Are You Observing the DOL's Impartial Conduct Standards for IRA Accounts?

Please be aware ...

(1) The U.S. Department of Labor's rules have only been partially delayed (now, until July 2019).

(2) While changes to the rules are expected before they are fully put into effect, including new or modified "streamlined" exemptions, the "impartial conduct standards" contained in the DOL's various rules are broadly applicable right now.

[NOTE, however, that level fee advisers and ongoing management of IRA accounts are treated differentl. Interestingly, level-fee advisers, as defined by the DOL B.I.C.E., are not bound by the impartial conduct standards for the ongoing management of IRA accounts. They are only governed by the impartial conduct standards during the IRA rollover process. This situation exists because level-fee advisers are not in need of a prohibited transaction exemption for the management of IRA accounts, as a statutory exemption already exists.]

(3) The DOL Rules' contract requirement, warranty requirement, and most of the disclosure obligations are not currently in place, under the recent rule approving an extension of the full rule's application until July 1, 2019.

(4) While the DOL has stated that it will not seek to mandate the prohibition against client waivers of their right to pursue class-action claims as to IRA accounts, individual claims can still be brought. Of course, these claims will end up in FINRA arbitration, for complaints brought against broker-dealer firms and their representatives (including most or nearly all dual registrants).

(5) The claims that can be brought involve breach of fiduciary duty, and specifically for violation of the impartial conduct standards. These are tough standards, as they include the application of the prudent investor rule and its duties to avoid waste of client assets and to minimize idiosyncratic risk.

How, specifically, can the claims be pursued?

The DOL's "Definition of Fiduciary" rule makes nearly all of those providing recommendations to ERISA-covered retirement plans and to IRA accounts "fiduciaries." As a result, fiduciary duties might be breached in these circumstances:

     (A) ADVICE PROVIDED TO PLANS, OR PLAN ACCOUNTS, GOVERNED BY ERISA. When a breach of fiduciary duty exists as to investment recommendations provided upon an ERISA-covered retirement plans, a private right of action exists under ERISA.

     (B) ADVICE ON IRA ROLLOVERS FROM ACCOUNTS GOVERNED BY ERISA. When an adviser provides recommendations regarding a rollover from an ERISA-covered account to another plan's account, or to an IRA account, a private right of action exists under ERISA. This private right of action extends only to the advice regarding the rollover. Since that advice requires a due diligence analysis (and documentation of the cost-benefit analysis so undertaken), which in turn requires a comparison of the investments in the ERISA-covered account with those that would be recommended, it is likely that the implementation of the recommendations immediately following the rollover would be considered part of the rollover process (otherwise the due diligence analysis would be faulty). The IRA rollover due diligence and documentation requirements apply to both "level fee" advisers as well as all other advisers.

     (C) ONGOING MANAGEMENT OF IRA ACCOUNTS: LIABILITY FOR BREACH OF FIDUCIARY DUTY AND/OR BREACH OF CONTRACT UNDER STATE COMMON LAW. For the ongoing management of IRA accounts, as to advisers who are not "level fee advisers" under the Best Interests Contract Exemption (prohibited transaction rule), there exists a "gray area" in the application of the fiduciary standards. There are two major theories, however, upon which fiduciary status can be asserted, and upon which fiduciary liability may rest.

These legal theories exist under "state common law" - i.e., judge-made law. For example, there are few statutes or regulations that set forth a cause of action (claim) for "negligence." Instead, the right to bring a claim for negligence exists as a result of the evolution of law, through judicial decisions, over the centuries. Similarly, the right to bring claims for breach of contract, and for breach of fiduciary obligation, originate in state common law.

And, it should be noted, when arbitration claims are filed against registered representatives and dual registrants in FINRA arbitration, the No. 1 cause of action filed is for breach of fiduciary duty, under state common law.

How does this relate to the DOL's rules?

              1. COMMON LAW FIDUCIARY STATUS LIKELY RESULTS FROM THE "DEFINITION OF FIDUCIARY" DOL RULE. There are reported court decisions in which status as a "fiduciary" under state common law has been found to exist by reason of the firm being a registered investment adviser or the individual individual adviser being an investment adviser representative by application of the Investment Advisers Act of 1940. In essence, because the law "declares" the person subject to registration under the Advisers Act to be a "fiduciary," courts have found that the person has fiduciary status under "state common law" (i.e., judge-made law, developed through the centuries). Sometimes this is a factor in determining fiduciary status - as to when a financial adviser is acting in a "relationship of trust and confidence" with the client. At other times court decisions have more or less (and I paraphrase here) directly proceeded from "you are a fiduciary under the Advisers Act" to "therefore you are a fiduciary under state common law." Not surprisingly, there are not a huge amount of cases in this area (as most complaints head to arbitration, and no court decisions result), and their are some differences among the several state courts that have addressed this issue.

It would be fair to say that, at a minimum, the DOL's imposition of fiduciary standards on those who provide ongoing advice to IRA accounts (and who are not "level fee advisers") makes in much more likely that state common law fiduciary status will be found to exist.

If common law fiduciary status is found to exist for the ongoing management of IRA accounts, then the question arises as to what specific standards exist. For example, is having a "reasonable basis" for the investment decision sufficient, or does the tougher duty of due care found in the prudent investor rule (imposed by the DOL's impartial conduct standards) apply? In this instance, the DOL states that the impartial conduct standards apply. There have been many instances where courts look to federal regulations for determining the standard of care, in a wide range of situations. Accordingly, it is highly likely that the impartial conduct standards would be deemed to apply.

                2. IMPLIED TERM OF AN EXPRESS CONTRACT. The DOL's rules that extend the deadline for full application of B.I.C.E. (and certain other prohibited transaction exemptions, such as portions of 84-24) do not require - during the extension period - that the contract with the client incorporate the impartial conduct standards, contain a fiduciary warranty, nor even acknowledge fiduciary status.

But, it is a long-standing principle of the state common law of contracts that adherence to the law is an implied term of nearly every express contract. (Indeed, a contractual term that obligates one to violate a law would likely be deemed void, as against public policy.)

Hence, fiduciary status may result, and the impartial conduct standards deemed to apply, if courts determine (as seems likely) that compliance with the DOL's impartial conduct standards (which the DOL mandates to so occur, under the extensions) is an implied term of every contract. And that any express term of the contract (e.g., brokerage firm - customer contract) that states otherwise (such as "you agree we are not fiduciaries") would be deemed null and void.


A. Advisers be aware. If you firm is saying to you, "Don't worry" - perhaps you should really be worrying.

In summary, for both ERISA-covered accounts and for rollovers from ERISA-covered accounts to IRA accounts, you are governed by the impartial conduct standards.
And, for IRA accounts, you are highly likely to be a fiduciary. (Time will tell, as these legal theories are tested in arbitration and/or litigation, as claims are brought against advisers and their firms for improper management of IRA accounts. However, I believe it is more likely than not that fiduciary status will be found to exist.)

ADVISERS - DON'T PUT YOUR REPUTATION AT RISK. If your firm continues to do business as before, and does not support full compliance with the DOL fiduciary rule, you are at risk. Firms find it easy to repair their reputations (by blaming actions on "rogue brokers" and via advertising). Advisers' reputations, once tarnished, are seldom brought back to a high degree of luster.

B. Become an expert in applying the impartial conduct standards, including the prudent investor rule.

It begins by understanding your role. As a fiduciary, you are a trusted, expert adviser. You don't sell products to the client. Rather, you act as the representative of the client. (And, please, don't attempt to wear "two hats" - the status as a fiduciary is simply incompatible with the status of a product manufacturer's representative, as many a jurist have opined.)

This means, quite simply, that you represent the client. Any duties you possess to your firm are secondary. (Fiduciary duties are subject to ordering, with the duty of the adviser to the client being paramount to any duties owned by the adviser to the firm.) You are no longer a salesperson. And, you should learn how to comply with the prudent investor rule, and all of its obligations.

While, under B.I.C.E., product-derived compensation is permitted, I would urge caution. The impartial conduct standards still apply, under B.I.C.E. In fact, if additional compensation (such as 12b-1 fees, payment for shelf space, soft dollar compensation, other forms of revenue sharing, etc.) received from recommending certain products are not offset against previously-agreed-upon compensation, I don't believe the impartial conduct standards can be effectively complied with. It is best not to mix product-derived compensation, with your own fees.

Then, comply with the tough prudent investor rule (which is part of the impartial conduct standards). Two main obligations flow from it - the duty to avoid idiosyncratic risk, and the duty to avoid the waste of client assets. (Other duties exist, as well.)

Under the prudent investor rule, you possess a duty to minimize idiosyncratic risk. While the subject of idiosyncratic risk and its minimization is worthy of an entire treatise, this duty relates primarily to the requirement of diversification. Minimization of idiosyncratic risk affects both the selection of an investment strategy (i.e., what asset classes do you include in the investment portfolio, and why), as well as the selection of appropriate investments within each asset class.

Under the prudent investor rule, you also possess the duty to not waste the client's assets. In the world of pooled investment vehicles, such as mutual funds, this means paying close attention to fees and costs. A huge amount of academic research supports the conclusion that higher investment product fees and costs lead to lower returns, especially over the long term. While mutual funds and ETFs provide a means of diversification among individual securities, the fees and costs of such funds deserve intense scrutiny. In essence, as seen in many cases brought against plan sponsors over the past decade, if you have the ability to recommend a lower-fee-and-cost mutual fund or ETF versus a higher-cost mutual fund or ETF, all other things being equal, do so.

Hence, ask yourself - is it time time to "up your game," when you undertake due diligence? Does the investment strategy you are utilizing backed by evidence? Are you minimizing idiosyncratic risk? Do the factors you apply in selecting investment products (to implement your strategy) flow from either common sense or do they possess academic support? Are you examining all of the fees and costs of the fund at hand? Are you comparing the product to all others in the marketplace?

While there have been many statements made by those who promote commissioned-based products that Class A mutual fund shares are "less expensive" for clients than fee-based compensation (i.e., ongoing AUM fees), I believe this debate needs some perspective. First off, the services provided for AUM-based compensation are often vastly different, as they often include ongoing financial planning and an ongoing duty to monitor and manage the investment portfolio. Second, 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. Moreover, Class A mutual fund shares also usually carry with them an ongoing 12b-1 fee, usually of 0.25%. Add this to the 15-year impact of a 5.75% sales load (0.43% a year), and you get 0.68% a year annual fees and costs - getting closer to the average AUM fee used in fee-based investment advisory accounts. In addition, many of the mutual funds that are sold with Class A shares have higher management fees (often due to revenue-sharing arrangements, such as payment for shelf space) and administrative fees than the funds/ETFs recommended by fiduciary investment advisers who are paid only by the client. Other higher costs often exist in funds that are sold on a commission basis - such as payment of soft dollar compensation to the brokerage firms that sell them, and inappropriate diversion of too great a portion of securities lending revenue (although this occurs in many low-fee ETFs, as well).

In addition, the application of Modern Portfolio Theory often leads to the need to rebalance a client’s investment portfolio. (In fact, without rebalancing, idiosyncratic risk may well creep into the 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, I would submit that commission-based compensation appears 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 registered representatives, 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.

[I'm not saying that all advisers who recommend Class A funds engage in this practice. There are many, many fine registered representatives out there, who do their best to "do the right thing" always. But, unfortunately, the lure of additional compensation, and/or simply poor training, results in inappropriate conduct. Economic incentives matter; they often influence, consciously or unconsciously, one's decisions.]

Lastly, if you are using alternative investments, then the degree of due diligence required only increases. Intense due diligence is required. Do you possess the expertise to undertake such due diligence? Have you throughly documented your due diligence efforts?

IN SUMMARY, I urge my colleagues to review their business practices, and to seek to fully comply with the DOL's impartial conduct standards when they apply. Don't risk damage to your own reputation, and the "black mark" on your U-4 that could follow you for the rest of your career.

Assume that you are a fiduciary when providing ongoing advice to IRA accounts. And then seek to fully comply with the impartial conduct standards, and the prudent investor rule contained therein.