PLANADVISER - January/February 2019 - 49

ERISA vista
'Reg BI' and
Dual Registrants
Advisory and 12b-1 fees may not be combined
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
In the final analysis, under
Reg BI, an adviser will need
to make best interest
investment recommendations
to retail investors.
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.
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