priorities giving broker-dealers and advisers guidance on areas of concern.

Examination Priorities for Both Brokers and Advisers

System-wide, the SEC will continue to focus on policies around fraud detection and prevention, corporate governance including the control environment and “tone at the top”, conflicts of interest, enterprise risk management, technology and supervision of IT systems.  The SEC will closely examine dual registrants and incentives to firms when customers choose to open accounts at dual registrants as an advisory client or brokerage client. The SEC also will scrutinize how advisers and brokers are addressing new laws and regulations, and sales and marketing practices related to retirement products such as IRAs and 401(k) plans. These broad areas affect nearly every adviser and broker-dealer, and all firms should be prepared for an SEC exam in these areas.

Examination Priorities Specifically for Investment Advisers and Investment Companies

Adviser Core Risks

Still stung by the failure to detect Madoff, for advisers, the SEC will continue to examine custody of client assets and compliance with the custody rules, paying particular attention to advisers that fail to realize that they have custody through non-conventional methods such as check-writing authority or powers of attorney.

Another core risk for advisers is conflicts of interest in business practices such as best execution, soft dollars, and agency/principal transactions. Examiners will scrutinize undisclosed compensation arrangements, allocation of investment opportunities, controls and disclosure when an adviser manages both performance-based accounts and traditional fee accounts, valuation of illiquid securities and higher risk products that are sold to retail and elderly investors. The SEC will review the accuracy of advisers’ performance advertising. Advisers that have wrap-fee programs should expect a review of fiduciary duties and controls to monitor wrap fee conflicts of interest, best execution and trading away from the wrap sponsor. Finally, the SEC will continue to review disclosure and compliance issues related to payments by advisers to distributors, solicitors and other intermediaries.

Areas of Focus for New Advisers Including Hedge Fund and Private Equity Fund Managers

New advisers that have not been examined in the last three years, including hedge and private equity fund managers, should expect a visit from the SEC in 2014. The SEC plans to look closely at new advisers’ marketing and sales practices, portfolio management including compensation methodologies, conflicts of interest and safety of client assets, and valuation particularly with respect to hard-to-value illiquid securities and their relationship to portfolio manager compensation.

Increasingly Aggressive Examinations

There is little doubt that the market and regulatory failures of the Great Recession has led to increasingly aggressive and skeptical examinations by the SEC. This creates compliance and reputational risks for firms. The 2014 exam priorities, although quite extensive, nevertheless provide a helpful guide for compliance professionals in determining where to devote finite compliance resources.

The CFA’s Code of Ethics and Standards of Professional Conduct May Be More Influential than You Think

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Jonathan Levy, J.D.

As you know, CFA members and candidates, must follow the CFA’s Code of Ethics and observe the Standards of Professional Conduct. These rules set a high standard of conduct that sets CFA members apart from other participants in the capital markets. Recent scandals in the financial services industry support the notion that CFA membership reflects a higher calling.

Code of Ethics

Among other things, the Code of Ethics requires that members act with integrity, competence, diligence, and respect,  Members must act ethically to the public, clients, employers, colleagues and other participants in the capital markets.

Standards of Professional Conduct

The Standards of Professional Conduct set specific behavioral requirements on professionalism, integrity, and discharging duties to clients,  employers, and the Institute. Members must comply with laws and regulations, and exercise independence and objectivity. For capital markets, members are of course prohibited from insider trading, tipping and market manipulation. Members must exercise duties of loyalty, fair dealing, and suitability. Members must present performance data accurately and preserve client confidentiality. Members also owe duties of loyalty to employers, and may not accept benefits that might create conflicts of interest. Members must be diligent, independent and thorough in making investment recommendations, and have a reasonable basis for recommendations supported by research. Members owe disclosure duties to clients and must retain records to support investment recommendations. Conflicts of interest must be disclosed fully, fairly, and prominently.  Transactions for clients must take priority over member’s own transactions. Finally, members may not engage in conduct that harms the reputation or integrity of the Institute including avoiding misrepresenting or exaggerating the meaning of membership. Continue reading →