While the Department of Labor is expected to announce its final Conflict of Interest Rule on Wednesday, questions about whether existing compensation models satisfy current standards are also intensifying. Regulators are scrutinizing current practices as they work to change fiduciary rules.
Firms who fully understand the current environment will be in the best position to respond to new regulation. This understanding will allow them to better assess the impact of necessary changes on their business model.
CONSIDERATIONS FOR BROKER-DEALERS
Broker-dealers are primarily compensated for selling and trading securities, not for their advice. They often receive 12b-1 fees as compensation for sales resulting from recommendations of mutual funds to clients. Regulatory scrutiny of the process involved in developing the recommendations that generate 12b-1 fee compensation is likely to intensify. In light of this reality, here are some action steps broker-dealers can take now:
• Prepare to explain the process used to determine which mutual funds have been approved for sale to clients.
• Be able to explain their due diligence process for product review and approval, and how the products approved for sale are anticipated to be used to meet particular client needs.
• Demonstrate the process for supervisory review of the funds that representatives have recommended to clients with a view to whether those recommendations are aligned to meet client interests.
A second practice that could present a conflict of interest for broker-dealers may occur if they receive revenue-sharing payments. This practice typically involves payments by the mutual fund's investment adviser or distributor from its own resources. Unlike 12b-1 fees, revenue-sharing payments are not directly derived from the fund itself. Generally, revenue-sharing payments are a percentage of broker-dealer client assets invested in a particular fund. While revenue-sharing arrangements are not unusual, broker-dealers need to carefully and thoughtfully decide to accept revenue-sharing payments by:
• Considering the purpose of the payments.
• If the arrangement is for purposes other than training and education, considering whether the arrangement presents an inappropriate conflict with client interests.
• Disclosing any revenue-sharing arrangement to clients and prospective clients.
CHALLENGES FOR HYBRID FIRMS
The challenges are particularly acute for hybrid or dually registered firms and will likely be exacerbated by the forthcoming DOL regulation. Advisory account relationships established by hybrid firms typically also involve a brokerage account with the same firm. In such instances, the sources of revenue available to the broker-dealer in connection with the account's holdings may create a potential conflict of interest.
With respect to mutual fund investments, for example, any revenue-sharing arrangements the broker-dealer may have with particular funds could provide a financial incentive to the firm's advisory arm to recommend funds based on those revenue considerations. Under such circumstances, it is important that the adviser identify the conflict to his or her client and take steps to assure the client has consented to the advice arrangement with full knowledge of the conflict.
With respect to individual retirement accounts, hybrid firms act as fiduciaries when recommending investments or exercising discretionary management authority over account assets. Investing these assets in funds that generate 12b-1 fees or other payments to the brokerage arm of a firm generates a potential conflict of interest. Although full disclosure of these conflicts is required by the SEC, disclosure alone may not be enough for retirement accounts in light of the prohibited transaction rules which govern these accounts.
Common revenue streams may need to be treated differently under different regulatory structures.
In the meantime, a review of revenue streams and potential conflicts will serve firms well. For any firm, good compliance practices require firm-wide controls and procedures for addressing potential conflicts of interest. With preparation, broker-dealer and hybrid firms can be better positioned to make adjustments to be compliant under new rules.
Robert Cirrotti is a managing director at Pershing, a BNY Mellon company, where he is head of investment and retirement solutions.