Interesting Angles on the DOL's Fiduciary Rule #97

Regulation Best Interest Recommendations by Broker-Dealers: Part 3

This is my 97th article about interesting observations concerning the Department of Labor’s (DOL) fiduciary rule and the SEC’s “best interest” proposals.

In my last two articles—Part 1 and Part 2 on this topic, I discussed the fact that proposed Reg BI and its best interest standard of care for broker-dealers did not apply to all of the recommendations made by broker-dealers. The proposed best interest standard for broker-dealers will apply only to securities transactions recommended to “retail customers.” (Reg BI defines a “retail customer” as “a person, or the legal representative of such person, who . . . uses the recommendation primarily for personal, family, or household purposes.”) I compared that to the SEC’s Interpretation for RIAs, which applies to all advice to all clients. This article gives examples of how the proposals will differ when applied to common scenarios.

Based on the discussions in the Reg BI package, and on my conversations with securities lawyers, the definition of “retail customers” appears to refer to individuals, participants’ accounts in retirement plans, IRAs, custodianships, guardianships, and personal trusts. That’s not meant to be an exhaustive list, but it is meant to point out that it doesn’t appear to apply to business accounts or retirement plans. Frankly, I’m surprised that it doesn’t apply, at the very least, to small businesses and small plans.

Let me explain. Assume that Jim and Joan Smith, a married couple, have been working for a large company, Acme Corporation. However, they decide to leave Acme and to start up “Jim and Joan’s Bakery.” Fortunately, the bakery is successful and their cash flow is strong enough to start a retirement plan for the two of them, who are the only workers at the bakery. Knowing that the company will grow, their advisor (who works for a broker-dealer) recommends that they set up a 401(k) plan and recommends the investments. Those recommendations would not be covered by the Reg BI best interest standard of care.

At the same time, though, the advisor recommends that Jim and Joan take distributions from the Acme 401(k) plan and roll that money into IRAs. Both the rollover recommendation and the recommended IRA investments would be covered by the best interest standard.

Jim and Joan were also participants in the Acme pension plan. The advisor recommends that the pension benefits be withdrawn and rolled to IRAs. It appears that the withdrawal recommendation would not be subject to the best interest standard (because it does not require that Jim and Joan buy, sell or hold any securities), but the recommendations about investing in the rollover IRA would be.

The advisor helps Jim and Joan invest their accounts inside their new 401(k) plan. That would be covered by the best interest standard of care.

As the business becomes more successful, Jim and Joan set up personal accounts with the broker-dealer. Recommendations on those personal accounts would be subject to the best interest standard. But, if they had an account for their business, those recommendations would not be.

The business continues to grow and the advisor recommends that Jim and Joan set up a cash balance plan and assists them in the asset allocation and selection of investments for the plan. That would not be subject to the best interest standard of care.

With the continued success of the business, Joan and Jim decide to have children and the advisor helps them set up 529 accounts for the children’s education. The 529 investments would be subject to the best interest standard.

Confused? You should be. All of the advice in this article was to Jim and Joan. And, Jim and Joan have the same sophistication for evaluating each of the recommendations. Yet, because of the definition of “retail customer,” the duties owed by the advisor and the broker-dealer under the proposed Reg BI bounce around. Ask yourself . . . will the average investor understand which rules apply to which situation? I don’t think so. The burden shouldn’t be on the investor to understand these technical rules. Instead, the rules should be consistent and understandable.

Needless to say, this is my opinion. It doesn’t mean it is right; but it does mean that I’ve thought about it.

POSTSCRIPT: All of the recommendations in this article, when made by an investment adviser (RIA), are covered by the best interest standard. That’s straightforward, consistent and understandable.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.