B.I.C.E.: Financial Advisors Beware
By Ron
A. Rhoades, JD, CFP®
As of
the date of this writing, the future of the DOL “Fiduciary Rule” remains
unclear. Judicial challenges remain, and the Trump administration has not yet (explicitly) expressed its view on whether the rule will be delayed and/or eventually repealed (and how long that will
take). Many broker-dealer and dual registrant firms have already spent millions
to comply with the rule – but are they choosing the right path for compliance?
Some
broker-dealer firms
– both wirehouses (e.g., Merrill Lynch, etc.) and IBDs – will choose not to use
the DOL’s Best Interests Contract Exemption (B.I.C.E.) and will move their
clients (to the extent not grandfathered) to fee-based accounts. Yet, other
broker-dealer firms will embrace B.I.C.E., which contains a proverbial
minefield of traps for both firms and their financial advisors.
What
does this mean for financial advisors in those firms that utilize B.I.C.E.? Here
are my insights and legal analysis. I question why any financial advisor would
want to use B.I.C.E., given the likelihood of significant reputational damage that
would result.
The U.S. Department of Labor issued its final
“Conflict of Interest” (“C.O.I.”) regulation in April 2016, with the effective
date of its core provisions on April 10, 2017. Under the C.O.I. regulation,
fiduciary status is imposed on nearly everyone providing investment
recommendations to ERISA-covered plan sponsors and plan participants, as well
as to owners of IRA accounts, Keogh plan accounts and health savings accounts.
While prohibited transaction exemptions (PTEs) (including the B.I.C.E. permit
the receipt of third-party compensation, as a practical matter firms – and
their advisors – should transition to fee-based accounts. Anything less will
result in significant reputational risk to advisors, as well as substantially
increased litigation risk to both firms and advisors.
The
237 words of the impartial conduct standards
B.I.C.E. permits commissions, 12b-1 fees and
other third-party compensation to be paid to broker-dealer firms. Much
attention has been focused on the voluminous disclosures required under
B.I.C.E.; some firms may wrongly believe that they can conduct “business as
usual” simply by providing these disclosures. However, the core of the DOL’s
rules are found in the 237 words that comprise the Impartial Conduct Standards.
These sStandards impose strict fiduciary duties of loyalty and due care upon
firms and advisors, require the receipt of only reasonable compensation, and
prohibit misleading statements. And, these Impartial Conduct Standards also
apply to recommendations of proprietary funds, principal trades and fixed-index
annuities.
B.I.C.E. imposes upon both
firms and their advisors an extremely strong fiduciary duty of “loyalty” that cannot be disclaimed by the firm or
advisor, nor waived by the client
Under B.I.C.E. and its Impartial Conduct Standards, recommendations
must be given to clients “without regard to the financial or other interests of
the Adviser, Financial Institution or any Affiliate, Related Entity, or other
party.”
“[F]or example, an advisor, in choosing between two investments, could not
select an investment because it is better for the advisor’s or financial institution’s
bottom line ….”
Moreover, neither the firm nor advisor may seek to limit its liability by
disclaiming their core fiduciary duty or loyalty, nor may the firm seek to have
the client waive the fiduciary duties owed to the client.
The
DOL’s strong fiduciary duty of due care is further rooted in the “prudent investor
rule,” which includes the duty to not waste the client’s assets
The Impartial Conduct Standards also incorporate,
as part of a firm’s and advisor’s fiduciary duty of due care, the tough
“prudent investor rule” (PIR).
The PIR has a decades-long history of interpretation, as it is the core of a
trustee’s duty to manage investment under trust law, and it is codified in most
states as a version of the Uniform Prudent Investor Act. The PIR requires the advisor
to manage risk across the investor’s portfolio, and to consider the risk and
return objectives of the portfolio in making decisions. The duties to diversify
investments and to avoid idiosyncratic risk are emphasized, in keeping with the
findings of modern portfolio theory.
Additionally, under the PIRPIR, the firm and advisor
possess a duty avoid waste. In other words, there exists a duty to minimize the costs incurred by the client
when determining which investment products to select. “[F]iduciaries …
ordinarily have a duty to seek … the lowest level of risk and cost for a
particular level of expected return.” In the particular
context of mutual funds and other pooled investment vehicles, advisors must pay
“special attention” to “sales charges, compensation, and other costs” and
should “make careful overall cost comparisons, particularly among similar
products of a specific type being considered for a … portfolio.”
Put simply, “[w]asting [clients’] money
is imprudent.”
The PIR’s duties to avoid idiosyncratic risk and
to avoid waste of the client’s assets bring into doubt the efficacy of several
programs already announced by certain firms. For example, an IRA platform for
smaller clients consisting only of individual stocks and bonds may render it
impossible for an advisor to minimize idiosyncratic risk.
The PIR also poses huge challenges to the use of
expensive funds and annuity products, where less expensive alternatives are
available. For example, a broker-dealer platform or program in which the
financial advisor is confined to the use of higher-cost mutual funds or
variable annuities would likely run afoul of the fiduciary’s duty to avoid
waste of the client assets, especially where similar lower-cost investments
were available in the marketplace. While the use of very-low-total-cost index
funds and index ETFs is not explicitly required by the rule, their utilization
is certainly implicitly favored and should be viewed as one step that could be
taken along the path toward risk reduction for the firm and its advisors.
Academic research has not ruled out the
utilization of all active management strategies. However, the research is
compelling that high-cost actively
managed funds should be avoided by advisors operating under the fiduciary duty
of prudence, given the consistent inverse relationship between investment
product fees and investor returns. Further research on the ability of
very-low-cost actively managed funds to beat appropriately chosen benchmarks is
desired, as the current research is insufficient to either support or undermine
their utilization.
When
providing advice to an account under the DOL Rules, it is far more likely that
the entire relationship will be deemed to be one of trust and confidence,
applying state common law
In private litigation and arbitration, firms and advisors
are normally sued not only for breach of contract, but also under state common
law for breach of fiduciary duty. In such proceedings broker-dealer firms and
their advisors usually deny the existence of fiduciary status. However, when
the prudent investor rule is imposed upon one portion of a client’s portfolio,
other portions of the portfolio should also be managed prudently given the
fiduciary’s duty to consider the client’s other investments and assets.
When fiduciary duties are applicable
contractually under B.I.C.E. for the management of IRA accounts, then it more
likely that common law fiduciary status will be found to exist for the entirety
of the advisor’s relationship with the client – including but not limited to
the IRA account and other brokerage and investment advisory accounts upon which
advice is provided. In other words, a court or arbitrator is more likely to
find that a relationship of trust and confidence exists for non-qualified
accounts when fiduciary duties are already imposed upon qualified accounts
managed by the advisor.
Under
state common law, the receipt of additional compensation by a firm or advisor
is a breach of fiduciary duty, which requires proof that the client is not
harmed
Given the higher likelihood of fiduciary status
under state common law, methods to comply with state common law fiduciary
duties should be reviewed.
The preferred method of complying with one’s
fiduciary duty of loyalty under state common law is to seek, in advance of any
investment recommendations, the client’s agreement to a reasonable “level fee”
arrangement (i.e.,
the fee is independent of the product sold to the client).
Such fee structures include asset-under-management fees, annual fixed fees,
project-based fixed fees, hourly fees, subscription fees, and combinations
thereof. After securing the client’s agreement on fees, the advisor should not
recommend any investment product that would provide the advisor with additional
compensation, absent an agreement to offset other fees the advisor receives.
This is because, under state common law, a “fiduciary who receives compensation
from an entity whose investment products the fiduciary recommends presumptively
breaches the duty of loyalty … [T]he common law … tolerates authorized
conflicts of interests, provided that the [advisor] acts fairly and in good
faith in pursuit of the beneficiary’s best interest.”
Once the burden of proof and/or persuasion shifts
from the client to the firm and advisor, proof must be offered that the client
was not harmed by the receipt of the additional compensation by the firm. As
discussed below, given at additional compensation necessarily is paid by
product providers from product fees, and that higher product fees on average
lead to lower returns for investors, especially over the long term, this is a
difficult burden of proof to meet.
The
“careful scrutiny” of additional fees received by a firm under B.I.C.E.
Unlike ERISA’s statutory “sole interests”
fiduciary standard (where conflicts of interest are prohibited), under
B.I.C.E.’s “best interests” standard a conflict of interest is permitted to
exist. Yet, when additional fees are received by a firm then the conduct of the
firm and advisor “will be subject to especially careful scrutiny.”
The DOL’s Impartial Conduct Standards do permit
“differential compensation” between “reasonably designed investment categories”
to financial advisors based upon “neutral factors” tied to the services
delivered to the client.
The DOL provided the example that a difference in compensation to the advisor
could be based upon the “time and analysis necessary to provide prudent advice
with respect to different types of investments.”
Self-dealing
and the receipt of additional fees from product providers: the impact of the
prudent investor rule and academic research
As indicated above, the receipt by of third-party
compensation is likely to be closely scrutinized under B.I.C.E. This is
especially true when additional compensation is received by a broker-dealer
firm, such as through 12b-1 fees, payment for shelf space and other forms of
revenue sharing and/or marketing reimbursements, as this amounts to a form of
self-dealing.
If additional fees and costs are received from
the recommendation of a particular investment, such additional compensation is
necessarily derived from the product’s costs. And here’s the rub … the academic
research is strong and compelling – higher product fees and costs result, on
average, in lower returns for investors.
Hence, under B.I.C.E. the test for receipt of
additional compensation is a tough one. “[A]n Adviser, in choosing between two
investments, could not select an investment because it is better for the
Adviser’s or Financial Institution’s bottom line, even though it is a worse
choice for the Retirement Investor.”
Furthermore, under B.I.C.E. “full disclosure is not a defense to making an
imprudent recommendation or favoring one’s own interests at the Retirement
Investor’s expense.”
“Commissions
are better for investors”? Not so fast!
Some financial advisors might argue that mutual
fund A share classes are better for investors, as the client does not need to
pay ongoing fees – just an upfront commission. Leaving aside for a minute that
most class A shares still impose a 0.25% or less annual 12b-1 fee, the impact
of the sales commission is often understated.
A 5.75% sales charge requires a mutual fund to
earn a 1.20% greater annual return (assuming a hypothetical 10% level return of
the fund), if the fund is held for five years. If held for 10 years, the impact
of the sales charge falls to 0.59% annually. If held for 15 years, the impact
falls to 0.43%. But, here’s the rub – according to the Investment Company
Institute the average holding period for stock mutual funds is only four years,
and for bond mutual funds only three years. With these average holding periods
a 5.75% sales charge translates into an annual fee well above 1.2% a year.
In addition, the application of Modern Portfolio
Theory often leads to the need to rebalance a client’s investment portfolio.
And, if the financial advisor just deals with mutual fund A share classes, it
may very well occur that the advisor would recommend that some of the shares of
a fund purchased by a client just a few months or few years before would need
to be sold for rebalancing purposes. In essence, commission-based compensation
is inconsistent with the application of Modern Portfolio Theory.
Some financial advisors will still argue that
breakpoint discounts on mutual fund A share class commissions will
significantly lower the commissions paid. Yet, in hundreds and hundreds of
investment portfolios I’ve reviewed, implemented by brokers, nearly 90% of them
appeared to be structured to avoid breakpoint discounts by spreading out
investments among funds from different fund companies. Under a fiduciary
standard the level of scrutiny intensifies, and it would be hard for brokers to
justify such a practice given the prudent investor rule’s duty to avoid the
waste of client assets. Financial advisors who operate under a fiduciary
standard will have to justify any action that negates breakpoint discounts;
given the existence of the conflict of interest in connection with breakpoint
discounts, the burden of proof and persuasion falls upon the financial advisor,
not the client. Subjective “good faith” is insufficient to meet this burden, as
the actions of the financial advisor are judged under an objective standard.
Lastly, the comparison of “sales commission” to
“1% annual fee” is often comparing apples to oranges. When a mutual fund A share
class is sold, the broker has no duty to continue to monitor the portfolio.
(However, several courts has found that, in situations when trailing
compensation exists and continued advice is provided to the investor, fiduciary
status existed under state common law, which included an ongoing duty.)
In contrast, investment advisors who charge 1% annual fees often provide a
large amount of ongoing financial planning and investment advice. And, of
course, many investment advisors charge less than 1%, particularly on larger
accounts.
‘Relying
on 12b-1 fees? Don’t!
In 2010 the U.S. Securities and Exchange
Commission (SEC) held hearings on whether 12b-1 fees should be continued. While
no action was taken by the SEC at that time, since then various SEC officials
have indicated that 12b-1 fees remain under review.
Even before the enactment of Rule 12b-1 the SEC
had generally opposed the use of fund assets
for the purpose of financing the distribution of mutual fund shares, noting
that "existing shareholders of a fund often derive little or no benefit
from the sale of new shares."
Given the substantial evidence that investors fail to understand 12b-1 fees,
their uncompetitive nature (as they generally cannot be negotiated), and the
indefinite continuation of 12b-1 fees in many instances even if the client no
longer desires ongoing investment advice, it is likely that 12b-1 fees will be
repealed at some future date.
The Manner of compensation is much more suspect than the amount of compensation
The DOL’s Impartial Conduct Standards set forth the existing
requirement that the both the firm and advisor receive no more than “reasonable
compensation.” As a
result of this standard, firms will likely benchmark their services and fees
against those of other firms in order to ensure that the total fees paid by the
client to the firm are not excessive.
Yet, as Tim Hauser, the Deputy Assistant Secretary for Program Operations of
EBSA at the DOL, explained at the Financial Planning Association's national conference in the Fall of 2016, it is very
difficult for a plaintiff’s attorney or an agency to prevail on allegations of
unreasonable compensation.
The courts generally defer to the parties to negotiate fees, provided the
negotiation occurs in an arms’-length bargaining and not as a result of
self-dealing by a fiduciary, in order that courts not get involved in
rate-setting.
B.I.C.E. can result in a
misalignment of the interests of the firm and those of its advisors, for the
firm can receive more compensation while the advisor’s compensation generally
must not vary
Under B.I.C.E. the firm may receive additional compensation from the
recommendation of particular products, but the firm must adopt policies and
procedures to ensure that individual advisors do not receive differential
compensation, bonuses, or awards “to the extent they are intended to or would
reasonably be expected to cause Advisers to make recommendations that are not
in the Best Interest of the Retirement Investor.”
In other words, while firms can receive additional compensation for the
recommendation of certain products, the advisor must not receive any portion of
such additional compensation. The distinction between compensation received by
the firm, versus those received by the advisor, results in a significant
disconnect between the interests of the firm and the interests of the advisor.
It is possible under B.I.C.E. to pay advisors additional compensation
when a more complex product, that requires additional time to explain, is
provided to a client. But plaintiff’s attorneys will likely question advisors
on the additional time spent to understand more complex products (which time,
in theory, would be allocated among many clients), and to explain the more
complex product to a specific client. These plaintiff’s attorneys will likely
assert that the amount of additional compensation provided to the advisor could
easily become an improper incentive to the advisor under B.I.C.E., given the
relatively small amount of additional time spent by the advisor with each
individual client.
Over time, the economic
incentives present will result in pressures placed upon advisors by their firms
to not act in the best interests of the client
Where financial products are recommended, due to the vast asymmetry of
information between a financial firm and its clients, incentives exist for the
firm to pass off low-quality goods as higher-quality ones.
Over time, such economic incentives tend to distort a fiduciary’s judgment, as
has often been recognized by the courts.
For example, the U.S. Supreme Court, in discussing conflicts of
interest, stated: “The reason of the rule inhibiting a party who occupies
confidential and fiduciary relations toward another from assuming antagonistic
positions to his principal in matters involving the subject matter of the trust
is sometimes said to rest in a sound public policy, but it also is justified in
a recognition of the authoritative declaration that no man can serve two
masters; and considering that human nature must be dealt with, the rule does
not stop with actual violations of such trust relations, but includes within
its purpose the removal of any temptation to violate them ....”
And, as the U.S. Supreme Court stated 170 years ago, the law “acts not on the
possibility, that, in some cases the sense of duty may prevail over the motive
of self-interest, but it provides against the probability in many cases, and
the danger in all cases, that the dictates of self-interest will exercise a
predominant influence, and supersede that of duty.”
As an eloquent Tennessee jurist put it before the Civil War, the
doctrine that conflicts of interest should be avoided “has its foundation, not
so much in the commission of actual fraud, but in that profound knowledge of
the human heart which dictated that hallowed petition, ‘Lead us not into
temptation, but deliver us from evil,’ and that caused the announcement of the
infallible truth, that ‘a man cannot serve two masters.’”
B.I.C.E. effectively limits the ability of individual advisors to
receive additional compensation. But under B.I.C.E. firms will still possess
the economic incentive to encourage their advisors to promote to clients
investment products that pay the firm (but not the advisor) additional
compensation. Advisors working in firms that utilize B.I.C.E. must confront the
substantial likelihood that their own interests will not align with those of
their firms.
The reputational risk for the
individual advisor is far greater than that of the typical firm
The single most important asset a financial advisor possesses is her
or his personal reputation. Damage to the advisor’s reputation is the greatest
risk individual advisors face today. Such risk is realized should client
complaints, usually triggered by the presence of conflicts of interest, lead to
resolutions that mandate disclosures of settlements or arbitration awards to
current clients of the advisor as well as to future potential clients.
Yet, for the larger financial services firm, reputational risk is far
less consequential. Those firms can more easily mask transgressions via
nondisclosure agreements with claimants during settlements, mandatory
arbitration of individual claims and voluminous documents that are seldom read
by clients. Moreover, a firm’s reputation is more easily repaired via marketing
and promotion, explaining away past transgressions as due to “rogue advisors”
who are no longer with the firm, and the inevitable passage of time that dims
consumer’s memories.
B.I.C.E. requires voluminous,
client-repulsive disclosures
Although much research has revealed the ineffectiveness of disclosures
due to various behavioral biases consumers possess, fiduciary duties generally
impose the burden upon individual advisors to ensure that their clients
understand when a conflict of interest is present, as well as understand the
consequences of such conflict of interest.
Hence, advisors who practice under B.I.C.E. will be confronted with an
affirmative duty to ensure client understanding of disclosures that are both
voluminous and onerous.
In the competition for
clients, firms that use fee-based accounts will possess a huge marketing
advantage over firms that utilize B.I.C.E.
Over the next several years many advisors will see a lot of “money in
motion.” Triggered by changing fee and compensation structures, enhanced disclosures
and the consumer press, clients will increasingly review their relationship
with their current advisor and seek out second opinions.
As the distinctions between firms that utilize B.I.C.E. and those that
don’t become known, the consumer press will steer their readers to firms that
don’t use B.I.C.E. for IRA accounts. Additionally, savvy fee-only firms already
provide questionnaires and checklists for prospective clients to utilize when
shopping for new advisors. These questionnaires highlight the benefits of
compensation structures that are more aligned with client interests.
As studies have demonstrated, the vast majority of consumers prefer
fee-based compensation over commissions. Over the past two decades, more and
more accounts have transitioned from commission-based to fee-based in reaction
to consumer preferences. The DOL’s COI rule only accelerates this trend;
fee-based accounts will rise from perhaps 40% of accounts today to 60% or greater
within a short time.
B.I.C.E. is unlikely to
survive the next decade
In other nations, such as Australia, New Zealand, and England,
regulation has progressed much further, in that commissions paid to financial advisors
for investment management services are largely banned. While these developments
have not yet reached U.S. shores, they are an indication of future policy
changes that may occur.
More important, however, will be the adverse result of firms using
B.I.C.E. Some firms may see the increased cost of doing business under B.I.C.E.
– primarily in the form of increased litigation costs – as just a “cost of
doing business.” As abuses take place, the DOL may well re-evaluate whether
B.I.C.E. is an effective solution. Should the courts set aside the DOL’s
prohibition on the inclusion of clauses in client agreements that negate the
ability of the client to participate in class actions, the DOL may become more concerned
that B.I.C.E.’s remaining enforcement mechanisms are insufficient to deter bad
conduct. As a result, a future administration may seek to sunset B.I.C.E. and
require all financial advisors to utilize level-fee compensation methods.
Avoiding B.I.C.E. is the
“right thing to do”
Finally, the most compelling reason to embrace “level-fee”
compensation and to avoid B.I.C.E. is simply this – to serve the client in the
best manner possible. Firms that embrace level fees, and eschew the receipt of
product-based compensation, will truly act as representatives of the client.
Larger firms will use the collective purchasing power of their advisors
and clients to squeeze asset manager’s compensation, in order to boost the
returns their clients enjoy. These firms may also require annuity and other
product manufacturers to create better and more transparent products.
As a result, products will compete – not on the basis of the amount of
revenue sharing provided to the product’s distributors – but rather on the
basis of each product’s individual merits. The real impact of the DOL’s
Conflict of Interest Rule and its exemptions will be upon asset managers. Some
financial advisors merely need to adjust the manner by which they receive their
compensation.
In conclusion, here is my message to financial advisors
(i.e., dual registrants and registered representatives). B.I.C.E. is a
minefield that will generate a huge number of explosions. Don’t be around when
the minefield starts to erupt. Rather, avoid B.I.C.E. and use a level-fee
methodology. It’s the right thing to do – for the firm, its clients and
especially for you, the financial advisor.
Ron
A. Rhoades, JD, CFP® serves as director of the financial planning program
for Western Kentucky University’s Gordon Ford College of Business. He is an assistant
professor – finance, an attorney, an investment advisor and a frequent writer
on the fiduciary standard as applied to financial services. A frequent speaker
at national and regional conferences, he also serves as a consultant to firms
on the application of the DOL Conflict of Interest Rules, fiduciary law and
related issues. This article represents his views only, and not those of any
institution, firm or organization with whom he may be associated. This article is believed to be correct at the
time it is written; subsequent laws, regulations, and/or developments regarding
the interpretation or enforcement of ERISA, the I.R.C., and DOL regulations
should be consulted. Please direct all questions and requests via email:
Ron.Rhoades@wku.edu.
While the U.S. Department of Labor does not possess
the ability to impose fiduciary standards on non-ERISA, non-IRA accounts,
prudent investor rule experts Max M. Schanzenbach and Robert H. Sitkoff
rightfully conclude that “proper diversification requires an assessment of the
portfolio as a whole, including the other assets of the investor.”
Schanzenbach, Max M. and Sitkoff, Robert H., Financial AdviserAdvisors Can't
Overlook the Prudent Investor Rule (August 1, 2016). Journal of Financial
Planning (August 2016).
81 Fed. Reg. 21,027 (Apr. 8, 2016). However,
“[d]ifferential compensation between categories of investments could be
permissible as long as the compensation structure and lines between categories
were drawn based on neutral factors that were not tied to the Financial
Institution’s own conflicts of interest, such as the time or complexity of the
advisory work, rather than on promoting sales of the most lucrative products.” Id. at 21,037.
See, e.g.,
Western Reserve Life Assurance Company of Ohio vs. Graben, No. 2-05-328-CV
(Tex. App. 6/28/2007) (Tex. App., 2007).
(A dual registrant crossed the line in "holding out" as a
financial advisor, and in stating that ongoing advice would be provided, and
other representations, and in so doing the dual registrant, who sold a variable
annuity, and was found to have formed a relationship of trust and confidence
with the customers to which fiduciary status attached. The court stated:
"Obviously, when a person such as Hutton is acting as a financial advisor,
that role extends well beyond a simple arms'-length business transaction. An
unsophisticated investor is necessarily entrusting his funds to one who is
representing that he will place the funds in a suitable investment and manage
the funds appropriately for the benefit of his investor/entrustor. The
relationship goes well beyond a traditional arms'-length business transaction
that provides 'mutual benefit' for both parties.") See also, e.g., Johnson v. John Hancock Funds, No.
M2005-00356-COA-R3-CV (Tenn. App. 6/30/2006) (Tenn. App., 2006) (in a case
involving sale of Class B mutual fund shares, the court stated: “If the
transaction is non-discretionary and at arm's length, i.e., a simple order to buy or sell a particular stock, the
relationship does not give rise to general fiduciary duties. However, if the
client has requested the broker or advisor to provide investment advice or has
given the broker discretion to select his or her investments, the broker or
advisor assumes broad fiduciary obligations that extend beyond the individual
transactions.) … When a stock broker or financial advisor is providing
financial or investment advice, he or she is required to exercise the utmost
good faith, loyalty, and honesty toward the client.”
See Bearing of Distribution Expenses by
Mutual Funds: Statutory Interpretation, Investment Company Act Release No. 9915
(Aug. 31, 1977) [42 FR 44810 (Sept. 7, 1977)] (quoting SEC, Future Structure of the Securities Markets (Feb. 2,
1972) [37 FR 5286 (Mar. 14, 1972)]).
See, e.g. Brock v.
Robbins,
830 F.2d 640 (7th Cir. 1987).
