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The DOL fiduciary rule's effect on small broker-dealers

The rule opens the door to future customer litigation and opportunity for regulators to impose sanctions or fines on smaller broker-dealers

May 4, 2016 @ 11:21 am

By Ross David Carmel

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In the current regulatory landscape, small to midsize broker-dealers are subject to an ever-increasing regulatory burden. The new Department of Labor fiduciary rule simply adds fuel to that fire.

Earlier this month, after five years in the making, the DOL finalized its new fiduciary rule to regulate investment advice in retirement accounts. Prior to this rule, which will take full effect in the next 12 to 18 months, registered representatives working at broker-dealers operated under the suitability standard when providing investment recommendations to owners of retirement accounts. The DOL fiduciary rule dramatically changes this standard and imposes fiduciary status on these registered representatives.

Fiduciaries are obligated to act in the best interest of their clients, and the rule provides that registered representatives are only to receive reasonable compensation for their services. While this may sound like a no-brainer, the rule as written is vague and opens the door to future customer litigation and additional opportunities for regulators to extract their pound of flesh from smaller broker-dealers in sanctions or fines.

(More: Coverage of the DOL rule from every angle)

Broker-dealers are operating in an era of increased regulation and scrutiny, especially as it pertains to small- and midsize firms. The stories and complaints about year-long Financial Industry Regulatory Authority Inc. exams and overly burdensome Securities and Exchange Commission audits have become all too commonplace.

Indeed, it is a rarity that a smaller broker-dealer finishes a Finra exam or SEC audit without having to pay some sort of nominal fine for an alleged minor infraction. There is little doubt that Finra and the SEC know that smaller broker-dealers will pay these fines, as the legal costs and potential repercussions of fighting back are far too great.

This increased regulatory scrutiny has constrained smaller broker-dealers to increase compliance staff and upgrade operational and surveillance systems. These additional overhead burdens result in increased costs and hits to their bottom line. The DOL fiduciary rule just increases these costs and gives regulators another method to sanction smaller broker-dealers.

(Related read: 2015 was indie broker-dealers' worst year since the credit crisis)

Because the new DOL fiduciary rule fails to provide a road map to ensure compliance, it is critical for smaller broker-dealers to document the process when a registered representative makes an investment recommendation for a retirement account. For example, when making a recommendation that relates to a retirement account, the registered representative should document the reasons why they believe the recommendation is in the best interest of the client. In addition, they should articulate to the client and document why they believe the cost associated with the recommendation is reasonable. They also should document what other products they reviewed, the reasons they made the eventual recommended investment and note the comparable costs of similar investments.

Of course, ensuring this documentation is completed and maintaining these records requires additional compliance oversight and increases the already demanding regulatory burden on small and midsize broker-dealers. The completion and maintenance of these records will not insulate smaller broker-dealers from future customer litigation, but will at least memorialize a current recollection as to why the investment recommendation was in the best interest of the client and the compensation was reasonable.

As the DOL fiduciary rule is vague, with no definition of best interest or reasonable compensation, there is little doubt that attorneys, on behalf of aggrieved customers, will play Monday morning quarterback years after investment recommendations were made. The DOL fiduciary rule will open the floodgates for opportunist attorneys and courts to define best interest and reasonable compensation through litigation.

These increased regulatory costs and additional liability risk for smaller broker-dealers will make retirement investment advice more expensive for the broker-dealer to provide, an increased cost that eventually will be passed on to the customer. If the retirement advice provided is in the best interest of the customer, I'm sure they won't complain about paying the increased reasonable costs, right?

Ross David Carmel is a partner at Carmel Milazzo & DiChiara.

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