sifma· - DOL Fiduciary Rule

sifma· Invested in America

EXECUTIVE SUMMARY

By U.S. Mail and Email: [email protected]

Office of Regulations and Interpretations Employee Benefits Security Administration Attn: Conflict ofinterest Rule, Room N-5655 U.S. Department of Labor 200 Constitution Ave., NW Washington, DC 20210

Re: RIN 1210-AB32

Ladies and Gentlemen:

The Securities Industry and Financial Markets Association ("SIFMA")1 is pleased to provide comments regarding the Department of Labor's ("Department") proposed regulation under the Employee Retirement Income Security Act of 1974, as amended ("ERISA") that would redefine the term "fiduciary" under section 3(21) ofERISA and section 4975(e) of the Internal Revenue Code of 1986, as amended (the "Code"). SIFMA appreciates the opportunity to comment and hopes that our comments are helpful to the Department as it assesses the dramatic impact of the proposal on the millions of American investors benefitting today through participation in retirement plans, Individual Retirement Accounts ("IRAs") and other retail accounts. 2 We respectfully request an opportunity to testify at the Department's August 10-13, 2015 hearing.

Our comments reflect SIFMA' s deep concerns that the Department has proposed a rule that would harm American investors, while completely re-casting the ERIS A definition of who is a fiduciary when providing investment advice for a fee. The Department has greatly expanded the scope of service providers subject to the fiduciary requirements of ERISA and the Code, and the significant prohibited transactions that come with such status under ERISA and the Code, while creating very limited, inflexible, and prescriptive exceptions and exemptions that do not work and will not be in the best interest of American retirement investors. The net effect is that this proposal, if enacted, would limit the ability of Americans to continue to receive personalized

1 SIFMA is the voice of the U.S. securities industry, representing the broker-dealers, banks and asset managers whose 889 ,000 employees provide access to the capital markets, raising over $2.4 trillion for businesses and municipalities in the U.S., serving clients with over $16 trillion in assets and managing more than $62 trillion in assets for individual and institutional clients including mutual funds and retirement plans. SIFMA, with offices in New York and Washington, D. C., is the U.S. regional member of the Global Financial Markets Association (GFMA). For more information, visit http://www.sifma.org.

2 The rule covers all employer sponsored retirement plans, all employer sponsored welfare plans, IRAs, Individual Retirement Annuities, Coverdell Education Savings Accounts, Archer MSAs and Health Savings Accounts.

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Case 1:16-cv-01035-RDM Document 33-5 Filed 08/10/16 Page 1 of 158


EXECUTIVE SUMMARY

investment guidance for retirement plan accounts, which would result in a less secure retirement for many Americans already seeking to save and invest for their financial futures.

Much of the discussion around the Department's recently proposed retirement regulation focuses on the question of a "best interest standard" for financial advisors providing guidance to IRA holders and employees who participate in 40l(k) plans. SIFMA and the broader financial services industry have long advocated for such a best interest standard when providing personalized investment advice. However, the Department has added hundreds of pages of extraneous conditions, restrictions, and prescriptions on top of its proposed best interest standard. The clear consequence of the Department's heavy hand with its proposed regulation is the explicit and implicit limitation on the types of investments individuals may choose to utilize with their retirement funds, as well as how they choose to pay for the service they seek.

Expanded Definition under Section 3(21) of ERISA

The Department seeks to turn sales pitches and cold calls into fiduciary conversations. The proposal so narrows "financial education" that only those already educated will understand what they are being told under the Department's new regime. The proposed education exception is expanded to cover IRAs; however, it does not allow for the naming of individual investment options. The provider would only be able to provide guidance that includes broad asset classes. Giving asset classes without allowing examples will not help participants. The Department's proposal would morph all of these educational and common sense conversations that are intended to help people prepare for retirement into "fiduciary" conversations, subject to a whole new restrictive, burdensome and liability-filled regime.

Further, the Department has proposed to expand the definition of providing investment advice so broadly that conversations that are merely designed to sell or pitch one's services would fall within its scope. Therefore, the Department wants to capture in its regulatory "fiduciary" web situations where a provider is merely speaking about the benefits of its services to an individual or small business owner to help them, and their employees, save for retirement.

The Department's proposal would also pull in all distribution and "rollover" conversations. These are conversations that a provider has with an individual about moving their assets out of their old employer's plan and into an IRA, which might help that individual keep better track of the funds, and take a more active role in managing their funds. SIFMA does not believe distribution recommendations are fiduciary advice. We do not believe that it is in the best interest of plan participants to discourage all conversations regarding distributions. By discouraging these conversations, leakage (dropping) out of the retirement system becomes far more likely.

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EXECUTIVE SUMMARY

Narrowed Exceptions

The proposal has many exceptions that were drafted too narrowly. In particular, the education exception and the seller's exception are both too narrowly drawn. The proposed seller's exception only applies to large institutional clients. Small plans and all retail investors are left out. It should apply to IRAs and small plans as well. It is simply not reasonable, and is entirely inconsistent with the views of primary securities regulators, that the Department can not offer an amount or type of disclosure that would be found sufficient to alert a listener to the fact that a conversation involves selling. There simply is no legal difference when one is selling in the retail context versus a large plan context.

Another major failing of this carve-out is that it does not currently cover services, such as brokerage services, futures execution and clearing services, prime brokerage services, custody services, and other appropriate and necessary services provided to plans. There is no reason for the Department to have such a limitation.

Unworkable Exemptions

In addition, SIFMA has filed today several comment letters on the Department's exemptive proposals that are part of this package, but it should be clear from the outset that virtually all of the exemption amendments, as well as the new exemptions, are not administrable, as required under ERIS A, nor do they meet the requirements that govern the Department's exemption granting authority under ERISA and the Code. The Best Interest Contract Exemption raises significant and insurmountable obstacles for broker-dealers, along with disclosure requirements that will not only overwhelm the customer with more information than they can possibly digest, but also impedes customer transactions and create losses for certain retirement accounts.

In addition, many of the requirements of the exemptions are so broad, subjective, and ambiguous in certain areas that it would be impossible to build systems and processes to ensure compliance. Compliance with the terms and conditions of any, or all, of these exemptions, would impose significant additional costs and liability on brokers-dealers which could likely cause them to change their business models in an effort to avoid unnecessary risk and punitive excise taxes that the Department is seeking to broadly expand. This change would lead to decreased access to oneon-one financial guidance for smaller retirement accounts, as well as potentially increased costs.

We believe the Department's proposal, if enacted, would result in fewer Americans having access to the help and guidance they need to save for retirement. The Department, in its own analysis of the 2011 final rule implementing the investment advice provision of the Pension Protection Act, found that financial losses from investing mistakes due to lack of advice likely amounted to more than $114 billion in 2010. The Department's new, and more complicated,

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EXECUTIVE SUMMARY

proposal risks reducing many investors' access to meaningful guidance and education while unnecessarily increasing their costs. This is particularly troublesome for low to middle-income savers who rely heavily on the brokerage model. Currently, 98 percent of IRA investors with less than $25,000 are in brokerage relationships.

Regulatory Impact Analysis

Not only does the regulatory impact analysis fail to show how this proposal would benefit the public quantitatively, but it also underestimates greatly the harm that this would cause American investors. The Department has no study data to compare the performance of accounts with a financial advisor who is a fiduciary to the performance of accounts with a broker or other financial advisor who is not a fiduciary. The Department cannot reasonably conclude that investors would be better off under an expanded fiduciary standard on the basis of the studies cited. In fact, NERA's analysis of actual account level data demonstrates that commission-based accounts do not underperform relative to fee-based fiduciary accounts. In addition, in its analysis of the "benefits" of the proposal associated with curtailing purportedly conflicted advice, the Department misapplied academic research that is key to its conclusions. The range of estimates of benefits is so wide as to raise serious questions about its applicability and credibility.

To help provide a relevant data set, SIFMA is including in its analysis of the Department's proposal a review, conducted by NERA Economic Consulting, of data from tens of thousands of IRA and 40l(k) accounts provided by SIFMA member firms. It is highly likely that most firms that offer retirement account services will be unable to offer commission-based accounts to retirement savings customers under the proposal, even under the Best Interest Contract exemption. Based on that premise, we can draw several key conclusions:

• Some commission-based accounts would become significantly more expensive when converted to a fee-based account under the Department's proposal;

• A large number of accounts do not meet the minimum account balance to qualify for an advisory account;

• There is no evidence that commission-based accounts underperform fee-based accounts; and

• The Department's own economic analysis is so broad as to undermine its validity and further it misinterprets the referenced academic literature.

In addition, a key finding of the NERA study is that customers do choose the fee model that best suits their needs and trading behavior. In 2014, the median trade frequency in commission-based accounts was just six trades. By comparison, in fee-based accounts the median trade frequency was 57 trades, with larger accounts generally trading more frequently than smaller ones. Thus, the data are consistent with the idea that investors who expect to trade often rationally choose

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EXECUTIVE SUMMARY

fee-based accounts whereas those that do not trade often are likely to choose commission-based account.

SIFMA also questions the Department's cost estimates for complying with its proposal. The Department's cost estimates rely primarily on data submitted by SIFMA to the SEC in regard to a request for information related to Dodd-Frank Section 913 in 2013 (the "SIFMA Data").3 Such reliance is inappropriate. The SIFMA Data was collected and submitted by SIFMA to the SEC for the sole purpose of estimating the costs of complying with a prospective SEC fiduciary rule established under Dodd-Frank Section 913, under specific assumptions that were applied to such a contemplated SEC approach. 4 Although the Department concedes that "there will be substantive differences between the [DOL] 's new proposal and exemptions and any future SEC regulation that would establish a uniform fiduciary standard ... ",the Department nevertheless elects to rely on the SIFMA Data as the basis for its cost estimates. 5 The Department's stated reason for doing so is that there are "some similarities between the cost components" in the SIFMA Data and the costs that would be required to comply with the Department's proposal. 6

The SIFMA Data was custom-generated for a wholly different prospective rule by the SEC, and is specific and exclusive to that purpose. The Department's proposal, on the other hand, introduces an entirely new and different set of requirements, obligations, liabilities and costs, which were not known or even contemplated at the time the SIFMA Data was generated nearly two years earlier. It is not possible and would be improper to use the SIFMA Data to estimate the cost of a separate and distinct Department regime. Because the Department did so, they started with a false premise, followed a flawed methodology, and generated costs estimates that are unfounded, inaccurate, and otherwise fatally flawed.

To help more appropriately understand the costs of compliance related to the Department's proposal, SIFMA conducted a survey of start up and ongoing compliance costs as documented in the Deloitte Report.7 SIFMA's survey found that the estimated cost to comply with the Department's proposal is considerably greater than the estimates for the broker-dealer industry provided by the Department in its Regulatory Impact Analysis. The results of the survey estimate that, for large and medium firms in the broker-dealer industry, total start-up costs alone would be

3 Regulatory Impact Analysis, http://www.dol.gov/ebsa/pdf/conflictsofinterestria.pdf, at pp. 160 - 65.

4 SIFMA Comment to SEC dated July 5, 2013, http://www.sifma.org/issues/item.aspx?id=85899443 l 7.

5 Regulatory Impact Analysis at p. 161.

6 Id.

7 Report on the Anticipated Operational Impacts to Broker-Dealers of the Department of Labor's Proposed

Conflicts of Interest Rule dated July 17, 2015

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EXECUTIVE SUMMARY

$4. 7 billion and on-going costs would be $1.1 billion. This is nearly double the estimated cost provided by the Department in its analysis. This is not surprising, given that the Department's estimate was based on a narrow dataset that was never intended to measure costs for compliance with this proposal.

Impact on Asset Managers

The impact of the Department's proposed retirement regulation raises concerns for asset managers who are already fiduciaries under ERISA when they act as discretionary investment managers or provide investment advice for clients that are retirement plans and IRAs. Asset managers are concerned that the expanded definition of investment advice definition will hamper their ability to act in the best interest of these clients. Asset managers will be less able to provide information and education than they are able to do currently. They may also be restricted in making available services and/or products or may only be able to do so at greater expense. In addition, because the proposal broadly imposes fiduciary obligations on market participants with whom asset managers transact on behalf of plans, those market participants will be less willing to engage in activities and services that assist in carrying out one's fiduciary duties, and will restrict information where providing it may transform their role into a fiduciary one. Moreover, asset managers and investors, already deemed sophisticated, will be burdened by standards designed for retail retirement savers.

Further, asset managers, separate and apart from their role as fiduciaries to plans, create and manage registered mutual funds, exchange traded funds, real estate investment trusts and hedge funds and other private funds that are purchased as investments for plans. Because different plans will have different investment objectives, different products and strategies will be best suited to help investors achieve their objectives. As drafted, the proposed rule and Best Interest Contract Exemption will result in substituting the variety of products currently available with a de Jure or de facto "legal list," and make the burdens of offering many funds and products effectively prohibitive. The asset managers are concerned that both the proposed rule and the Best Interest Contract Exemption will have the effect of limiting or restricting asset managers' products that are available to plans and promoting certain types of products (e.g., low-cost index products) over others.

Conclusion

SIFMA reiterates its long and much-documented support for a best interests of the customer standard, and in many ways, through the highly regulated securities industry overseen by the SEC and FINRA, the industry is already headed in that direction. Those regulatory bodies should remain in the lead on the issue, and best interests standard should apply across the entire retail market, not just the tax deferred retirement market. The proposal's voluminous and

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EXECUTIVE SUMMARY

overreaching terms, prescriptions and conditions - separate and apart from the best interests standard - would create a myriad of new requirements and systems that would make the process of helping American savers prepare for retirement far too complex to implement without causing undue harm. In the end, the very same investors the Department seeks to protect would likely inadvertently be harmed with limited choices, less access to retirement advice, and higher costs.

Sincerely,

Kenneth E. Bentsen, Jr. President and CEO

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APPENDIX3

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July 20, 2015


Office of Ex emption Determinations Employee Benefits Security Administration Attn: D-11712 Suite 400 U.S. Department of Labor 200 Constitution Avenue, N.W. Washington, D.C. 20210

Re: ZRIN: 1210-ZA25; PTE Application D-11712


The Securities Industry and Financial Markets Association ("SIFMA")1 is pleased to provide

comments regarding the Department of Labor's ("Department") Proposed Best Interest Contract

Exemption2 ("BIC Exemption") under the Employee Retirement Income Security Act of 1974,

as amended ("ERISA"). We appreciate the opportunity to comment and hope that our comments

are helpful to the Department as it assesses whether the exemption, as written, can be

accommodated into the broker-dealer model that exists today, or whether, as written, it will

result in the loss of professional investment advice for small retirement accounts.3 We

respectfully request an opportunity to testify at the hearing on the proposed exemption.

1 SIFMA is the voice of the U.S. securities industry, representing the broker-dealers, banks and asset managers

whose 889 ,000 employees provide access to the capital markets, raising over $2.4 trillion for businesses and municipalities in the U.S., serving clients with over $16 trillion in assets and managing more than $62 trillion in assets for individual and institutional clients including mutual funds and retirement plans. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association (GFMA). For more information, visit~"-'-'-'-.!..!...!-'--'-'-'-'~""""~·

2 Proposed Best Interest Contract Exemption, 80 Fed. Reg. 21960 (April 20, 2015).

3 80 Fed. Reg. at 21961.

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Attached hereto are SIFMA' s submissions for the related rulemakings being undertaken by the

Department. These attachments are an integral part of this submission. 4

Although the preamble states that the proposed BIC Exemption "seeks to preserve beneficial

business models by taking a standards-based approach that will broadly permit firms to continue

to rely on common fee practices," the exemption as currently proposed raises significant and in

many respects insurmountable obstacles for broker-dealers, including the ability to offer

commission-based advice. For example, the contract requirements of the proposed exemption do

not comport with the manner in which financial professionals enter into relationships with retail

customers. SIFMA further believes that the written disclosures required under the proposed

exemption will not only overwhelm customers with more information than they can possibly

digest, but also seriously impede customer transactions and cause timing and opportunity losses

for smaller retirement accounts.

Moreover, complying with the terms and conditions of the proposed exemption will impose

significant additional costs on broker-dealers and other providers of financial services. That will

make it extremely difficult, if not impossible, for smaller retirement accounts to receive financial

advice from the professionals who currently serve them. As a result, many of these smaller

retirement accounts may be terminated or maintained such that the investor receives no

assistance and the broker is no more than an order taker. To the extent that the investment

education currently provided by financial professionals ceases to be available, the result will be

accelerated leakage of retirement savings out of tax-advantaged accounts, less people saving for

retirement and widespread confusion on the part ofretirement investors, none of which is in the

best interest of these investors.

4 See Appendices numbered 1-8.

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SIFMA shares the Department's interest in ensuring that investors receive appropriate, informed

assistance with decisions concerning retirement. However, SIFMA respectfully believes that this

proposed exemption, and the package of proposals accompanying it, are not the proper way of

proceeding. SIFMA also does not believe that the Department may use a new definition of

"fiduciary," in combination with its exemptive authority, as a means of establishing a new

regulatory and enforcement program for financial professionals, ERISA plans, and non-ERISA

plans such as IRAs. SIFMA expresses this objection with regard to the BIC Exemption, and the

other, related exemptive rules that have been proposed.

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Comments on specific provision can be found on the pages indicated below:

I. Scope of the Best Interest Contract Exemption

II. Contract

a. Contract Requirement

b. Voluntary Assumption of Fiduciary Status

c. Impartial Conduct Standards

d. Warranties

e. Contract Disclosures

f. Prohibited Contract Provisions

III. Disclosure Requirements

a. Cost Disclosure at Time of Purchase

b. Annual Fee and Compensation Disclosure

c. Web Disclosure

5

11

13

15

19

24

25

26

27

30

31

IV. Range oflnvestment Options 32

V. Disclosure to the Department, Recordkeeping and Data Requests 37

VI. Exemption for Pre-Existing Transactions 39

VII. Comment on a Low Fee Streamlined Exemption 43

VIII. Definitions 44

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Section I: Scope of the Proposed Best Interest Contract Exemption

SIFMA respectfully believes that the Department's new "fiduciary" definition, and this proposed

exemption, exceed the Department's statutory authority. SIFMA offers the comments and

recommended changes in this letter to assist the Department in improving this exemptive rule in

the event the Department resolves to adopt this package of proposals in final form, despite the

deep concerns they present. Nothing in these comments should be understood to mean that

SIFMA concurs with the construction of ERISA and the Code underlying the Department's

proposals, or with the policy views regarding the financial services industry that the Department

has articulated in presenting its proposals.

Advice Recipients Covered by the BIC Exemption.

The proposed BIC Exemption permits an adviser to receive compensation for services provided

to a "Retirement Investor" in connection with a purchase, sale or holding of an "Asset" by a

plan, a plan participant or an IRA. "Retirement Investor" is defined to include a plan participant

or beneficiary with the ability to self-direct his or her account or take a distribution, an IRA

owner, or a plan sponsor of a plan with fewer than I 00 participants that is not participant

directed. We urge the Department to include advice to sponsors of participant directed plans

with fewer than I 00 participants on the composition of the menu of investment options available

under such plans. Without such relief, sponsors of such plans would have to enter into a fixed

fee arrangement with an adviser to obtain advice regarding menu selection, which many small

employers would be unwilling to do. We also note that the Department has omitted Keogh plans

from the list of retirement investors, which we assume was inadvertent.

As a result of the Department's decision to limit the availability of the BIC exemption to the

"retail" retirement marketplace, no financial professional can receive any third party fees on

behalf of any plan with more than 100 participants. We urge the Department to permit receipt of

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mutual fund third party payments in connection with plans with more than 100 participants under

PTE 86-128 (amended consistent with SIFMA's comment letter addressing the Department's

proposed amendments to PTE 86-128), with full disclosure in the manner that has worked

successfully under that exemption for the last 30 years.

We also believe that the 100 participant ceiling in the BIC exemption will be operationally

unworkable from a compliance perspective. For example, how often would the financial

professional need to confirm that the number of participants in the plan is at or below 100? It

would not be possible to confirm the number of participants prior to every transaction or every

recommendation. If the 100 participant cap is intended to protect less sophisticated plan

sponsors, we suggest as an alternative that the Department use an asset based test in Section

(b )(l)(i)(B) of the proposed regulation5 that aggregates the assets of all plans sponsored by the

employer and its affiliates. Many large employers sponsor multiple plans, some of which may

be quite small. In such cases, the plan sponsor is not likely unsophisticated or in need of the

protection of the BIC Exemption. Such employers can take advantage of other exemptions for

any small plans that they sponsor and should not be forced into the BIC Exemption. If the

Department determines to keep the 100 participant test, we urge the Department to amend the

proposed exemption to provide that the test must be met as of the latest Form 5500 filed by the

plan sponsor and publicly available from the Department at the time the account is opened.

Transactions Covered by the BIC Exemption.

The exemption covers only the receipt of compensation in connection with the purchase, holding

or sale of a specified list of "Assets." We believe it also needs to cover the receipt of

5 See Definition of the Term "Fiduciary": Conflict of Interest Rule-Retirement Investment Advice, 80 Fed. Reg. 21928, 21957 (Apr. 20, 2015).

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compensation in connection with extensions of credit, since by its terms, the exemption covers

debt instruments, bank deposits and certificates of deposit. 6

We are troubled by the narrow scope of the permitted "Assets" and urge the Department to

reconsider its approach to this concept. The term "Asset" is defined to include onlv: bank

deposits; certificates of deposit; shares or interests in registered investment companies, bank

collective funds, insurance company separate accounts, exchange-traded REITs, or exchange

traded funds; corporate bonds offered pursuant to a registration statement under the Securities

Act of 1933; agency debt securities as defined in FINRA Rule 6710(1) or its successor; US

Treasury securities as defined in FINRA Rule 671 O(p) or its successor; insurance and annuity

contracts; guaranteed investment contracts; and equity securities within the meaning of 17 C.F.R.

§ 230.405 that are exchange-traded securities within the meaning of 17 C.F.R. § 242.600. 7 The

term "Asset" is expressly defined to exclude "any equity security that is a security future or a

put, call, straddle, or other option or privilege of buying an equity security from or selling an

equity security to another without being bound to do so."

The investments excluded from the Department's proposed list of permissible "Assets" include

such transparent and liquid securities as municipal bonds, federal agency and government

sponsored enterprise guaranteed mortgage-backed securities, foreign bonds, foreign equities, and

foreign currency. It also omits other common investments such as over the counter equities,

structured products (other than U.S. corporate bonds), hedge funds, private equity and other

6 The BIC Exemption also provides no relief for principal transactions, which effectively denies relief under the exemption for the acquisition of shares of unit investments trusts. Although unit investment trusts are organized as registered investment companies, they are typically sold out of inventory. In a separate comment letter, SIFMA is recommending that the proposed exemption for principal transactions in debt securities be expanded in such a way that it would provide relief for the acquisition of unit investment trust shares.

7 These "exchange" definitions make clear that only equities traded on a US exchange are covered under the exemption.

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alternative investments, options, and futures contracts. In enacting ERISA, Congress chose not

to prohibit these types of investments, and the Department has historically declined to create a

"legal list" of investments for plan fiduciaries. 8

The creation of an enumerated list of permissible asset types for small plans and IRAs is a

marked departure from the Department's practice over the last 40 years. For the first time, the

Department is proposing to create a "legal list" that substitutes its judgment for that of the plan

fiduciary, IRA owner or plan participant. We question whether the Department has the legal

authority to specify what retirement accounts can invest in. Had Congress wanted to place

investment restrictions, it could have done so, as it did in IRC § 408(m) for IRA accounts.

Because there are no such prohibitions in ERISA, we do not believe that the Department has the

requisite authority to impose them now. We also question the Department's ability to expand the

list of prohibited investments for IRAs given the language in IRC § 408(m) which does not

include any of the securities prohibited under this proposed exemption.

We also believe that the "legal list" is fundamentally inconsistent with a fiduciary standard. An

adviser may in good faith believe that an investment not on the list of "Assets" is in the best

interest of the plan, plan participant or IRA owner. If an adviser so believes and fails to act on

his or her belief, will adherence to the list be a defense? Limiting the ability of advisers to take

action that they truly believe would be in the best interest of IRA owners, plans and their

participants would substitute the Department's judgment for that of advisers, IRA owners, plans

and their participants, and seems counter to the Department's stated goals.

8 See Investment of Plan Assets under the "Prudence" Rule, 44 Fed. Reg. 31369 (June 1, 1979) ("the Department does not consider it appropriate to include in the regulation any list of investments, classes of investment, or investment techniques that might be permissible under the prudence rule"). We note that exchange traded funds did not exist in 1979 and thus could not have made any such list at the time.

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Furthermore, limiting the types of permissible assets would create major operational challenges.

As outlined in the Deloitte report submitted with this comment letter, SIFMA member firms

would have to bifurcate accounts to accommodate products that would not be permissible under

the exemption. Significant oversight would be required to ensure that advised retirement

accounts are holding only permissible assets and that retirement investors are being advised only

with respect to such assets. For pre-existing retirement accounts, SIFMA member firms will be

barred from providing much needed advice to the account owners concerning the holding or sale

of any assets that are not on the Department's proposed list. These negative consequences are

discussed in greater detail below in SIFMA' s comments regarding Section VII of the proposed

exemption.

Although the Department suggests plans and IRAs can obtain exposure to impermissible assets

through mutual funds, mutual funds does not have the risk, reward or fee structure of those assets

(e.g., sovereign bonds or foreign securities). It is not reasonable to suggest that a mutual fund is

a substitute for an asset that the Department has excluded. We urge the Department to replace

the term "Asset" in Section I(a) with the phrase "securities or other property." Given the

impartial conduct standard required by the BIC Exemption, there should be no limit on the types

of assets covered by the exemption. As proposed, the BIC Exemption purports to require

brokers to act in the client's best interest, but then trumps the broker's judgment on what is or is

not a suitable investment. Moreover, as the investment world constantly evolves, the sort of

static list proposed in the BIC Exemption could impede investments in new vehicles that have

the same level of transparency and liquidity cited by the Department as primary criteria in

selecting "Assets." We believe that any such limitation is inappropriate.

The BIC Exemption also makes no provision for the receipt of compensation for two specific

activities that the Department has included in the proposed definition of fiduciary investment

advice: rollover advice and manager advice. Under the proposal, one becomes a fiduciary by

recommending that a plan participant roll his or her account balance over to an IRA or by

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recommending a manager, but BIC Exemption provides no relief for the receipt of fees in

connection with the rollover or the manager selection process.

In addition to substituting the phrase "securities or other property" for the term "Asset," SIFMA

urges the Department to provide explicit relief for compensation received in connection with a

recommendation to take a distribution of benefits or rollover into a plan or an IRA, as well as in

connection with a recommendation concerning the selection of investment managers or advisers.

We believe that these omissions must have been inadvertent, since it does not seem reasonable to

make a person a fiduciary for a particular type of advice but provide no exemption for any

compensation that may flow from that recommendation.

Because the proposed BIC Exemption is tailored to the recommendation of an "Asset," it is

unworkable for recommendations of investment managers or advisers, including

recommendations of separate managed account strategies or wrap fee programs (collectively,

"advice programs"). These advice programs are for discretionary management services that,

when provided for retirement accounts, are already subject to the full protections of ERISA

today. A separate, modified BIC Exemption must be adopted that is more tailored and relevant

to the recommendations of these advice programs. To address potential conflicts, such an

exemption could incorporate the same impartial conduct standards and other requirements as

contained in the BIC Exemption (subject to the necessary clarifications and modifications

discussed below in this letter). To avoid encumbering unnecessarily the pre-investment

conversation, and to leverage existing requirements and practices under the Advisers Act for

discretionary management services, the exemption should allow the contractual requirements to

be incorporated into an advice program agreement. It should be possible for that agreement to be

executed after the adviser recommends the advice program, but prior to any actual investment

through the advice program. For example, a required clause could state that an advice program

recommendation was made in the best interest of the client. In lieu of the BIC Exemption

disclosures, which are asset-based and therefore inapposite to the recommendation of advice

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programs, the Department should require 29 C.F.R. § 2550.408b-2 disclosures that could be

incorporated into the advisory program's ADV Part 2 disclosure brochure that is already

delivered to clients under the Advisers Act. The concept of leveraging§ 2550.408b-2

disclosures is discussed in more detail below.

Section II: Contracts, Impartial Conduct and Other Requirements

Contract Requirement

The BIC Exemption requires that a contract be entered into before any recommendation is made

to a retirement investor. There are several reasons why this requirement is simply incompatible

with the markets and relationships it is intended to regulate. As a threshold matter, it is

completely at odds with the manner in which brokers typically enter into relationships with retail

customers. Given the uncertain scope of the term "recommendation" and the risk of non

compliance with the exemption, this proposed condition may leave brokers no choice but to ask

retirement investors to enter into written contracts before any meaningful conversations have

taken place. That could make retirement investors so uncomfortable that they simply decide not

to proceed any further. Requiring a contract before any recommendation is made would also

preclude reliance on the BIC Exemption for certain types of advice (such as rollover

recommendations), because participants are not likely enter into a contract until they have

considered the advice and made a decision.

There are other operational incompatibilities as well. The practical reality of the marketplace is

that contracts are generally entered into between the financial institution and the IRA owner,

plan fiduciary or participant acting on behalf of the IRA, plan or participant account. Advisers

do not sign these contracts, and it would not be feasible for them to do so. Advisers are merely

agents of the financial institution and they may leave that institution at any time. Having

advisers sign the agreements would require the execution of a new contract whenever an adviser

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leaves the firm or an account is reassigned to another adviser. Likewise, if the adviser is not

available, a recommendation could not be made by anyone else since the contract would be non

transferrable between advisers. Similarly, where an IRA or small plan account is serviced by a

team of advisers, all of the advisers would have to sign the agreement, and a new contract would

be required whenever an adviser leaves the team, or a new adviser joins the team.

Requiring advisers to sign a written contract would also create problems for financial institutions

that have call centers and a rotating team of employees who may be permitted to provide advice.

The Department declined to provide a "carve out" for call centers in the proposed definition of

fiduciary advice. Can IRAs be allowed to use the call center if no one in the call center has

signed the contract? If call center staff are fiduciaries, does each staff person in the call center

have to sign the contract if an IRA owner could get a different person every time the IRA owner

calls? These are just two examples of why this requirement is impractical.

Furthermore, there are close to fifty million IRAs and plans with current brokerage contracts.

To amend, reprice, and resign all of those current contracts in the eight month period between the

effective date and the applicability date would be an impossible undertaking. The Department

has noted the impracticality of obtaining signatures on revised contracts in more than twenty

prohibited transaction exemptions permitting deemed consent or negative consent. We

respectfully request that any contract requirement be replaced by a written undertaking on the

part of the financial institution; if the plan fiduciary, participant or IRA owner continues the

relationship after being provided with the written undertaking, he or she will be deemed to have

consented to it. At a minimum, the BIC Exemption should be revised to make clear that either

negative consent or an electronic signature is sufficient, and that the written undertaking can be

delivered either by mail or by electronic means.

Finally, we note that the proposed exemption for principal transactions targets the plan or IRA

account as the counterparty to the agreement by requiring that the retirement investor enter into

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the contract "acting on behalf of the Plan, participant or beneficiary account, or IRA." This

language makes clear that any advice provided by the adviser is being provided only with respect

to the retirement account covered by the agreement. Although we have commented separately

that the contract requirement of the proposed principal transaction exemption should likewise be

replaced by an undertaking, we think treating the retirement account as the counterparty is more

workable than the approach taken in the proposed BIC Exemption, which views the retirement

investor as the counterparty.

Voluntary Assumption of Fiduciary Status

The BIC Exemption requires the adviser and the financial institution to affirmatively state that

they are "fiduciaries under ERISA or the Code, or both, with respect to any investment

recommendations to the Retirement Investor." The "Retirement Investor," as that term is

defined in the exemption, will be a person or entity who may have more than one account with

the adviser or the financial institution or both. At the very least, this language should be revised

to clarify that the affirmative statement applies only with respect to recommendations provided

with respect to the specific retirement account covered by the undertaking.

The required acknowledgement of fiduciary status creates other complications as well. For

example, the preamble states that the requirement to adhere to a best interest standard "does not

mandate an ongoing or long-term advisory relationship."9 Section (c) of the proposed

regulation 10 appears to limit the scope of any fiduciary duty to those assets for which a person

exercises discretionary authority or renders investment advice. However, the Department should

9 80 Fed. Reg. at 21969.

10 See Definition of the Term "Fiduciary": Conflict of Interest Rule-Retirement Investment Advice, 80 Fed. Reg. at 21959.

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make clear in the BIC Exemption that advisers and financial institutions can limit any

acknowledgment of fiduciary status and the requirements of the exemption to the specific assets

for which investment advice has in fact been rendered, and if the investment advice is non

discretionary, that they can also limit the scope of any fiduciary obligation so that it does not

extend to ongoing monitoring of that asset position. To do otherwise would require a financial

institution to provide an additional investment advisory service (account monitoring) that neither

the financial institution nor the plan, participant, or IRA owner may want or be willing to pay

for. The Department should not imply that the adviser and/or financial institution will be acting

in a fiduciary capacity any time they discuss investments for an account that holds an asset that

was subject to non-discretionary investment advice. To do so would in fact preclude the adviser

and financial institution from relying on the carve-outs to fiduciary status, including the ability to

provide investment education, for any trade executed in the account.

In conjunction with the BIC Exemption's narrow definition of "Asset," the acknowledgement of

fiduciary status must not result in self-directed IRA owners and plan participants being denied

the ability to invest in assets of their choice. If a client with an advised IRA instructs the

custodian to acquire a non-recommended investment that is excluded from the list of permissible

"Assets," the broker should be able to execute the trade for a commission because the broker did

not provide investment advice on that asset. The Department should make this clear. Otherwise,

broker-dealers may be unwilling to risk dual-role accounts, where recommendations are made as

to some but not all investments. This is a very common model for some broker-dealers whose

advisers may provide occasional advice but not all the time and not with respect to all assets in

the account, and it is consistent with Section (c) of the proposed regulation. If broker-dealers are

instead forced to restrict advisory accounts to the acquisition, holding or sales of "Assets" as

defined in the BIC Exemption, the result will be to deny clients the ability to invest their

accounts in the assets of their choice. This does not seem to be the Department's intent, and in

the final adoption the Department should make this clear.

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Even if the above situation is addressed, dividing IRAs into advised and non-advised IRAs will

create its own set of problems, not unlike the situation where a client has both a personal

brokerage account and a plan or an IRA account. Assume that the broker recommends an

investment for the client's personal account that would not be on the BIC Exemption's list of

permitted "Assets," and that the client then instructs the broker to purchase the same investment

for the IRA. The broker has not made a recommendation for the IRA and should be permitted to

execute the transaction in the non-advised IRA as a non-fiduciary broker. However, the broker

may risk being sued for a prohibited transaction by following the client's instruction with respect

to the IRA If the broker does not follow the client's instruction, the broker risks losing the

client's business.

These types of risks are likely to drive many broker-dealers away from commission-based

compensation arrangements entirely, contrary to the Department's stated goal of "flexibly

accommodate[ing] a wide variety of business practices" through use of the BIC Exemption. 11

The broad undertaking of fiduciary responsibility, the prevalence of individuals having multiple

accounts with the same financial institution and broker, and the severely constrained list of

permitted "Assets" make the BIC Exemption an ineffective solution for the modem investment

marketplace.

Impartial Conduct Standards

The BIC Exemption requires that the adviser and the financial institution affirmatively agree to

comply with, and then in fact comply with, impartial conduct standards. The impartial conduct

standards require the adviser to provide advice that is "in the Best Interest of the Retirement

Investor (i.e., advice that reflects the care, skill, prudence and diligence under the circumstances

11 80 Fed. Reg. at 21961.

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then prevailing that a prudent person would exercise based on the investment objectives, risk

tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the

interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party)."

The Department has thus taken ERISA' s prudence standard and turned it into a prohibited

transaction applicable to both plans and IRAs.

Congress saw no reason to impose a prudence standard for IRAs and believed that a violation of

the prudence standard for ERISA plans should be remedied through litigation in federal court.

Nonetheless, the proposal purports to condition relief under Section 4975 of the Code on the

contractual assumption of a prudence standard that would be enforceable by IRA owners in state

court through class action litigation or in arbitration on an individual claim basis. We do not

believe that Congress intended a breach of the duty of prudence to violate the prohibited

transaction provisions of ERISA and the Code.

We also do not believe the Department has a basis to apply its best interest standard to ERISA

plans. The Department acknowledges in the preamble that the best interest standard "is based on

longstanding concepts derived from ERISA and the law of trusts"; in particular, the duties of

prudence and loyalty imposed by ERISA § 404(a). Requiring advisers to ERISA plans or plan

participants to agree to, and comply with, a best interest standard separate and apart from their

existing ERISA fiduciary duty is redundant and unnecessary to achieve the Department's stated

goals. For ERISA plans, requiring advisers and financial institutions to adhere to a best interest

standard as a condition for relief under the BIC Exemption ramps up the consequences of any

fiduciary breach by imposing an excise tax on a prudence violation. We believe that is both

inappropriate and contrary to the statutory framework and Congress's intent.

In our view, the Department lacks statutory authority to require compliance with a prudence rule

as a condition of a prohibited transaction exemption. Congress has issued more than 20 statutory

exemptions. Not one of those exemptions has imposed a vague "reasonable person" standard or

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a subjective "misleading disclosure" standard as a condition punishable by transaction reversal

and an excise tax, regardless of whether there is a loss on the trade and regardless of whether the

disclosure is entirely correct but simply unclear. Nor has any exemption previously issued by the

Department contained such vague and subjective conditions. These conditions simply are not

administrable and therefore do not meet the standards for issuance of an exemption under ERISA

§ 408(a). If the Department insists on retaining compliance with a non-misleading disclosure

condition in the exemption, we suggest instead that the Department explicitly adopt FINRA

guidance relating to Rule 2210 regarding the term "misleading." 12 In addition, we ask that the

provision be clarified to require only that the financial institution and any adviser acting for the

financial institution reasonably believe that the statements are not misleading. Because the

failure to comply with a prohibited transaction exemption has such dire consequences, we do not

believe that an inadvertent, immaterial statement taken in the wrong way by a client should result

in reversal of the transaction, a guarantee of losses and the imposition of an excise tax.

We also question the language purporting to require advisers and financial institutions to prove

that advice was given "without regard to the financial or other interests of the ... Related Entity

or any other party." We have several concerns with respect to this formulation. First, we

believe the requirement that advice be "without regard" for the financial interests of the adviser

sets up a standard that an adviser will fail any time a plaintiff can prove that the adviser did not

recommend the investment that paid him the least. In guidance regarding the suitability rule,

FINRA uses a much more common sense approach that does not contain this flaw: that the

adviser provide recommendations that are in the best interest of his client and put his client's

interest before his own. 13 We urge the Department to use this formulation.

12 See, e.g., FINRA Frequently Asked Questions regarding Rule 2210, currently available at www.finra.org/industry/fima-rule-2210-questions-and-answers.

13 See, e.g, FINRA Regulatory Notice 12-25, Ql at p.3 (May 2012) (citing FINRA rules that adhere to this formulation).

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In addition, the proposed exemption in the language quoted above refers to "other interests" of

"any other party," with no apparent limitation. We do not know what these "other interests" and

"other parties" are intended to address; nor does the preamble explain them. We request that this

language be deleted from the definition of "best interests" in the exemption.

The impartial conduct standards also prohibit the adviser, financial institution and their affiliates

and related parties from receiving unreasonable compensation "in relation to the total services

they provide to the Retirement Investor." This new formulation of reasonable compensation is

unexplained. Nor does the Department attempt to justify the differences between this

formulation and Congress's view of reasonable compensation, which does not require all

compensation received by a financial institution to be justified by a particular set of services to a

particular account. We believe that this language is troublesome and we urge the Department to

use the language it has used since the enactment of ERISA and as recently as 2012, when it

entirely revised its regulations under ERISA § 408(b )(2). 14

The impartial conduct standards also prohibit misleading statements about the recommended

asset, fees, material conflicts of interest and other matters pertinent to the retirement investor's

investment decisions. While SIFMA generally agrees that misleading statements about such

matters should be prohibited, we do not believe that such statements should be remedied by a

prohibited transaction excise tax and rescission of related trades. We also note that the definition

of "Material Conflicts oflnterest" in Section VIII(h) of the proposed exemption provides no

14 See 29 C.F.R. § 2550.408b-2(d) ("Section 2550.408c-2 of these regulations contains provisions relating to what constitutes reasonable compensation for the provision of services."); 29 C.F.R. § 2550.408c-2(b )(1) ("In general, whether compensation is 'reasonable' under sections 408(b )(2) and (c)(2) depends on the particular facts and circumstances of each case.").

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explanation of the term "Material."15 The proposed definition in Section VIII(h) is so broad that

it will be virtually impossible for financial institutions to enumerate every conceivable existing

or potential conflict of interest. A materiality standard should be added to the proposed

exemption by amending the definition of "Material Conflict of Interest" to state as follows: "A

'Material Conflict of Interest' exists when an Adviser or Financial Institution has a financial

interest that, from the perspective of a reasonable person, could affect the exercise of its best

judgment as a fiduciary in rendering advice to a Retirement Investor regarding an Asset."

Warranties

The proposed BIC Exemption requires that the adviser and the financial institution warrant that:

(i) they and their affiliates will comply with all applicable federal and state laws regarding

investment advice and securities transactions; (ii) the financial institution has adopted written

policies and procedures reasonably designed to mitigate the impact of material conflicts of

interest and "ensure" that its advisers adhere to the impartial conduct standards; (iii) in

formulating its policies and procedures, the financial institution specifically identified material

conflicts of interest and has adopted measures to prevent material conflicts from causing

violations of the impartial conduct standards; and (iv) the financial institution and its affiliates

and related entities do not use "quotas, appraisals, performance or personnel actions, bonuses,

contests, special awards, differential compensation or other actions or incentives to the extent

that they would tend to encourage individual Advisers to make recommendations that are not in

the Best Interest of the Retirement Investor." Although differential compensation encouraging

the adviser to act in a manner that is not in the client's best interest would breach that warranty,

differential compensation received by the financial institution itself would be permitted.

15 The term "Material Conflicts oflnterest" appears throughout the proposed exemption, and our comment on that term should be deemed restated each time the term appears. The repeated use of the term makes it even more important that the definition in Section VIII(h) be clarified.

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These warranties are extremely troublesome, particularly in light of the resulting exposure to

class action litigation. SIFMA requests that the first warranty be modified to warrant that the

advisor, the financial institution and their affiliates have adopted policies that are reasonably

designed to achieve compliance with all applicable law, not that they "will comply" with all

applicable law. This is the regulatory standard that FINRA uses, and which the SEC approved. 16

We hope that the Department will recognize that this warranty would be provided in the context

of the safeguards established by the SEC and FINRA and not require an absolute, strict liability

declaration.

SIFMA also requests clarification regarding the second and third warranties. The Department

should make clear that the second warranty requires the financial institution to warrant that it has

adopted written policies and procedure that are reasonably designed to ensure that its advisers

adhere to the impartial conduct standards, not that policies and procedures "ensure" such

adherence. Similarly, the third warranty should be modified to warrant that the financial

institution has adopted measures that are reasonably designed to mitigate material conflicts of

interest, not that the financial institution has adopted measures "to prevent" such conflicts from

causing violations of the impartial conduct standards. The financial institution cannot possibly

adopt measures that will "prevent" material conflicts of interest.

SIFMA urges the Department to eliminate the fourth warranty regarding compensation practices

entirely. Contrary to the Department's statement that the BIC Exemption "will broadly permit

firms to continue to rely on common fee practices," 17 we believe that this warranty will require a

16 Rule 31 lO(a) provides that: "Each member shall establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with the applicable securities laws and regulations, and with applicable FINRA rules."

17 80 Fed. Reg. at 21961.

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substantial, if not a complete, overhaul of broker compensation arrangements. Indeed, as far as

we can tell, it will require the elimination of commission-based advice. Although the preamble

indicates that the failure to comply with the mandated warranties would not result in a loss of the

exemption, any breach of these warranties in the IRA setting, including the warranty regarding

compensation policies and procedures, would be actionable under state contract law. 18 Thus, any

warranty that differentiated commissions, sales loads, trail commissions,12b-l fees and other

payments from third parties do not "tend to encourage" violations of the best interest standard

would expose financial institutions to the risk of class action litigation. To avoid that risk,

financial institutions would be forced to eliminate differential and third party compensation

arrangements with advisers (including attendance at training or other seminars to which advisers

may be invited), as well as any bonus or incentive programs for advisers, in the provision of

investment products and services to small plans and IRAs.

The preamble suggests several methods of satisfying the "policies and procedures" warranty,

including the use of computer models to generate advice delivered by advisers, asset-based

compensation, fee offsets, compensation systems based on the financial institution's

determination of what products take more time or effort to sell, and compensation arrangements

that are designed to align the interests of the adviser with the interests of the investor. None of

these examples would reasonably permit the continuation of commission-based advice. Thus,

contrary to what the Department says in the preamble, commission-based advice would be

eliminated in brokerage accounts for IRAs, and an important choice for retirement investors

about how to pay for advice would be gone.

18 See 80 Fed. Reg. at 21970 ("Failure to comply with the [policies and procedures] warranty could result in contractual liability for breach of warranty."); id. at 21972 ("The Department intends that all the contractual obligations (the Impartial Conduct Standards and the warranties) will be actionable by IRA owners.") (emphasis added).

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Given their resulting exposure to class actions for breach of warranty, SIFMA believes that its

members will either terminate their relationships with smaller plans and IRAs or offer only fee

based compensation arrangements. As the head ofFINRA noted quite recently:

... I have practical concerns with the Labor proposal in a number of areas. First,

the warranty and contractual mechanism employed by Labor used to address their

limited IRA enforcement jurisdiction, appears to me to be problematic. In one

sweeping step, this moves enforcement of these provisions to civil class action

lawsuits or arbitrations where the legal focus must be on a contractual

interpretation. I am not certain how a judicial arbiter would analyze whether a

recommendation was in the best interests of the customer "without regard to the

financial or other interests" of the service provider. I'm not sure, but I suspect, a

judicial arbiter might draw a sharp line prohibiting most products with higher

financial incentives no matter how sound the recommendation might be.

Similarly, I'm not sure how a judicial arbiter would evaluate which compensation

practices "tend to encourage" violations of the exemption. It would appear likely,

however, that firms would be required to demonstrate, at least, that any higher

compensation was directly related to the time and expertise necessary to provide

advice on the product, as specifically suggested by DOL. To say the least, making

that case is not a simple proof standard.

This all leads to my second concern that there is insufficient workable guidance

provided either to the firm or the judicial arbiter on how to manage conflicts in

most firms' present business models other than moving to pure asset-based fees,

or a completely fee-neutral environment...! fear that the uncertainties stemming

from contractual analysis and the shortage of useful guidance will lead many

firms to close their IRA business entirely or substantially constrain the clients that

they will serve. Put another way, the subjective language of the PTE, coupled

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with a shortage of realistic guidance, may lead to few providers of these critical

investor services. 19

We believe that these concerns are well founded. Full and prominent disclosure, brought to the

client's attention with some frequency, will do far more to shed light on fee differences, and

educate clients regarding these differences, than arbitrarily banning fee differences in a business

model that treats agency transaction compensation, principal transaction spreads, mutual fund

fees and insurance company commissions differently. It is a not a "principles based" change to

require this kind of massive overhaul in the way all brokers are compensated. In 2010, the

Department suggested that it wanted a change in the law to make its enforcement program easier.

We are very concerned that this exemption has the same aim, but at a huge cost to the financial

services industry and those saving for retirement. We strongly urge the Department to

reconsider this requirement.

If the Department determines to proceed with this approach, we ask the Department to delay the

differential compensation rules for thirty six months. As the Department is well aware, the

compensation paid to brokers differs within asset types and across asset types. It is simply

unrealistic to require a change of this magnitude in eight months. Financial professionals with

IRA or other plan clients would have to be excluded from firm-wide bonus pools that reflect the

profitability of the entire firm, including retirement clients. Financial professionals also would

have to be excluded from training programs if such programs are sponsored or supported by a

mutual fund complex or similar provider of investment offerings. Changes like this will take

years to plan and implement. Financial institutions cannot renegotiate the contractual

arrangements with third parties and venders to alter the pay practices of every adviser within the

eight month period provided in the proposed exemption. Delaying the differential compensation

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rules by thirty six months should give financial institutions the time to redesign their programs,

review all bonus and incentive programs, set new policies and procedures, retrain all necessary

compliance, audit and risk teams, and put in new systems to accommodate these rules.

Contract Disclosures

Under the proposed BIC Exemption, the written contract must disclose all material conflicts of

interest, and inform the investor of the right to obtain complete information about all fees

associated with the assets in which the plan or IRA is invested, including "all of the direct and

indirect fees paid [sic] pqyable to the Adviser, Financial Institution, and any Affiliates."

(Emphasis added). It must also disclose the existence of proprietary investment products, any

fees that the adviser will receive from third parties in connection with the purchase, holding or

sale of any asset, and the address of the website required by the exemption. Failure to include

any of these disclosures would preclude reliance on the exemption, and advisers and financial

institutions will be exposed class action lawsuits challenging the completeness of any such

disclosures.

Again, the use of the prohibited transaction framework here is troublesome. For example, many

indirect fees cannot be attributed to specific transactions or customers due to the nature of the

compensation arrangements utilized by investment providers and do not affect the customer's

bottom line. For example, a mutual fund company may agree to pay a broker a flat fee that is

unaffected by sales volume. The payment would be made regardless of whether the broker

provides services to retirement investors and the payment may be insignificant when attributed to

individual investors. Yet the smallest omission would require reversal of the transaction and

payment of an excise tax, even where the omission had no effect on the transaction.

We urge the Department to incorporate the materiality standard described above in the definition

of "Material Conflicts of Interest." Otherwise, even the most inconsequential omission would

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require reversal of the transaction and payment of an excise tax and expose advisers and

financial institutions to class action litigation. For purposes of assessing the disclosures, we

recommend, and assume that the Department intends, that the terms "direct" and "indirect" have

the same meanings ascribed to them in the recent amendments to the regulation under ERISA §

408(b)(2).

Prohibited Contract Provisions

As an initial matter, we note that the Department does not have the authority to create a new

private right of action, which is what is done with the BIC requirement. Beyond this, SIFMA

has concerns with a number of the contractual prohibitions in the BIC Exemption. The

Exemption provides that the written contract may not limit the liability of the adviser or the

financial institution for violations of the contract, nor may it waive or limit the retirement

investor's right to participate in class actions against the adviser and the financial institution.

The Department states in the preamble that "[t]he right of a Retirement Investor to bring a class

action claim in court (and the corresponding limitation on fiduciaries' ability to mandate class

action arbitration) is consistent with FINRA's position that its arbitral forum is not the correct

venue for class-action claims." The Department also states, however, that "this section would

not affect the ability of a Financial Institution or Adviser, and a Retirement Investor, to enter into

a pre-dispute binding arbitration agreement with respect to individual contract claims."

We believe that the BIC Exemption should allow advisers and financial institutions to exclude

liability for actions and omissions outside of their control. If an adviser recommends a

transaction, the investor approves it, but the transaction fails or is cancelled for lack of funding

by the client, then the client should be responsible for the failure to settle the trade and any

compensation received by the adviser should not be at risk under the BIC Exemption. Similarly,

the acts or omissions of a third party, such as a custodial error in recording assets or trades, or

impossibility due to an occurrence outside the control of the financial institution (a force

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maj eure) should not cause liability on the part of a broker.

We also ask the Department to confirm in any final rule that, consistent with existing law, the

contract with the retirement investor may exclude liability for punitive and consequential

damages. In addition, we ask the Department to clarify that the contract may require the use of

FINRA' s securities dispute resolution forum as the venue for arbitrating claims under the

contract. Finally, we urge the Department to eliminate the proposed prohibition of provisions

waiving the right to bring a class or other representative action in court. The Department has no

authority to prohibit such agreements under the Federal Arbitration Act.

Section III: Disclosure Requirements

As a general matter, SIFMA agrees that appropriate cost disclosure may enhance a retirement

investor's ability to assess prospective transactions, whether in a plan or in an IRA However,

SIFMA is very disappointed that the Department chose not to rely on the detailed disclosures

required by the 2012 amendments to its regulation under ERISA § 408(b)(2). 20 SIFMA's

members opposed many of the requirements of that disclosure regime, largely on the ground that

the costs of implementing the new requirements would greatly outweigh any benefits to be

gained from them. But the entire industry complied with those requirements just three years ago.

Now, after SIFMA's members have spent millions of dollars building the systems necessary to

implement that disclosure regime, the Department is proposing to require a new disclosure

framework, different from the first, which would be far more costly to design and implement.

Rather than continue down this path, SIFMA suggests that the Department incorporate the fee

disclosure requirements of 29 C.F.R. § 2550.408b-2(c) into the BIC Exemption. Following

20 See Reasonable Contract or Arrangement Under Section 408(b )(2)-Fee Disclosure, 77 Fed. Reg. 6632 (Feb. 3, 2012).

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adoption, the Department could take the appropriate time to judge whether those disclosures

provide plan fiduciaries, participants and IRA owners with sufficient information to assess

conflicts of interest, and then determine based on actual experience with those disclosures

whether it is still necessary to mandate the additional disclosures set forth in the proposal. This

would allow SIFMA's members to rely on the systems already in place to make disclosures to

IRA owners. With this approach the Department should make clear that it is permissible for

financial institutions that are operating under the Advisers Act (e.g., when recommending

discretionary investment management services or advice programs as discussed above) to

include the 408b-2 disclosures in their Form ADV disclosure brochures, as this will be more

manageable for both advisers and their clients.

SIFMA offers the following additional comments with respect to the disclosure requirements of

Section III of the proposed BIC Exemption:

Cost Disclosure at Time of Purchase

Under the proposed BIC Exemption, whenever an adviser executes a purchase of an asset for a

retirement investor, the investor must be given a chart showing the "total cost" of the acquired

asset over periods of one, five, and ten years. "Total cost" includes the acquisition cost (e.g.,

loads, commissions, mark-ups on assets bought from dealers, and account opening fees), ongoing

fees and expenses of pooled investment funds (e.g., annualized mutual fund expenses), and costs

of disposition (e.g., surrender fees and back-end loads). The Department states that its proposal

is designed to direct attention to fee information "in a time frame that would enable the

Retirement Investor to discuss other (possibly less costly) alternatives with the Adviser prior to

executing the transaction" and invites comment on all aspects of the provision of data both at the

time of the transaction and annually.

We believe that this chart is unworkable. Providing an investment's "total cost" over one, five

27

AR038135


and ten year periods will require return assumptions, which no financial professional will be

prepared to speculate about. The SEC and FINRA have for years taken the position that

projected return information is unreliable and misleading to investors. Indeed, a communication

to a retirement investor that purports to predict or project performance would violate FINRA

Rule 2210(d)(l)(F). The Department lacks any special expertise in this area and should not

attempt to override the judgment of the agencies that have that expertise,

We firmly believe that this disclosure requirement should be eliminated. Differing assumptions

across firms to calculate future performance of products could mislead retirement investors.

Forward-looking cost estimates, based on future performance speculation, is simply

unsubstantiated speculation. Will the 1-, 5- and 10-year data be deemed to satisfy the

requirement if they are calculated using FINRA rules? To the extent that an investment is not

subject to FINRA's oversight (e.g., GIPS standards or state insurance regulations), what

assumptions would advisers be required to make in order to comply? Do the 1, 5 and 10 year

calculations apply to stocks and bonds and bank deposits, and if so, how? No financial

professional could operationalize these requirements and they should be dropped.

The chart would also slow trading to the disadvantage of retirement investors alone. While the

financial professional creates the chart, provides it by mail or electronically, and waits for the

retirement investor to see and approve it, the market moves, pricing changes, and valuable

opportunities are lost. By focusing on cost to the exclusion of other investment characteristics

such as historical performance, the chart also provides a distorted picture of the relative merits of

a particular investment. In short, we believe that the chart envisioned by the Department would

help no one, and at worst, would seriously undermine the financial institution's duty of best

execution.

Practical issues surrounding the timing and mode of delivery of this chart provide yet another

reason why it should be eliminated. How long would the adviser have to wait after mailing,

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emailing or other means of delivery to the investor before the adviser could reasonably assume

the investor has reviewed the information? If the disclosure is provided in a compliant form, will

the investor be precluded from later claiming that the adviser failed to explain the information

sufficiently or that the investor did not find the disclosure to be adequate to assess a course of

action? In all cases, an investor must instruct the adviser to make a trade only after having the

full disclosure in hand. Will the adviser be required to furnish the disclosure, even if by postal

mail, before the transaction can be placed? If so, the disclosure requirement might actually

impede best execution or affect the advisability of the particular transaction.

Furthermore, many substantive elements of the disclosure make no sense given the narrow

definition of permissible "Assets." We are confused by the reference to mark-ups in the costs of

acquisition. Mark-ups are charged only on principal transactions, which are not covered by the

exemption. Even if a fixed income security is sold on an agency basis, the adviser would have

no way of knowing what the mark-up is, since it is charged by an unrelated dealer that has no

legal duty to disclose the mark-up. If mark-up includes spread revenue on annuities, then the

proposed disclosure requirement is inconsistent with the disclosures required by 29 C.F.R. §

2550.404a-5. The reference to account opening fees is also puzzling. Accounts do not seem to

be covered as an Asset. What is contemplated by the required disclosure of mark-downs on

assets sold to dealers? That information will not be available to the financial professional or the

financial institution; if required, the third party dealer will not engage in the trade.

Various types of accounts impose fees at the time of opening, and some may have fees if the

account is materially changed - such as transitioning an account from a pure investment vehicle

to an annuitized account without liquidating any investments. Unless the definition of "Asset"

under the BIC Exemption is revised to include a rollover account, the fees associated with

opening a rollover account are not costs of acquiring an "Asset." More importantly, while we

recognize that the Department's goal is to provide the investor with a sound basis to assess costs,

we do not believe that including this type of account fee in the disclosure makes sense in the

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overall context of the regulation. Similarly, fees imposed to close an account do not have a

connection to any "Asset." In our view, these disclosure items need to be rethought and better

tailored to reflect the narrow list of assets permitted under this exemption.

Annual Fee and Compensation Disclosure

Under the BIC Exemption, within 45 days after the end of each year, the adviser must give the

retirement investor a list of each asset purchased, sold, or held for his account during the

preceding year, as well as a statement of all fees and expenses paid by the investor, directly or

indirectly, during the year with respect to each asset. A statement of the total compensation

received by the adviser and financial institution directly or indirectly from any party, as a result

of each asset purchased, sold or held for the investor's account during the year also must be

included.

We believe that this requirement should be eliminated. Requiring annual disclosure of all fees

and expenses paid by the investor during the year would be duplicative of disclosures made at

the time of sale (e.g., through prospectuses and trade confirmations) and would only impose

unnecessary costs on financial institutions that would ultimately be passed on to retirement

investors. It would also be extremely difficult for advisers and financial institutions to identify

all of the indirect compensation that they may receive. As stated previously, many indirect fees

cannot be attributed to specific transactions or customers due to the nature of the compensation

arrangements utilized by investment providers. By the same token, the amount of any indirect

compensation attributable to a specific transaction or customer may be insignificant, and the

failure to disclose even an immaterial amount of indirect compensation could result in a

complete loss of the exemption.

If the Department insists on retaining this annual disclosure requirement, it should be expressly

limited to assets/or which investment advice was provided during the preceding year. We

30

AR038138


assume that is the Department's intent, and request that the Department make that limitation

clear. We also respectfully request that the timing of the annual disclosure be revised to match

the timing requirements for the annual Form 5500. We do not believe any meaningful purpose is

served by requiring the disclosure within forty-five days after each year end. Further, our

members believe that this time frame is not reasonable and should, at the very least, be extended

to ninety days. Also, for fees and expenses paid by the investor, estimates should permitted, as

they are in the Department's current regulation under ERISA § 408(b )(2) - for example, fees for

pooled investment vehicles are estimated based on the average annual fee rates of those vehicles.

The Department should also permit estimates for indirect compensation and require only that

material amounts be disclosed.

Web Disclosure

The BIC Exemption requires the financial institution to maintain a web page that lists all "direct

or indirect material compensation" payable to the adviser for services in connection with each

asset (or, if uniform across a class of assets, the class of assets) that an investor is able to

purchase, hold or sell through the adviser and that has been purchased, held or sold in the last

365 days, along with the source of the compensation and how it varies within and among assets.

The information also must be accessible in a machine readable format. This presumably requires

the detailing of every insurance company separate account, every collective trust by unit class,

every mutual fund by share class, every annuity contract and every GIC.

SIFMA views the web page disclosure requirement as overly broad, very impractical, and

extremely costly and cumbersome to build, administer and maintain. SIFMA's members have

had the experience of modeling disclosure for plans and participants in the last five years. They

do not believe that such an undertaking would achieve the Department's stated goal of providing

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AR038139


"a broad base of information about the various pricing and compensation structures adopted by

Financial Institutions and Advisers."21 In addition, although the Department states that a related

goal is to provide information that enables "financial information companies" to analyze and

compare fee and compensation practices of advisers and financial institutions, this is a massive

undertaking, requiring daily review for product and fee changes, and would cost millions of

dollars for every single financial institution. We simply do not see how establishing a publicly

available web page would serve the interests of the public and it certainly could not be cost

justified. Even if the Department's goal is to condense information that would then be

aggregated and disseminated by "financial service companies," the varying degrees of payments

that could be attributed across the many types of institutions would be meaningless. In addition

to these steep challenges, the information would not have any use for members of the public,

even for participants of plans that invest in privately managed accounts.

We urge the Department to abandon the proposed web page disclosure requirement as a

condition for relief under the BIC Exemption. This requirement, coming so close on the heels of

the massive section 408(b )(2) project, is simply impossible to justify. On its own, it will result in

brokers refusing to use the exemption, which in tum will result in more leakage of retirement

savings from tax-advantaged accounts and widespread confusion on the part ofretirement

investors, neither of which is in their interest.

Section IV: Range of Investment Options

Under the BIC Exemption, the financial institution must offer and the adviser must make

available a range of assets that is broad enough for the adviser to make recommendations with

respect to every asset class necessary to serve the retirement investor's best interests. The

21 80 Fed. Reg. at 21973.

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exemption permits the financial institution to offer only proprietary products, only those that

generate third party fees or only those of a particular asset class or product type, if it makes a

written finding that the limitations do not prevent the adviser from providing advice that is in the

investor's best interest, if the compensation received for the services provided to the investor is

reasonable, and if the investor is given written notice of the limitations placed on assets that may

be offered to the investor. The adviser must notify the investor if the adviser does not in fact

recommend a sufficiently broad range of assets to meet the investor's needs.

The precise language in Section IV(a) of the exemption states that the financial institution and

adviser must offer "a range of Assets that is broad enough to enable the Adviser to make

recommendations with respect to all of the asset classes reasonably necessary to serve the Best

Interests of the Retirement Investor in light of its investment objectives, risk tolerance, and

specific financial circumstances." The Department should make clear that the term "asset

classes" refers to the broad categories of equity, debt and cash instruments, rather than

subcategories or other classifications that are less easily categorized. Any other intended

meaning would be unworkable and lead to confusion.

The Department's use of the phrase "range of Assets" in Section IV(a) is also confusing. Could

a financial institution that offers only mutual funds have a "range of Assets" that is broad enough

to satisfy the requirements of Section IV(a)? What about a financial institution that offers bank

deposits, CDs and money market funds? How would the requirement of a "broad enough" array

of "Assets" apply in cases where a financial institution specializes in a limited range of asset

classes? Could a specialist in fixed income satisfy the broad "range of Assets" requirement of

Section IV(a) if the specialist recommends a broad range of corporate bonds, agency debt and

U.S. Treasury securities that meet the definition of an "Asset" under the BIC Exemption, or

would the specialist have to advise on an entire range of asset classes? Could such a fixed

income specialist satisfy the broad "range of Assets" requirement in Section IV(a) with respect to

some retirement investors but not others? The Department acknowledges that some firms

33

AR038141


"specialize in particular asset classes or product types" and suggests that such firms may still be

able to use the exemption;22 however, it is unclear how the "range of Assets" requirement could

be satisfied outside the context of mutual funds. We urge the Department to limit this

requirement to recommendations to purchase, hold or sell mutual funds.

Section IV(b) focuses on financial firms that exclusively offer specialized and/or proprietary

products, which may or may not cross an array of asset classes. Many of the above questions

about Section IV(a) reflect confusion about the interplay between Sections IV(a) and (b ). We

believe that Section IV(b)'s "Section (a) notwithstanding" language should be clarified to

delineate the scope of the general rule and the exceptions and conditions.

We are also unclear about how the conditions of Section IV(b) would be applied in operation.

The conditions of Section IV(b) specify that the firm and adviser must satisfy the best interest,

impartial conduct and reasonable compensation standards contemplated by the proposal and

notify the retirement investor of the limitations placed on the Assets offered to the investor.

These requirements of Section IV(b) raise a number of questions.

• To the extent that a financial institution offers a limited range of investment

options, does Section IV(b)(l) require the financial institution to make a separate

written finding for each retirement investor that the limitations on Assets

available for purchase do not prevent the advisor from acting in the best interest

of the retirement investor or otherwise adhering to the impartial conduct

standards? Can this requirement be satisfied by a written finding that applies to

all of the financial institution's retirement investor clients?

22 See 80 Fed. Reg. at 21975.

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• How would the adviser address questions from a client in a case where Section

IV(b )( 4) requires the adviser to provide notice that it is not recommending a

sufficiently broad range of investment options to meet that client's needs? For

example, assume a financial institution's business model is to sell only funds with

agreements for compensation, and it and the adviser make the finding required

under (b )(1 ). Further narrowing the range of investments, the individual adviser

advises only on bond funds regardless of whether other advisers may recommend

a broader range. Does Section IV(b )( 4) require the adviser to provide the investor

with a notice stating literally that "the Adviser does not recommend a sufficiently

broad range of Assets to meet the Retirement Investor's needs"? Section IV(b )( 4)

should be revised to make clear that the notice can be phrased in less pejorative

terms that are more tailored to fit the circumstances - e.g., "Please understand that

the adviser provides recommendations only on bond funds and that the adviser's

recommendations are not intended to encompass the entire range of assets that

might be necessary to meet your needs."

In addition to the questions noted above, it is unclear whether the notice required by Sections

IV(b )(3) must be repeated every time a recommendation is made, updated or changed. Similarly,

under what circumstances would a change in the limitations on Assets offered to retirement

investors render a notice provided under IV(b )(3) insufficiently specific? For example, what if

the financial institution changes the amount or percentage of revenue sharing it expects to

receive? Would it be sufficient in all such cases to state in a notice that the firm expects to

receive payment from the investment providers whose products are being offered, or is more

specific disclosure required as to the relative amounts of such compensation?

The requirements of Section IV(b )(1 ), (3) and ( 4) are vague and confusing. We urge the

Department to eliminate these sections, or repropose them with more clarity and objective

requirements. Failure to meet this exemption requires reversal of the transactions done under it,

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AR038143


and payment of a significant excise tax. It is quite unfair to impose a vague, internally

inconsistent, and ill-defined requirement with these severe penalties.

Finally, we request that Section IV(b )(2) be deleted. That condition requires that any

compensation be "reasonable in relation to the value of the specific services provided to the

Retirement Investor in exchange for the payments and not in excess of the services' fair market

value." Because the impartial conduct standards already prohibit the receipt of compensation in

excess of what is reasonable, Section IV(b )(2) should be unnecessary.

To the extent that Section IV(b )(2) purports to establish a different standard of "reasonable

compensation," we believe that it is too prescriptive and narrow to be workable. A standard

requiring that compensation be no more than "fair market value" for the specific services

provided to plan investors and individual investors alike would be extremely difficult to apply.

How would a financial institution prove reasonableness in relation to the specific services

provided to the retirement investor if the firm has only omnibus expenses that are based on

services and profitability across a large retirement plan book of business? Would it be

reasonable to allow an adviser to recommend one mutual fund over another where the adviser

knows that the recommended fund's investment manager pays the adviser's firm more than

another fund manager? Would the firm be prepared to show that the adviser's only economic

benefit would be greater fees paid to his firm, or would the firm be better advised to recommend

only funds with the lowest third party payments? Third party fees vary widely. If a financial

institution accepts a low fee from one fund, would all other fund fees in excess of that level be

unreasonable on the ground that the benefit to the firm is indirectly compensating the individual

adviser?

In short, the "reasonable compensation" standard articulated in Section IV(b )(2) is unreasonable,

and appears to be drafted as an impossibility: unless a financial professional can trace every

dollar to a particular service to a particular account in connection with a particular transaction

36

AR038144


and demonstrate that others charge the same way, he is destined to fail. We suggest that this has

never been the law, nor even the Department's position with respect to the reasonable

compensation requirements of the statutory exemption for services.

Sections V and IX: Disclosure to the Department, Recordkeeping and Data Requests

Section IX of the BIC Exemption requires financial institutions to maintain information at the

financial institution level by quarter, concerning investment inflows, outflows and holdings for

each asset purchased, sold or held under the exemption, including: the identity and quantity of

each asset purchased, held or sold; the aggregate dollar amount invested or received and the cost

to the investor for each asset purchased or sold; the cost incurred by the investor for each asset

held; all revenue received by the financial institution or its affiliate in connection with the

purchase, holding or sale of each asset, disaggregated by source; the identify of each revenue

source and the reason for the payment. In addition, financial institutions must maintain

information at the investor level concerning the identity of the adviser, the beginning- and end

of-quarter value of each investor's portfolio, and each external cash flow to or from the

investor's portfolio during the quarter.

Section V(b) of the BIC Exemption further requires that this data be maintained for a period of

six years from the date of the transaction for which relief is sought under the exemption and that

it be made available to the Department upon request within six months from the date of the

request. In addition, Section V( c) requires the financial institution to maintain for a period of six

years records demonstrating that the conditions of the exemption have been satisfied. Such

records must be made available to the Department, the Internal Revenue Service (IRS), any

retirement investor and any contributing employer or employee organization whose members are

covered by a plan that engaged in a transaction under the exemption.

The preamble states that the purpose of the Section V(b) data request requirement is to "assist the

37

AR038145


Department in evaluating the effectiveness of the exemption." The effect of that requirement,

however, would be to invalidate past and future compensation covered under the exemption if

the Department's data request cannot be met within the six month period. Creating a system that

would be able to respond to such a data request will be extremely costly and time consuming.

The cost implications of these data request requirements are described in greater detail in the

Deloitte report submitted with this comment letter. We do not believe that these costs are

justified by the benefit the Department suggests would be obtained. We urge the Department to

eliminate the data request requirements of Sections V(b) and IX entirely.

If the Department decides to move forward with the data request requirements of Sections V(b)

and IX, it should extend the effective date of these requirements by at least thirty-six months to

give the industry adequate time to develop the systems necessary to capture the data and perform

the calculations contemplated by the requirements. We also ask the Department to eliminate the

Section IX( e) public disclosure provision. We believe it is entirely inappropriate to disclose

portfolio return information alongside the identity of the individual advisor in a public filing. It

appears that the entire purpose of this disclosure is to embarrass or otherwise call out advisors

whose clients have lower returns, regardless of whether the clients' returns are determined by

their own choice of strategies, and not by their advisor's skill or expertise. It is a blunt

instrument, without any differentiation between asset classes, age or risk tolerance of the

investor, or any other parameter that would actually be relevant to a comparison.

In addition, we ask that the data request requirement in Section V(b) be modified to parallel the

exception in the proposed recordkeeping requirement of Section V(c) for records that are lost or

destroyed due to circumstances beyond the control of the financial institution. We also request

clarification that, to the extent a financial institution cannot rely on the exemption due to a failure

to maintain or provide information that complies with a data request under Section V(b ), that the

inability to rely on the exemption will apply only prospectively from the date the BIC Exemption

becomes unavailable to that institution, and that there will be no retroactive consequences.

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In contrast, we believe that the comprehensive disclosure framework administered by the SEC

and FINRA is far more targeted and nuanced in an appropriate manner. Particularly in light of

the privacy risks highlighted by the widely-publicized hacking of confidential personal

information concerning millions of federal employees, we believe that sensitive information

about individual investors should either be excluded from the data request requirements of

Sections V(b) and IX, or at the very least subject to a right on the part of the investor to "opt out"

of having their sensitive financial information scrutinized, or even inadvertently disclosed, by

federal regulators. At the very least, we believe this section should require all retirement

investors to be warned that every transaction they engage in will be reported to the federal

government.

Section VII: Exemption for Pre-Existing Transactions

The supplemental relief for pre-existing transactions would provide relief from the prohibitions

ofERISA §§ 406(a)(l)(D) and 406(b) and Code§§ 4975(c)(l)(D), (E) and (F) for the receipt by

advisers of prohibited compensation in connection with transactions that were entered into prior

to the applicability date of the proposed regulation. The supplemental relief for pre-existing

transactions applies to the receipt of compensation for services in connection with the purchase,

holding or sale of an "Asset" by IRAs, participant accounts and all ERISA plans, regardless of

size and whether or not the plan is participant-directed. The supplemental relief would cover

advisers who did not consider themselves fiduciaries prior to the applicability date, as well as

advisers who considered themselves fiduciaries but relied on an exemption that has since been

amended. The proposed conditions for supplemental relief would require that the compensation

be received under an arrangement that was entered into prior to the applicability date. The

proposed conditions also would require that the adviser not provide any "additional advice"

regarding the purchase, holding or sale of the asset after the applicability date. The proposed

conditions would also exclude transition relief for any compensation received in connection with

39

AR038147


a purchase or sale that was a non-exempt prohibited transaction when it occurred.

SIFMA does not believe that it would be in the best interests of retirement investors to deny

transition relief for advice to hold or sell or otherwise dispose of assets already held in such

accounts. Not providing advice to a retirement investor on assets that the advisor previously

recommended will only confuse the investor. Advisers should be able to continue to receive

compensation for any asset in the retirement investor's account prior to the effective date of the

rule as long as the adviser does in fact continue to give advice to the investor. That is a common

sense approach and is in the retirement investor's best interest.

We also would ask that any acquisitions or dispositions that are effected after the applicability

date of the regulation pursuant to any standing or automatic investment instructions effected

before the applicability date (e.g., investment instructions to rebalance back to the original

investment allocation) be afforded protection under the BIC Exemption. These modifications

would allow investors and advisers to continue on previously agreed courses of action, with the

relief to end immediately upon any new recommendation or transaction that otherwise would

trigger the contractual and other requirements of the BIC Exemption.

We believe that investors are best served by transition guidance that enables them to dispose of

assets that they or their advisers no longer wish to own. The adoption of a new set of rules

should not make it more cumbersome to advise, recommend or process an order to liquidate a

pre-existing position, particularly given the time it will undoubtedly take to bring pre-existing

accounts into compliance with the new rules. Rather, the disposition of a pre-existing position

for cash should be grandfathered under existing rules, although any recommendation to re-invest

that cash would, appropriately, be subject to the new fiduciary definition. Any other approach

would be, at best, confusing to explain and apply, and at worst, inhibit communications between

advisers and clients about poorly performing assets. In the event there is no relief for advice

regarding pre-existing holdings, however, we recommend that prohibited transaction relief for

40

AR038148


such advice be conditioned only on compliance with the "best interests" standard proposed by

FINRA. In this way, firms will be able to limit sales or other dispositions of assets that may

generate extra compensation for the adviser, such as a back-end load or surrender charge.

We believe that it is equally important to extend transition relief to acquisitions of investments

that are part of an automatic savings and investment program. For example, if a plan participant

elects automatic salary deferrals into the plan after receiving advice from an adviser prior to the

applicability date, we do not believe it serves the interests of anyone involved to require that

such advice be revisited and, most likely, given again subject to the fiduciary standard, with or

without the BIC Exemption. It would create an enormous burden for financial firms, and it is

difficult to understand how it would benefit the participant. If, of course, the adviser

recommends any increase in the investment amount, or changes the recommended asset mix after

the applicability date, the new fiduciary framework would apply. Similarly, standing asset

allocation (and rebalancing) instructions and automatic dividend reinvestment should not be an

inadvertent compliance trap, so long as it is not changed or advised to be changed. Mutual fund

and annuity "dollar-cost averaging," where an individual purchases a highly liquid interest,

usually a money market fund, and has the money fund account automatically fund other

investments at pre-set intervals, also should be unaffected if the dollar-cost averaging advice and

investment program were set before the applicability date.

SIFMA is also concerned that the narrow definition of the term "Asset" could have serious

adverse consequences if the exemption for pre-existing transactions is adopted in its proposed

form. As we understand the proposed transition relief in Section VII, if a pre-existing holding is

not an "Asset" within the meaning of the BIC Exemption, Section VII will provide no relief for

any compensation received with respect to that holding going forward, and Section I likewise

will provide no relief for any advice or recommendations with respect to that holding going

forward. Denying transition relief for compensation received with respect to pre-existing

holdings that are not "Assets" not only defeats legitimate expectations of the contracting parties,

41

AR038149


but will create a huge compliance burden from the instant the rules become applicable. Advisers

and financial institutions will have to determine promptly which pre-existing accounts hold

investments that meet the definition of an "Asset," which hold investments that do not meet that

definition, and which hold both types of investments. For any pre-existing accounts that hold

investments that are not "Assets," advisers and financial institutions will have to immediately

suspend the receipt of any compensation attributable to such assets and cease to provide any

advice or recommendations with respect to such non-"Assets" going forward. For accounts that

hold both "Assets" and non-"Assets," segregating any ongoing compensation associated with

"Assets" covered by the transition rule will present its own technical challenges, and advisers

and financial institutions may have no choice from a compliance perspective but to split the

"Assets" and non-"Assets" into separate accounts. Such splitting into separate accounts would

not only increase recordkeeping and other costs, but also make it more difficult for the account

owner to monitor his accounts with the financial institution.

Furthermore, because of the time it would take to identify every account holding non-"Assets,"

advisers and financial institutions may have to place all of their retirement accounts into a "no

advice" category until all of these issues can be sorted out. The process of identifying all pre

existing account holdings that are not "Assets" will be extremely costly and time consuming, and

the account owners themselves are likely to be bewildered and upset by the entire experience.

We do not believe this is workable and we urge the Department to broaden the scope of

transition relief

The transition relief also suffers from the concerns we have previously raised regarding multiple

accounts, such as an IRA and a non-retirement account, and the limited scope of the "Asset"

definition. We will not reiterate all of those concerns in this section of our comments, but we

wish to point out that, apart from the fiduciary requirements and proposed exemptions, there is

no history in account construction or composition that differentiated among assets as the

Department now proposes. Therefore, while the issues we raised above certainly apply in the

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AR038150


context of future accounts, assets and recommended transactions, the complications are

multiplied where financial firms are maintaining multiple pre-existing accounts for clients. It

will be next to impossible to succinctly explain to clients or advisers how the rule regarding

"Assets" is to be applied, particularly with long-standing investment accounts.

The Request for Comment on a Low Fee Streamlined Exemption

The preamble to the proposed exemption seeks comments on whether the Department should

issue a separate class exemption, with fewer conditions, for advice concerning low-fee index

funds. Examples mentioned in the preamble are "a long-term recommendation to buy and hold a

low-priced (often passively managed) target date fund that is consistent with the investor's future

risk appetite trajectory" and "a medium-term recommendation to buy and hold (for 5 or perhaps

10 years) an inexpensive, risk-matched balanced fund or combination of funds, and afterward to

review the investor's circumstances and formulate a new recommendation."

This contemplated exemption appears, similar to the "Asset" definition, to indicate a policy

preference by the Department for passively managed target date funds. Neither ERISA nor the

Code authorizes the Department to implement such policy changes. Further, we disagree with

this approach because there is no good evidence that passively managed investments are "safer"

than actively managed investments. An investment in an S&P 500 index fund reflects an

affirmative decision to invest in large U.S. equities (and incidental futures used to smooth

rebalancing transactions, or large inflows and outflows). The fund's investment strategy is quite

simple to explain, but its underlying assets are subject to all of the market volatility and to some

extent sector volatility that underlie all equity investing. We do not believe that any element of

such vehicles, in and of itself, lends itself to a different fiduciary analysis, and we reiterate our

view that the Department's desire to simplify the investment advice for retirement investors

should not result in the Department lending favored status to any particular investment type. We

recommend even-handed treatment of investments in the BIC Exemption and in the fiduciary

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AR038151


regulation overall absent specific features that demand special precautions.

Section VIII: Definitions

Many of SIFMA' s questions and comments regarding the proposed definitions in the BIC

Exemption are addressed as they arise in the proposal itself What follows is a list of additional

comments and questions concerning the definitions, not specific to any particular functional part

of the exemption.

Adviser - Under the proposed fiduciary regulation, there is no carve out for call centers or their

personnel. SIFMA has separately commented on that proposal. For purposes of the BIC

Exemption, call center employees may be compensated in a way that puts them in a position that

requires relief However, to meet the definition of an "Advisor" under Section VIII( a) of the

BIC Exemption, call center employees would have to "[s]atisfy the applicable federal and state

regulatory and licensing requirements of insurance, banking, and securities laws with respect to

the transaction." We are concerned that this language may require call center employees to

register with the SEC as "advisers" under the Investment Advisers Act of 1940 ("Advisers Act").

Unless the Department decides to include a specific carve out in the fiduciary regulation for call

centers, we urge the Department to clarify that call center employees do not have to register as

"advisers" under the Advisers Act to qualify for relief under the BIC Exemption.

The Department, in the proposed fiduciary regulation, has cited its extensive coordination with

securities regulators. We are hopeful that the SEC and the Department are aligned on the

"Adviser" definition, and that invoking the relief provided by the BIC Exemption will not, by

itself, trigger a separate registration requirement with the SEC under the Advisers Act to the

extent there was no other need to register under that statutory framework.

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Affiliate - We urge the Department to revise this definition to provide greater consistency with

the federal securities laws, particularly with respect to the individuals covered in paragraph

VIII(b )(2). The ERISA and Code definitions cited in that section will introduce an additional

compliance hurdle to the extent those definitions do not align with the common definitions

applied in the securities law context. 23 We recommend using the existing framework of broker

dealers' compliance programs, which are predicated not only on an "affiliate" definition but also

on an "associated person" definition.

Best Interest - The proposed best interest standard requires advisers and financial institutions to

prove that their recommendation was made "without regard to the financial or other interests of

the Adviser, Financial Institution or any Affiliate, Related Entity or other party." We

recommend that this clause be replaced with the phrase "and place the interests of the Retirement

Investor ahead of their own." At a minimum, for the reasons explained in our comments on the

impartial conduct standards, we urge the Department to delete the phrases "other interests" and

"or other party" from the current formulation of the standard.

Financial Institution - Section VIII( e )(2) defines the term "Financial Institution" to include a

bank or similar financial institution supervised by the United States or a state, or a savings

association, "but only if the advice resulting in the compensation is provided through a trust

department of the bank or similar financial institution or savings association which is subject to

periodic examination and review by federal or state banking authorities." We see no reason to

23 Rule 12b-2 under the Securities Exchange Act of 1934 defines "Affiliate" as a

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AR038153


limit this definition to advice provided through a bank's trust department. Advice to IRA owners

may emanate from any department of a bank and all areas are subject to federal or state

superv1s1on.24 Accordingly, we request that the entire "but only if' clause be dropped.

Independent - As written, the definition of "independent" would disqualify any company that

provides services to the financial institution, such as its accounting firm, lawyers, cleaning

services, food services, security services, parking services, window washing services, etc. To the

extent any of those companies sponsors a plan, the plan sponsor would not be "independent,"

regardless of how small the amount of income received from the financial institution.

Historically, the Department has recognized this fact in virtually every exemption it has granted

and we assume its failure to do so here was inadvertent. Accordingly, we suggest that subsection

(2) of the definition of "independent" in Section VIII(±) should be replaced with the following:

"Receives less than 5% of its gross income from the Adviser, Financial Institution or Affiliate."

In addition, subsection (3) should be revised to make clear that an IRA owner will not be deemed

to fail the independence requirement simply because he or she is an employee of the financial

institution.

Individual Retirement Account- We believe that health savings accounts (HSAs) should not

be included in the definition. HSAs by their terms are not intended for retirement income but

rather health care expenses. To be clear, we argue the same is true for other tax favored savings

vehicles that are not intended to provide retirement security, such as college or other educational

savings accounts that may be offered through broker-dealers.

24 The bank regulators at the federal level include the Office of the Comptroller of the Currency, the Consumer Financial Protection Board and the Securities and Exchange Commission.

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Material Conflict of Interest - This definition should be revised to incorporate the standard of

materiality described above in our comments concerning the impartial conduct standards.

Without more, the Department's proposed definition could be interpreted to cover even the most

remote financial interest that could possibly affect one's best judgment, regardless of whether the

effect of the financial interest would be material.

Proprietary Product - Section VIIIG) defines a "proprietary product" as one that is "managed

by" the financial institution or any of its affiliates. However, investment products are generally

considered "proprietary" to a firm when they are issued or sponsored by the firm or an affiliate.

We recommend a definition more in line with these concepts and believe that the term "managed

by" is not a meaningful indicator of "proprietary" status.

SIFMA and its members appreciate the opportunity to comment and look forward to meeting

with the Department to discuss our concerns. For further discussion, please contact the

undersigned at 202-962-7329.

Sincerely,

Lisa J. Bleier Managing Director, Federal Government Relations and Associate General Counsel

47

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APPENDIX6

AR038206


July 20, 2015


Office of Ex emption Determinations Employee Benefits Security Administration U.S. Department of Labor 200 Constitution Avenue, N.W., Suite 400 Washington, D.C. 20210

Re: ZRIN: 1210-ZA25; PTE Application D-11850


The Securities Industry and Financial Markets Association ("SIFMA")1 is pleased to provide

comments regarding the Department of Labor's ("Department") proposal to amend and partially

revoke Prohibited Transaction Exemption ("PTE") 84-242 under the Employee Retirement

Income Security Act of 1974, as amended ("ERISA"). We appreciate the opportunity to

comment and hope that our comments are helpful to the Department as it assesses whether

changing the current exemption and eliminating the ability of individual retirement accounts

("IRAs") to rely on the exemption will serve the interests ofretirement investors.

1 SIFMA is the voice of the U.S. securities industry, representing the broker-dealers, banks and asset managers

whose 889 ,000 employees provide access to the capital markets, raising over $2.4 trillion for businesses and municipalities in the U.S., serving clients with over $16 trillion in assets and managing more than $62 trillion in assets for individual and institutional clients including mutual funds and retirement plans. SIFMA, with offices in New York and Washington, D. C., is the U.S. regional member of the Global Financial Markets Association (GFMA). For more information, visit="""-'--'-'-'-'--'-'-'=== 2 Proposed Amendment to and Proposed Partial Revocation of Prohibited Transaction Exemption (PTE) 84-24 for Certain Transaction Involving Insurance Agents and Brokers, Pension Consultants, Insurance Companies and Investment Company Principal Underwriters, 80 Fed. Reg. 22010 (April 20, 2015).

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Attached hereto are SIFMA' s submissions for the related rulemakings being undertaken by the

Department. These attachments are an integral part of this submission.3

Proposed Amendments to and Partial Revocation of PTE 84-24

In its current form, 4 PTE 84-24 provides relief from the prohibitions ofERISA §§ 406(a)(l)(A)

through (D) and 406(b) and the parallel provisions of the Internal Revenue Code of 1986, as

amended ("Code") for certain transactions relating to purchases by ERISA plans and IRAs of

insurance and annuity contracts and for the receipt by an insurance agent, broker or pension

consultant of a sales commission in connection with such purchases, provided that the conditions

of the exemption are satisfied. PTE 84-24 also provides similar relief for purchases by ERISA

plans and IRAs of mutual fund shares and for the related receipt by principal underwriters of a

sales commission, if the exemption's conditions are met.

The proposed amendments to PTE 84-24's conditions would require anyone providing fiduciary

investment advice to an ERISA plan or an IRA in reliance on the exemption to satisfy Impartial

Conduct Standards, which require the adviser to act in the investor's best interest, disclose

material conflicts of interest, and not make misleading statements about recommended

investments, fees, material conflicts of interest and any other matters relevant to the investor's

decision. With respect to IRAs, the Department proposes to revoke PTE 84-24 for IRA

purchases of variable annuities and other annuity contracts that "are securities under the federal

securities laws", for IRA purchases of mutual fund shares, and for the receipt by insurance agents

and brokers, pension consultants and principal underwriters of commissions in connection with

such sales. Insurance agents, brokers, pension consultants and insurance companies engaging in

3 See Appendices numbered 1-8.

4 See 49 Fed. Reg. 13208 (Apr. 3, 1984); 49 Fed. Reg. 24819 (June 15, 1984) (correction): Investment in Load Mutual Funds Where Fund Principal Underwriter, Etc. or Affiliate is Service Provider or Fiduciary, as amended 71 Fed. Reg. 5887 (Feb. 3, 2006).

2

AR038208


such transactions would instead rely on the Department's proposed exemption to allow certain

investment advice fiduciaries to receive compensation in connection with transactions involving

plans and IRAs (including the supplemental exemption for purchases of insurance and annuity

contracts) ("BIC Exemption"). 5 PTE 84-24 would continue to apply to IRA purchases of

insurance and annuity contracts that "are not securities" and for the receipt by insurance agents

and brokers and pension consultants of a sales commission in connection with such purchases,

provided that the conditions of the exemption are satisfied.

In addition, the DOL proposes to add specific definitions for "insurance commissions" and

"mutual fund commissions" that would be covered by PTE 84-24. Under these narrowed

definitions, insurance agents, brokers, and pension consultants selling insurance contracts to

ERISA plans under this exemption would have to limit their compensation to a sales commission

as newly defined, and principal underwriters selling mutual fund shares to ERISA plans would

have to limit their compensation to a sales load, and would be unable to receive revenue sharing,

12b-l fees, subtransfer agency fees, or any other compensation related to their sale or holding.

Thus, because these fees are currently paid to plan service providers, retirement accounts will

likely be changed to wrap fee arrangements to allow for an offset of any third-party payments

against the wrap fee.

SIFMA disagrees with the amendments to, and partial revocation of, PTE 84-24 and urges the

Department to permit plans covered by ERISA to decide for themselves how their service

providers should be compensated, so long as that compensation is fully disclosed. 6 All of these

5 Proposed Best Interest Contract Exemption, 80 Fed. Reg. 21960 (April 20, 2015).

6 We believe that the amendments are unnecessary and reflect a lack of consideration of other, more appropriate and cost-effective approaches. For over thirty years, PTE 84-24 has permitted fiduciary advisers to both IRAs and plans to sell insurance or annuities, purchase and sell affiliated mutual fund shares and receive compensation in connection therewith. This is not an exemption from 197 5, where the Department did not consider the abilities and sophistication of IRA owners in fashioning relief and now requires a fresh look. It is an exemption that the Department revisited in 2004 without changing a single provision relating to IRAs. The Department has had every

3

AR038209


same service providers entirely revised their disclosure under the Department's section 408(b )(2)

regulations just three years ago. But these amendments signal that no amount of additional

disclosure is enough and that all but certain limited fees are simply prohibited. The Department

has not provided a record to support its case that disclosure for fiduciaries is not adequate for

ERISA covered plans. Despite its amendment of this exemption four times since it was first

granted in 1977, the Department has never suggested that the fully protective disclosure

conditions of the exemption, which has always applied to investment advice fiduciaries, do not

work. We urge the Department not to finalize the amendments to this exemption.

We are concerned that the Department has significantly underestimated the cost and burden that

financial institutions will have to bear to make sure that they have not received any of the now

prohibited compensation. The change to the industry - the overwhelming majority of financial

professionals who were not subject to fiduciary rules suddenly being subject to them - upends

the compensation systems of financial institutions vis a vis mutual funds and insurers. The

communications and revision to systems to carve out all ERISA and IRA accounts from these

revenue streams will take years and involve reprogramming, testing, verifying and reconciliation

with each insurance company and each mutual fund complex. There is no simple switch to tum

off, and no simple formula for revising flat dollar payments, such as revenue sharing or training

allowances, to meet the Department's ban on this compensation. With an unreasonably short

transition period and the massive amount of work necessary to tum off this compensation, we

believe the Department has not adequately thought through the work and costs involved for

financial institutions.

SIFMA also believes that the impartial conduct standards are unnecessary for ERISA plans and

adds costs and burdens that lack any justification under ERISA or in the history of the

opportunity to modify the exemption conditions in connection with IRAs and has chosen, as recently as 2004, not to do so. The amendments are not supported by any convincing policy reasons.

4

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marketplace since PTE 84-24 was granted. ERISA plans already operate under a fiduciary

standard. That standard was, until this exemption, based on disclosure and not on prescriptive

fee engineering by the Department. As explained in the preamble to the proposal, the

Department's primary goal in amending and partially revoking PTE 84-24 is to "increase the

safeguards" relating to covered transactions. SIFMA is concerned that the Department proposes

to increase safeguards and, thus, the costs and difficulty of complying with the exemption

conditions, without offering any evidence that the existing safeguards, which have been in place

for over 30 years, have failed to protect plans or IRAs. SIFMA is concerned that the increased

costs and difficulty of moving all advised IRAs out of this exemption and into the BIC

exemption will result only in diminished choices for participants.

Section I. Covered Transactions

Who can use the exemption. The Department has significantly restricted the persons who can

use the exemption by excluding IRAs from most of the relief provided. It has neglected,

however, to mitigate the confusion caused by Footnote 4 of Advisory Opinion 2000-15, which

suggests that the exemption cannot be used where fiduciaries are providing investment advice for

a fee. Under the text of current PTE 84-24, a principal underwriter, or its affiliate, can receive

compensation under the exemption so long as it does not have discretionary authority over the

assets of a plan. However, in Advisory Opinion 2000-15, the Department suggested that PTE

84-24 would not cover any fiduciary providing investment advice for a fee. The proposed

amendment leaves this language unchanged and does not mention the advisory opinion in the

preamble.

Since the net result of the Department's definition of fiduciary proposal will be to make many

financial professionals fiduciaries and require them to provide written acknowledgement of their

services, if not a written contract, we are concerned that the exemption will not be available to

virtually any fiduciary. We urge the Department to make clear that advisory fiduciaries

5

AR038211


expressly appointed to provide investment advice for a fee are covered by the relief under the

exemption.

The proposed amendment provides as follows:

(a) The insurance agent or broker, pension consultant, insurance company, or investment company Principal Underwriter is not (1) a trustee of the plan or IRA (other than a Nondiscretionary Trustee who does not render investment advice with respect to any assets of the plan}, (2) a plan administrator (within the meaning of ERISA section 3(16)(A) and Code section 414(g)), (3) a fiduciary who is expressly authorized in writing to manage, acquire or dispose of the assets of the plan or IRA on a discretionary basis, or (4) an employer any of whose employees are covered by the plan. Notwithstanding the above, an insurance agent or broker, pension consultant, insurance company, or investment company Principal Underwriter that is Affiliated with a trustee or an investment manager (within the meaning of Section VI(e)) with respect to a plan or IRA may engage in a transaction described in Section I(a)(l)-(4) of this exemption (if permitted under Section I(b )) on behalf of the plan or IRA if the trustee or investment manager has no discretionary authority or control over the assets of the plan or IRA involved in the transaction other than as a Nondiscretionary Trustee.

We have several comments on this language. First, we believe the formulation in the last

sentence is confusing and would benefit from clarification that the trustee or investment manager

may have discretion over certain assets of the plan, so long as such trustee or investment

manager does not have discretion over the assets involved in the transaction. In this regard, we

suggest the following:

Notwithstanding the above, an insurance agent or broker, pension consultant, insurance company, or investment company Principal Underwriter that is Affiliated with a trustee or an investment manager (within the meaning of Section VI(e)) with respect to a plan or IRA may engage in a transaction described in Section I(a)(l)-(4) of this exemption (if permitted under Section I(b)) on behalf of the plan or IRA if the trustee or investment manager has no discretionary authority or control over the IRA 's or Plan's assets involved in the transaction other than as a Nondiscretionary Trustee.

We are also concerned that a financial professional will not be able to receive a commission with

respect to its own IRA, or the IRA of any family member (including parents, children, brothers,

6

AR038212


sisters and spouses of brothers and sisters) when purchasing a fixed annuity. Nor will such a

commission be payable for small family owned businesses where the financial professional is

related to the owner of the business who would have to approve the transaction. The language

provides as follows:

(2) Following the receipt of the information required to be disclosed in paragraph (b)(l), and prior to the execution of the transaction, the independent fiduciary acknowledges in writing receipt of the information and approves the transaction on behalf of the plan. The fiduciary may be an employer of employees covered by the plan, but may not be an insurance agent or broker, pension consultant or insurance company involved in the transaction. The fiduciary may not receive, directly or indirectly (e.g., through an Affiliate), any compensation or other consideration for his or her own personal account from any party dealing with the plan in connection with the transaction.

We would suggest the following change:

(2) Following the receipt of the information required to be disclosed in paragraph (b)(l), and prior to the execution of the transaction, the independent fiduciary acknowledges in writing receipt of the information and approves the transaction on behalf of the plan. The independent fiduciary may be an employer of employees covered by the plan, but may not be an insurance agent or broker, pension consultant or insurance company involved in the transaction except with respect to the person's own IRA or the IRA of a family member. The independent fiduciary shall be deemed to be independent of such person even if he or she is a relative of such person. The independent fiduciary may not receive, directly or indirectly (e.g., through an Affiliate), any compensation or other consideration for his or her own personal account from any party dealing with the plan in connection with the transaction

Commissions. The proposal covers, among other things, "Insurance Commissions" and "Mutual

Fund Commissions." An "Insurance Commission" is defined in Section VI as "a sales

commission paid by the insurance company or an Affiliate to the insurance agent or broker or

pension consultant for the service of effecting the purchase or sale of an insurance or annuity

contract, including renewal fees and trailers, but not revenue sharing payments, administrative

fees or marketing payments, or payments from parties other than the insurance company or its

Affiliates." The term "Mutual Fund Commission" is defined to mean "a commission or sales

load paid either by the plan or the investment company for the service of effecting or executing

7

AR038213


the purchase or sale of investment company shares, but does not include a 12b-l fee, revenue

sharing payment, administrative fee or marketing fee." SIFMA believes that these definitions

should cover all forms of disclosed and agreed upon compensation, regardless of the source of

payment. Agents, brokers, consultants and principal underwriters, including both employees and

independent contractors and persons overseeing their activities, are compensated in a variety of

ways, including commissions, revenue sharing, service fees, salaries and other consideration.

There is no valid basis for favoring one form of disclosed and agreed compensation over another.

Accordingly, we urge the Department to make clear that all disclosed and agreed compensation

be covered and to delete the proposed specific exclusions.7

There is no reason why financial professionals should be denied relief for any form of

compensation for their services to plans, particularly in light of the enhanced fee disclosure

regulations in place. In addition to the substantial increases in disclosures implemented by the

Department, the SEC has vastly simplified the disclosure of 12b-l and other investment

company fees through implementation of the widely used summary prospectus disclosure

document. We therefore see little advantage in the limitations in these definitions, while we do

see disadvantages to them. In the absence of relief for these other expenses under PTE 84-24,

financial professionals will charge asset-based fees that are likely to be higher, and simply offset

the 12b-l fees, service fees, sub-transfer agency and other fees dollar for dollar, which may well

exceed current fee levels. Further, as discussed in detail earlier in this comment, the amount of

work necessary to effect this change will be enormous and, if the Department proceeds with

7 We are particularly concerned about subtransfer agency fees. As the Department knows, many financial

institutions use omnibus accounts at mutual fund companies, allowing the mutual funds to avoid recordkeeping for the hundreds of thousands accounts at the financial institution, and using the financial institution to do that recordkeeping and subaccounting for them. It would be an enormous burden on mutual funds and highly inefficient for the markets in general if mutual funds could not rely on and pay financial institutions for these services. Financial institutions will not perform these functions for free, so clients will be charged additional amounts for subtransfer agency services if the financial institution cannot receive subtransfer agency fees from the mutual fund. We urge the Department to rethink exclusion of subtransfer agency fees.

8

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them, the transition rules should permit any compensation currently received to continue for at

least 18 months after the effective date.

The definition of "Insurance Commission" provides for sales commissions to be paid to an

insurance agent, broker or pension consultant from either the insurance company or an Affiliate,

as that term is defined in Section VI( a). Because references to insurance companies and other

persons are deemed to include Affiliates under Section 6( e ), the Department should delete the

words "or an Affiliate" after the words "insurance company" in the definition of "Insurance

Commission."

Exclusion of Mutual Fund and Variable Annuity Purchases by IRAs. SIFMA believes that

the Department should retain PTE 84-24 for all annuity and mutual fund purchases by IRAs.8

The Department states that the partial revocation proposed, and the consequential use of the BIC

Exemption, "better protect the interests of IRAs with respect to investment advice regarding

securities products." The Department presents no evidence that the current exemption fails to

protect such interests. While the Department states that IRAs have grown and that financial

services generally have become more complex in recent years, the Department provides no

explanation as to how this growth and complexity have specifically affected transactions in

annuities and mutual funds. Notably, Rule 12b-l under the Investment Company Act of 1940,

adopted in 1980, had been widely used in mutual fund pricing dating well before PTE 84-24 was

granted. Regulation of mutual fund sales loads also became more stringent in the decade after

PTE 84-24, and the limitations remain in place today. 9

8 In Advisory Opinion 2000- l 5A, the Department clarified that PTE 84-24 applies to IRA transactions.

9 In 1992, the Securities and Exchange Connnission ("SEC") approved amendments to NASD Conduct Rule 2830, which in effect limited the maximum 12b-l fees that many funds could deduct from fund assets pursuant to a rule 12b-l plan, The NASD sales charge rule is administered by FINRA, which derives authority to regulate the level of mutual fund sales charges from section 22(b )(1) of the Investment Company Act of 1940. See Order Approving Proposed Rule Change Relating to the Limitation of Asset-Based Sales Charges as Imposed by Investment Companies, 57 Fed. Reg. 30985 (July 13, 1992), NASD Notice to Members 92-41 .

9

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Forcing all mutual fund and variable annuity purchases by IRAs out of this exemption, and into

the far more limited and restrictive BIC Exemption, is not supported by any convincing policy

reasons, and the Department fails to explain why it is appropriate to do so. We respectfully

submit that the Department has no reason to amend this exemption to exclude IRAs from its

coverage. IRAs already receive all of the disclosure required with respect to plans under the

exemption.

In addition, the Department's proposal fails to appreciate the difference between sophisticated

investors and investors with smaller investable assets. It makes little sense to deprive

sophisticated investors of the benefits of the exemption or force them into wrap programs with

higher fees or the restrictive BIC Exemption, which the Department designed for unsophisticated

investors. We believe that these amendments should be abandoned and re-proposed, changing

only the disclosure conditions for IRAs.

At the very least, sophisticated IRA owners should be able to use the exemption under the same

conditions applicable to plans. The Department has not analyzed the costs and benefits of

continuing to permit IRA owners, much less sophisticated IRA owners, to use the exemption.

We think it must do so. 10

10 The Department could adopt the framework set forth in the Securities Act of 1933 for accredited investors, which sets forth specific qualifying criteria and verification standards. 17 CFR 230.50l(a)(5) and (6). We believe this is a commonly used and commonly understood test and reflects a well-recognized standard of investors who are able to look after their affairs in a financially sophisticated manner. The Jumpstart Our Business Startups (JOBS) Act introduced the current test, and the test is consistently applied based on rule amendments and interpretive guidance , In its current form, the test provides as follows:

(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000.

(i) Except as provided in paragraph (a)(5)(ii) of this section, for purposes of calculating net worth under this paragraph (a)(5):

(A) The person's primary residence shall not be included as an asset;

(B) Indebtedness that is secured by the person's primary residence, up to the estimated fair market value of the primary

residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time,

10

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The Department's proposed revocation of coverage for IRAs purchasing a variable annuity "or

other annuity contract that is a security under federal securities laws" is particularly puzzling.

The Department cites as the underpinning for distinguishing between these and other annuities

its concern that the BIC Exemption, including some of its disclosure requirements, may not be

readily applicable to insurance and annuity contracts that "are not securities", or to distribution

channels with characteristics that would not fit within the BIC Exemption. Conversely, the

Department indicates in the preamble that it believes that annuities that "are securities" and

mutual funds are distributed through the same channels as many other investments covered by

the BIC Exemption, thereby leading it to propose to place these transactions into the BIC

Exemption framework.

We urge the Department to abandon this distinction based on an annuity contract's status as a

"security". The federal securities laws expressly cover all investments that are deemed to be

securities under the Securities Act of 1933, which in turn subjects securities to the laws regarding

registration, trading, sanctions for fraud, and many other substantive requirements. Some

other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and

(C) Indebtedness that is secured by the person's primary residence in excess of the estimated fair market value of the

primary residence at the time of the sale of securities shall be included as a liability;

(ii) Paragraph (a)(5)(i) of this section will not apply to any calculation of a person's net worth made in connection with a

purchase of securities in accordance with a right to purchase such securities, provided that

(A) Such right was held by the person on July 20, 2010;

(B) The person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and

(C) The person held securities of the same issuer, other than such right, on July 20, 2010.

(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

11

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instruments that are deemed to be securities are exempt from registration with the SEC, but are

nonetheless subject to other substantive regulations. Other securities are exempt from certain of

the offering provisions of the federal laws. To place this distinction at the heart of Department of

Labor exemptive relief creates uncertainty for investors in annuities and poses a definitional

landscape that will shift over time, prompting changes in firms' abilities to rely either on PTE 84-

24 or the BIC Exemption. This is underscored by the fact that we assume the Department meant

to permit IRAs to be covered under PTE 84-24 for insurance contracts that are securities, so long

as they are exempt securities. 11 Requiring plan and IRA fiduciaries, as well as financial

intermediaries, to understand not only these very dense and prescriptive exemptions as well as

the status of insurance products under the securities laws is unfair, costly and likely fraught with

confusion. We urge the Department to permit all insurance products to continue to be sold under

PTE 84-24. For example, many variable annuities have a fixed annuity component. How is that

component to be treated under this exemption? In any event, if, however, the Department retains

a limitation on IRA purchases of annuities in a final exemption, we recommend that the

Department change the criteria in Section I(b) from an annuity that "is a security" to an annuity

that is a registered security.

Section II. Impartial Conduct Standards

The proposal amends PTE 84-24 to require the fiduciary to comply with impartial conduct

standards. We object to this requirement.

11 See the recent controversy at the SEC regarding indexed annuities. The SEC adopted a new regulation, Rule

151A under the Securities Act of 1933, which would have required SEC registration of equity indexed annuity contracts as securities and the sale of these products by registered broker dealers in accordance with SEC and FINRA sales practice standards. Rule 15 lA, which had a delayed effective date and never became effective, was challenged in court and vacated on procedural grounds. Today, the SEC does not specify whether or not these contracts are subject to federal securities laws: "Variable annuities are securities regulated by the SEC. An indexed annuity may or may not be a security; however, most indexed annuities are not registered with the SEC. Fixed annuities are not securities and are not regulated by the SEC." U.S. Securities and Exchange Commission website, Investor Information, Fast Answers, Annuities. http://www.sec.gov/answers/annuity.htm. Since that time, Congress has periodically considered legislation that would expressly exclude equity indexed annuities from the federal securities laws, and instead would have such annuities overseen by state insurance regulators.

12

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Congress saw no reason to have a prudence standard for IRAs and believed that a violation of the

prudence standard for ERISA plans should be remedied through litigation in federal court.

Nonetheless, the proposal purports to condition relief under Section 4975 of the Code on the

contractual assumption of a prudence standard that would be enforceable by IRA owners in state

court. We do not believe that Congress intended a breach of the duty of prudence to violate the

prohibited transaction provisions of ERISA and the Code. Our specific comments follow.

SIFMA strongly objects to these standards for plans covered under Title I of ERISA. The

Department acknowledges in the preamble that the best interest standard "is based on

longstanding concepts derived from ERISA and the law of trusts"; in particular, the duties of

prudence and loyalty imposed by ERISA section 404(a). Requiring advisers to ERISA plans or

plan participants to agree to, and comply with, a best interest standard separate and apart from

their existing ERISA fiduciary duty is redundant and unnecessary to achieve the Department's

stated goals. For ERISA plans, requiring advisers and financial institutions to adhere to a best

interest standard as a condition for relief under the exemption ramps up the consequences of any

fiduciary breach by imposing an excise tax on a prudence violation. We believe that is both

inappropriate and contrary to Congress's intent. Title I has its own remedy scheme that

Congress carefully crafted to be based on losses, not on foot faults. These plans are already

covered by a comprehensive disclosure scheme and a regulation issued just three years ago. We

urge the Department to delete this requirement from the exemption, and if the Department

declines to do so, to make it applicable only to plans not covered under Title I of ERISA, but as

modified below.

Respectfully, the Department does not have the statutory authority to require compliance with a

prudence rule as a condition of a prohibited transaction exemption. Congress has issued more

than 20 statutory exemptions; not a single one has, as a condition, a subjective and "reasonable

person" standard or a subjective "misleading disclosure" standard which is punishable by

transaction reversal and an excise tax, regardless of whether there is a loss on the trade and

13

AR038219


regardless of whether the disclosure is entirely correct but simply unclear. Nor has any

exemption previously issued by the Department contained such a vague and subjective condition.

These conditions are not administrable and therefore do not meet the standards for issuance of an

exemption under section 408 ofERISA. If the Department insists on retaining compliance with

a non-misleading disclosure condition in the exemption, we suggest instead that the Department

explicitly adopt FINRA guidance relating to Rule 2210 regarding the term "misleading.

Because violation of a prohibited transaction exemption has such dire consequences, we do not

believe that an inadvertent, immaterial statement taken in the wrong way by a client should result

in a reversal of the transaction, a guarantee of losses and an excise tax on the entire principal

amount. We ask that the provision be clarified to require that the financial institution and any

adviser acting for that institution reasonably believe that their statements are not misleading.

For the sake of completeness, we discuss below our other concerns with the best interest and

other impartial conduct provisions. However, at the heart of the matter, these provisions should

be eliminated for far more fundamental legal infirmities.

The language in the best interest standard that purports to require fiduciaries to prove that they

acted "without regard to the financial or other interests of the ... fiduciary, any affiliate or any

other party" is unworkable. First, we believe the requirement that advice be "without regard" for

the financial interests of the fiduciary will fail any time a plaintiff can prove that a covered

person under the exemption did not receive the least possible compensation. We urge the

Department to use a formulation consistent with that found in FINRA Rule 2111, namely, that

the statements made in connection with the covered transactions are in the best interest of the

client and put the client's interest before those of the person making those statements.

In addition, the proposed exemption in the language quoted above refers to "other interests" of

"any other party" with no apparent limitation. We do not know what these references to other

interests and other parties are intended to address and the preamble does not explain them.

14

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Further, as noted above, to the extent applicable to ERISA plans, the best interest standard is

inconsistent with ERISA and the Code. We request that this language be deleted from the

exemption.

Section III. Recordkeeping Requirements

As with other exemptions being proposed, relief is conditioned on enhanced recordkeeping

requirements. Our comments on those requirements follow immediately below.

Manner of Recordkeeping. First, the proposal specifically requires that the records be

maintained "in a manner that is accessible for audit and examination". We believe that the term

"reasonably" should be inserted immediately prior to the term "accessible", so that the subjective

views of the person wishing to examine or audit the records do not become the basis for the

imposition of excise taxes on the adviser.

Scope of Access. Second, the exemption should clarify that fiduciaries, employers, employee

organizations, participants and their employees and representatives shall have access only to

information concerning their own plans. Similarly, the exemption should clarify that any failure

to maintain the required records with respect to a given transaction or set of transactions does not

affect exemptive relief for other transactions.

Section IV: Definitions

Many of SIFMA's questions and comments regarding the proposed definitions for PTE 84-24

are raised above, as they arise in the exemption. What follows is a list of additional questions

and comments concerning the definitions that are not specific to any particular functional part of

the exemption.

Individual Retirement Account -- We believe that health savings accounts (HSAs ), educational

and other tax-favored savings vehicles not intended for retirement income should not be included

15

AR038221


in the definition of IRA. Such other accounts are, by their terms, not intended for retirement

income, but, rather, for health care, educational and other expenses.

Material Conflict of Interest -- The exemption does not include any standard of materiality.

Without a clear standard, "material" could be interpreted to cover even the most remote financial

interest, regardless of whether the effect of the financial interest on one's judgment would be

material. Is this definition intended to be consistent with case law addressing the scope of an

adviser's fiduciary duties under the Advisers Act? If not, how is this definition intended to be

different?

Relative. In the definition of Affiliate in Section VI(a)(2), which is unchanged from the existing

exemption, we note that a "relative" as defined in Section VI(l) includes siblings and spouses of

siblings, in contrast to other proposals included in the overall fiduciary advice proposal where

the term is limited to those relatives specified in ERISA and the Code. For the sake of

consistency, we recommend that the term as used in PTE 84-24 be modified to conform to that

used in the BIC Exemption and other relief

SIFMA and its members appreciate the opportunity to comment and look forward to meeting

with the Department to discuss our concerns. For further discussion, please contact the

undersigned at 202-962-7329.

16

Sincerely,

Lisa J. Bleier Managing Director, Federal Government Relations and Associate General Counsel

AR038222


Gibson, Dunn & Crutcher LLP

1050 Con necticut Avenue, N.W.

Wash ington, D.C. 20036-5306

Tel 202.955.8500

www.gibsondunn .com

Eugene Scalia Direct: +1 202.955.8206 Fax: +1 202.530.9606 [email protected]

July 20, 2015

VIA ELECTRONIC MAIL

Office•• of•Regulatio11 •• and Interpretati()ns Office ofExernptiol1 Determinations Employee Benefits Security Administration IJ.S, ])eparttnent of Labor 200 Constitution Ave., NW Washington, DC2 0210

Re: Definitfon ofthe Term "Fiduciary''; CortflictofTnterestRule~· Retirement Investment Advice CRIN 121 O-AB32); Proposed BestT11terestCol1tractExenmtion (ZRINl 210,,ZA25)

To the Office of Regulation andlri.terpretations:

[write to commenton the rules proposed by the Employee Benefits Security _Administrationto broaderrthe definitionoP'fiduciary" under ERISAand the1ntema1 Revtmue Code, andtoinstitute "best interest .contract" requirements for .financial representatives falling within this new definition. The purpose ofthiscomment is to address certain legal flaws in the ttl.lemakings and proposed rules.

TheDepartmentstates that"changes in t he marketplace'' and its ''experience" with

the current definition offiduciary have caused it t0, proposeanew regulatory framework for

broker-dealers and IRAs. Definition of the Term ''Fiduciary"; Conflict. ofJnterestRule- ... Retirement IIlvestment Advice, 80 Fed. Re~. 21 ,928, 21,932{Apr. 20, 20l5){to be codified at29 C.E.R pts ... 2509, 2510). TheDOLalso assettsthat broker-dealers laborunderconflicts

ofinterest that cause them to actcontrary totheir client's interests, which warrants a regulatoryrespOnse by the Depart!Tieiit. Id. at 21,934.

The Department's assertion that ''conflicted investment advice" by broker-dealers has resulted in substantial investment underperformance might~ifaccurate-· ·be reason to call

on Congress to enact corrective l~gislation.. Indeed, Congress has already acted in the area

by •• authorizin~·· ·the ••Securities••and···Exc.hange •• Commissign .. to •establish a •. fiduciary •• standard .. of conduct for brokers and dealers consistent withthe standard.applicable to investment advisers under theJnvestment Advisers Actof 1940(.,IAA'' or the "Advisers Act"). Dodd

Franlc Wall Street Reform at14 Consumer Protection A_ct of2010, Pub. L. No .•• 111-203, § 913(g), 124 Stat. 1376, 1828 (2010). But the Department's perceptions ofbroker-dealel's

Be1jmg ·Brussels •Century City· Dalli1s · Denver· Pub<ii • Hong Kong· London· LosAngeles • Muruc;h

New York· Orange County· Pato.Alto • Paris ·San Franci5co • Sa.o Paulo· Singapore· Washington, o.c.

AR038891


GIBSON DUNN

JU1y 20,2015 Page2

and investmentperforJ:nartce do not empowerifto radically rewrite its long-standing

definition • •of.''~dµciary··i11vestment.•advice'' ··in• a••manner .. that···cqnflicts •• with •• ERISA~s••plain

statutory language, its common law roots, and the framework established by Congress forth.e

regulation ofbroker-dealers and investment advisers. Nor do the Department's policy views

authorize it to deploy its ex.emptive authoritytoconstruct awholenewregulatory and

enforqeme11t regime for IRAs and .. broker-dealers.

For atleast two overarching reasons, therefore, theDepartmenHs expansive new

regulatory•· program •is•.•legally··flawed.

First, the Departll1ent's prop?sed interpretation of"fiduciary" is vastly dverbroad and

impermissible. In enacting ERlSA's fiduciary.definition, Congress drew upon principles of

trustlaw and theJawgoverning investll1entadvisers and broker-dealers that must be

considered in ·interpretingthe statµte today. See Corning Glass Works v. Brennan~ 417 US.

l88,20L(1974};Blit'Zv. Donovan.,740F.2d 1241, 1245 (D.C. Cir.1984}. UndertrU.Stlaw,a

fiduciary relationship arises in the context ofarelationship ofspeciaF''trustand confidence''

between the parties. The DO L proposal, ho\Vever, woul~ deem persons to be fiduciaries

where those hallmarks ofa ~duciaryrelationship are absent, for example, when making a

recomm.endation regardingasingle transactio11. See~O Fed. Reg .. at 21,934. Fµrther,

E~ISA's •• reference••to• ''render[ing]•••investment •• advice for ···a.•fee. or•·other •• colllpensation"

incorporates terminology inthe LA.A, which-in accordance with the industry understanding

and practice when the IAA was enacted-excludes .. broker-dealers executing sales from the

definitfon of''investtnent adviser..." That is becausethe payment to broker-dealers is

principally forthe prod¥ctacg¥ired ?r so19,not the advi.ce. Th~t li1Tlitatio~ is incorporatedin

ERISA: The phrase "render[ing]jnvestmentadvice for a fee' ' byitstenns meansthatthe

paymentis principally made for the investmentadvice provided, and noffor execution of a

financial transaction orthe sale ofa financial product.

Second, the DepartmentJacksthe authority:to establish new standards and a

regulatory and.enforcement progn:un for.broker-dealers. Inthe Dodd-Frank Wall Street

R.eform •• anq •.. consu,met Protectiort .. Act .. of20.l .O(''Dodd~Frank'.'}, Congress comrnittedth.e

authority to establish uniform fiduciary duty standards for broker-dealers and investment

advisers fo the SEC--the agency that haslong held principal regulatory responsibility in that

area-·· and only afterthe Commission completed a study on.the effects of anysuch standards.

DQL may notfront--rl1Il theCommissionby craftingitsownnewstandards and enforcement

program, and .• certainly .. ll1ay··11ot •• do ·so .by••bootstrapping•.its•.authdl'ity to··.intetpret••''fiduciary''

into a sweepingnewregulatory prograrnreplete withprivaterights of action and mandatory

class actions.

AR038892


July 20,2015 Page3

DISCUSSION

I~ The Department's Definition Of "Fiduciary" Is Vastly OverlJroadAnd Impermissible.

Th.e Departmenthasprqpose?. adefinitionof''?~uciar~'' . so broad thatit 111ust.be

accompanied by seven carve-outs and six prohibited transaction .exemptions to limit the

scope ofevenasmalLportion ofthe vastnewregulatory regime itwouldestablish over

broker-dealers and t he IR.A market.. Aregulatory definition that cannot function orbe

harmonized with generations ofpractiee ttnlessit ist¢-wotked throughadizzying array of

carve~outs• •. and••exel1lptio11s •is, .• axiomatically, ••a••definitionthat •• de>es ne>t •faitbfully .. interpret. the

words Congress wrote.

ERISA does not ·allow forthis expansive new definition. Indeed, as discussed below,

its plain text ptecludesit. 1

A. The Proposed Defi.nition Corillicts With ERISA's Plain Text.

ERISAis a ''comprehensive and reticulated statute," Nachman (Jorp. v. PBGC, 446

11.S.359, 361 (1980}, and its defiriitionof''fiduciary'' is no diffete11t. Under ERISA,

[A] person is a ~duci~ry with . respect to a plan to .the extent (i} he exercises

any discretionary authority qr discretionary controLrespecting managementof

such plan or exercises any authority or ce>ntrol respecting management or

dispositiQn of its assets, (ii) he renders investment advice for afe~ or other

compensation, direct or indirect;withrespectto anymoneys orotherptoperty

ofsuchplan,••••or ... ~as .. any .. authority .. or .. responsibility•.to .. do ··so, ... or ··(iii) pe has .. any discretionary authority ordiscretionary responsibility in.the administration.of

such plan.

29 U.S.€.§ 1002(2l)(A) (emphasis added).

Congress did not deveJopthis provision in a vacuum; but drew from e.X.istinglaw.

See, e,g.,Firestone Tire &RubberCo ... v. Bruch,489U.S. l01,110-1l (1989). Thatincluded

the lawof trusts and the lawembodied<in, and developed under, the IAA. Seeinfrapp. 4-6.

t For si!Ilplicity,this cc)Jnment refers to the proposed rule's interpretation ofERISA' s

definition of"fiduciary," butthe discussion applies equallyto the Code's definition of

"fiduciary," whichis identicalas relevanthere.

AR038893


GlBS0Ni DlJNN

July 20., 2015 Page

Ininterpreting the definition of ''fiduciary," therefore, both the conunonJaw of trusts and the

IAA•••rn11st be•• consulted, .•• $ince•it •• is pres~med• that•· ''Congress•• is •. knowledgeable •. aboµt existing law pertinentto the.legislation itenacts}' GoodyearAtomic Corp. v. Miller, 486 U.S. 174, 185(1988).

Afundamental principle oftrustlaWis5hata "fiduciary" relationship arises only

under certain circumstances, specifically, where ''special intimacy or ..... trust and

confidence" existsbet\veel1t~eparties .. Bogert'sTrusts . &Trustees § 481; . see also .Black's

Law Dictionary 753 •(rev. 4th ed.1951) (defining "fiduciary" based on the ''trustand

confidence involveci''in therelationship). For example, atthe tirne ofERISA's enactment,

courts•.had• b.eld .• relationships •• ·such as .. physician-patient•••Or •. director-corporatiqnlstpckhol<fer··to

be fiduciary based onthe particularly close and trusting relationship between the parties.

See, e.g.,Twin-LkkOil Co. v .. Marqury,91 .U.S.587,588{l876)(recognizing.that "a

director of a joint-stock corporation occupies.fa] fiduciary relation[ ship] [and}his dealings

witr the sµbject-matter .of his trustpr age!lcy, and with the beneficiary or party whose

interestis confidedtohis care'' are protected1Jy courys); Hammo~dsv . . 4etnaClas. &Sur.

C'o .• ,.237F. Supp. 96, 102 (N.D. Ohio 1965) (deeming physiciana"fiduciary'' to hispatierit

where patient ''entrusted'' information to the doctor).

~elati~nships•lacking••that •• special•••degree ·.of ''trust•••and••confidence''-=stich.•as everyday busi11ess interactions- are not fiduciary. The cm1rt in In re Codman,284 F .... 273, 274 {0. Mass. 1922),Jor example,rejectedthe co!ltehtionthat ''ther{)lation ofthehroker to

his margin customers is a fiduciary or trust relation," describingitinstead as a ''debto.r and

creditor'' relationship . . And in .Robinsonv . . Merrill Lynch, Pierce, Fenner .~Smith, Inc., 337

E. Supp. 107, 1 l3-14(N.D. Ala. 1971 ), .the court concluded thata broker "had no fiduciary

relationship to.the plaintiff"where he was merely ''executing the plaintiff's orders ori.an

ope11·· market.''

These pri!lciples were well established by the time of.ERlSA's enactment aridw{)re

incorporated into ER.ISA. See Bruch, 489 U .S .. at 1 10-11. As thereport of the .House of

Reprnsentatives stated insetting out ERlSA's definition oftheterm, "[a] fiduciary is One.

who occupies aposition ofconfi~ence 9rtrust." H.~.Rep. No. 93-533,at Fl(I973); see

also id. .. (''The fidµciary responsibilitysection, fa . essence, codi~es and makes applicable to

these fiduciari.es certain pdncipl{)s developed in the evolution of the law oftrusts;n). One

who does notbccupy.that position of heightened trustand confidence cannotbe considered a

fiduciary under ·BRISA.

The law of t_rusts is notthe only body oflawthat infonnsthe meaning of

"'fiduciarf' in ERISA; So,too, does thelaw embodied in, and developed. under, the IAA. In

the investment-advice prong of ERIS.A's d(;)finitiqn offi<iuciary; Congress used. the phrase

AR038894


July 20, 2015 Page 5

''renders·••investment .• advice for •• a fee. or other .col11pensation.'' .. That .•. lari$Uage .•. reflects tenninologyAn theIAA, which for decadeshadheldacentral place inthe .regulatioriof

investment advisers, and which defines ''in\lestlllentadviser" as a person who ''for

cornfensation .... a~vis[es}others .. . astothe valueof securities orastothe advisability of

investing in, purchasing, or selling securities/' 15 U.S.C. § 80b ... 2(a)(ll) .• (emphasis added),

The language and history ofthe Advisers Actis informative of BRISA' s meaningin

two ways .....•. First,·•bY ... thetillle .ofERISA's .enactlllent, •• investmenta~visers were widely understood to be fiduciaries----and the reason they were fiduciaries was thatthey hada

closer, ~eeper relationship with their clients than did other financial professionals. . Thus,fhe

Supreme Court wrote in 1963 thattheAdvisers .A.ct "reflects a c0ngressional recognition of

the delicate fiduciary nature ofari investme11tadvisoryrelationship''; therefore, "Congress

recognized theinvestment adviser to be" "a fiduciary."' SEC v. Capital Gains Research

Bureau, Inc.+375UB. 180, 191, 194-95(1963). Iriteachingthis conclusion, the Courtrelied

on le$islative history thatrecognizedthe ''personalized.characterofthe services of

investment advisers,'·'· id. atl91, and cited congressional testimonythatcharacterized

investment .• advisers •.. as. having .• relatiortships •• of.'<trust.•and confidence wi ththeir clients,'' .. icl ..•. at

190 (intemaLquotationmarks omitted). The Court cited this legislative history two decades

later••in••reiterating •the••fid11ciary· ·''character''of the •• investment~adviser.relatio11ship . .• Lowe v. SE.C, 472 U.S. 181, 190 (1985). Being an investmentadviser, the Court said, isa "persona.1-

service professfon [which] ~epen~s for its success upon a closepersonal and cpnfidenttal

relationship between theinvestment-counsel firm and its client• It requiresfrequentand

personal contactofa professional nature between [the advisers] and[their]clients." Id. at

195(emphasesalteredand intemalquotatiori marks omitted).

Second and ·related, whenfovestmenta<ivisers.were being. described by the . Court as

haying the sort ()f''clbse arid personal" relationship With clientS,...,...-Qharacterizedby "frequent

and personal contact"~that rose to theleveLof a fidttciarytelationship, the Court was not

considering irtvestmentadvisers 111 isolation, butratherin contrast with other financial

professionals. whose t elationships •• did•• not .• rise••io. the•••same·· level., I1amely, •• broker-dealers,

t hus, the ,A.dvisersActincluded. ac.arve-outwhichclarified that''investment adviser'' did not

include ''any broker or dealer" who provided advice that was ''solely .incidental to the

conduct of his business as .a broker or dealer and who rece.iVes no . special compensation

therefor." 1SU.S.C. § 80b-2(a)(L1)(C).

This exemption from the definition of investment adviserwasnotinttoducedbythe

IA}\,Jhe I).C. Circuithas . explained, but"ret1e.cted [a]distinction" then . existing between the

"two generaLforms of compensation" that financial professionals rec.eived in connection with

offering investmentassistance. Fin. Planning Ass 'n v. SEC, 482 F.3d 481, 485 (D.C. Cit.

2007). '"Some [representatives] charged on1y ... commissions (earning ac;ertain amount for

AR038895


GIBSON •· .. IJUNN

.ftily 20, 2015 Page6

each securities transaction completed). Others charged a separate advice fee · (often i:tcertairt

percentage of the customer's assets under advisementorsupervisio11).'' Id. This difference

incompensation structures-.... ·· andthe notion that a feefor a.civicewas suggestiveofa

fiduciary relationship, wherea_s acommission on .a sale. was not-. Was .. captµred by the IAAin

the broker-dealer exemptiqn. A financiarrepresentative became an ''investment adviser''

when "[a]tleast part[of] the .. charge to customers receivingadvice[was] attributable to such

advice,''but not where the payment was principally. for the sale of the product.. SECOp.,

1940 SEC .. LEXIS.l466,•at*7 .. (1940); .see.also.Thomas v ... .J.1etro.Lve Ins. (io., .. 631. F.3d 1153, • 1166 (10th Cir. 201.1) C'[T]he IAA excludes a. broker-dealer who provides advicethat

is attendant to, or given in connecti?n witll, the br?ker-dealer' s conductas a broker or dealer,

so long as he does notreceive compensationthatis (1 }received in exchange forthe

investment advice, a.s oppqsed to .. .. the sale of the product; and (2) distinct from a

commission or··analogous •• transaction-based •.form···oftmnpensatiollfor••the .•• sale •• of a product}'). As explained in the Senate.and House reports,.the broker-dealer exemption was ''so ·defihed as specifically to exclude. . br?kers {insofarastheiradvice is merely.incidental

to brokerage transactions for which they receive only brokerage commissions)." S. Rep. No.

76~ 1775, .at 22(1940); H.R. Rep. No. 76~2639,at 28(1940).

Following theJAA's enactment, this . limitation on''invest111entagvice'' was

repeatedly·•recognized .and •• enforced. ·· In .. Robinson, •for .example, •• the •• district ··cou:rt •• concIµded

that the brokerwas not an investment adviser and "had nofiduciary relationship to the

plaintiff' where ''any investm.ent advice W'1S incidental to brokerage. sel'vic.es .. " 337F. Supp.

at 113·44. TheSECemphasizedthat ''render[ingfinvestment adyice merely asahirtciderttto

. . ~roker,,dealer activities'' does not byitself Pl~ce broker-dealers "in a positionoftrust and

cqnfiden.ce as to their customers." Broker-Dealer Registration, Exchange Act Relea.seNo.

404§,J948 . WL. 29537, ~t*7 {Feb.18•, 1948), af!'d, Hu~hesv. SEC, 174 F .. 2d 969 (I>.C. Cir.

1949). See also Kaufman v ... Merrill Lynch, Pierce, Fenner &.Smith, Inc., 464 .. F. Supp. 528,

538 .. (IJ. Md. L9J8){br?~ernot aninvestmentad~iserwhere " [t]here is .noindication that

[defendant} received any · fees specificaHyfor his.advising {plaintiff].; ratherjtappears that

the commissions received were for his services in effecting the transactions, not for his

rendering •• of·•advice'').

3. This understanding of whatmade iri.vestment advisers' relationship fiduciary in

character-• as well · as the form of compensation associated with it, andthe difference from a

simple broker-dealettelatidnship--waswell establishedwhe~ERIS.f\ wasenacted in1974.

Accordipgly, when(Jongress used the phrase "renders investment advice for a fee or other

compensatio11"in ERISA'sfiducfo.ry definition, it "is deemed to Tl1aveJknow[h] the ...

jucliciatgloss given to [that]• language andJht1s [to hav¢] adopt[ed] the existinginterpretation

unless itaffil1Il.atively act[~d] to change the meaning;"Blitzv. Donovan,740¥.2d 1241,

l245(IJ.C. Cir. 1984)(intermil ql.lotatiohmarksomitted). See alsoJ.JniteciStates v. Wells,

AR038896



519 U.S. 482., 491 (1997) (it is presumed "that Congress incorporates the common-law

meaning ofthe terms itusesifth()se tenn.s b.ave accumulated settlec! rneaning under the

commonlaw and· the statute does not otherwise dictate'' (alterations and internal quotation

marks o!llitted)); Corning- Glass Work.Y v. Brennan, 41J .u.s. ... 188, 201 (197 4) (''[W]here

Congress has usecLtechriical. words or terms .of art, 'it [isl proper to explainthern by reference

to the art or science .to whicht}ley[are] appropriate.'' {alterations in .original) (quoting

Greenleaf v. Goodrich, 101 U.8 ... 278, 284 {1880))). Any interpretation oftheinvestme11.t-

11dvice prong musttherefo:te be consistent with(l) therecognition under the law of trusts that

only relationshipsmark~d by a heightened degree oftrustand confidence.are fiduciary, and

(2)the•com111on law recognition ······ · · · embodie~ ••in· ··the•••Ij\A-that••?roker-dealers .. providing

advice incidental to the sale>of a product are notprovidinginvestmentadvice inafiduciary

capacity. Th11fl1'leaning cannot be altered by Department ofLaborregulation. See Chevron

US.A.lnc. v. Nat'l Res. qef. Council, Inc.,467U.S .. 837, 84~-43 (198~);Thiess v .. Witt, TOO

F.3d 915, 9L8{Fed. Cir. 1996) (11gency interpretationof''compensationH i111permissible

becaµse it confliCted. with the. term's est11blished meaning in the employment context),

The···current .. regulatory •. interpretatioti, ... which. was adopted···shortly•••after. enactmentof

ERJSA,reflectedthese established limitati~ns onthe ineaajng of ''fiduciary." See 29 C.F .R.

§ 25 L0.3--2T(c). The 1975regulation appropriately clarifies that investmentadvice will

triggerfi~~ciarydutiesonlywhen. renciered "ona regular basisto theplan,'' ''pµrsuant toa

rnutual agreement" lliatthe services .will be a uprimary basis" on which the plan makes

investment decisions. Id. Providing advice "orla regularbasis,'' for example, reflects the

Supreme Court'SJeco~nitio11Jn ~owe,4'72 U.S ... at 191-95, thatafiduciarytypically renders

advicein a closerel~tionship. characterized by "frequent" contact Thishelps ensure

presence ofthe heightened "trustandconfidence'' associated with fiduciary status, and that

the adviceis notmerely ''incidental" to the sale/Of a product.

The .• Departm~mt's .. proposal, by contrast, •• tadically•.departs . .from .. these .•. settled

limitations. Theproposed rule conflicts with trust-law principles becauseit would deem

persons •. •not •. in .. special telationships• •of•''ttust.·and• confidence''•······· e.g .. , .• bl'oker-dea1¢rs··exe<IUting

sales--to befi~µciaries . . Tomake a person a "fiduciary"for providing a ''one-time, ..

recommendation or valuation'' {80 Fed. Reg. at 21 ;934), for example, cannotreasonably be

viewed as consistentwith the specialrelationship of.trust .and confidence envisio11ed under

thelawof trusts-a relationship, the Supreme Cqurthas said, characterized by"frequentand

person11Lcontact.''Lowe,472 .U.S, atJ 9S {eIT1phasis omitted) .. The ptoposaLreflects no

consideration of this trµst -law principle (or others}---eventhough the.DOL. acknowledges

thatthe law of trusts mustinforrl1 its.interpretation ofERISA, 80 Fed .. Reg. at2I,932,

21,938.

AR038897



The methodappliedhy the Departmentin itsproposal is irtsteadto identify acts that

in •its•·•opini011 .should•.be••performed••by• ·~?uciaries, .. and .th¢nto.•·duht]1ose actorsfi.guciaries

even when under the accepted meaningof that.term and as a matter of historical fact,theyare

l1ot. In doing so, the Department departs notonly from the accepteci understanding of what

relationships .are fiduciary in character, but also fromthe stamtoryrequirementthatan

investment fiduciary "render[ }investment advice for a fee .'' Under this langtiage,. if is the

''advic.e'' thatmust be .. the thing paid for, not the productthatthe purchaser selects; or the

trans~ction . she cgnducts.2 Because .a cortunissioned broker-dealeris ol'llypaidif a productis

purchased, the client's pay111entis plainly for the product, not for advicethatmight have

accompanied the sale.

The very definitionof a broker is a ''person en,gaged in the business ofeffecting

transactions in securities .. forthe .account of others," 15 U.S.C'. § 78c(a)(4)(A); by definition,

he does .. not provideinvestment advice for a fe.e. Congress recognized th.is inthe IA~ .. by

excludirtg .. ordinary • bro~er services .. fromthe. ·"investment.• adviser'' de~nition, . as discussed

above. The Department's proposed definitionignoresthat exclusion, and instead

encompasses many activities customarily performed by broker-dealers that are not properly

considered J'advice." For example, under the proposal, a broker's sales pitch is transformed

into advice when providedto a retail investor, but thesamepitchis notadvicewhertmadeto

.an ''expert pla~irtvestor.'' .. !he IJepart111ent's reasoningthat an expert b~yer "7ill tmderstand

"that itis buying aninvestment product, not advice,'' but that a retail buyer will not(80 Fed.

Reg: at21~941 .. 42), has nobasis in principle orthe lon~-stahding finartcialregulatory

framework established byCongtess. Sales pitches are a common experience, whether for

cars, electronics,. or .a range offihartcial products, and no ground existsfor corieludihgJhata

broker's offer is transformed into"advice'' when tendered to a potentially less sophisticated

buyer.

The extent to whichJhe Department's proposal captures activities ordinarily

conducted••by· broker-dealers• is, .• in.fact,•••poWerful ••evidert<;e.•oftb.e ?ver· breacith •• ofits "fiduciary" definition. At law, fiduciaries and broker~dealers are distinct, and broker-dealers

are• paid •• bY••ccnnmissiou. .. But.··with••its proposal,• the •. Department •• first .. mis .. defines. •''fiduciary''

2 The .Department's proposed interpretation is also inconsistentwiththe term "render.,, To

"re11der" is ''to pronounce ordeclare(a judgment, verdict, etc.), as in court," Webster's

New WorldDictionary 1 J3 fr(3ci ed .. 1~88), or ''tofumish for consideration, ~pproval, or

information; as(l) ·to hand down (a legaljudgme11t){2)toagree onandreport (a

verdict),'' Nferrlatn-Webster 's Collegiczte1Jictionary1054 (11th ed. 2003), Thaftneans

something more than merely rnakinginvestmentsuggestions in the contextofa sales

transaction;

AR038898


GIBSON DUNN

July 20,2015 Page9

so broadly thatit swe.eps in hundreds ofthousands o.fbroker-dealers, and thenfocatesa

sµppose? •·CQnflict •. ofinterest•.in.·broker-dealers···being••paid .• in• ex:actly··the •• manner•they by

definition are paid. See Fin,. PlanningAss 'n, 482 F.3d at 485 ("Some [representatives]

charged only commissions (earning a certain amount for each securities transaction

completed). Others[whichthe Advisers Acttreats as fiduciaries]charged a separate advice

fee (often .a certain percentage ofthe cttstorner's assets under advisement or supervision).'').

It is notbroker~dealers' compensation structµre that is flawed, itis the Department's attempt

to define broker-dealers as fiduciaries,

B. Thel)epart1nent's Interpretation Also Conflicts WithThe Statutory Uefinitioµ Of "Fidu~iary" As .A. Whole.

Section3 (21) of ERIS A identifies three waysthat a person or entity becomes a fiduciary: by (i) "e.xercis[ing] an)' discretionary authority ordiscretionary control'' over the

''management''ofaplan or its assets; (ii)"render[ing] investmentadvicefor afee orother

cqmpensation, direct••or···indirect''; •and·• (iii)• exercising•• ''discl'etiol1acy•·•a1JthoJ:ity•·ot

discretidnarytesporisibility in" the plan' s ''administration.'' 29 U.S.C.§ 1002(21)(A). The

management••and •• administratiori.ofa•·plan.·ate•·central• .• fu11.ctio11.s, •. ·inv()lving ··a .meaningful,

substantial, and.ongoing relationship tothe plan. Subsection (ii)rnust bereacLin a fl1anuer

consistent•·with. these •• provisio11s .• •congress.··would •. not, •• for.two .•• of.the .. provisions, have

required; a substantiaLand directconnection to the essentials of plan operation, and for the

provisfort lyirtgin-betweeri haverequired only a .short-term relationship whose .essence was

sales rather than significant investment.advice provided on a regular basis. See .Pollardv.

E.I. du Pontde ~emours &Co., 532 tJ.S. 843, 85~ (200 I) ("[WJemust notbe gui?ed by a

single · sentence or member of a sentence, butlooktothe provisions of the whole law.''

(alteratiOn .in originaland internaLquotationmarks omitted)); Garcia v. Vanguard Cat Rented

USA,. Inc.} . 540 . .F.3d 1242, 1247 (11th Cir. 209s1 (''By construing proximate statutory terms

inJightof oneanother, cot.trts avoid giving ' t1llintended breadth to the acts ofCongress. '"

(quoting G'ustajSQrtv. Alloyd Co ... , 511 U.S. 561, 575 ( 1995))); This further demonstrates · that

the definition.in thepropos~d regulatiorlis overbroad.

C. The Uepart1nent Errs By Illexplicably Departing FromJts 2005 Advisocy

Opinion To Treat Actions InConnection With Rollovers As Fiduciary.

A significantconsequence of the errors by theDepal'.'tmeritdesctibed above is that the proposed••rule •• would111ake~ny •• ad~ice • •r~garciing •• investments••of distributions .. from .•.an •.. ERISA plan or IRA "fiduciary advice,'' regardless whether the advice is merely incidental to .a sale

(orproposed sale). orw~ether it is specifically pai4 for, or evenrelated to assets no longer

held by the plan. Thus, the proposed rule appears so .broadthat itmightcover advice

AR038899


July 20, 2015 Page 10

regarding• •investment •of .a ••• distribution·from .• an•ERISA.pJan .. intO an. equity or. debt.security

rendered on a one""'timebasis.

Thatis improper, and ditectlyconttadictstheDOL's cd11clusi6njust tenyears ago

that a recommendation regarding a rollover ofplanassets toanIR.A does not constitute

fiduciary advice . . Bee. Advisory0pinion200 5-231\.· For an ~ctto.be fl~uciaryfo character,

ER.ISA(andthe Code) require, first; there be ''advice" related to an''investment.'' 29U.S.C.

§ I002(2l)(A)(ii) .•. Adistributionis notani11vestment; itfollowsthat areco111me~dation to

rollover plan assets is outside the scope of the statute because itdoes not "concern[ Ja

particular investme11t.''3 Advisory Opinion 2QQ5-2JA. Second, advice provided with respe.ct

to theproceeds ofa distributiondoesnot foll within BRISA because the statuterequires that

the advice relate to''any moneys or other property of[the ERISA]pla11.'' 29U.S.C.

§1002(21 )(A)(ii}. Upon distribution,the proceedsareno longer "mo~eys or.other property''

of the plan a~d th.erefore do not fallwithin the scope ofthe statute. S'ee Advisory Opinion

2005-23A; see qlso, e.g., Beeson v. Fireman 'sFund1ns. Clo., 2009 WL 2761469, at*6 (N.D.

Cal. Aug. 31,2009) (statingthat''providing financiaLadvice as to the investment ofnon-plan

assetsis generally nota ficiuciary duty undetERISA'' and noting that~ DOL .publication

"[did]not state that providing investment advice(orhiringadvisorsto do so) will be

considered a fiduciary act simply because the advice may cause participants. totemove

moneyfrom a pla.n'').

ER.ISA' s plain language, accordingly, permits only oneoonclusionabout whether

actions in connection with rollovers are. fiduciary: They are hot. Unlike the 2 005 Advisory

Opinion, theDOL's currentpositio11regarding rollovers cannot be reco11ciled with the

statutory text. Forthatreason, itis precluded. See Chevron, 467 U.S. at84243.

II.. The Department Lacks Statutory Autbonty To Adopt Its New Proposed.

Regulatory . Framework.

Together,.•the .. Department's ''fiduciary''.rule ... and ... "BIC''·.Exerrtptiorl.Wotdd

imperrnissibly expandthe Department'sauthority outsidejtsjurisdiction. As the Department

adl11its, the principal goaLoftherulemakingisJo regulate IR.As and th.e broker-dealers. who

offer them (see80 Fed. Reg. at 21,928, ~1 ,932)--even though the DOL has no enforcement

authority over IR.As.· Congress, moreover, recentlymade clear that the SEC, not the DOL,

should beJhe arbiter ofwhatfiduciary standarcis of conduct should goveriibroker-dealers,

3 Si111ilarly, providing• a valuation opinion. or .appraisal is notequivalent to ''render[ing]

investment advice.'' The valuation provides information regarding the market value of a

security or other property, but does not itself recommend its purchase.

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GIBSON DUNN

Ju1y20,2015 Page 11

and w~atregulatory actionshoul? belaktm,ifany. Jl1 addition, the l'.)QUs proposed BJC

Exemption? which would affectmostofthe IRA.n1a.rket, purports to create a privaterightof

action for plans andparticipants. to sue broker,.dealers who offer IRAsJor breach of contract.

Butonly Congress !llaY create private rights of action, Alexander v. Sandoval, 53 2 U.S. 275,

286 (2001}, .. and nothing in ERISA orthe Internal Revenue Code per:trlits the cause of action

proposedinthe BIC Exemption. Infact,sectiol14975 of the Code, whichprohibitscertain

transactions involving IRAs, does notprovide for any civil enforcement. The BIC is also

flawed becauseth.e DOL lacks authority to ban. class action waiversjn arbitration

agreenJents,c/ 15U.s,c. § 780{0) (permitting SEC toregµlatearbitrationagreements of

''customers •• or clients• c)f''· ·broker-dealers .. for••disputes •••arising••under ·•the •securities .• laws··•and

regulations), and its atte!llpt to enact such a ban conflicts with the lllfl!1date .of the Federal

Arbitration Act ("FAA") that arbitration agreements be enforced according totheir terms,

Compu,CredU Corp. V; Greenwood, 132 s .. Ct. 665; 669 (2012).

In .short, ••DOL••is· · ·theregulatorof11either.the ··•IRA •.lllar~etin .. particular nor .. thefinaiicial industryin general, and itcannotregulate through "exemption" matters that arebey0nd its

a~thority .toregulate affirmatively. ln a word, itcanl1bt create ''backdoortegulation'' by

''manipulat[ing] the safe harbor criterion [of a re9.ulation] to compel.different orbroader

compliance" by actors in thatfield, Hecwth, Patio ,& Barbecue.Ass 'n v ... fJ.S. Dep 't of

Energy.706F.3d499,507-"08 (D.C. Cir. 2013).

A. The SEC, Not The DOL, Has Authority To Establish Standards Df

ConductFor Broker-Dealers;

the l'.)OL seeks tO apply fiduciary standards of co11ductto broker~dealers. Congress,

however, recently consideredt~e process for a possible .. extension. offidueiary duties to

broker-dealers, andinDodd-Frarik gave the SEC, which has nearly eightyyears' experience

regulating Ji~anciaLmarkets, the authority to .adopta uniform .fidu?iary standard following .a

study of the effects of sucharegulatory change, and subject to certain express limitations.

This•··recent• de!llonstration ... of•congressional••intent••confirms• that. the ••• Department lacks.•the

power to promulgate the proposed rules.

Section. 913.. .ofDodd .. Frartk directs .the SECto.evaluatethestandards of carethat

currently govern broker~dealers and invest!llentadvi.sers . . I.Jedd-Frank. Wall Street Reform

and Consull1erProtectio11 Act of2010, •Pub ... L •. No. lll-203, §. 913, 124 Stat. 137 6, .• 1824

(201 OJ; •• Specifically, itinstructs the SEC to consider"the.potential ·i!llpactofeliminating the

broker and dealer exclusionfrom the definition of'investment adyiser' under section

2Q2(a)(ll )(C) of the InvestmentAdvisers }\ct of 1940[.]" Id. § 913(c)(10). Dodd-Frankalso

empowers··the•••SEC• •• to··''promulgate••rules•·to••Provide··•that, •.. with. respect·to ... abroket .or dealer,

when pr0vidirtg personalized investment advice aboutsecurities to aretaiLcustomer ~ . . the

AR038901


July 20, 20-15 Page 12

standard of conduct .. . shall be the same as the standard. ·ofconductapplib<Ible to an

investment adviser." 1d. § 913(g)( 1).

TheDOL's attemptto establish a n.ew standard ofcare for broker~dealers disregards

Gorigress's expressed directivethatsuchadecision isforthe SEC;. The Supreme Court

recentlyinstructedthat;whete '.'a queStionofdeep economic andpoliticalsi~ificancethat is

centralto [a]statµtory scheme" exists,. ~~had Congress wished to assignthat question to an

agency,itsurely would have done so expressly." . King v. Burwell, No .... 14-Ll4, 2015 WL

2473448, at*8 (I).S. June 25, 2015) (internal quotation marks qmitted). Further, "[i]t is

especially·•unlikel~ .• thatCongress would .. have .. delegated .• this •.• decisiqn tQ. [an •• agency] [with]•••no

expe~ise" int he matter. Id. Congress gave DOL nosuchauthorityhere,but did expressly

assignthe question of further broker-dealer regulation·--·which would have broad effects on

financial prdfessidnals and theirclients------to an ag~ncy with expertise in theindustry: the

SEC. In doing· so, Congress did not leave the door open for DOL to use the Tax Code to

.craft and.impose its own fiduciary duties for more than halftheassets.in broker~dealer retail

custo1ner accbUntS,

The Department'·s encro!chment ontheSEC (arid FINRA)··ts•also ~otecfoSed by·· FDA

v.Brown &Jf'illiamson.Tobacco Corp .,529 U.S .• 120,J43, l(il C?QOO) . . There, the Supreme

Court held that the Food and Drug Administration lacked authority to regulate tobacco

becm1se ofthe ''tobacco-specific legislation that Congress ha[d] enacted overthe[pl'evious]

.35years." Id. . atJ43. At the .time a statuteis enacted,theCourtexplained,it1nayhave."a

range ofplausiblemeanings" that could seem to permitagencyregulation, but "[o]ver time

. . .. subsequent actscaris}iape orfocusthose1neanings." . Id. Jnparticular, later .. enacte~

statutesthatHmore specifically addressthe topic a t hand' ' may occupythe fieldina manner

thatforecloses agency action, even. ifthat subsequenflegislatiqn dqes pqt explicitlyblockthe

agency's jurisdiction. See id. at 127,)43, l.57. So, here, even ifDOL once possessed

authority to promulgate regulations ofthe nature proposed (it did not),. Dodd:.Ftank "mqre

specificallyaddress[ es]" procedures for evaluating the standardof care forbroker-dealers,

committingitfo SEC review and, possibly, SEC . .tegulatiol1. Action onthe subjectis

foreclosed totheDepartinent.

The specific tenns oftheDepartment's proposed rules are barr.edasweH. Dodd

Frankreqtiires that any new standard of conduct for broker-dealers be ''the same'' as

''applicable .• to •• an•.inyestnientadviser ul1defsection .. 2•1·••P' ... qfthe••Adyisers .. Act. ···•Dodd-Frank

§ 913(g). The standards imposed by the new rules are far more onerous thanunderthe IAA.

In Dodd~Frartk Congress •••also•.•Pr?vide~that '~[t]he··receipt•••of . compensation based .. on

commissionor other standard coin.pensationforthe sale ofsecuritiesshaH not,in andof

itself( be considered a violation of such standard applied to a broker or dealer/' ld. DQ[.'s

AR038902


GIBSON DUNN

July 20, 2015 Page 13

"fiduciary'' rule makesbroker•dealers' "standard compensation'' a prohibited ttansactiQ11,

with only partialre1ief(sl1pposedly) a.vailable tl:lroughtheunadministrableBlC3Exemption.

The Dodd-Frank provisions regarding apotential u11ifor'I11 fiduciary standardsho\.ythe

analysis underlying theDepartrnent's rules to beJlawed as well. Congress instructed the

SEC. to conduct a.study and report to Congress before adopting a new standar&for broker

dealets, enumerating in detailthe potential .effects on customers thatthe SEC study "shall''

consider, including ''the potentialill1pact 011access ofretaiLcusto111erstothe range of

products andservices·offered by brokers and dealers," and loss of accessto "personalized

investment advice." Dodd-Frank§§ 913(c)(9)-(10), 9l3(d). Commenters in the C11ffent

rulemakingwill showthat these (and other) effects ofthe Department's rules will be severe,

yet the Department makes no attemptto consider these effects il1 i ts ''regulatory impact

analysis?' That is.clearerror: The proposals' effect on access to professional financial

assistance was an ''importantaspect oftheproblem" thatthe Departmentwasobligatedto

consider under .anyp ircll!llstance, A{otor.VehicleMfrs. 4ss'n v. StateFarm}.1ut. Auto. Ins.

Co. , 463 U.S ... 29, 43 ( 1983), and certainly the Departmentcould notfail to address the issue

· whe11Congress directed the SEC to considerthatvery thing before ..imposing fiduciary

standards onbroker-dealers. The Department must cqnduct thatassessment and make it

available for public review and comment. See Ghamberd[Commerce v.SEC,443 .F.3d. 890,

894, 900 (D.C. Cir. 2006).

The inappropriateness ofthe DOL leaping out in front oftheSECis confinnedbythe

findings of SEC staff in the study they performed underDodd-Frank. After examining the

potential.effect .. ofeliminatirtg thebroker~deaierexclusion, ••. SECstaffrecom111endedagainst

such an amendment, inview ofthe negative effect onconsl!tners. SECStudy o11Tnvestment

Advisers & Brok.et-Dealers 140, I 52 (20Ll). As the sta£f explained: ' 'If, in resp011se to the

eli111ination of the broker-dealer exclusion, broker-dealers .. elected to convert their brokerage

accounts••from··co!Ilmission-based .•accounts• to fee-})ased• accounts, .. certain.retail customers

migetface increas.ed costs, and consequently teeprofitability .oftheirinvestment decisions

could be eroded, especially accounts thatare not activelytraded[.]" Id. at 152(footnote

omitted). IRAs ate just such accounts, yetthe DOL fails to give appropriate consideration to

those adverse effects.

Others · with responsibilityoverbroker-dealers have voiced··similar concerns. The

Chairman artdCEO.of FINRA, Richard Ketchum, has said the SEC "should lead'' the

drafting of a fiduciary standard applicable to broker-dealers, be.causeit has the pecessary

expertise••and •• is ..• betterpositioned.than. •• DQLto .• design •• and ••. implement.•the •. standard. Oversight

of the Financial Industry Regulatory Authority: Hearing Bef ore the 8ubcomm .. on Capital

Mkts .. &Gov 't Sponsored Enters. of the. H •• Comm. ·onFin. Servs. , ll4th. Cong .. (2015)

(statement ofRichard G. Ketchum, Chairrn.an and CEQ ofFINRA). In testimony before

AR038903


July 20,2015 Pagel4

Congress, ChairmanKetchtim expressedconcern that.theDOL'sproposed rl1lewould result

in Conflicting standards qfcare and stated that ''therightway to move forward is for .... . the

[SEC] to look[at] the possibility of a balancedtiduciary standardacrossall products.'' Id.

These cautions fromthe self-regulatory organization with responsibility overbtoker-dealers

should be given great weight, andfurther demonstrate why proceeding with these proposed

rulesis particularly inappropriate in lightof the SEC's authority over the financial industry.

B. The DeparttnentCannot Leverageits Interpretive Authority To Exercise

Enfol'cement •. Authority••Not Confel'red .•Hy Congress.

The DOLdoes nothaveregulatoryauthority over IRAs beeauseTRAs-• · when sold to

individual clients-are not ''employee welfare benefit plans'' or "employee pension benefit

plans" that.are ''.established or .. maintained by art employer or by an empfoyee organization;''

See29U.S.C. § 1002(1) &{2). To be sure,theDepartmenthasauthori}ytointerpretthe

definition of "fiduciary" under ER.IS}\ andthe Internal Revenue Code. Its en.forcement authority, however, is limitedtoERlSA. SeeReorganizationPlan.No.4 ofl978, § 105.

Only the Treasury Department has .authority to enforce Section4975 ofthe Code, an

authority that is restricted.to imposing excisetaxesand condttcting audits. Id. A.stheDOL

acknowledgesin the proposal, ERISA.'sduties.of prudence and lqyalty do notapplyto IR.A..

fiduciaries, .· and•••IRA •fiduciaries.•are .!lot••Hable.under ERISA.••for··losses·•arising •• fro11:i .breacbes ofsuch duties: "Under the Code, advisers to IRAs are subject only to the prohibited

transactioptules,'' alid "no private rightof action µnder ERIS.A is available toIRA .owners;''

80 Fed. Reg. a,t.21 ,938.

ThiS admissio11 is fatal to the DOL's attempt inthe BIG Exemption •to leverage its

interpretive authorityinto .ertforcemen(power over matters outside the Department's

jurisdiction, Among otherthings, DOL conditiops the BICExemption- which is necessary

fotthe rule's newly-discovered fiduciaries to continue long':standing corn.pensation

practices-•• onthe fiduciary's consent to be sued by ER.ISA plans, IRAs, participants, and

others for breach of contract related to the best interest standards createdin the rule.

Proposed Best Interest Contract Exempti011, 80.Fed. Reg. 21,960, 21,962, 21,972.(f\pr, .. 20,

2015) (to be codified at 29 (J.F .R. pt. 2550). That is anew private right of action. Itis

axiomatic, however, that only Congress, not an agency, may create a caus~ ?faction .. I~

Sandoval, forinstance, the Supreme Court rejected.the government's argument that "the

regulations col'ltainrights-creatingJanguage and so must be privately enforceable." 532 U.S.

at.•291... ''Language. in •• a •.regulatiort •m.ay•••invoke••·a•pt'ivate •.right .. of action •• that• Congress .• through

stiitutorytext created, but itmaynot create a right that Congress has not. .... [I]t is most

certainly incorrectto say that language il1 aregulation can conjure up aprivate cause of

action that has not been authorized by Congress." Id. (citation omitted).

AR038904


July 20, .. 2015 Page15

WhatScmdovql forbids is whatthe DOL attempts to do. NothiJ:lgin ERIS A .Or the

Code .. •even• hints•·•that••a •·state-law·.contract •. a9tion.can •• be •·brought••against •• purported• fiduciaries to enforce statutory provisions. ERISA's civiLremedies arelimited bothin nature and scope,

G-reat-W. Life &-iJ.nnuitylns . . co. v. J5nu&on, 534 U.S. 204, 209-10 (2002), atidJhe statute

~roadly preempts most state law, including breach-of-contract actions, Cromwell v. Equicor

Equitable HCA Sorp. , 944 F.2d 127~, 1275 {6th (;ir. 1991 ); F\lrthe1\ ERISA'sremedies

have no application to non--ERISJ\.plans such as IR,As. See 29lJ.S:C. § 1002(1)&{2). Th.e

reme?ies under the Code .are.even more. restricted than ERISA' s, extending only to

conducting auciits and imposingtaxes. 26 U .S .C. § 4975; see a/so .. Reorganization Plan No ... 4

ofl 978,§ 105. Accdrdingly, ERISA, the Code, andbasicprinciplesofseparation ofpowers

preclude DOL's attemptto .. create.itsnew ''BIG" private rights ofacti()n. See also Mertensv .

.HewittAssocs., 508TJ.S . 248, 254(1993) (stating Court's ''unwillingness to infer cattses of

action in. the ERISA context, since thatstatute's carefully crafted and detailed enforcement

scheme provides str9ng evidencethat Congress did not intend to .. authorize other remedies

that it simply forg9t toi11corpprate expressly'' (intemaLquotati9nmarks omitted));

Transamerica Mortg. Advisors, Inc. v. Lewis, 444 U.S. 11, 19 (1979) ("[I]t is anelemental

canon. of statutory . constructio?that\Vherea. stat~te expressly provides aparticular remedy or remedies, a court rnustbecharyofreadingothers into it'').

Itis no answerthat the DOL has interprettitive authority with respecttb the definition

of''fiduciary''in b.Othstatutes. The courts will rejectan age:ncy'sattempt to use interpretive

authority toregultitebeyondt}iatauthority, InAmePicqnJJankersAss- 'nv. §EC, 804 F.2d

739, 754.-55 (D.C. 91r. 1986), forexample, theD.G. Gircuitexplainedth.at n[t]he

[Commission] cannotuse its definitionaLauthority .to expand its ownjuris?iction ~ndt?

invade the jurisdiction" ofotheragenciesthrough ·rulemaking. In that case, the agencywa.s

a.uthorized to regulate banks, notbroker-dealers, but wrongly soughtto "re.define" "ban~'' in

awaythatgaveitauthority over broker-dealers as welL Id. at 742-43. See also Business

Roundtable v. SES, 905 F.2d406, 412-13(~.C. Gir.1990) (SEChad power to IT1andaJe

listing standards, but exceeded its authority by attempting. to leverage thatpower to regl{late

corporate governance). And in Home Care Ass'n oJAmerica v. Weil, 2014 U.S. Dist. LEXIS

176307, at *14-15 (D.D;C. 2014), the courtrejected th<;lJ)QU s attemptto use ''its

definitional authority'' in away that eliminated part of a statutory exemption, explait1ing that

''Congress surely didnotdelegatetotheDepartment ofI~abor ... the authority t?issue a

regulation thattransforms defining statutory terms into drawing policy lines." So, here, the

DOL seek$ to define ''fiduciary" in .a way thatgivesit authority over plans and persons

outside its reach, andthen~having defined the term in anjmpossiblyonerousmanner-•••.

wield.sits exempti ve authority to off er. clemency to. those who are willi11gto .accede tbnew

duties and priv~te rig~ts ofactionthathave no· basis in the statute DOL~c1ministers. But the

Department may not conduct ' 'backdoorregulation'' througltmanipulation of ''safe harbor

criterion.'' Hearth; Patio&BarbecueAss'n; 706F.3dat507'-08 .•. See alsoChqmberof

AR038905


July 20,.20·15 Pagel6

Commerce v.1.J.S. JJep't ofLabor, 174.F' .. 3d 206, 210(D.C.Cir. J999)(concltiding0SHA

had authority to conductinspections, but could not us.eJhat as/ 'leverage" tq ·impose

obligations h()trequited bylaw).

''[I]t is funda!llentaLthat an age~cy may no! b()otstrap itself into ~n area in whfohit

has nojurisdiction, '' . AdamsFruit 90.v. Barrett, 494 U.S. 638, 650 (1990) (internal

quotation marks omitted). That is what the DOL attempts to do tbtoughthese proposa1sf arid

for this reason too, the proposals are impermissible.

C. The DepartmentLack$ Auth(lrity 'To Ba11 ClassAdiou Waivers In (J9nnection With Arbitration Agreements.

The Department a1so. e}(ceeds its statutory authority by purporting, inthe .BIC

.E)x:;emption, to bar all waivers ofparticipationin class actions orother representative actions,

withoutregard to whetherthose waivers are inconnectionwith arbitration agreements. 80

Fed. Reg. at2I,973, 21,985.

Uµder •• the .. fAA. •.• ·va1id·.arbitration.•a8reements •• m~st•be •.. enforced •. acc()rding••to •• their terrns unless the FAA "has been overridden bya contrary congressionalcomrnand.''

CompuCredit, 1328. Ct. at 669(internaLquotationmarks omitted); see also, e.g., Am.

ExpressCo. v. ltalian ColorsRest., 133 S. Ct.230~,2309~11 (2013}(ruleapp1iesevento

statutes that ' 'expressly permit[] collective actions"). This includes arbitrationprovisions

donfaiiling class waivers; whiCh the Supreme Court has repeatedly upheld. Italian Colors,

l33S. Ct.at 2312;AT&TMobilit.yLLCv ... Concepcion, lJls .•. 9. 1740,1748(2011).

''When [Congress] hasrestricted the use of arbitration," moreover, .. ''ithas done so with , ...•.

clarity/' CompuCredit, 132 S. Ct. at 672.

Nothing in EJ.nsA gives DO L clear authOdty-----0r any authority-• to preclude

financiaFinstitutions••and. their .. clients·••from •enteringint() •.• and enforcing arbitration. agreements th.at include class waivers. See Kramer v. Smith Barney, 80F.3d 1080, 1084(.Sth Cir.1996)

(''Congress. did notintendto. ~xempt statutoryE~ISA claims from the dictates of the

[FAA].''); Bircjv .. shearson Lehman/Am.Express, Jnc., 92frF.2d 116, 120.(2d Cir. 1991)

(concluding ER.ISAdoes not preclude waiver of a judidaLforumfor ER.ISA claims); As for

Code. Section 4975, iris not enforceable through a private right ofactionatall, sgg supra.,

AR038906


G.lBSON DUNN

J11ly 20,2015 Page 17

and plainly furnishes DOL. no authority to regµIate parties' arbitratioiragreemertts. Simply,

DQL'slackof authority to regulate arbitration agreementsis dispositive of its attempt fo bar class waivers in those agreements . . See CornpuCre.dit, 132 S . Ct. a,t672,

In this respect, a.sin so manyothersinthis bundle of proposed rules, the Department

has overstepped its bounds.

ES!bmr

cc: Office ofExe111ptiQn Determinations

AR038907


UNIVERSITY OF MIAlVII

J July 20, 2015

Office of Regulations and Interpretations Office of Exemption Determinations Employee Benefits Security Administration U.S. Department of Labor 200 Constitution Ave., NW Washington, DC 20210

Investor Rights Clinic Phone: 305-284-8234 1311 Mil ler Drive, Suite A312 Fax: 305-284-9368 Coral Gables, FL 33146

RE: Conflict of Interest Rule Proposal (RIN 1210-AB32) and Related Exemption Proposals (ZRIN 1210-ZA25)

Dear Sir or Madam:

The University of Miami School of Law Investor Rights Clinic ("the IRC") 1

appreciates the opportunity to comment on the Department of Labor's ("the Department's") Conflict of Interest Rule proposal (RIN 121 O-AB32) and related Exemption proposals (ZRIN 1210-ZA25). Over the past few years the IRC has assisted and represented a range of investors who have suffered financial losses in their retirement accounts, or to funds intended for retirement. In our experience, the increasing availability and complexity of investment products-while beneficial in many respectshas also increased the opportunity for investor exploitation. An<l notably, it is not just the most vulnerable who have suffered losses: The IRC has represented well-educated investors who hold bachelor's and advanced degrees. Thus, as the Department is already aware, we reiterate that a typical retirement investor is simply no match for the sophistication of today's broker-dealer industry when it comes to ensuring a level playing field. Something more than the current suitability standard is needed for retirement accounts.

The IRC often encounters clients of particularly modest means who have been let down by the very individuals and firms whom they trusted to help build and/or protect their nest eggs. In certain respects, the regulatory system has let them down, particularly investors who have done everything "right": made a responsible choice to save a portion

1 Launched in January 2012, the IRC was initially funded with a $250,000 grant from the FINRA Investor Education Foundation. Like other law school securities arbitration clinics, the IRC provides pro bono representation to investors of modest means who have suffered investment losses as a result of broker misconduct but, due to the size of their claims, cannot find legal representation. Under faculty supervision, law students provide legal assistance and advice to investors who have potential claims involving misrepresentation, unsuitability, unauthorized trading, excessive trading, and failure to supervise, among other claims. For more information, please see http://investorrights.law.miami.edu.

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of their income for retirement; decided to invest those savings; accepted normal market risks; and sought out investment expertise-most often from a broker-dealer employing trusted professionals to guide those investors through a complex and intimidating investment landscape. Oftentimes, these same investors are then recommended fee-laden investments that could in no rational way be considered in the investors' best interest. For low-income investors, losing as little as $10,000 can mean the difference between making ends meet and having to rely on family members or social welfare programs.

IRC clients have suffered losses in retirement accounts at smaller firms as well as some of the nation's best known broker-dealers. Thus, the IRC strongly believes that the conflicts of interest targeted by the Department's proposal are pervasive throughout the broker-dealer industry.

We believe that a fiduciary standard for retirement accounts will provide a strong deterrent against misconduct, preventing harm before it occurs in many cases. The current suitability standard simply leaves too much room for abuse in retirement accounts.

Best Interest Contract Exemption

The IRC supports the Department's Best Interest Contract Exemption that would allow investment advice fiduciaries to receive otherwise prohibited compensation from various sources, provided those fiduciaries fulfill various contractual disclosure requirements. We think this exemption is key to ensuring that broker-dealers can adapt their business models and continue serving investors of all means. Even assuming, without agreeing, that low-balance accounts subject to a fiduciary standard will become unprofitable under certain existing business models, we believe investors will be better off under a fiduciary standard in the long run. We are confident that the resourcefulness of the broker-dealer industry, coupled with competition within it, would soon lead to viable business models for servicing low-balance retirement investor accounts under a fiduciary standard.

The Department proposes that multiple disclosures accompany the use of the exemption. We have two related comments. First, we support the proposed mandatory "web page" disclosures. We agree that once investors can access publicly disclosed fees, useful and accessible comparisons will result. Better educated, discerning customers and increased competition should follow. Second, we believe the "Individual Transactional" disclosure format should draw from at least two of the ideas proposed by the Department. The model chart released by the Department is a good starting point. But instead of simply providing an example, the Department should require use of a standardized chart. Such standardization would help prevent subtle data manipulation in presentations to investors.

A "cigarette warning" -style disclosure-another Department idea- should accompany the standardized chart. Without some eye-catching and authoritative text, we fear that trusting investors could be easily misled by a lack of emphasis on the costs reflected in the chart. Also, the Department should consider requiring a separate signature

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line beside the chart for investor acknowledgment. We do not think a "cigarette warning" -style disclosure alone is sufficient.

Streamlined Low-Fee Exemption

The Department has requested comments on a contemplated streamlined highquality low-fee exemption. This exemption would permit otherwise prohibited compensation without fiduciaries meeting many of the Best Interest Contract Exemption requirements. Implemented appropriately, we believe this exemption could both empower investors and further incentivize competition within the industry.

Well-publicized low-fee products could act as guideposts to the most vulnerable investors. Many retirement investors have little idea how their retirement funds should be allocated, or what constitutes a reasonable fee. These investors enter their relationships with broker-dealers at a distinct disadvantage. The low-fee exemption, however, could help change that. An informed investor would be able to request the low-fee exemption option from a broker and to compare that broker's offerings with other brokers'. Although compelling reasons might exist for an investor to ultimately select a higher-fee product, the low-fee products would at least serve as good starting points for many who are otherwise uninformed.

We encourage the Department to limit the "streamlined" exemption to mutual funds-both equity funds and bond funds, including target-date funds. Inclusion of more complex products, with separate low-fee thresholds, into the exemption could be counterproductive. The Department's objectives may be frustrated if a greater than appropriate number of investors were inappropriately recommended (for example) annuities that, though offering the lowest fees among their peers, can be orders of magnitude more expensive than alternatives such as diversified bond or equity funds.

We believe that competition within the industry should obviate the Department's concern that the cost of already-low-fee products might rise to meet a devised cut-off. And even if certain products were to increase in cost, a low cut-off should limit harm to investors' portfolios.

We suggest that the Department require yearly cost-data submissions from fund providers who desire low-fee status. The data submitted by providers should mirror the expense ratios published in fund prospectuses. The Department could then release an annual list of funds that meet the cut-off for the low-fee exemption. This web-accessible list could help ease industry's compliance costs. Sales loads should be permitted but implicitly discouraged. Any sales loads, as a percentage of initial investment, should be added to the fund's annual expense ratio. Only the smallest of loads could survive. The negative effect that sales loads have on ultimate returns supports an approach that limits their use within retirement accounts. Relatedly, we believe empirical evidence sufficiently demonstrates that no-load funds offer the most compelling options for the vast majority of retirement investors.

To set the low-fee cut-off, we suggest that the Department first collect the annual

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expense ratios for all broad-based index-tracking funds available in the marketplace for the previous year (e.g., those tracking the Wilshire 5000, S&P 500, Barclays Aggregate). The Department could then calculate a simple average of those expense ratios; this average, plus a reasonable charge for one-time sales costs, would serve as the upcoming year's low-fee cutoff. This process could be repeated yearly. Because target-date funds may have higher operating expenses than non-target-date funds, the Department should consider establishing a separate low-fee cut-off for those products alone.

Modifications to Prohibited Transaction Exemption (PTE) 84-24

The Department proposes to modify PTE 84-24 so that compensation related to the purchase of security-designated annuity products and mutual fund shares in IRAs must meet the Best Interest Contract Exemption requirements. We support this modification. However, we disagree with the Department's intent to continue to allow non-security annuity and life insurance product compensation under PTE 84-24.

In our experience, annuities and life insurance products of virtually all varieties are a minefield for investors. Though these products are suitable in certain scenarios, attendant complexity, commissions, illiquidity, and fees (oftentimes hidden) require strong investor protection measures. Thus, the IRC believes compensation stemming from all annuities and life insurance products in retirement accounts should be permitted only through the Best Interest Contract Exemption.

The IRC strongly supports the Department's efforts to protect retirement investors through its proposed rule and related exemption proposals. We thank you for the opportunity to comment on these proposals.

Respectfully submitted,

Legal Intern, Investor Rights Clinic

Scott Eichhorn Practitioner-in-Residence, Investor Rights Clinic

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Ron A. Rhoades, JD, CFP® Grise Hall #324

1906 College Heights Blvd., Bowling Green, KY 42101-3576

Phone (cell): 352.228.1672 E-mail: [email protected]

July 20, 2015 Office of Regulations and Interpretations Employee Benefits Security Administration Attention: Conflicts of Interest Rule Room N-5655 Office of Exemption Determinations Employee Benefits Security Administration Attention: D-11712 and D-11713 United States Department of Labor 200 Constitution Avenue, N.W. Washington, D.C. 20210 RE: Proposed Conflict of Interest Rule and Related Proposals, RIN-1210-AB32

Dear Madam or Sir:

I write in support of the DOL’s proposed Conflict of Interest proposed rule and to suggest enhancements to the BIC exemption, and to further suggest a new exemption relating to IRA rollovers.

As a longtime researcher into fiduciary law as applied to financial and investment advisers, I currently serve as Asst. Professor of Finance at Western Kentucky University, Bowling Green, KY, where I Chair the undergraduate (B.S. Finance) Financial Planning Program with the Gordon Ford College of Business and teach classes in retirement planning and investments. I am also an investment adviser, having served as the Director of Research, Chair of the Investment Committee, and Chief Compliance Officer of an SEC-registered investment adviser firm, and I currently serve as the principal of my own registered investment adviser firm. I am also currently a Certified Financial Planner™, a member of the Steering Group for The Committee for the Fiduciary Standard, consultant to the Garrett Planning Network, and a member of both the Financial Planning Association (where I served on its “Fiduciary Task Force” and “Standards of Conduct Task Force”) and the National Association of Personal Financial Advisors (where I served on its national Board of Directors, and where I currently serve on the South Region Board of Directors). In the past I served as a consultant to a large financial services firm on a program relating to retirement planning. I am also a member of The Florida Bar, and have advised clients on tax and estate planning issues. I have previously commented extensively on fiduciary rule proposals and often provide writings and presentations on the topic. These comments represent my personal views.1

1 This comment letter reflects my personal views. These views are not necessarily representative of the views of any institution, organization, group or firm with whom I may be, or have been, associated.

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First, I desire to express my personal gratitude for the courage shown by the White House, the Secretary of the DOL, and Asst. Secretary Borzi and her dedicated staff, as they seek the necessary changes to better the retirement security of our fellow Americans. The tenacity shown to effect these much-needed updates to the standards of conduct applicable to the delivery of advice to retirement accounts are particularly noteworthy, given the flood of money and resources flowing from many Wall Street firms and their lobbying organizations into Washington, D.C. in an effort to delay or halt these important and long-overdue changes.

Second, I provide the rationale for the imposition of fiduciary standards upon providers of investment advice to ERISA-governed retirement accounts and individual retirement accounts (IRAs). This requires an understanding of the high rent extraction by most providers of financial products today, and the monumental adverse affect of this extraction of rents by Wall Street. These high rents not only hinder the retirement security of hundreds of millions of our fellow Americans, but also hinder the growth of the U.S. economy and the future economic prospects for all Americans.

Third, I provide a discussion of a bona fide fiduciary standard, and contrast the authentic “best interests” fiduciary standard of conduct with the wholly misleading and ineffective “best interests” standards of conduct now proposed by SIFMA and most recently by FINRA. I urge policy makers, such as those in Congress and in our regulatory agencies, to not be fooled by these 11th-hour attempts to deter the expansion of true fiduciary duties.

Fourth, I comment on the “Best Interests Contract Exemption,” also known as the BIC exemption. I provide suggestions which will serve strengthen the exemption and lead to better personal financial outcomes for our fellow citizens, as (given the advocacy by SIFMA on its “best interests” proposal, and other attempts to re-define commonly used legal terms) there is a danger that the term “best interests” will be, in the future, interpreted incorrectly.

Fifth, I recommend the adoption of a new prohibited transaction exemption (PTE) for independent investment advisers who are bound by the “sole interests” standard of ERISA, regarding the conflict of interest all providers of personalized investment advice possess regarding the important decision of Americans as to whether to undertake a rollover of a qualified retirement plan (QRP) account into one or more individual retirement accounts (IRAs).

Sixth, I comment on the “Seller’s Exemption.” There has been a long history of “expert advisers” failing to provide excellent and non-conflicted advice to retirement plan sponsors. I propose some enhancements to this exemption.

Seventh, I observe that it is extremely easy to reconcile different standards of conduct advisers might practice under, under different regulatory regimes, despite the assertions by FINRA, broker-dealers and insurance companies to the contrary.

I also hereby incorporate by reference my previous comment letters regarding a previous version of the proposed rule.2 These letters set forth additional legal authority for the propositions contained in this letter. I attempt to not duplicate these earlier submissions, except as necessary to address the specific issues raised by this important proposed rule and the new or modified PTEs associated therewith.

Thank you for your consideration. I would be pleased to discuss this proposal at your convenience with Department staff. By separate submission I have requested to testify at the DOL’s August 2015 hearing on these matters.

Yours truly, Ron A. Rhoades, JD, CFP®

2 My prior comment letters, dated April 11 and 12, 2011, can be found at https://www.dol.gov/ebsa/pdf/1210-AB32-PH026.pdf and https://www.dol.gov/ebsa/pdf/1210-AB32-PH029.pdf, respectively.

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COMMON SENSE 2015:

ADDRESSED TO THE

I N H A B I T A N T S

OF

A M E R I C A ,

on the following interesting

S U B J E C T S .

I. ON THE FAILURE OF THE FINANCIAL SERVICES INDUSTRY TO SERVE THE PUBLIC GOOD. ...................... 4

A. An Illustration: The Compton’s Expensive, Tax-Inefficient Portfolio. ................................................................. 4 B. Wall Street’s High Extraction of Rents from Our Fellow Americans .................................................................... 8 C. Wall Street’s Excessive Fees and Costs Impair the U.S. Economy ........................................................................ 9

II. THE UNWORKABLE CURRENT STATE OF AFFAIRS: THE FAILURE OF

“SUITABILITY” AND DISCLOSURE ALONE; SIFMA’S AND FINRA’S

“BEST INTERESTS” PROPOSALS AS MISLEADING AND WEAK .................................................................................. 10 A. The Unworkable Current State of Affairs of Americans ......................................................................................... 10 B. The Failure of the Suitability Doctrine to Protect Investors ................................................................................... 11 C. The Limits of Disclosure as a Means of Consumer Protection ............................................................................ 13 D. The Requirements of the Fiduciary Duty of Loyalty ................................................................................................ 17 E. The Non-Waiver of Core Fiduciary Obligations; Limits on Estoppel ................................................................ 19 F. SIFMA’s and FINRA’s “Best Interests” Proposals: ................................................................................................... 21 Misleading and Wholly Ineffective ........................................................................................................................................ 21

III. OF THE NEED FOR GOVERNMENT INTERVENTION AND CONSTRAINTS ON GREED. .............................. 27 A. Even John Locke Embraced the Need for Government Regulation .................................................................. 27 B. Adam Smith’s Recognition of the Need to Constrain Capitalism ........................................................................ 28

IV. ON THE DISTINCTION BETWEEN ARMS-LENGTH AND FIDUCIARY RELATIONSHIPS ............................. 28 V. ON THE NECESSITY OF FIDUCIARY STANDARDS ..................................................................................................... 29

A. The Vast Disparity in Expertise ........................................................................................................................................ 29 B. The Importance of Trust to Economic Growth ......................................................................................................... 30 C. Other Compelling Reasons for Imposition of Fiduciary Status ............................................................................ 32

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VI. ON DOL’S EXPANDED DEFINITION OF “FIDUCIARY” & SERVICE TO SMALL INVESTORS ..................... 35 VII. ON THE BIC EXEMPTION, GENERALLY. ................................................................................................................. 38

A. On the Difficulties Presented by Differential Compensation. ............................................................................... 39 B. Expressly Place the Burden of Proof, to Demonstrate Compliance with Fiduciary Duties, on the Adviser and His or Her Firm. ...................................................................................... 46 C. Establish the Standard for the Admissibility of Evidence ........................................................................................ 47 D. Highlight the Requirements of the Fiduciary Duty of Loyalty, When A Conflict of Interest is Present ................................................................................................................................ 47 E. The DOL Should Provide Examples of Unreasonable Compensation. ........................................................... 48 F. Sunset the BIC Exemption After Five Years. ............................................................................................................... 50

VIII. ON THE SALE OF VARIABLE ANNUITIES UNDER THE BIC EXEMPTION. .................................................. 52 IX. ON THE SALE OF EQUITY INDEXED ANNUITIES UNDER THE BIC EXEMPTION ....................................... 56 X. ON THE SALE OF FIXED ANNUITIES UNDER THE BIC EXEMPTION ................................................................ 58 XI. ON THE REGULATION OF IRA ROLLOVERS BY INDEPENDENT ADVISERS .................................................. 59 XII. ON THE SELLER’S EXCLUSION FOR LARGE RETIREMENT PLANS. ................................................................. 61 XIII. ON THE INTEGRATION OF DOL’S FIDUCIARY STANDARD WITH OTHER STANDARDS. .................... 63 XIV. IN CONCLUSION ............................................................................................................................................................. 63

Written by: R O N A . R H O A D E S .

______________________________________________________

"The best security for the fidelity of men is to make interest coincide with duty."

– Alexander Hamilton

______________________________________________________

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I. ON THE FAILURE OF THE FINANCIAL SERVICES INDUSTRY TO SERVE THE PUBLIC GOOD.

A. AN ILLUSTRATION: THE COMPTON’S EXPENSIVE, TAX-INEFFICIENT PORTFOLIO.

Jake and Missy Compton Seek A Second Opinion. Jake and Missy Compton (not their real names, for reasons of confidentiality), husband and wife for the past 10 years, and both in their early 40’s were doing relatively well financially. Jake was an executive at a multi-national company with a compensation package that was mid-six figures. Missy was attentive to the needs of home and her husband, diligently saving, paying bills, planning each modest vacation for maximum enjoyment, and ensuring no debt (other than their very-low-interest-rate mortgage) was incurred. After maximizing contributions to Jake’s 401(k) plan and electing to defer as much income as possible in the company’s nonqualified compensation plan, over the past several years the Comptons were still left with extra funds to invest. After several years of investing with the current wealth manager, Jake and Missy sought me out for a “second opinion.”

Before beginning to invest with their existing wealth manager, several years before, Jake and Missy already had investments. In addition to their condominium (their home, in a major city), Missy owned two condominiums in another state. These rental properties were generating positive cash flows for Jake and Missy.

Several years before a friend had previously referred the Comptons to the wealth manager’s firm. This “wealth management” firm’s stated policy, per their web site (retrieved 2/22/15) was “to provide independent and sound investment advice whatever your financial situation … trust is important.” (Emphasis added.) The firm also held out as “your expert partner in all things financial.” (Emphasis added.) The wealth manager they were referred to, a founder of the firm, touted his ability to “compete based on knowledge, relationship and world class service.” My review of the wealth manager’s registrations revealed that he was a dual registrant (i.e., possessing registration as both the registered representative of a broker-dealer firm and as the investment adviser representative of a registered investment adviser firm), and that he also possessed life insurance and annuity provider state licensure.

The wealth management firm suggested, for the Comptons, investments in many different types of accounts – traditional and Roth IRA, joint, and individual (taxable) accounts. Many different types of investments were undertaken. Variable universal life (VUL) insurance policies were also recommended and sold to both Jake and to Missy by the wealth manager. A nonqualified equity indexed annuity (EIA) was also recommended and sold to Jake.

After a few years, as Missy reviewed the many monthly and quarterly statements she received, she thought something might be amiss. She couldn’t put her finger on it, but she suspected that things were “not right.” Despite the tremendous increase in stock market values over the past few years, it appeared that the value of their investment portfolio was substantially lagging.

After reading an article I had written years before, Missy contacted me for a second opinion, to which I consented. (I call such second opinions or portfolio reviews “BearScans,” as my students often refer to me as “Da’ Bear” – perhaps due to my size or perhaps because I may growl at them.) I gathered detailed information from Jake and Missy Compton, including about their lifestyle, spending habits, past personal history, and goals, as well as monthly or quarterly statements of all of their investment accounts.

The Compton’s Retirement Goals. Jake desired to retire in about 15 years, and he believed that he was well on his way to doing so. With no children and none expected, Jake and Missy were not anticipating any major expenses prior to retirement. Working for a multinational company, Jake felt his position was very secure. The Comptons desired to retire to a state that had no state income tax. Their accumulated deferred compensation was invested per the plan at a rate slightly exceeding the prime rate, with no interest rate risk present. Additional contributions to the deferred comp plan were likely.

Compton’s Tax Return Reveals Unnecessary Tax Drag on Investment Returns. Even with the substantial deferred compensation arrangement, their recently prepared Form 1040 showed that their marginal tax rate was 28% for federal income tax purposes, and additional state income tax was paid. They possessed $9,000 of net capital loss carryforwards (NCLCF). Their tax return for the prior year indicated over $18,000 of ordinary dividend income and $4,000 of qualified dividend income. Three of their taxable investment accounts had generated realized net short capital gains

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exceeding $5,000, and five of their taxable investment accounts had generated realized net long-term capital gains exceeding $21,000. Due to a combination of deductions for state income taxes, the presence of qualified dividends, a small amount of tax-free interest income, and their long-term capital gains, the Comptons were subject to alternative minimum tax.

At first glance, the amount of nonqualified dividends seemed alarming, as were the realized capital gains from publicly traded investments. The continued realization of long-term capital gains would likely result in increases to their alternative minimum tax liability.

No Investment Policy for the Comptons. I then turned to Jake and Missy’s investments, made on the advice of their current wealth manager. First, I inquired, had an “Investment Policy Statement” been prepared by their current wealth management firm? No, the clients responded, inquisitive as to what an Investment Policy Statement was all about. The Comptons indicated that they would be contacted by their wealth manager whenever they contributed cash to their accounts, and recommendations would then be undertaken and discussed verbally. But they did not recall any “asset allocation” target percentages being discussed.

The Compton’s Oil & Gas Limited Partnership. The immediate question Jake and Missy posed to me was whether they should invest more into an oil and gas limited partnership, which recommendation they just received from their wealth manager just one week before they contacted me (in Nov. 2014). Of their total in the investment accounts with the wealth manager, nearly 20% had been invested in oil and gas limited partnerships with this same master general partner. A review of the investment revealed that outside investors in nearly all of the private placements arranged by the master limited partner either lost money or just about broke even. In fact, the limited partnerships were so poorly designed, so as to benefit the master limited partner over the limited partners, that a law firm had posted a notice stating that it was “interested in hearing from investors who have lost money investing in [the master limited partner’s] oil and gas investments.” With such red flags appearing, and with dramatically falling petroleum prices in the Fall of 2014, it was readily apparent that the risks of the investment outweighed the potential for returns, and I discouraged the Comptons from purchasing any more of these partnership interests.

While Jake and Missy extolled the tax credits they had received from these investments, and the current 6% dividend yield, I explained that the dividend was likely to fall in the months ahead as oil and gas revenues declined (which it subsequently did – quite dramatically). I also explained the “tax tail” should never wag the “prudent investor” dog. Tax credits would not offset the fact that their investments in these limited partnerships were highly unlikely to generate any reasonable rate of return. One does not invest to generate losses, but rather to generate gains. This fundamental truth seems have to been ignored by their wealth manager, at least with respect to these investments.

I also pointed out that the limited partnership interests were highly illiquid. In fact the value of these (non-liquid) investments had already likely fallen substantially. This was confirmed later when, seeking to sell one of their existing limited partnership interests, the best offer the Comptons received was for about 13% of the initial purchase price they paid for the units.

Why did their wealth manager recommend such a poor investment? Especially in November 2014, when despite rapidly falling oil prices the wealth manager recommended an even greater amount be invested? The answer appeared obvious. The sale of the limited partnership interests netted the “wealth management firm” commissions in the range of 10% to 15% - far in excess of the commissions which would have been charged had the Comptons purchased a mutual fund (especially when breakpoint discounts are applied).

Review of the Compton’s Other Tax-Inefficient and Costly Investments. I then turned to other accounts Jake and Missy possessed.

First Taxable Account. I would have expected that tax-efficient investments would be utilized and that avoidance of realization of capital gains, especially of a short-term nature, would be sought. Yet, the stock mutual funds possessed in these accounts had relatively high turnover and were woefully tax-inefficient. Some of the mutual funds held in the account were municipal bond funds; yet, these funds held few bonds in the Compton’s state of residence (leading to state income taxation of the otherwise “tax-free” interest income.) Another concern in this account was the layering of fees. In addition to investment advisory fees paid to their wealth management firm (which appeared to be

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about 1% a year, per the firm’s Form ADV), another advisory firm (“separate account manager”) was called upon to select the funds and was likely paid a fee of 0.6% to 1.0% according to its Form ADV. Then there were the fees and costs of the mutual funds themselves. A short review indicated annual expense ratios (AERs) as high as 1.91%, with most of the stock mutual funds possessing AERs exceeding 1%. Additional costs would be incurred within the stock funds – i.e., various transaction and opportunity costs due to the high amount of securities trading and sometimes relatively high cash holdings.

Second Taxable Account. Several stock and asset allocation funds were used in the account, all of which possessed relatively high portfolio turnover rates. The annual expense ratios of the mutual funds ranged from 0.89% to 1.25% for the three largest holdings in the account. Again, relatively high cost funds existed. With an allocation of 27% of the account to fixed income investments and most of the balance to stock mutual funds which generated substantial realized capital gains as well as taxable interest income, the account was not invested tax-efficiently.

Review of the Compton’s Non-qualified Equity-Indexed Annuity. Jake was also sold a nonqualified equity-indexed annuity (EIA), the value of which was less than the value shown on their brokerage statement, as surrender fees still applied (which reduced its actual market value). When I explained the likely rates of return of the EIA’s various investment options (given the crediting mechanisms and the caps), the tax restrictions on taking funds from the non-qualified annuity prior to age 59½, and the large commission paid to their wealth management firm upon the purchase of the EIA, Jake was not pleased. What struck me, as well, was that given the substantial qualified (401k) and nonqualified (deferred compensation) plans in which Jake was enrolled, there did not appear to be any good reason, from an overall tax planning perspective, to contribute to any non-qualified tax-deferred accounts.

The Compton’s Non-Publicly Traded REITs. The Comptons had also been sold two REITs by the wealth management firm. Both were non-publicly traded. Given the Compton’s other privately held real estate investments, any additional asset allocation to real estate was inappropriate. In addition, the REITs (which generate ordinary income, most of which must be distributed to the owners of the REITs) were held in taxable accounts. More alarming was the fact that the initial offering price of the REIT was still being utilized for purposes of valuing the shares on the statements, despite the fact that commissions of 8-10% and additional “marketing expenses reimbursements” were paid to the various brokerage firms that sold the REIT. A recent spreadsheet provided by their wealth manager indicated that this investment had “no fees” that year (perhaps accurate, but only in the sense that the large commission had already been paid and no investment advisory fees were paid on these investments). I explained to Jake and Missy that REITs pay their managers (or outside managers) fees to manage the properties, and other expenses exist within the REIT itself. I also explained that the value of the REIT was likely far below the value listed on the brokerage statement.

The Expensive Futures Ltd. Partnership. Jake and Missy also possessed a taxable (joint) account, invested in a non-publicly traded limited partnership that invested with other “Trading Advisors” who in turn invested primarily in futures contracts. One Trading Advisor’s compensation was 2% and 20% of the “net new trading profits.” Others had compensation of “0 and 30%” or “0.75% and 25%” or similar. In addition, the limited partnership charged an annual management fee of 1.5%, plus 7.5% of the new profits calculated monthly. Selling agent fees also were 2% annually. To the Comptons I explained the likely long-term returns of commodities, as an asset class, the historical returns of commodities, the tax implications of the fund, as well as the many layers of fees and costs. I also explained the lack of liquidity for this investment. Needless to say, the Comptons were again not pleased with their wealth manager’s advice to invest in this investment product.

Roth IRA Investments – What the Hell? I then reviewed the Comptons’ Roth IRA accounts, invested in a mix of U.S. and foreign stock funds as well as some bond funds. Of course, two things stood out immediately. First, foreign tax credits can result from international stock mutual funds, which flow though to U.S. owners of those funds when held in taxable accounts. These tax credits are lost when the international stock mutual funds are held in Roth IRA or tax-deferred accounts. Second, fixed income investments have no place in this Roth IRA account. Roth IRAs generally grow income tax-free, and these accounts will likely be the client’s last source of withdrawals during retirement. Accordingly, allocation to the asset classes with the best expected long-term returns would be far more appropriate.

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Very Expensive VUL Policies. Both Jake and Missy had variable universal life insurance (VUL) policies that which were sold to them by the wealth manager in 2010. Missy’s death benefit was $381,000, and her accumulation value was $57,377. Jake’s policy had a death benefit of $336,000 and an accumulation value of $54,000. The accumulation values remained far below the total premiums paid, given the high commissions paid to the wealth manager during the VUL policies’ first few years.

I would never have recommended permanent life insurance for them. The only need for life insurance was to replace Jake’s lost income, or cover possible expenses upon Missy’s end of lifetime. I would have recommended term policies, with a far larger death benefit for Jake and far less of a death benefit for Missy (as she did not have earned income).

It should be noted that there was no need to secure liquidity to pay estate taxes. In fact, during the year the policies were sold to the Comptons (2010), the federal estate tax did not exist. In December 2010 the federal estate tax exemption was established at $5m for 2011 (with increases tied to inflation thereafter, and with spousal portability). There simply was no need for the clients to possess permanent life insurance. I surmised that the only plausible reason that the Comptons were sold these policies was due to the fat commissions paid to the wealth manager.

However, since the Comptons already possessed these policies, and had paid hefty commissions on the premiums paid and since the policies still possessed surrender fees, more analysis was needed to determine whether to continue with the policies and/or continue to pay premiums. In-force projections would have been ordered, using conservative rates of return and with minimal or no future premiums paid. Comparisons of mortality fees paid under the policy, to the insurance charges from new term insurance policies, would also need to be undertaken. Regardless of whether, following more analysis, the current policies will be surrendered or not, more term life insurance for Jake was likely needed, which will be handled through one or more new term life policies.

The Compton’s Non-Managed 401(k). Jake also had a 401(k) with his company. Fortunately, this account was not managed by the wealth management firm. The Vanguard funds in the account had been selected by Jake. While the asset allocation was not favorable, from an overall portfolio standpoint, this could be easily fixed. I wondered, however, why the “wealth management” firm had not provided advice on the 401(k) investments, given the need to consider a client’s overall asset allocation in order to ensure tax-efficiency and adherence to a sound investment policy; perhaps they had not been asked to do so. I explained to the Comptons that the best means to tax-efficiently an overall investment portfolio is to hold all of their desired asset allocation in tax-deferred accounts, such as this one (and the nonqualified retirement plans mentioned above), while holding tax-efficient stock funds in taxable accounts, all other things being equal.

In Summary - The Compton’s Portfolio Fiasco. Upon reflection, I wondered what expertise, if any, had been applied to the construction and management of the investment portfolio. The overall portfolio did not seem to possess any overall investment strategy. Investments were recommended that appeared to pay either high commissions (REITs, oil and gas limited partnerships, VUL policies, EIA) or which incurred layer after layer of annual fees and costs. Most of the investment portfolio was structured tax-inefficiently, leading to a huge tax drag on investment returns. Several of the investments were quite illiquid and would likely take years to unwind.

From the facts available to me, I concluded that the wealth management firm had not, in my opinion, delivered upon their promise of “independent and sound investment advice.” Multiple conflicts of interest existed. Little or no expertise was applied. Even in the investment advisory accounts (subject to the fiduciary duties imposed by the Advisers Act) it did not appear that due consideration was given to avoidance of high fees and costs. And, under state common law, at least in some states, fiduciary duties extend to the entirety of the relationship.

The Comptons, in their own words, “trusted” this “financial professional.” It was a trust betrayed.

The Comptons became a client of my own investment advisor firm. Over the first year of our relationship, in which I am paid a reasonable flat fee, I have been undertaking a restructuring of their investment portfolio to become much more tax-efficient and to dramatically reduce the extraordinarily high fees extracted from many of their investments. In addition, as part of that fee, I have provided advice on their estate plan, advised on the impact of changes undertaken by Jake’s company to the nonqualified profit-sharing plans the company offered to him, income tax planning, and much more. After this first year my annual flat fee will be cut in half, as much less professional services will be needed

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by Jake and Missy Compton, once I spend a year straightening out their current accounts (to the extent such corrective action is possible).

B. WALL STREET’S HIGH EXTRACTION OF RENTS FROM OUR FELLOW AMERICANS

I wish I could say that the Compton’s experience was rare. But it is far from a rare event. Rather, the experience of receiving non-expert, highly conflicted financial and investment advice results for most Americans today.

Jake and Missy Compton are both very highly educated. They asked many of the right questions. But, lacking knowledge of the complex array of financial products their wealth adviser presented to them, the Comptons were at a substantial disadvantage. They were unaware of the many conflicts of interest possessed by their wealth manager. And they were unaware of just how much their wealth manager had been able to extract from them by way of commissions and other fees.

I have seen similar situations, some less complex, some more complex, for clients who came to me with $1,000 accounts, and for clients who came to me with total accounts in the tens of millions of dollars. Regardless of the amount involved, and regardless of the educational level and “sophistication” of the client, nearly all of these clients were subject to payment of relatively high fees and costs – and payment to their “advisor” of fees (often hidden from view) – which were excessive in nature.

In my nearly 30 years as an estate planning and tax attorney, and in my nearly 15 years as a fiduciary investment adviser, I have possessed the opportunity to review hundreds of clients’ investment portfolios. When the clients’ investment portfolios were advised upon by either broker-dealer firms, by dual registrants (firms and individuals with both securities broker/dealer licensure and registered investment adviser licensure), or by insurance agents, the allure of high-fee investment and insurance products to the registered representative of the broker-dealer firm, or to the insurance agent, was nearly always too strong to resist. Over 95% of the time, in my reviews of hundreds of clients’ portfolios, I discerned high-cost investments, tax-inefficient portfolios, or both.

Economic incentives matter, and they matter a great deal. When a salesperson has the opportunity to receive much higher compensation from the sale of one product, compared to another, the allure of the investment product with the higher compensation (and higher fees to the client) nearly always win.

These insidious conflicts of interest cause great harm to the financial and retirement security of our fellow Americans. The academic research in this area is compelling – higher-cost investments lead, on average, to lower returns. In fact, there is a strong negative correlation between the total fees and costs of an investment product and the returns of that product over the long term, relative to similar investments:

As stated in a 2011 paper by Michael Cooper et. al., using data on active and passive U.S. domestic equity funds (the sample included a total of 13,817 funds within the CRSP Mutual Fund Database) from 1963 to 2008, the authors observed:

Similar to others, we first show that fees are an important determinant of fund underperformance – that is, investors earn low returns on high fee funds, which indicates that investors are not rewarded through superior performance when purchasing ‘expensive’ funds. We explore a number of hypotheses to explain the dispersion in fees and find that none adequately explain the data. Most importantly, there is very little evidence that funds change their fees over time. In fact the most important determinant of a fund’s fee is the initial fee that it charges when it enters the market. There is little evidence that funds reduce their fees following entry by similar funds or that they raise their fees following large outflows as predicted by the strategic fee setting hypothesis. We also do not find evidence that higher fees are associated with proxies for higher service levels provided to investors.”3 (Emphasis added.)

In a recent paper by Vidal et. al., they also found that high mutual fund fees predict lower returns. “[We confirm the negative relation between funds´ before fee performance and the fees they charge

3 Michael Cooper, Michael Halling and Michael Lemmon, Fee dispersion and persistence in the mutual fund industry (March 2011).

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to investors. Second, we find that mutual fund fees are a significant return predictor for funds, fees are negatively associated with return predictability. These results are robust to several empirical models and alternative variables.”4

And, in another recent paper by Sheng-Ching Wu, it was noted that it is not just the disclosed fees (found in the commissions or redemption fees paid and the annual expense ratio), but also the transaction costs resulting from turnover of securities within the fund, that matter. “[F]unds with higher portfolio turnovers exhibit inferior performance compared with funds having lower turnovers. Moreover, funds with poor performance exhibit higher portfolio turnover. The findings support the assumptions that active trading erodes performance….5

America must act now to substantially reduce this excessive rent seeking by Wall Street via broker’s sale of expensive investment products to unwitting consumers. And the best way to do this is to eliminate, or at least substantially reduce, the many conflicts of interest that drive the extraction of such high rents by brokers and insurance agents from the portfolios of our fellow citizens.

C. WALL STREET’S EXCESSIVE FEES AND COSTS IMPAIR THE U.S. ECONOMY

The high costs of Wall Street’s services and products not only engender the retirement security of individual Americans, but also impair the American economy. As the role of finance has grown ever larger, instead of providing the oil that ensures the American economic engine churns efficiently, the peddling of expensive investment products to Americans has led to a sludge that impairs the vitality and threatens the future of not only our fellow Americans, but of America itself.

The growth of the financial services industry has grown to an extraordinary proportion of the overall U.S. economy. As stated in a recent article by Gautam Mukunda appearing in the Harvard Business Review:

In 1970 the finance and insurance industries accounted for 4.2% of U.S. GDP, up from 2.8% in 1950. By 2012 they represented 6.6%. The story with profits is similar: In 1970 the profits of the finance and insurance industries were equal to 24% of the profits of all other sectors combined. In 2013 that number had grown to 37%, despite the aftereffects of the financial crisis. These figures actually understate finance’s true dominance, because many nonfinancial firms have important financial units. The assets of such units began to increase sharply in the early 1980s. By 2000 they were as large as or larger than nonfinancial corporations’ tangible assets ….6

The result of this excessive rent extraction by Wall Street is a substantial impediment to the present and future growth of the growth of the U.S. economy. As Steve Denning recently noted:

The excessive financialization of the U.S. economy reduces GDP growth by 2% every year, according to a new study by International Monetary Fund. That’s a massive drag on the economy–some $320 billion per year. Wall Street has thus become, not just a moral problem with rampant illegality and outlandish compensation of executives and traders: Wall Street is a macro-economic problem of the first order … Throughout history, periods of excessive financialization have coincided with periods of national economic setbacks, such as Spain in the 14th century, The Netherlands in the late 18th century and Britain in the late 19th and early 20th centuries. The focus by elites on “making money out of money” rather than making real goods and services has led to wealth for the few, and overall national economic decline. ‘In a financialized economy, the financial tail is wagging the economic dog.’7

4 Marta Vidal, Javier Vidal-García, Hooi Hooi Lean, and Gazi Salah Uddin, The Relation between Fees and Return Predictability in the Mutual Fund Industry (Feb. 2015). 5 Sheng-Ching Wu, Interaction between Mutual Fund Performance and Portfolio Turnover, Journal of Emerging Issues in Economics, Finance and Banking (JEIEFB) 2014 Vol: 3 Issue 4.

6 Gautam Mukunda, “The Price of Wall Street’s Power,” Harvard Business Review (June 2014), available at https://hbr.org/2014/06/the-price-of-wall-streets-power/ar/1. 7 Steve Denning, “Wall Street Costs The Economy 2% Of GDP Each Year,” Forbes (May 31, 2015), available at http://www.forbes.com/sites/stevedenning/2015/05/31/wall-street-costs-the-economy-2-of-gdp-each-year/

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Wall Street’s lack of legal and ethical constraints have been opined by many as the root cause of the financial crisis of 2008-9 and the resulting recession in the United States, from which we still have not fully recovered. In fact, the failure of the U.S. economy to recover may partly be due to the excessive rent seeking Wall Street undertakes.

As Jack Bogle, founder of Vanguard, observed: “Self-interest, unchecked, is a powerful force, but a force that, if it is to protect the interests of the community of all of our citizens, must ultimately be checked by society. The recent crisis—which has been called ‘a crisis of ethic proportions’ – makes it clear how serious that damage can become.”8

II. THE UNWORKABLE CURRENT STATE OF AFFAIRS: THE FAILURE OF “SUITABILITY” AND DISCLOSURE ALONE; SIFMA’S AND FINRA’S “BEST INTERESTS” PROPOSALS AS

MISLEADING AND WEAK

A. THE UNWORKABLE CURRENT STATE OF AFFAIRS OF AMERICANS

Is America the greatest country? Not by many measures, when compared to other developed nations of the world. Yet, with the concerted effort of entrepreneurs, innovators, educators, and the providers of monetary and human capital, tempered properly by logical and efficient standards of conduct imposed by necessary government regulation so as to constrain excessive rent seeking and to deter improper conduct, I believe America can once again become the greatest country.

Essential to these efforts is the need to better ensure the future retirement security of all Americans. At the present time trust in our system of financial services remains at a historical low. Americans in need of financial advice are reluctant to seek out such advice, given the presence of so many conflicts of interest from purveyors of investment products.

While SIFMA, FSI and other representatives of many of the broker-dealer firms have referred to the DOL rule as “unworkable,” the reality is that the current conflict-ridden product-sales business model of Wall Street does not desire to see its high extraction of rents from individual Americans terminated.

Yet, the delivery of investment advice to small business owners and large business owners (plan sponsors), and to individual Americans (whatever the size of their account), is currently undertaken under a fiduciary standard of conduct. In fact, independent registered investment advisory firms and their investment advisers representatives deliver fiduciary investment advice to millions of Americans at the present time, under a fiduciary business model.

The current sad state of affairs is untenable. If Americans are not aided by fiduciary advice, and if the continued high extraction of rents occurs by Wall Street from the hard-earned retirement savings of millions of Americans, then federal, state and local governments will be all called upon to provide increased support for individual Americans, especially those in retirement, who possess far too less in their investment portfolios in the future. This will further create a burden upon governments, resulting in pressure to raise taxes. This in turn would further constrain future U.S. economic growth.

Every effort should be undertaken to better arm our individual Americans with fiduciary investment advice. The DOL proposal to expand the application of fiduciary status is an outstanding part of the solution required to ensure a better future not just for our fellow Americans, but for America itself.

8 John Bogle, “The Fiduciary Principle,” ETF.com (June 22, 2009), adopted from a speech given to the Columbia University School of Business, New York City, NY, April 1, 2009.

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B. THE FAILURE OF THE SUITABILITY DOCTRINE TO PROTECT INVESTORS

------------------------------------------------------------------------------------------------------------------------------------------- “I am a stock and bond broker. It is true that my family was somewhat disappointed

in my choice of profession.” – Binx Bolling, THE MOVIEGOER (1960)9

------------------------------------------------------------------------------------------------------------------------------------------

Generally, “suitability” refers to the obligation of a full service broker to recommend to a customer only those securities that match the customer’s financial needs and goals. There are essentially two major dimensions of the suitability obligation: (1) “reasonable basis” or “know your security” suitability that focuses on the characteristics of the recommended security and requires a minimal degree of product due diligence prior to the sale of the security to any client; and (2) “customer-specific” or “know your customer” suitability, which focuses on ascertaining the financial objectives, needs, and other circumstances of the particular customer before recommending investment products to that customer. A third dimension of suitability guards against churning.

In simplistic terms, the “reasonable basis” aspect of suitability prohibits one from selling investments which are high explosives, as brokers cannot sell investments are “unsuitable” for any investor, regardless of the investor’s wealth, willingness to bear risk, age, or other individual characteristics. This might, for example, present a barrier to the sale of unregistered securities with no operations, assets or earnings. However, under “reasonable basis suitability” the sale of high-risk Roman candles and other firecrackers might be permitted as a portion of some investors’ portfolios.

However, the “customer-specific” aspect of suitability prevents the sale of Roman candles and firecrackers to certain particular investors who might be unable to bear the risks of certain investments. It prevents brokers from selling by high-risk, illiquid, and/or complex securities to elderly, inexperienced or unsophisticated customers who do not understand the risks of such investments.

While the suitability obligation was for a time imposed directly10 by the U.S. Securities and Exchange Commission (SEC) upon brokers who were not a member of a self-regulatory organization (SRO), the SEC’s regulation was rescinded in 1983 when all broker-dealers were required to be a member of an SRO. Hence, the source for the suitability obligation is now found exclusively in the rules of the National Association of Securities Dealers (NASD), renamed as the Financial Services Regulatory Authority (FINRA), and in FINRA Rule 2111.11

The Exchange Act directs that FINRA’s rules be “designed to prevent fraudulent and manipulative acts and practices.” FINRA also imposes on its members the duty to “observe high standards of commercial honor and just and equitable principles of trade.”12 This duty has been interpreted by FINRA to he prohibit registered firms from making false, misleading, or exaggerated statements or claims or omitting material information in all advertisements and sales literature directed to the public.

At its core, when it applies to the provision of advice, the suitability doctrine actually lessens the duty of due care. In the context of advisory recommendations, suitability serves to confine the duties of broker-dealers and their registered representatives to their customers to below that of the broad common law duty of due care.

9 Walter Percy, THE MOVIEGOER (New York: Ivy Books, 1960), pg. 6. 10 1934 Act Rule 15b10-3. 11 FINRA generally explains its current version of the suitability rule, FINRA Rule 2111, as follows: “FINRA Rule 2111 requires, in part, that a broker-dealer or associated person ‘have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the [firm] or associated person to ascertain the customer's investment profile.’ In general, a customer's investment profile would include the customer's age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance. The rule also explicitly covers recommended investment strategies involving securities, including recommendations to "hold" securities. The rule, moreover, identifies the three main suitability obligations: reasonable-basis, customer-specific, and quantitative suitability. https://www.finra.org/industry/faq-finra-rule-2111-suitability-faq#sthash.LWz8PjDs.dpuf (retrieved June 10, 2015). 12 FINRA Conduct Rule 2110: Standards of Commercial Honor and Principles of Trade.

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By way of explanation, with the early 20th Century rise of the concept of the duty of due care, and the commencement of actions for breach of one’s duty of due care (via the accelerated development during of the negligence doctrine during such time), broker-dealers sought a way to ensure they would not be held liable under the standard of negligence. After all, “[t]o the extent that investment transactions are about shifting risk to the investor, whether from the intermediary, an issuer, or a third party, the mere risk that a customer may lose all or part of its investment cannot, in and of itself, be sufficient justification for imposing liability on a financial intermediary.”13 This appears to be a valid view as to the duty of care that should be imposed upon a broker-dealer. However, this low duty of care is only appropriate if the broker-dealer is only providing only trade execution services to the customer.

In essence, the suitability standard was originally designed solely to protect brokers who provided trade execution services from breaches of the duty of due care applicable to all product sellers, given the inherent risks of investing in individual securities. Yet, as broker’s services have expanded, the suitability standard has inappropriately been applied to broker’s other services, including those services that are clearly of an advisory nature.

In contrast to the individual stocks and bonds for which brokers mostly executed transactions in the 1930’s, currently brokers often recommend mutual funds and other pooled investment vehicles (including but not limited to unit investment trusts, ETFs, variable annuity subaccounts and equity indexed annuities). Indeed, mutual fund sales exploded a thousand-fold shortly following the SEC’s abolition of all fixed commission rates effective May 1, 1975. But, along the way, no longer were broker-dealers just performing trade execution services, but they were, in fact, providing advice through their recommendation of investment managers. Yet, inexplicably, the SEC and FINRA permitted the suitability doctrine to be extended to incorporate broker-dealers’ recommendations of the managers of pooled investment vehicles. As a result, brokers operate with a free hand today when providing advice on mutual fund selection. Brokers, as a result of the incorrect expansion of the application of the suitability doctrine, are unburdened by the duty of nearly every other person in the United States with respect to their advisory activities, which, at a minimum, for other providers of advice require adherence to the duty of due care of a reasonable person.

Suitability’s abrogation of the duty of care means that suitability lacks teeth when investment advice is provided.

• Suitability does not generally impose upon broker-dealers any obligation to recommend a “good” product over a “bad” one.

• Suitability does not impose upon brokers and their registered representatives a duty to recommend a less expensive product over an expensive product, even where the product’s composition and risk characteristics are almost identical, and even though substantial academic research concludes that higher-cost products return less to investors than similar lower-cost products over longer periods of time.

• Suitability does not require brokers and their registered representatives to recommend products that meet a client’s objectives for tax-efficient and prudently structured investment portfolios.

• Suitability does not require brokers and their registered representatives to avoid conflicts of interest, nor to properly manage the unavoidable conflicts of interest that remain to keep the clients’ best interests paramount at all times.

In summary, the suitability standard permits the conflict-ridden sale of highly expensive, tax-inefficient and risky investment products, leaving the customer with little or no redress.

Suitability remains a “nebulous and amorphous with respect to its content and parameters.”14 It essentially imposes upon broker-dealers only the responsibility to not permit their customers to “self-destruct.”

In summary, the “suitability” standard was not originally designed to, nor should it be permitted to, apply to the provision of investment advice. Suitability abrogates the all-important duty of care required of nearly every other provider of services.

13 60 Am. U.L. Rev. 1265, 1275. 14 Lowenfels and Bromberg, Suitability in Securities Transactions, THE BUSINESS LAWYER (Aug. 1999) 1557.

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In essence, suitability is a shield that protects brokers, not investors. It is such a low standard of conduct that, even when surrounded by a multitude of other rules and an enforcement regime, it is but a loud dog that lacks any teeth.

C. THE LIMITS OF DISCLOSURE AS A MEANS OF CONSUMER PROTECTION

In recent years various proposals have been advanced by Wall Street to merely enhance the suitability doctrine. These suggestions include adding certain mandated disclosures, usually of a casual nature (such as “our interests may not be aligned with yours”). Wall Street advances these proposals in hopes of defeating the imposition of fiduciary status on brokers who provide investment advice. Yet, as Wall Street is fully aware, disclosures are seldom read by consumers, and even when read they are rarely understood. While disclosure is said to be a key component of the federal securities laws, the Investment Advisers Act of 1940 and ERISA were enacted, subsequent to the regulations imposed under the ’33 Securities Act and the ’34 Securities Exchange Act (and the ’37 Maloney Act amendments thereto), in order to impose fiduciary standards upon those who provide investment counsel to our fellow Americans. In essence, Congress recognized that disclosure was insufficient to safeguard the interests of investors, and hence public policy dictated that fiduciary obligations be imposed.

While federal and state securities laws and regulations have imposed certain disclosure obligations upon brokers, such disclosures are inherently ineffective as a consumer protection measure, for a variety of reasons. Indeed, the necessity for the rise of fiduciary standards of conduct throughout several centuries of the law reflects the realization, over the centuries, that disclosures possess limited impact as a means of consumer protection. If disclosures were a sufficient means of protection, then the common law would have never created the fiduciary standard.

Even in the 1930’s, the perception existed that disclosures would prove to be inadequate as a means of investor protection. As stated early on by Professor Schwarcz:

Analysis of the tension between investor understanding and complexity remains scant. During the debate over the original enactment of the federal securities laws, Congress did not focus on the ability of investors to understand disclosure of complex transactions. Although scholars assumed that ordinary investors would not have that ability, they anticipated that sophisticated market intermediaries – such as brokers, bankers, investment advisers, publishers of investment advisory literature, and even lawyers - would help filter the information down to investors.15

Academic research exploring the nature of individual investors’ behavioral biases, as a limitation on the efficacy of disclosure and consent, also strongly suggests that client waivers of fiduciary duties are not effectively made. In a paper exploring the limitations of disclosure on clients of stockbrokers, Professor Robert Prentice explained several behavioral biases which combine to render disclosures ineffective: (1) Bounded Rationality and Rational Ignorance; (2) Overoptimism and Overconfidence; (3) The False Consensus Effect; (4) Insensitivity to the Source of Information; (5) Oral Versus Written Communications; (6) Anchoring; and (7) Other Heuristics and Biases. Moreover, as Professor Prentice observed: “Securities professionals are well aware of this tendency of investors, even sophisticated investors, and take advantage of it.”16 Much other academic research into the behavioral biases faced by individual investors has been undertaken, in demonstrating the substantial challenges faced by individual investors in dealing with those providing financial advice in a conflict of interest situation.

Behavioral biases also negate the abilities of “do-it-yourself” investors. As shown in DALBAR, Inc.’s 2009 “Quantitative Analysis of Investor Behavior,” most individual investors underperform benchmark indices by a wide margin, far exceeding the average total fees and costs of pooled investment vehicles. A growing body of academic research into the behavioral biases of investors reveals substantial obstacles individual investors must overcome in

15 Steven L. Schwarcz, Rethinking The Disclosure Paradigm In A World Of Complexity, Univ.Ill.L.R. Vol. 2004, p.1, 7 (2004), citing “Disclosure To Investors: A Reappraisal Of Federal Administrative Policies Under The ‘33 and ‘34 Acts (The Wheat Report),“ 52 (1969); accord William O. Douglas, “Protecting the Investor,” 23 YALE REV. 521, 524 (1934). 16 Robert Prentice, Whither Securities Regulation? Some Behavioral Observations Regarding Proposals For Its Future, 51 Duke L.J. 1397 (available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397#H2N5).

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order to make informed investment decisions,17 and reveal the inability of individual investors to contract for their own protections.18

Financial advisors also utilize clients’ behavioral biases to their own advantage, if not restricted by appropriate rules of conduct. As stated by Professor Prentice, “instead of leading investors away from their behavioral biases, financial professionals may prey upon investors’ behavioral quirks … Having placed their trust in their brokers, investors may give them substantial leeway, opening the door to opportunistic behavior by brokers, who may steer investors toward poor or inappropriate investments.”19 (as was the case with the Comptons, and as is the case with tens of millions of other Americans.)

Practice management consultants train financial and investment advisors to take advantage of the behavioral biases of consumers. In fact, I have been so trained. The instruction involves actions to build a relationship of trust and confidence with the client first, far before any discussion of the service to be provided or the fees for such services. It is well known among marketing consultants that once a relationship of trust and confidence is established, clients and customers will agree to most anything in reliance upon the bond of trust that has been formed.

The SEC’s emphasis on disclosure, drawn from the focus of the 1933 and 1934 Securities Acts on enhanced disclosures, results from the myth that investors carefully peruse the details of disclosure documents that regulation delivers. However, under the scrutinizing lens of stark reality, this picture gives way to an image a vast majority of investors who are unable, due to behavioral biases and lack of knowledge of our complicated financial markets, to undertake sound investment decision-making. As stated by Professor (and former SEC Commissioner) Troy A. Paredes:

The federal securities laws generally assume that investors and other capital market participants are perfectly rational, from which it follows that more disclosure is always better than less. However, investors are not perfectly rational. Herbert Simon was among the first to point out that people are boundedly rational, and numerous studies have since supported Simon’s claim. Simon recognized that people have limited cognitive abilities to process information. As a result, people tend to economize on cognitive effort when making decisions by adopting heuristics that simplify complicated tasks. In Simon’s terms, when faced with complicated tasks, people tend to ‘satisfice’ rather than ‘optimize,’ and might fail to search and process certain information.20

17 As stated by Professor Ripken: “[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one’s own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is ‘doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases’ … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.” Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528. 18 See Robert Prentice, Whither Securities Regulation Some Behavioral Observations Regarding Proposals for its Future, 51 Duke Law J. 1397 (March 2002). Professor Prentices summarizes: “Respected commentators have floated several proposals for startling reforms of America’s seventy-year-old securities regulation scheme. Many involve substantial deregulation with a view toward allowing issuers and investors to contract privately for desired levels of disclosure and fraud protection. The behavioral literature explored in this Article cautions that in a deregulated securities world it is exceedingly optimistic to expect issuers voluntarily to disclose optimal levels of information, securities intermediaries such as stock exchanges and stockbrokers to appropriately consider the interests of investors, or investors to be able to bargain efficiently for fraud protection.” Available at http://www.law.duke.edu/shell/cite.pl?51+Duke+L.+J.+1397. 19 Id. See also Stephen J. Choi and A.C. Pritchard, “Behavioral Economics and the SEC” (2003), at p.18. 20 Troy A. Parades, Blinded by the Light: Information Overload and its Consequences for Securities Regulation, 83 Wash.Univ.L.Q. 907, 931-2 (2003).

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In reality, disclosures, while important, possess limited ability to protect investors, particularly in today’s complex financial world. As Professor Daylian Cain has often remarked, “The saying that ‘sunlight is the best disinfectant’ is just not true.”

The insufficiency of disclosure as a means of investor protection was highlighted at the Fiduciary Forum, held in September 2010 in D.C. and co-sponsored by the Committee for the Fiduciary Standard, CFP Board, NAPFA, FSI, and FPA. Two of the professors presenting at that conference also have written extensively regarding the inherent limits of disclosure as a means of consumer protection.

In a paper by Professors Daylian Cain, George Loewenstein, and Don Moore, "The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest," they challenged the belief of some that disclosure can be a reliable and effective remedy for the problems cause by conflicts of interest, and concluded:

In sum, we have shown that disclosure cannot be assumed to protect advice recipients from the dangers posed by conflicts of interest. Disclosure can fail because it (1) gives advisors strategic reason and moral license to further exaggerate their advice, and (2) the disclosure may not lead to sufficient discounting to counteract this effect. The evidence presented here casts doubt on the effectiveness of disclosure as a solution to the problems created by conflicts of interest. When possible, the more lasting solution to these problems is to eliminate the conflicts of interest. As Surowiecki (2000) commented in an article in the New Yorker dealing specifically with conflicts of interest in finance, ‘transparency is well and good, but accuracy and objectivity are even better. Wall Street doesn’t have to keep confessing its sins. It just has to stop committing them.’[21

In another paper co-authored by Professor Cain, he opined:

Conflicts of interest can lead experts to give biased and corrupt advice. Although disclosure is often proposed as a potential solution to these problems, we show that it can have perverse effects. First, people generally do not discount advice from biased advisors as much as they should, even when advisors' conflicts of interest are honestly disclosed. Second, disclosure can increase the bias in advice because it leads advisors to feel morally licensed and strategically encouraged to exaggerate their advice even further. This means that while disclosure may [insufficiently] warn an audience to discount an expert-opinion, disclosure might also lead the expert to alter the opinion offered and alter it in such a way as to overcompensate for any discounting that might occur. As a result, disclosure may fail to solve the problems created by conflicts of interest and it may sometimes even make matters worse.22

The dimensions of the biases of advisors, when attempting to deal with non-avoided conflicts of interest, was revealed in a paper citing earlier research by Professor Cain and others, as Professor Antonia Argandoña observed:

As a rule, we tend to assume that competent, independent, well trained and prudent professionals will be capable of making the right decision, even in conflict of interest situations, and therefore that the real problem is how to prevent conscious and voluntary decisions to allow one’s own interests (or those of third parties) to prevail over the legitimate interests of the principal – usually by counterbalancing the incentives to act wrongly, as we assume that the agents are rational and make their decisions by comparing the costs and benefits of the various alternatives.

Beyond that problem, however, there are clear, unconscious and unintended biases in the way agents gather, process and analyze information and reach decisions that make it particularly difficult for them to remain objective in these cases, because the biases are particularly difficult to avoid. It has been found that,

• The agents tend to see themselves as competent, moral individuals who deserve recognition.

• They see themselves as being more honest, trustworthy, just and objective than others.

21 See http://papers.ssrn.com/sol3/papers.cfm?abstract_id=480121 22 Cain, Daylian M., Loewenstein, George F. and Moore, Don A., The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest (December 1, 2003). Available at SSRN: http://ssrn.com/abstract=480121

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• Unconsciously, they shut out any information that could undermine the image they have of themselves – and they are unaware of doing so.

• Also unconsciously, they are influenced by the roles they assume, so that their preference for a particular outcome ratifies their sense of justice in the way they interpret situations.

• Often, their notion of justice is biased in their own favor. For example, in experiments in which two opposed parties’ concept of fairness is questioned, both tend to consider precisely what favors them personally, even if disproportionately, to be the most fair.

• The agents are selective when it comes to assessing evidence; they are more likely to accept evidence that supports their desired conclusion, and tend to value it uncritically. If evidence contradicts their desired conclusion, they tend to ignore it or examine it much more critically.

• When they know that they are going to be judged by their decisions, they tend to try to adapt their behavior to what they think the audience expects or wants from them.

• The agents tend to attribute to others the biases that they refuse to see in themselves; for example, a researcher will tend to question the motives and integrity of another researcher who reaches conclusions that differ from her own.

• Generally speaking, the agents tend to give far more importance to other people’s predispositions and circumstances than to their own.

For all these reasons, agents, groups and organizations believe that they are capable of identifying and resisting the temptations arising from their own interests (or from their wish to promote the interests of others), when the evidence indicates that those capabilities are limited and tend to be unconsciously biased.23

In essence, disclosure – while important - has limited efficacy in the delivery of financial services to clients. Making disclosures “simpler” does not solve the problem of their effectiveness, either. As stated by Professor Ripken:

[E]ven if we could purge disclosure documents of legaleze and make them easier to read, we are still faced with the problem of cognitive and behavioral biases and constraints that prevent the accurate processing of information and risk. As discussed previously, information overload, excessive confidence in one’s own judgment, overoptimism, and confirmation biases can undermine the effectiveness of disclosure in communicating relevant information to investors. Disclosure may not protect investors if these cognitive biases inhibit them from rationally incorporating the disclosed information into their investment decisions. No matter how much we do to make disclosure more meaningful and accessible to investors, it will still be difficult for people to overcome their bounded rationality. The disclosure of more information alone cannot cure investors of the psychological constraints that may lead them to ignore or misuse the information. If investors are overloaded, more information may simply make matters worse by causing investors to be distracted and miss the most important aspects of the disclosure … The bottom line is that there is ‘doubt that disclosure is the optimal regulatory strategy if most investors suffer from cognitive biases’ … While disclosure has its place in a well-functioning securities market, the direct, substantive regulation of conduct may be a more effective method of deterring fraudulent and unethical practices.24

The inability of disclosures to overcome the substantial economic self-interest that brokers possess when selling products can also be understood through judicial prose. If disclosures were sufficient, there would be no need for the fiduciary obligation. But disclosure, being insufficient as a means of consumer protection, requires that individual investors seeking investment advice be served under a bona fide fiduciary standard. In Bayer v. Beran, 49 N.Y.S.2d 2, Mr. Justice Shientag observed:

23 Anonia Argandoña, Conflicts of Interest: The Ethical Viewpoint (2004). 24 Ripken, Susanna Kim, The Dangers and Drawbacks of the Disclosure Antidote: Toward a More Substantive Approach to Securities Regulation. Baylor Law Review, Vol. 58, No. 1, 2006; Chapman University Law Research Paper No. 2007-08. Available at SSRN: http://ssrn.com/abstract=936528.

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The fiduciary has two paramount obligations: responsibility and loyalty. * * * They lie at the very foundation of our whole system of free private enterprise and are as fresh and significant today as when they were formulated decades ago. * * * While there is a high moral purpose implicit in this transcendent fiduciary principle of undivided loyalty, it has back of it a profound understanding of human nature and of its frailties. It actually accomplishes a practical, beneficent purpose. It tends to prevent a clouded conception of fidelity that blurs the vision. It preserves the free exercise of judgment uncontaminated by the dross of divided allegiance or self-interest. It prevents the operation of an influence that may be indirect but that is all the more potent for that reason.25

In summary, disclosures are not the answer. If disclosures were sufficient as a means of protecting consumers in a relationship of trust and confidence with another, then the fiduciary standard would have never arisen under English law, nor would it have been transported into American law. ERISA properly reflects the reality that disclosures are insufficient and that a strict fiduciary standard must be applied to protect individual investors and plan sponsors from transgressions by far more knowledgeable advisers.

At its very core, the fiduciary standard is a constraint upon greed. The fiduciary standard of conduct imposes important duties upon fiduciary advisors in order to protect the consumer of advice. As the U.S. Supreme Court has observed: “[T]he primary function of the fiduciary duty is to constrain the exercise of discretionary powers which are controlled by no other specific duty imposed by the trust instrument or the legal regime. If the fiduciary duty applied to nothing more than activities already controlled by other specific legal duties, it would serve no purpose.”26

D. THE REQUIREMENTS OF THE FIDUCIARY DUTY OF LOYALTY

While suitability is a very low standard of conduct, the fiduciary standard of conduct is well known as the “highest standard under the law.”

While there have been many judicial elicitations of the fiduciary standard, including Justice Benjamin Cardozo’s lofty early 20th Century elaboration, a relatively recent and concise recitation of the fiduciary principle can be found in dictum within the 1998 English (U.K.) case of Bristol and West Building Society v. Matthew, in which Lord Millet undertook what has been described as a “masterful survey” of the fiduciary principle:

A fiduciary is someone who has undertaken to act for and on behalf of another in a particular matter in circumstances which give rise to a relationship of trust and confidence. The distinguishing obligation of a fiduciary is the obligation of loyalty. The principle is entitled to the single-minded loyalty of his fiduciary. This core liability has several facets. A fiduciary must act in good faith; he must not place himself in a position where his duty and his interest may conflict; he may not act for his own benefit or the benefit of a third person without the informed consent of his principal. This is not intended to be an exhaustive list, but it is sufficient to indicate the nature of the fiduciary obligations. They are the defining characteristics of a fiduciary.27

In the U.S., the “triad” of fiduciary duties is most commonly referred to as the duties of due care, good faith and loyalty. But other fiduciary duties are said to exist, including but not limited to the “duty of obedience” and the “duty of confidentiality.”

A further elicitation of fiduciary duties can be discerned from English law, from which the U.S. system of jurisprudence was initially derived. Under English law, it is reasonably well established that fiduciary status gives rise to five principal duties:

(1) the “no conflict” principle preventing a fiduciary placing himself in a position where his own interests conflict or may conflict with those of his client or beneficiary;

25 Bayer v. Beran, 49 N.Y.S.2d 2 (N.Y.Sup.Ct. 1944). 26 Varity Corp. v. Howe, 516 U.S. 489, 504, 116 S. Ct. 1065, 134 L. Ed. 2d 130, 1996 U.S. LEXIS 1954, 19 Employee Benefits Cas. (BNA) 2761 (1996). 27 Bristol and West Building Society v Mothew [1998] EWCA Civ 533

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(2) the “no profit” principle which requires a fiduciary not to profit from his position at the expense of his client or beneficiary;

(3) the “undivided loyalty” principle which requires undivided loyalty from a fiduciary to his client or beneficiary;

(4) the “duty of confidentiality” which prohibits the fiduciary from using information obtained in confidence from his client or beneficiary other than for the benefit of that client or beneficiary; and

(5) the “duty of due care,” to act with reasonable diligence and with requisite knowledge, experience and attention.

When one is engaged as a fiduciary, the fiduciary steps into the shoes of the client, in order to act on the client’s behalf. As Professor Arthur Laby observed: “What generally sets the fiduciary apart from other agents or service providers is a core duty, when acting on the principal’s behalf, to adopt the objectives or ends of the principal as the fiduciary’s own.”28

In fiduciary relationships, a transfer of power occurs – if not the actual transfer of assets (as may occur in a trust or custody relationship), then the transfer of power through the taking, by the client, of the fiduciary’s advice and counsel (as may occur in a lawyer-client or investment adviser-client relationship).

The client permits this close, confidential relationship to exist in recognition that the expertise of the fiduciary, brought to bear for the benefit of the client, can lead to much more positive outcomes.

But such expertise, if improperly applied, can be used to take advantage of the client. The fiduciary, as a expert, possess a much greater knowledge of investments, portfolio management, etc. Also, the client’s guard is down; due to a variety of behavioral biases, client consent to action by the fiduciary is easily secured.

Hence, U.S. fiduciary law applicable to investment advisers guards against the abuse of the consumer through its "no conflict" rule. Reflective of English law’s “no benefit” and “no conflict” principles, the Restatement (Third) of Agency (all agents are, to a degree, fiduciaries) dictates that the duty of loyalty is a duty to not obtain a benefit through actions taken for the principal (client) or to otherwise benefit through use of the fiduciary’s position.29

The “no conflict” rule has nothing to do with good or bad motive. The U.S. Supreme Court, in discussing conflicts of interest, stated:

The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them ....30

And, as the U.S. Supreme Court said a hundred years ago, the law “acts not on the possibility, that, in some cases the sense of duty may prevail over the motive of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.”31

28 Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act Of 1940, 91 Boston Univ. L.Rev. 1051, 1055 (2011). 29 See RESTATEMENT (THIRD) OF AGENCY § 8.02 cmt. a (2006) (explaining that under duty of loyalty, “an agent has a duty not to acquire material benefits in disconnection with transactions or other actions undertaken on the principal’s behalf or through the agent’s use of position”). 30 Capital Gains, 375 U.S. at 196 (citing United States v. Mississippi Valley Generating Co., 364 U.S. 520 (1961)); id. at 196 n.50 31 Michoud v. Girod, 45 U.S. 503 555 (1846). The U.S. Supreme Court also stated in that decision: “if persons having a confidential character were permitted to avail themselves of any knowledge acquired in that capacity, they might be induced to conceal their information and not to exercise it for the benefit of the persons relying upon their integrity. The characters are inconsistent. Emptor emit quam minimo potest, venditor vendit quam maximo potest.” Id. at 554.

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And, in the seminal case addressing the fiduciary duties of investment advisers under the Investment Advisers Act of 1940, the U.S. Supreme Court observed:

This Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of the authoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them ….’32

Or, as an eloquent Tennessee jurist put it before the Civil War, the doctrine “has its foundation, not so much in the commission of actual fraud, but in that profound knowledge of the human heart which dictated that hallowed petition, ‘Lead us not into temptation, but deliver us from evil,’ and that caused the announcement of the infallible truth, that ‘a man cannot serve two masters.’”33

E. THE NON-WAIVER OF CORE FIDUCIARY OBLIGATIONS; LIMITS ON ESTOPPEL

The stark difference between arms-length and fiduciary relationships is also found in the treatment of the doctrines of waiver and estoppel. The DOL’s proposed BIC exemption correctly notes this distinction by prohibiting disclaimer or waiver of the adviser’s fiduciary obligations.

In arms-length relationship consent by a customer to proceed, when a conflict of interest is present, is generally permitted. Caveat emptor (“let the buyer beware”) applies to such merchandiser-customer relationships. The customer is not represented by the merchandiser but is rather in an adverse relationship - that of seller and purchaser.

In such instances, it is a fundamental principle of the common law that volenti non fit injuria – to one who is willing, no wrong is done. Customer consent to the transaction generally gives rise to estoppel – i.e., the customer cannot later state that he or she can escape from the transaction because a conflict of interest was present, or because full awareness of the ramifications of the conflict of interest were absent. The customer, in such instances, bears the duty of negotiating a fair bargain. The law permits customers, in arms-length relationships, to enter into “dumb bargains.” Generally, jurists will not set aside unfair bargains unless fraud, misrepresentation, mutual mistake of fact exists or unless the contract is so unjust and burdensome that it is deemed unconscionable.

But the fiduciary relationship is altogether different. The entrustor (client) and fiduciary actor have formed a relationship based upon trust and confidence. In such a form of relationship, the law guards against the fiduciary taking advantage of such trust. As a result, judicial scrutiny of aspects of the relationship occurs with a sharp eye toward any transgressions that might be committed by the fiduciary.

Hence, mere consent by a client in writing to a breach of the fiduciary obligation is not, in itself, sufficient to create waiver or estoppel. If this were the case, fiduciary obligations – even core obligations of the fiduciary – would be easily subject to waiver. Instead, to create an estoppel situation, preventing the client from later challenging the validity of the transaction that occurred, the fiduciary is required to undertake a series of steps:

First, disclosure of all material facts to the client must occur. [For some commentators on the fiduciary obligations of investment advisers, this is all that is required. Often this erroneous conclusion is derived from misinterpretations of the landmark decision of SEC v. Capital Gains Research Bureau.]34

32 SEC v. Capital Gains Research Bureau, 375 U.S. 180; 84 S. Ct. 275; 11 L. Ed. 2d 237; 1963 U.S. LEXIS 2446 (1963). The principle is also found in early Christianity: “Christ said: ‘No man can serve two masters, for either he will hate the one and love the other, or else he will hold to the one and despise the other. Ye cannot serve God and Mammon [money].’" Beasley v. Swinton, 46 S.C. 426; 24 S.E. 313; 1896 S.C. LEXIS 67 (S.C. 1896), quoting Matthew 6:24. 33 Tisdale v. Tisdale, 2 Sneed 596 (Tenn. 1855). 34 See my previous 2011 comment letter and its detailed discussion of Wall Street’s wishful misinterpretation of SEC vs. Capital Gains.

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Second, the disclosure must be affirmatively made and timely undertaken. In a fiduciary relationship, the client’s “duty of inquiry” and the client’s “duty to read” are limited; the burden of ensuring disclosure is received is largely borne by the fiduciary. Disclosure must also occur in advance of the contemplated transaction. For example, receipt of a prospectus following a transaction is insufficient, as it does not constitute timely disclosure.

Third, the disclosure must lead to the client’s understanding. The fiduciary must be aware of the client’s capacity to understand, and match the extent and form of the disclosure to the client’s knowledge base and cognitive abilities.

Fourth, the informed consent of the client must be affirmatively secured. Silence is not consent. Consent is not obtained through coercion nor sales pressure.

Fifth, at all times, the transaction must be substantively fair to the client. If an alternative exists which would result in a more favorable outcome to the client, this would be a material fact which would be required to be disclosed, and a client who truly understands the situation would likely never gratuitously make a gift to the advisor where the client would be, in essence, harmed.35

These requirements of the common law – derived from judicial decisions over hundreds of years – have found their way into our statutes. For example, ERISA’s exclusive benefit rule unyieldingly commands employee benefit plan fiduciaries to discharge their duties with respect to a plan solely in the interest of the plan’s participants and for the exclusive purpose of providing benefits to them and their beneficiaries. And the Investment Advisers Act of 1940 was widely known to impose fiduciary duties upon investment advisers from its very inception, and it contains an important provision that prevents waiver by the client of the investment adviser’s duties to that client.

As one examines the foregoing requirements, it is important to realize that disclosure is neither a fiduciary duty nor a cure (without much more) to the breach of one’s fiduciary obligations. In other words, it must be understood that, quite frankly, there exists fiduciary duty of disclosure. While disclosure may be imposed by other law or regulation, or by contractual obligations created between the parties, disclosure is not, itself, a core fiduciary obligation found in the common law.

Rather, fiduciaries owe the obligation to their client to not be in a position where there is a substantial possibility of conflict between self-interest and duty. This is called the “no-conflict” rule, derived from English law. Fiduciaries also possess the obligation not to derive unauthorized profits from the fiduciary position. This is called the “no profit” rule, also derived from English law.

While there is no fiduciary duty of disclosure, questions of disclosure are often central in the jurisprudence discussing fiduciary law, as many cases involve claims for breach of the fiduciary duty due to the presence of a conflict of interest. In essence, a breach of fiduciary obligation – either the obligation not to be in a position of conflict of interest and the duty to not make unauthorized profits – may be averted or cured by the informed consent of the client (provided all material information is disclosed to the client, the adviser reasonably expects client understanding to result given all of the facts and circumstances, the informed consent of the client is affirmatively secured, and the transaction remains in all circumstances substantially fair to the client).

In essence, asking a client to consent to a conflict of interest by the fiduciary is requesting that the client waive the no conflict rule, the no profit rule, or both rules. Again, clients would only do so in circumstances where the client is not harmed. It would be difficult to believe that client is so gratuitous to his or her investment adviser that the client would incur a detriment, beyond reasonable compensation previously agreed to, in order to provide the adviser with more lucre or other benefits.

Hence, disclosure, alone, is not a cure. And disclosure is only one of the five important requirements, all of which must be met, for a client’s waiver of a fiduciary obligation to be valid.

35 These steps, and legal authority for these requirements, are contained in my prior 2011 comment letters.

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As the DOL and SEC further consider the imposition of fiduciary obligations upon those providing advice to retirement plan sponsors, retirement plan participants, IRA account holders, and more broadly to any American receiving personalized investment advice, let us first understand that the fiduciary's obligation includes, at its core, the obligation to not put herself or himself into a situation which is in conflict with the client. And, since some conflicts of interest are unavoidable, when such conflicts do occur this series of five important requirements must be met to properly manage the conflict.

The core of fiduciary law requires nothing less. Nor should the DOL and the SEC.

F. SIFMA’S AND FINRA’S “BEST INTERESTS” PROPOSALS: MISLEADING AND WHOLLY INEFFECTIVE

--------------------------------------------------------------------------------------------------------------------------------- “Goldman's arguments in this respect are Orwellian. Words such as ‘honesty,’ ‘integrity,’ and ‘fair dealing’ apparently [in Goldman’s eyes] do not mean what

they say; [Goldman says] they do not set standards; they are mere shibboleths. If Goldman's claim of ‘honesty’ and ‘integrity’ are simply puffery, the world of

finance may be in more trouble than we recognize.” – Judge Paul Crotty, Richman v. Goldman Sachs Group, Inc., 868 F. Supp. 2d 261 (S.D.N.Y. 2012).

-------------------------------------------------------------------------------------------------------------------------------

In just the past couple of months, SIFMA has advanced a “best interests” standard of conduct, as an amendment to FINRA’s suitability obligation.36 FINRA, in its July 17, 2015 comment letter to the U.S. Department of Labor regarding the Conflict of Interest rule proposal and the exemptions relating thereto, also proposes a “best interests” standard. Upon close examination it is apparent that the rhetoric emanating from SIFMA and broker-dealer firms regarding the “best interests” proposal, and the proposals themselves, are but eleventh-hour attempts to defeat the U.S. Department of Labor’s proposed Conflict of Interest Rule. SIFMA and FINRA, by these proposals, seek to deny the imposition of fiduciary status upon those who provide investment advice to retirement plans and retirement accounts, and in so doing seek to preserve a product-sales-driven “caveat emptor” relationship which is inappropriate for the delivery of personal investment advice. It is also apparent that the term “best interests” should not be utilized by either SIFMA or FINRA at all, given its understanding for centuries in the context of delivery of trusted advice to mean adherence to the fiduciary duty of loyalty.

For example, Richard Ketchum, Chairman and CEO of FINRA, recently summarized the protections for customers of brokers, stating that these protections “show that depictions of the present environment as providing ‘caveat emptor’ freedom to broker-dealers to place investors in any investment that benefits the firm financially with no disclosure of their financial incentives or the risks of the product, are simply not true.”37 However, Mr. Ketchum’s characterization of broker-dealer firms’ customers as not being subject to the ancient principle of ‘caveat emptor’38 is largely incorrect; by his statement he obfuscates the sales origins and present reality of today’s broker-customer relationships. Additionally, while certain disclosure obligations are imposed on broker-dealers, these disclosures are often casual in nature, do not require the adviser to ensure client understanding of the conflicts of interest and their ramifications, and do not require that any proposed transaction wherein a conflict of interest exist remain (even with disclosure and informed consent) substantively fair to the client.

36 SIFMA announced a “best interests” proposal in late May 2015, and then provided a “mark-up of existing FINRA Rules that outlines the broad contours of how a best interests standard for broker-dealers might be developed as part of the path forward on this most important investor protection issue.” Retrieved from SIFMA web site, June 10, 2015. 37 Richard G. Ketchum, Remarks From the 2015 FINRA Annual Conference, Washington, DC (May 27, 2015). 38 BLACK’S LAW DICTIONARY 252 (9th ed. 2009) (defining “caveat emptor” as a Latin phrase meaning “let the buyer beware”); see also Matthew P. Allen, A Lesson from History, Roosevelt to Obama – The Evolution of Broker-Dealer Regulation: From Self-Regulation, Arbitration, and Suitability to Federal Regulation, Litigation, and Fiduciary Duty, 5 ENTREPRENEURIAL BUS. L.J. 1, 20 n.77 (2010) (“Caveat emptor is an old property law doctrine under which a buyer could not recover from the seller for defects in the property that rendered it unfit for ordinary purposes. The only exception was if the seller actively concealed latent defects.”).

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I would observe FINRA’s recent support of a new “best interests” standard recently advanced by SIFMA,39 the broker-dealer lobbying organization, grounded upon a weak suitability obligation accompanied by somewhat enhanced casual disclosures of additional information to investors, continues 75 years of FINRA’s failure to advance standards to the highest levels, as envisioned by Senator Maloney and others, and fails to protect individual investors. FINRA’s stated opposition to the Department of Labor’s Conflict of Interest rule proposal is further evidence that FINRA serves only the interests of its broker-dealer members, and fails to adequately protect the investing public. Rather than embrace any changes to FINRA’s suitability obligation by means of a misleading and wholly ineffective “best interests” standard, I would suggest that FINRA should be disbanded and its quasi-government oversight functions of the market conduct of broker-dealer firms and their registered representatives should be returned to federal and state agencies.

SIFMA has proposed that its “best interests” standard be adopted in lieu of the imposition of fiduciary standards of conduct upon brokers who provide investment advice. Yet, SIFMA’s proposed “best interests” standard is also a far cry from the significantly enhanced protections afforded to consumers by a bona fide fiduciary standard of conduct, as proposed by the U.S. Department of Labor in its “Conflict of Interest” rule proposal (April 2015) and as found in existing common law applicable to those in relationships of trust and confidence with their clients. SIFMA’s proposed “best interests” standard would – if enacted – deny consumers, in today’s complex financial world, important protections by keeping individual investors in the situation where “caveat emptor” remains the rule for investors, even for those in relationships of trust and confidence with individuals and firms who provide personalized investment advice.

SIFMA’s new “best interests” standard is also inherently misleading and deceptive, as the term “best interests” is commonly understood by consumers to mean that the advisor is acting on behalf of the consumer/investor, keeping the consumer’s interests paramount at all times.40

FINRA’s July 17, 2015 comment letter to the DOL also outlines its version of a “best interests” standard. This proposal demonstrates FINRA’s continued inability to substantially raise the standards of conduct of brokers to the highest levels, as contemplated by Senator Maloney and others at the time of FINRA’s inception (when it was called

39 SIFMA provided a “mark-up of existing FINRA Rules that outlines the broad contours of how a best interests standard for broker-dealers might be developed as part of the path forward on this most important investor protection issue.” Retrieved from SIFMA web site, June 10, 2015. 40 Legal commentators also continue to equate the term “best interests” with the requirement of the fiduciary duty of loyalty. See, e.g.:

• Edward J. Waitzer and Douglas Sarr, Fiduciary Society Unleashed: The Road Ahead for the Financial Sector, 69 Bus.Lawyer 1081, 1090 (Aug. 2014). (“these individuals need to trust that the specialists they rely upon will keep their best interests at heart … Fiduciary law aims to promote this trust. It applies to relationships in which one party, the fiduciary, gains discretionary power over another party, the beneficiary, in circumstances where both parties would ‘reasonably expect’ that the fiduciary will exercise this power in the best interests of the beneficiary”) (Emphasis in original; emphasis added.)

• Gold, Andrew S., The Loyalties of Fiduciary Law (December 20, 2013). Philosophical Foundations of Fiduciary Law, Andrew S. Gold & Paul B. Miller, eds., Oxford University Press, 2014, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2370598 (“Another conception of fiduciary loyalty suggests that the fiduciary must act in the best interests of the beneficiary … This conception can readily be linked to the first conception, given the possibility that the rules against conflicting interests are designed to increase the likelihood that a fiduciary will act in the beneficiary’s best interests.”) (Emphasis added.)

The influential Restatements of the Law also equate “best interests” or “placing the interests of the principle first” with the fidicuairy duty of loyalty:

• American Law Institute, Restatement of the Law of Trusts (Third) § 78. (“[A] trustee must refrain, whether in fiduciary or personal dealings with third parties, from transactions in which it is reasonably foreseeable that the trustee’s future fiduciary conduct might be influenced by considerations other than the best interests of the beneficiaries.”) (Emphasis added.)

• Restatement (Third) of Agency § 8.01 comment b. (“Although an agent’s interests are often concurrent with those of the principal, the general fiduciary principle requires that the agent subordinate the agent’s interests to those of the principal and place the principal’s interests first as to matters connected with the agency relationship.”) (Emphasis added.)

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the NASD). FINRA’s willingness to continue to protect brokers, under the shield of an inherently weak suitability standard (whether or not “enhanced” by its “best interests” proposal), also confirms the necessity of the U.S. Department of Labor moving forward to impose fiduciary status upon investment advisers to ERISA-governed retirement plans and to IRAs, as contemplated by the proposed rule.

In the table below I summarize the flaws in SIFMA’s and FINRA’s recent “best interests” proposals and demonstrate why SIFMA’s proposed changes to FINRA’s suitability rule do not come even close to the protections provided by the fiduciary standard:

A Concise Comparison: Bona Fide Fiduciary Standard vs. SIFMA’s and FINRA’s “Best Interests” Proposals

What requirements are imposed upon the person providing personalized investment advice?

Bona Fide Fiduciary Standard

SIFMA’s “Best Interest” Proposal (as outl ined in i ts

June 2015 release)

FINRA’S “Best Interest” Proposal (as outl ined in i ts

July 17, 2015 comment let ter) 41

Who does the financial representative represent?

The client. The brokerage firm, and, through the firm, various product manufacturers. The financial representative functions as a “seller’s representative” with no substantial allegiance required to the purchaser (customer).

The brokerage firm, and, through the firm, various product manufacturers. The financial representative functions as a “seller’s representative” with no substantial allegiance required to the purchaser (customer).

41 FINRA states, in its comment letter of July 17, 2015 to the U.S. Department of Labor, that “any best interest standard for intermediaries should meet the following criteria:

• The standard should require financial institutions and their advisers to: o act in their customers’ best interest; o adopt procedures reasonably designed to detect potential conflicts; o eliminate those conflicts of interest whenever possible; o adopt written supervisory procedures reasonably designed to ensure that any remaining conflicts, such as

differential compensation, do not encourage financial advisers to provide any service or recommend any product that is not in the customer’s best interest;

o obtain retail customer consent to any conflict of interest related to recommendations or services provided; and o provide retail customers with disclosure in plain English concerning recommendations and services provided,

the products offered and all related fees and expenses.”

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June 2015 release)



Does a duty exist upon the representative to clearly and fully disclose all compensation received by the person providing advice, and by his/her firm?

Yes. No. While annual disclosure occurs of “a good faith summary of the investment-related fees” associated with an investment, there is no requirement in SIFMA’s proposal that the compensation of the broker-dealer or its registered representative be affirmatively quantified and then disclosed. As a result, customers will remain uninformed of the precise amount of the compensation of the broker and its registered representative. Hence, the client will not possess the means to assess the reasonableness of the compensation so provided, and the receipt of only “reasonable compensation” is a requirement for a fiduciary actor.

No. While annual disclosure occurs of a product’s “fees and all related expenses,” there is no requirement in FINRA’s proposal that the compensation of the broker-dealer or its registered representative be affirmatively quantified and then disclosed. As a result, customers will remain uninformed of the precise amount of the compensation of the broker and its registered representative. Hence, the client will not possess the means to assess the reasonableness of the compensation so provided, and the receipt of only “reasonable compensation” is a requirement for a fiduciary actor. Why do broker-dealer firms resist the fiduciary requirement to fully disclosure a material fact – their compensation – to their customers? Because a large proportion of these customers believe that their registered representative and brokerage firm is acting gratuitously,42 given broker-dealers’ ability to hide compensation from the customers.43

42 See, e.g., Study Regarding Obligations of Brokers, Dealers, and Investment Advisers, Rel. No. IA-3058; File No. 4-606 (a.k.a. the “Rand Report” of 2008), in which over one-fourth of consumers surveyed related that they paid “$0” for the brokerage or advisory services they were provided. Since registered investment advisers are required to provide clients with periodic statements of the fees paid, under the requirements of the Investment Advisers Act of 1940 and regulations thereunder, and since the survey included a large number of clients of dual registrants (which fosters confusion among titles), it is likely that the survey understates the number of customers of broker-dealer firms who hold such firm. I have personally observed many, many customers of brokers who believed that their broker provided his or her services “for free” and “without compensation,” and I have never met a customer of a full-service brokerage firm who understood all of the ways, or the high amounts, of the compensation received by the broker or the brokerage firm. 43 Information regarding all of the compensation paid by product providers to the brokers is not provided by brokers to their customers, except piecemeal and in multiple lengthy documents, such as often 50+ page disclosure statements signed upon the opening of accounts, mutual fund prospectuses, and various web site disclosures. Even then, such disclosures are often ambiguous, such as “we may receive compensation from” a product provider or (in product provider documents, such as prospectuses) “we may compensate a broker.” Indeed, even the author – who is trained in reading legal documents and who possesses a broad and deep knowledge of investment products, often cannot discern the sum total of compensation provided to a full-service broker resulting from many investments, given that the sum total includes not only commissions and 12b-1 fees, but also payment for shelf space, sponsoring of seminars for prospective customers, sponsorship of events at broker-dealer firm meetings, payment of brokerage commissions including soft dollar compensation, and other forms of revenue-sharing payments. The disguising of the total compensation paid to broker-dealer firms and their registered representatives appears to be a central concern of the broker-dealer community, since if full and complete disclosures were made of the compensation arrangements, the fact of differential compensation, and the amounts paid, most customers would likely choose not to be business with the brokerage firm. I have observed many a client, once I informed them of my estimate of what they had been paying to their broker-dealer firm over the past year, become very angry. Yet, a remedy for their grief is usually not available, as the “suitability” standard does not require that a broker-dealer firm receive only “reasonable compensation.” In contrast, the fiduciary standard of conduct requires affirmative disclosure to the client of all material facts, which by necessity includes all compensation the fiduciary investment adviser receives, stated in terms that are clear, concise and understandable by the client. In addition, the fiduciary standard of conduct requires that compensation received be reasonable.

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June 2015 release)



Is there a duty upon the representative to ensure client understanding of material facts, including material conflicts of interest?

Yes. No. Under SIFMA’s proposal disclosures must only be “designed to ensure client understanding.” There is no requirement, as exists for a fiduciary, that client understanding of conflicts of interest, and their ramification, actually occur.

No. Under FINRA’s proposal disclosures relating to products must only be provided to the customer. There is no requirement, as exists for a fiduciary, that client understanding of conflicts of interest, and their ramification, actually occur by means of affirmative obligations placed upon the registered representative.

Is informed consent of the client required prior to the client undertaking each and every recommended transaction?

Yes. No. There is no requirement in SIFMA’s proposal that the client’s consent be “informed” – a key requirement of fiduciary law before client waiver of a conflict of interest can take place. Nor is there a requirement that the client provide informed consent prior to each and every transaction. Rather, SIFMA would only require: “Customer consent to material conflicts of interest or for other purposes as appropriate may be provided at account opening.” Of course, consent “at client opening” often involves a customer briefly initialing a line, as one of many initials or signatures provided in account opening forms which are often dozens of pages long. The result of SIFMA’s proposal is that clients can and will consent to be harmed – an outcome which cannot exist under a bona fide fiduciary standard. And such “consent” will hardly ever be “informed.”

No. There is no requirement in FINRA’s proposal that the client’s consent be “informed” – a key requirement of fiduciary law before client waiver of a conflict of interest can take place. Nor is there a requirement that the client provide informed consent prior to each and every transaction. Rather, FINRA would only require brokers to “obtain client consent” to conflicts of interest. Such consent, often given with little or no understanding by the customer of the broker, creates an estoppel defense for the broker, who is in an arms-length relationship with the customer. As explained in this comment letter, the role of estoppel is very limited in fiduciary relationships, and much more than “simple consent” is required for the fiduciary to proceed when a conflict of interest is present.

Must the transaction remain, at all times, substantively fair to the client?

Yes. No. There is only a requirement that the transaction be in accord with the client’s “best interest” – a new SIFMA-proposed standard that is ill defined and which remains subject to much interpretation. Such interpretations will primarily occur through FINRA’s much-maligned system of mandatory arbitration. In contrast, the fiduciary standard possesses centuries of interpretation and application. Under a bona fide fiduciary standard, clients are unable to waive core fiduciary duties; the role of estoppel is quite limited. This is enforced by the courts by requiring both informed consent of the client and that the transaction remain substantively fair to the client.

No. There is only a requirement that the transaction be in accord with the client’s “best interest” – a new FINRA-proposed standard that is ill defined and which remains subject to much interpretation. Such interpretations will primarily occur through FINRA’s much-maligned system of mandatory arbitration. In contrast, the fiduciary standard possesses centuries of interpretation and application. Under a bona fide fiduciary standard, clients are unable to waive core fiduciary duties; the role of estoppel is quite limited. This is enforced by the courts by requiring both informed consent of the client and that the transaction remain substantively fair to the client.

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June 2015 release)



Does there exist a duty to properly manage investment-related fees and costs that the client will incur at all times?

Yes. No. SIFMA expressly states: “Managing investment-related fees does not require recommending the least expensive alternative, nor should it interfere with making recommendations from among an array of services, securities and other investment products consistent with the customer’s investment profile.” These caveats leave the door wide open for the broker to recommend highly expensive products, including products which pay the broker more, in which the total fees and costs incurred by the customer will substantially lower the long-term returns of the investor.

No. FINRA does not appear to recognize that, under fiduciary law, there is an obligation imposed upon the fiduciary to ensure that any expenditures of the client’s funds, through payment of product-related fees and costs, be undertaken with close scrutiny. FINRA appears to desire that high-cost products could still be recommended compared with lower-cost products that possess nearly the same risk and other characteristics. The fiduciary standard of due care requires that the client’s expenses be controlled and that avoidable expenses be avoided. The fiduciary is permitted to obtain reasonable, professional-level compensation, through agreement with the client at the inception of the relationship, and with full disclosure of same.

Does there exist a duty to properly manage the design, implementation and management of the portfolio, in order to reduce the tax drag upon the customer’s investment returns?

Yes. No. There is no express duty under SIFMA’s proposal to properly manage the tax consequences of investment decisions. Far too often under the suitability standard, and under this proposed “best interests” standard, customers of broker-dealers have and will possess substantial tax drag upon their investment returns that otherwise could have been avoided through expert advice.

No. Nothing in FINRA’s proposal addresses portfolio management. FINRA is mired in the ancient practice of providing products under the suitability standard. Today’s investors deserve expert advice from true fiduciaries, not the sale of products which generate high profits for the broker without proper consideration of how the product fits into the client’s overall portfolio.

As seen, SIFMA’s and FINRA’s proposed “Best Interests” standards fall far short of the protections afforded by ERISA’s fiduciary standard. The fact of the matter is that Wall Street wants to eat its cake and have it too. It wants to be perceived as acting in customer's "best interests," but enjoy the freedom to act in its own interests. Wall Street’s new “Best Interests of the Consumer” proposal is, in reality, only “Wall Street’s Self-Interest.”

As alluded to in the chart above, by its “Best Interests” proposal SIFMA and FINRA do not turn brokers from sell-side merchandizers into buy-side purchaser’s representatives and fiduciaries. Rather, SIFMA’s and FINRA’s proposal are nothing more than an attempt to obfuscate into some kind of obscene and confusing hybrid between the two. In fact, the enhancement to the inherently weak suitability standard under these proposals is extremely modest.

This begs the question – who does the broker under SIFMA’s and FINRA’s proposed “best interests” standards represent? This is a key question, for the following is well known in the law:

The characters of buyer and seller are incompatible, and cannot safely be exercised by the same person. Emptor emit quam minimo potest; venditor vendit quam maximo potest. The disqualification rests … on no other than that principle which dictates that a person cannot be both judge and party. No man can serve two masters. He that it interested with the interests of others, cannot be allowed to make the business an object of interest to himself; for, the frailty of our nature is such, that the power will too readily beget the inclination to serve our own interests at the expense of those who have trusted us.44

44 Carter v. Harris, 25 Va. 199, 204 (1826); 1826 Va. LEXIS 26; 4 Rand. 199 (Va. 1826).

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It is obvious that under SIFMA’s and FINRA’s proposed “best interest” standards the registered representative would continue to act as sellers of products, thereby representing the broker-dealer firm and product manufacturers. This is a far, far cry from acting as a fiduciary, and acting as the representative of the purchaser. And it fails to achieve a key objective that the U.S. Department of Labor alluded to in its release for the BIC exemption: “In the absence of fiduciary status, the providers of investment advice are neither subject to ERISA's fundamental fiduciary standards, nor accountable for imprudent, disloyal, or tainted advice under ERISA or the Code, no matter how egregious the misconduct or how substantial the losses.”45

The U.S. Department of Labor should reject any proposal from SIFMA, FINRA, or broker-dealer firms, or insurance companies, which seeks to advance such a woefully inadequate rule. These are proposals that, like the suitability standard today, protect Wall Street, and utterly fail to protect consumers from Wall Street’s greed.

Let us not permit Wall Street profess to act in the "best interests" of customers, when any sensible consumer would conclude that Wall Street's definition of "acting in your best interests" is wholly deceptive to consumers. Such fraud46 has no place in government regulatory efforts, nor even in self-regulatory organization rulemaking activities. SIFMA’s and FINRA’s proposals should be loudly and firmly rejected by the DOL and other policymakers. And the recent embrace by FINRA of SIFMA’s proposal should subject FINRA to further scrutiny over whether FINRA’s market conduct regulation of brokers should be transferred back to federal and state governments for direct oversight,47 especially when FINRA characterizes its proposal as a “fiduciary ‘best interests’” proposal – when it clearly is not.

III. OF THE NEED FOR GOVERNMENT INTERVENTION AND CONSTRAINTS ON GREED.

Raised within the legacy of Adam Smith, as a lifelong student of economics and a professor of finance, I am a committed Capitalist. I believe in our Free Market Economy, its opportunities presented to all, and the immutable Spirits of Innovation and Entrepreneurship, and our personal drive to seize and profit from opportunity. America was founded in part upon these and other principles.

A. EVEN JOHN LOCKE EMBRACED THE NEED FOR GOVERNMENT REGULATION

John Locke, whose words so influenced our founding fathers that their majesty found way into our Declaration of Independence, espoused the natural rights of man and the right to retain of each of us to retain his or her income and property.

Locke conceived of the concept of government wherein citizens give over these rights (some wholly, others only partially) to government in trust, as a means of protecting the natural rights of man. In essence, those who we elect to represent us in our republican form of government are bound by fiduciary principles to use the power so entrusted to balance the competing needs of those in society, as we would ourselves.

John Locke is well known for the principle that each of us possess the rights to his or her own property. However, libertarians quoting John Locke often overlook Locke’s spirit of compassion for his neighbors, and his belief in the role of charity. In his Second Treatise Concerning Civil Government, Locke observed this law of reason:

Whatsoever then he removes out of the state that nature hath provided, and left it in, he hath mixed his labour with, and joined to it something that is his own, and thereby makes it his property. It being by him

45 BIC exemption release at pp. 21962-3. 46 As Professors Angel and McCabe observed: “The relationship between a customer and the financial practitioner should govern the nature of their mutual ethical obligations. Where the fundamental nature of the relationship is one in which customer depends on the practitioner to craft solutions for the customer’s financial problems, the ethical standard should be a fiduciary one that the advice is in the best interest of the customer. To do otherwise – to give biased advice with the aura of advice in the customer’s best interest – is fraud. This standard should apply regardless of whether the advice givers call themselves advisors, advisers, brokers, consultants, managers or planners.” James J. Angel, Ph.D., CFA and Douglas McCabe Ph.D., Ethical Standards for Stockbrokers: Fiduciary or Suitability? (Sept. 30, 2010). (Emphasis added.) 47 I have previously written about FINRA’s seven-decades long failure to live up to the aspirations of the Maloney Act to raise the principles of broker-dealers firms to the highest level. See “Disband FINRA,” available at http://scholarfp.blogspot.com/2013/07/disband-finra-unabridged-and-with.html.

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removed from the common state nature hath placed it in, it hath by this labour something annexed to it, that excludes the common right of other men: for this labour being the unquestionable property of the labourer, no man but he can have a right to what that is once joined to, at least where there is enough, and as good, left in common for others … Charity gives every Man a Title to so much out of another’s Plenty, as will keep him from extream want, where he has no means to subsist otherwise. (Emphasis added.)

Many of us derive the basis of our own personal political and economic views from philosophers such as John Locke. Yet Locke and others recognize that opposing rights exist among the members of a society, and accordingly the rights of men and women must be balanced. As even John Locke alluded to, the right to generate profits from own labors has limits. In certain situations duties are imposed through government law and regulation to protect those susceptible to harm. Hence, government has a role to play to ensure that the rights of all of its citizens are balanced and respected.

B. ADAM SMITH’S RECOGNITION OF THE NEED TO CONSTRAIN CAPITALISM

Armed with the understanding that one father of libertarianism believes that government has a role to play in the regulation of the affairs of men, we now turn to the words of another father of libertarianism, Adam Smith, widely known as also the founder of Modern Economics. Perhaps all of us are aware of Adam Smith’s The Wealth of Nations, published in 1776, in which he famously and correctly argued that economic behavior was motivated by self-interest, writing: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.”

As Adam Smith pointed out, capitalism has its positive effects. Actions based upon self-interest often lead to positive forces that benefit others or society at large. As capital is formed into an enterprise, jobs are created. Innovation is spurred forward, often leading to greater efficiencies in our society and enhancement of standards of living. Indeed, a person in the pursuit of his own interest “frequently promotes that of the society more effectually than when he really intends to promote it.”

Yet, while Smith espoused the principle of the free market, he also advocated the principle of constraint. While Adam Smith saw virtue in competition, he also recognized the dangers of the abuse of economic power in his warnings about combinations of merchants and large mercantilist corporations. In essence, Adam Smith balanced the “commercial society” with the judicious hand of a paternalistic state.

Adam Smith also recognized the necessity of professional standards of conduct, for he suggested qualifications “by instituting some sort of probation, even in the higher and more difficult sciences, to be undergone by every person before he was permitted to exercise any liberal profession, or before he could be received as a candidate for any honourable office or profit.” In essence, long before many of the professions became separate, specialized callings, Smith advanced the concepts of high standards of conduct.

Unfettered capitalism results in greed. Unconstrained the excesses of capitalism become apparent, as evidenced by the misconduct which fostered financial crisis of 2008-8, the resulting Great Recession, and untold suffering imposed upon millions of our fellow Americans. The fiduciary standard, at its core, is a restraint upon greed.

Into the void of wholly free markets, efficient government regulation is altogether necessary. For, to quote the words of one of America’s founding fathers, James Madison, “If men were angels, no government would be necessary.”

Many believe in small, efficient government. But even the fathers of libertarisim, John Locke and Adam Smith, recognized the need for certain constraints to be imposed by government upon the conduct of men and women, lest greed run amuck and destroy our great country.

IV. ON THE DISTINCTION BETWEEN ARMS-LENGTH AND FIDUCIARY RELATIONSHIPS

In every commercial relationship misrepresentations in contract formation are outlawed and good faith in performance is required. In certain situations the purchaser is aided by disclosures of certain facts, mandated by law and regulation, as a means to evaluate whether to enter into the transaction. Even with mandated additional disclosures, however, the relationship between the parties is arms-length, and the consumer possesses the duty of personal due diligence under the doctrine of caveat emptor – “let the buyer beware.”

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Yet, in some forms of relationships much more is required than just the mere avoidance of actual fraud, performance of one’s contractual obligations in good faith, and even the making of required disclosures. In these types of relationships fiduciary obligations are imposed upon the provider of goods and services. These fiduciary duties include the fiduciary duty of loyalty, which requires the fiduciary to step into the shoes of the entrustor (client) and act in the client’s sole interests or best interests. The fiduciary duties also encompass due care, which requires the fiduciary to possess and exercise a high level of expertise.

The result of the imposition of fiduciary duties is a complete change in the role of the provider of goods or services. No longer does the advisor act as a merchandizer – representing the manufacturer or dealer of a product. Rather, the advisor is transformed, wholly and absolutely, into a representative of the purchaser of the good or service.

V. ON THE NECESSITY OF FIDUCIARY STANDARDS

Why does such a dramatic transformation in the form of the commercial relationship mandated in these instances? It is because trust is not an absolute, in that it either exists or does not exist. Rather, trust falls along a continuum. In many commercial relationships the purchaser is aware of the need to exercise his or her own due diligence prior to entering into, or consummating, the transaction; in such instances the need for trust is minimal. But, in this increased era of specialization in society, and vast disparities in knowledge and expertise when dealing with complex matters, a much higher degree of trust must be present in order to protect consumers who receive certain types of services, such as investment advice.

A. THE VAST DISPARITY IN EXPERTISE

During the provision of specialized goods and services (including advice) that society treasures and where a vast imbalance of knowledge and expertise is present, the purchaser of goods or services is at such a disadvantage the purchaser’s own due diligence cannot guard against the potential for abuse by the service provider. In these situations the law rightly and justly goes further and imposes fiduciary status upon the provider of such goods or services.

The consumer of investment products and services today is simply overwhelmed by information. Our fellow Americans are thrust into a highly complex financial environment in which a high degree of expertise is required to properly undertake portfolio design and management, and investment product selection. To prosper in today’s modern financial world requires not just the ability to understand often-complex financial products, but also a knowledge of Modern Portfolio Theory (MPT), concepts intertwined with MPT (such as variance, correlation, and the benefits of diversification), strategic vs. tactical asset allocation, multi-factor models of risks and returns, tax and risk characteristics of various asset classes and particular investments, the extent of regulation (or non-regulation) of various types of investment managers, and much, much more.

Where such information disparity and complexity exists, “the traditional tools for supervising counterparties, available through the law of contract, cannot guarantee the effective delivery of specialized services. Individuals simply do not have the resources or the expertise to determine on their own whether these specialized services are actually serving their interests. Instead, these individuals need to trust that the specialists they rely upon will keep their best interests at heart.”48

Accordingly, by necessity our consumers justly rely upon specialists. Just as they do in medicine, law, and other disciplines, consumers rely on financial and investment advisers to help them take advantage of the many advances in understanding of how the capital markets function and how the returns of the capital markets can be brought to bear to achieve the individual’s lifetime financial goals.

As Professor Tamar Frankel, long the leading scholar in the area of fiduciary law as applied to securities regulation, once observed:

48 Edward J. Waitzer and Douglas Sarr, Fiduciary Society Unleashed: The Road Ahead for the Financial Sector, 69 Bus.Lawyer 1081, 1090 (Aug. 2014).

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[A] prosperous economy develops specialization. Specialization requires interdependence. And interdependence cannot exist without a measure of trusting. In an entirely non-trusting relationship interaction would be too expensive and too risky to maintain. Studies have shown a correlation between the level of trusting relationships on which members of a society operate and the level of that society’s trade and economic prosperity.49

Fiduciary duties are imposed by law when public policy encourages specialization in particular services, such as investment management or law, in recognition of the value such services provide to our society. For example, the provision of investment consulting services under fiduciary duties of loyalty and due care encourages participation by investors in our capital markets system. Hence, in order to promote public policy goals, the law requires the imposition of fiduciary status upon the party in the dominant position. Through the imposition of such fiduciary status the client is thereby afforded various protections. These protections serve to reduce the risks to the client that relate to the service, and encourage the client to utilize the service. Accordingly, the imposition of fiduciary status thereby furthers the public interest.

Some might opine that financial literacy efforts can fulfill this role. Yet, the body of academic research, and my own experience in dealing with thousands of clients, reveals that financial literacy efforts only significantly assist consumers with basic personal finance training, such as in expenditures budgeting and saving for future needs. However, the complexity of the financial markets, and the limits of time each consumer possesses to devote to training in finance, renders the vast majority of consumers unable to become investment experts or to understand the many terms and concepts required, even with the aid of a multitude of disclosures. We are just as likely to turn a consumer of financial services into a highly knowledgeable designer and manager of her or his investment portfolio as we are to turn a patient needing a brain operation into a neurosurgeon.

We must recognize that the combination of specialization and interdependence found today is essential to the progress of our society. This combination fosters both the development of new knowledge and expertise. It provides great benefits to consumers, provided the advice is delivered with a high degree of due care and in the consumers’ best interests. It enables consumers to place the fruits of their hard-earned labor to work in the capital markets, with the expectation that the returns offered by the markets will be returned to the consumer, less only a reasonable amount for professional-level compensation to the specialist and the carefully scrutinized fees and costs of any investment product.

B. THE IMPORTANCE OF TRUST TO ECONOMIC GROWTH

In this section, we must first ask, “What is ‘trust’?” I submit that there exists “at least implicitly accepted a definition of trust as a belief, attitude, or expectation concerning the likelihood that the actions or outcomes of another individual, group or organization will be acceptable . . . or will serve the actor’s interests.”50

How important is trust to commerce, generally? Aristotle once observed that the doctrine of good faith is so fundamental to the making and performance of contracts that, “[i]f good faith has been taken away, all intercourse among men ceases to exist.”

Trust itself is also crucial to a society’s economic success. Nobel laureate economist Kenneth Arrow has stated that “[v]irtually every commercial transaction has within itself an element of trust,” and that “much of the economic backwardness in the world can be explained by the lack of mutual confidence.”51

Several studies have documented the positive relationship between trust in society and economic growth. Increased trust between actors in commercial transactions has a direct positive and significant effect on income per capita

49 Tamar Frankel, Trusting And Non-Trusting: Comparing Benefits, Cost And Risk, Working Paper 99-12, Boston University School of Law. 50 Sim B. Sitkin & Nancy L. Roth, Explaining the Limited Effectiveness of Legalistic “Remedies” for Trust/Distrust, 4 ORG. SCI. 367, 368 (1993). 51 Kenneth Arrow, Gifts and Exchanges, 1 Philosophy & Pub. Affairs 343, 357 (1972).

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growth.52

Individuals need to trust that the specialists they rely upon will keep their best interests at heart. The imposition of broad fiduciary duties of due care, loyalty, and utmost good faith promotes this essential relationship of trust. It permits entry into the capital markets by those without the knowledge and skill to navigate their complex waters. As stated by Luhmann:

Trust is necessary in order to face the unknown, whether that unknown is another human being, or simply the future and its contingent events. Seldom, if ever, can we obtain all the information we would need in order to take decisions in a completely rational manner. At a certain point in our 'intelligence-gathering' about the world we have to call a halt, say ‘enough is enough’ and take a decision based on what we know and the way we feel. That decision will inevitably partly be based on trust. Trust is thus a way of reducing uncertainty. It lies somewhere between hope and confidence, and involves an element of semi-calculated risk-taking. Trust, by the reduction of complexity, discloses possibilities for action which would have remained unattractive and improbable without trust - which would not, in other words, have been pursued.53

I have personally seen the trust of consumers betrayed, over and over again, by providers of financial and investment advice who act out of their own self-interest, not bound by a fiduciary standard. Immense personal harm results, involving the destruction of the hopes and dreams of the consumer.

For society the cost of abuse of trust in the provision of investment advice is even greater. I have personally seen consumers, burned and unwilling to trust any other financial or investment adviser, flee from the capital markets – likely for all time. Like most of the Greeks, such consumers resort to placement of their savings in commercial banks. As a result, the costs of capital increase, for the capital markets are deprived of direct funding and the provision of available equity capital, in particular, is diminished.

Investment advisory services rendered in a relationship of trust and confidence, as a fiduciary, encourage participation by investors in our capital markets system, which in turn promotes economic growth. The first and overriding responsibility any financial professional has is to all of the participants of the market. This primary obligation is required in order to maintain the perception54 and reality that the market is a fair game and thus encourage the widest possible participation in the capital allocation process. The premise of the U.S. capital market is that the widest possible participation in the market will result in the most efficient allocation of financial resources and, therefore, will lead to the best operation of the U.S. and worldwide economy. Indeed, academic research has revealed that individual investors who are unable to trust their financial advisors are less likely to participate in the capital markets.55

52 See, e.g., Tatsi, Eirini and Zafar, Tasneem, Social Capital and Economic Growth: Evidence from OECD Countries (May 1, 2011). 53 Niklas Luhmann, Trust and Power (John Wiley & Sons; Chichester, 1979), p. 4. 54 “Applying the Advisers Act and its fiduciary protections is essential to preserve the participation of individual investors in our capital markets. NAPFA members have personally observed individual investors who have withdrawn from investing in stocks and mutual funds due to bad experiences with registered representatives and insurance agents in which the customer inadvertently placed his or her trust into the arms-length relationship.” Letter of National Association of Investment advisers (NAPFA) dated March 12, 2008 to David Blass, Assistant Director, Division of Investment Management, SEC re: Rand Study. 55 “We find that trusting individuals are significantly more likely to buy stocks and risky assets and, conditional on investing in stock, they invest a larger share of their wealth in it. This effect is economically very important: trusting others increases the probability of buying stock by 50% of the average sample probability and raises the share invested in stock by 3.4 percentage points … lack of trust can explain why individuals do not participate in the stock market even in the absence of any other friction … [W]e also show that, in practice, differences in trust across individuals and countries help explain why some invest in stocks, while others do not. Our simulations also suggest that this problem can be sufficiently severe to explain the percentage of wealthy people who do not invest in the stock market in the United States and the wide variation in this percentage across countries.” Guiso, Luigi, Sapienza, Paola and Zingales, Luigi. “Trusting the Stock Market” (May 2007); ECGI - Finance Working Paper No. 170/2007; CFS Working Paper No. 2005/27; CRSP Working Paper No. 602. Available at SSRN: http://ssrn.com/abstract=811545.

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C. OTHER COMPELLING REASONS FOR IMPOSITION OF FIDUCIARY STATUS

The key to understanding fiduciary principles, and why and how they are applied, rests in discerning the foregoing public policy objectives the fiduciary standard of conduct is designed to meet, as well as the other public policy objectives set forth in this section.

Fiduciary Status Address “Overreaching” When Person-to-Person Advice is Provided

The Investment Advisers Act of 1940 “recognizes that, with respect to a certain class of investment advisers, a type of personalized relationship may exist with their clients … The essential purpose of [the Advisers Act] is to protect the public from the frauds and misrepresentations of unscrupulous tipsters and touts and to safeguard the honest investment adviser against the stigma of the activities of these individuals by making fraudulent practices by investment advisers unlawful.”56 “The Act was designed to apply to those persons engaged in the investment-advisory profession -- those who provide personalized advice attuned to a client's concerns, whether by written or verbal communication57 … The dangers of fraud, deception, or overreaching that motivated the enactment of the statute are present in personalized communications….”58

Consumers’ Lack of Desire to Expend Time and Resources on Monitoring

The inability of clients to protect themselves while receiving guidance from a fiduciary does not arise solely due to a significant knowledge gap or due to the inability to expend funds for monitoring of the fiduciary. Even highly knowledgeable and sophisticated clients (including many financial institutions) rely upon fiduciaries. While they may possess the financial resources to engage in stringent monitoring, and may even possess the requisite knowledge and skill to undertake monitoring themselves, the expenditure of time and money to undertake monitoring would deprive the investors of time to engage in other activities. Indeed, since sophisticated and wealthy investors have the ability to protect themselves, one might argue they might as well manage their investments themselves and save the fees. Yet, reliance upon fiduciaries is undertaken by wealthy and highly knowledgeable investors and without expenditures of time and money for monitoring of the fiduciary. In this manner, “fiduciary duties are linked to a social structure that values specialization of talents and functions.”59

The Shifting of Monitoring Costs to Government

In service provider relationships which arise to the level of fiduciary relations, it is highly costly for the client to monitor, verify and ensure that the fiduciary will abide by the fiduciary’s promise and deal with the entrusted power only for the benefit of the client. Indeed, if a client could easily protect himself or herself from an abuse of the fiduciary advisor’s power, authority, or delegation of trust, then there would be no need for imposition of fiduciary duties. Hence, fiduciary status is imposed as a means of aiding consumers in navigating the complex financial world, by enabling trust to be placed in the advisor by the client.

Fiduciary relationships are relationships in which the fiduciary provides to the client a service that public policy encourages. When such services are provided, the law recognizes that the client does not possess the ability, except at great cost, to monitor the exercise of the fiduciary’s powers. Usually the client cannot afford the expense of engaging separate counsel or experts to monitor the conflicts of interest the person in the superior position will possess, as such costs might outweigh the benefits the client receives from the relationship with the fiduciary. Enforcement of the protections thereby afforded to the client by the presence of fiduciary duties is shifted to the courts and/or to regulatory bodies. Accordingly, a significant portion of the cost of enforcement of fiduciary duties is shifted from

56 Lowe v. SEC, 472 U.S. 181, 200, 201 (1985). 57 Id. at 208. 58 Id. at 210. 59 Tamar Frankel, Ch. 12, United States Mutual Fund Investors, Their Managers and Distributors, in CONFLICTS OF INTEREST: CORPORATE GOVERNANCE AND FINANCIAL MARKETS (Kluwer Law International, The Netherlands, 2007), edited by Luc Thévenoz and Rashid Barhar.

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individual clients to the taxpayers, although licensing and related fees, as well as fines, may shift monitoring costs back to all of the fiduciaries that are regulated.

Consumers’ Difficulty in Tying Performance to Results

The results of the services provided by a fiduciary advisor are not always related to the honesty of the fiduciary or the quality of the services. For example, an investment adviser may be both honest and diligent, but the value of the client’s portfolio may fall as the result of market events. Indeed, rare is the instance in which an investment adviser provides substantial positive returns for each incremental period over long periods of time – and in such instances the honesty of the investment adviser should be suspect.

Consumers’ Difficulty in Identifying and Understanding Conflicts of Interest

Most individual consumers of financial services in America today are unable to identify and understand the many conflicts of interest that can exist in financial services. For example, a customer of a broker-dealer firm might be aware of the existence of a commission for the sale of a mutual fund, but possess no understanding that there are many mutual funds available that are available without commissions (i.e., sales loads). Moreover, brokerage firms have evolved into successful disguisers of conflicts of interest arising from third-party payments, including payments through such mechanisms as contingent deferred sales charges, 12b-1 fees, payment for order flow, payment for shelf space, and soft dollar compensation.

Survey after survey (including the Rand Report) has concluded that consumers place a very high degree of trust and confidence in their investment adviser, stockbroker, or financial planner. These consumers deal with their advisors on unequal terms, and often are unable to identify the conflicts of interest their “financial consultants” possess.

Transparency is important, but even when compensation is fully disclosed, few individual investors realize the impact high fees and costs can possess on their long-term investment returns; often individual investors believe that a more expensive product will possess higher returns.60 Nor will competition, even with transparency, serve to substantially lower costs due to the economic incentives advisers possess to sell higher-cost funds.61

For Fiduciaries, the Cost of Proving Trustworthiness is Quite High

How does one prove oneself to be “honest” and “loyal”? The cost to a fiduciary in proving that the advisor is trustworthy could be extremely high – so high as to exceed the compensation gained from the relationships with the advisors’ clients.

60 In a 2005 study, Professors “Madrian, Choi and Laibson recruited two groups of students in the summer of 2005 -- MBA students about to begin their first semester at Wharton, and undergraduates (freshmen through seniors) at Harvard. All participants were asked to make hypothetical investments of $10,000, choosing from among four S&P 500 index funds. They could put all their money into one fund or divide it among two or more. ‘We chose the index funds because they are all tracking the same index, and there is no variation in the objective of the funds,’ Madrian says … ‘Participants received the prospectuses that fund companies provide real investors … the students ‘overwhelmingly fail to minimize index fund fees,’ the researchers write. ‘When we make fund fees salient and transparent, subjects' portfolios shift towards lower-fee index funds, but over 80% still do not invest everything in the lowest-fee fund’ … [Said Professor Madrian,] ‘What our study suggests is that people do not know how to use information well.... My guess is it has to do with the general level of financial literacy, but also because the prospectus is so long." Knowledge@Wharton, “Today's Research Question: Why Do Investors Choose High-fee Mutual Funds Despite the Lower Returns?” citing Choi, James J., Laibson, David I. and Madrian, Brigitte C., “Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds” (March 6, 2008). Yale ICF Working Paper No. 08-14. Available at SSRN: http://ssrn.com/abstract=1125023. 61 See Choi, James, David Laibson, and Brigitte Madrian. 2010. Why does the law of one price fail? An experiment on index mutual funds. Review of Financial Studies 23(4): 1405-1432. [“[Subjects overwhelmingly failed to minimize index fund fees. Instead, they placed heavy weight on irrelevant attributes such as funds’ annualized returns since inception. Highlighting these misleading historical returns caused student subjects (in one of our randomized experimental treatments) to chase those returns even more intensely, despite the negative future return consequences such behavior had. Even subjects who claimed to prioritize fees in their portfolio decision showed minimal sensitivity to the fee information in the prospectus. Subjects apparently do not understand that S&P 500 index funds are commodities … In the real world, this problem is likely to be exacerbated by the financial advisors whose compensation is increasing in the fees of the mutual funds they sell to their clients. When consumers in a commodity market observe prices and quality with noise, a high degree of competition will not drive markups to zero ….” [Emphasis added.]

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In his influential article discussing the creation of the federal securities acts, and in particular their moral purpose, John Walsh (formerly of the SEC’s OCIE) reviewed the legislative history underlying the creation of the Investment Advisers Act:

As part of a congressionally mandated review of investment trusts the agency also studied investment advisers. The Advisers Act was based on that study. By the time it passed, it was a consensus measure having the support of virtually all advisers.

Investment advisers’ professionalism, and particularly their professional ethics, dominated the SEC study and the legislative history of the Act. Industry spokespersons emphasized their professionalism. The “function of the profession of investment counsel,” they said, “was to render to clients on a personal basis competent, unbiased and continuous advice regarding the sound management of their investments.” In terms of their professionalism they compared themselves to physicians and lawyers. However, industry spokespersons indicated that their efforts to maintain professional standards had encountered a serious problem. The industry, they said, covered “the entire range from the fellow without competence and without conscience at one end of the scale, to the capable, well-trained, utterly unbiased man or firm, trying to render a purely professional service, at the other end.” Recognizing this range, “a group of people in the forefront of the profession realized that if professional standards were to be maintained, there must be some kind of public formulation of a standard or a code of ethics.” As a result, the Investment Counsel Association of America was organized and issued a Code of Ethics. Nonetheless, the problem remained that the Association could not police the conduct of those who were not members nor did it have any punitive power.

The SEC Study noted that it had been the unanimous opinion of all who had testified at its public examination, both members and nonmembers of the Association, that the industry’s voluntary efforts could not cope with the “most elemental and fundamental problem of the investment counsel industry—the investment counsel ‘fringe’ which includes those incompetent and unethical individuals or organizations who represent themselves as bona fide investment counselors.” Advisers of that type would not voluntarily submit to supervision or policing. Yet, all counselors suffered from the stigma placed on the activities of the individuals on the fringe. Thus, an agency was needed with compulsory and national power that could compel the fringe to conform to ethical standards.

As a result of the Commission’s report to Congress, the Senate Committee on Banking and Currency determined that a solution to the problems of investment advisory services could not be affected without federal legislation. In addition, both the Senate and House Committees considering the legislation determined that it was needed not only to protect the public, but also to protect bona fide investment counselors from the stigma attached to the activities of unscrupulous tipsters and touts. During the debate in Congress, the special professional relationship between advisers and their clients was recognized. It is, said one representative, “somewhat [like that] of a physician to his patient.” The same Congressman continued that members of the profession were “to be complimented for their desire to improve the status of their profession and to improve its quality.”62

This is why it is important to fiduciary advisors to be able to distinguish themselves from non-fiduciaries. A recent example of the problems faced by investment advisers was the “fee-based brokerage accounts” final rule adopted by the SEC in 2005, which would have permitted brokers to provide the same functional investment advisory services as investment advisers but without application of fiduciary standards of conduct. This would have negated to a large degree economic incentives63 for persons to become investment advisers and be subject to the higher standard of

62 John H. Walsh, “A Simple Code Of Ethics: A History of the Moral Purpose Inspiring Federal Regulation of the Securities Industry,” 29 Hofstra L.Rev. 1015, 1066-8 (2001), citing SEC, REPORT ON INVESTMENT COUNSEL, INVESTMENT MANAGEMENT, INVESTMENT SUPERVISORY, AND INVESTMENT ADVISORY SERVICES (1939). 63 One might reasonably ask why “honest investment advisers” (to use the language of the U.S. Supreme Court in SEC vs. Capital Gains) had to be protected by the Advisers Act. Was it not enough to just protect consumers? The answer can be found in economic principles, as set forth in the classic thesis for which George Akerlof won a Nobel Prize:

There are many markets in which buyers use some market statistic to judge the quality of prospective purchases. In this case there is incentive for sellers to market poor quality merchandise, since the returns for good quality accrue mainly to the

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conduct. The SEC’s fee-based accounts rule was overturned in Financial Planning Ass'n v. S.E.C., 482 F.3d 481 (D.C. Cir., 2007).

Monitoring and Reputational Threats are Largely Ineffective

The ability of “the market” to monitor and enforce a fiduciary’s obligations, such as through the compulsion to preserve a firm’s reputation, is often ineffective in fiduciary relationships. This is because revelations about abuses of trust by fiduciaries can be well hidden (such as through mandatory arbitration clauses and secrecy agreements regarding settlements), or because marketing efforts by fiduciary firms are so strong and pervasive that they overwhelm the reported instances of breaches of fiduciary duties.

VI. ON DOL’S EXPANDED DEFINITION OF “FIDUCIARY” & SERVICE TO SMALL INVESTORS

I fully support the DOL’s expanded definition of “fiduciary.” This definition is better in accord with the actual language of the statute. Additionally, the expanded definition encompasses most of the relationships of trust and confidence, for the provision of investment advice to retirement accounts, to which fiduciary status usually attaches under state common law, which common law serves to inform the development of federal law.

SIFMA, FSI and other broker-dealer lobbyists, and insurance company lobbyists, have proclaimed loud and clear that small investors cannot be served under the DOL’s best interest proposal. The fallacy of this argument is evident in the fact that, for decades, fiduciary advisers have been serving both plan sponsors and individual clients, of all sizes, under a bona fide fiduciary standard of conduct, and doing so extremely well and with the clients paying far less in fees and costs than the compensation paid to registered representatives and to insurance agents.

Fiduciary Advice is Readily Available to Even Small Investors

For example, suppose an investor desires to invest $10,000 in an IRA account. Currently many such investors succumb to the marketing prowess of Wall Street and end up undergoing a brief conversation with a broker (i.e., a registered representative) and thereafter receive a singular investment recommendation.

Often that broker’s recommendation is to invest IRA account cash into a Class A mutual fund shares, in which the broker charges a 5.75% upfront commission. In addition to the $575 up-front commission on a $10,000 account, ongoing 12(b)-1 fees are also typically paid to the brokerage firm, usually in the amount of 0.25% a year. These commissions and annual fees are in addition to the management and administrative fees charged by the fund itself.

And, far too often, a portion of the often-high mutual fund management fees is paid to the brokerage firm as “payment for shelf space” or via sponsorship of events at “educational gatherings” at brokerage firms.

Wall Street’s large firms have often made threats to abandon smaller investors as regulators contemplate changes to rules governing their conduct. What if they make good on those threats? Should fiduciary obligations be imposed upon brokers who provide personalized investment advice? The Financial Services Institute complains loudly about the U.S. Department of Labor’s proposed Conflicts of Interest Rule and its broadened imposition of fiduciary standards of conduct that “millions of hard-working Americans could find financial advice priced out of their reach.”

entire group whose statistic is affected rather than to the individual seller. As a result there tends to be a reduction in the average quality of goods and also in the size of the market.

George A. Akerloff, The Market for "Lemons": Quality Uncertainty and the Market Mechanism, The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), p.488.

George Akerloff demonstrated “how in situations of asymmetric information (where the seller has information about product quality unavailable to the buyer), ‘dishonest dealings tend to drive honest dealings out of the market.’ Beyond the unfairness of the dishonesty that can occur, this process results in less overall dealing and less efficient market transactions.” Frank B. Cross and Robert A. Prentice, The Economic Value of Securities Regulation, 28 Cardoza L.Rev. 334, 366 (2006). As George Akerloff explained: “[T]he presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.” Akerloff at p. 495.

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The other major broker-dealer lobbyist organization, SIFMA, argues that adoption of fiduciary standards of conduct for those who provide personalized investment advice to consumers “is likely to have a negative impact on consumers, particularly smaller investors.”

Does Wall Street serve the small investor?

Before I proceed to rebut these fallacious arguments, I must point out that many of the larger broker-dealer firms mandate minimums for their registered representatives to receive compensation, which discourages such brokers from providing services to small investors. Often, individual brokers are not compensated until the account size grows to $100,000 or even $500,000.

As a result, these smaller investors are often directed to advisors located in “call centers,” if they are served at all. Hence, to the extent Wall Street firms threaten to “abandon” small investors, it must first be realized that many of these brokerage firms have, in essence, already largely abandoned smaller investors.

Still, we must ask: do FSI’s and SIFMA’s claims hold merit? Will small investors not be served if brokers abandon the small IRA account-owner market? More specifically, we might inquire: “Where else can a small IRA investor receive investment advice on a $10,000 IRA account, for $575 or less?”

Let’s examine the evidence, by looking at just a few of the offerings that currently exist to serve small IRA investors.

Garrett Planning Network: Fiduciary, hourly advice

One group has long existed to provide advice to investors both large and small. Its vision is succinctly explained on their website: “Everyone needs competent, objective financial advice from time to time. The Garrett Planning Network has a nationwide membership of over 300 independent, fee-only financial planners providing advice to people from all walks of life, without minimum account requirements, sales commissions, or long-term commitments. Our members proudly embrace their fiduciary duty, always placing their clients’ best interests first.”

When Sheryl Garrett founded the Garrett Planning Network (currently celebrating its 15th year), its groundbreaking philosophy was to provide fee-only, fiduciary advice under hourly fee arrangements. Since then, Sheryl’s vision has substantially influenced the industry. Innovations have been adopted by many of its members in recent years, such as the “two-hour financial checkup” — often costing only about $300 to $500.

Not only might the consumer receive a recommended strategic asset allocation, as well as specific investment recommendations, but these recommendations are provided in context with financial planning recommendations around the key issues the client may face at that moment. Given the high quality of the truly objective financial and investment advice provided, the consumer gets far greater and better advice for fees that are lower. And, since all GPN’s advisors eschew third-party payments such as 12(b)-1 fees, and nearly all favor very-low-cost, no-load mutual funds, clients incur far less total fees and costs over the long run.

In a recent e-mail exchange I had with Sheryl Garrett, she opined: “Demand for investment advisory services from our members is great and increasing exponentially. The marketplace has changed significantly, driven in part by public awareness of the benefits of working with a fiduciary advisor. Advisors also are attracted to the fiduciary space, as it puts them on the same side of the table as their clients. If brokerage firms stop serving small investors just because they will now be forced to do what is in a client’s best interest, there are a lot of fiduciary advisors who are willing to take up the slack and take care of these investors’ advisory needs.”

No wonder President Obama chose to highlight Sheryl Garrett in her visit to the White House earlier this year, as he announced his support of the DOL’s rulemaking efforts.

NAPFA: The largest network of fee-only advisors

More than 30 years ago a group of industry visionaries gathered and established a professional organization that has now grown to over 2,400 members, with members located in 49 of the 50 states. The nation’s largest professional organization of fee-only personal financial advisors, the National Association of Personal Financial Advisors — NAPFA — has members ranging from solo practitioners to some of the largest registered investment advisory firms in the United States today, many of them serving thousands of individual investors.

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While some NAPFA member firms have minimums, many others do not — even many of the larger NAPFA-member firms. For example, Abacus Wealth Partners, a fee-only firm with over $1 billion of assets under management, has six offices and serves clients in 40 different states. Abacus offers consumers a “Financial Checkup” involving a two-hour phone or in-person session with a 30-minute telephone follow-up. For a fixed fee of $600, small IRA investors and other clients can receive financial and investment advice.

“We’ve made it part of our mission to serve anyone who needs our help,” J.D. Bruce, president of Abacus Wealth Partners, conveyed to me via a recent e-mail. “We’ve eliminated our investment management minimum and we find a way to offer some level of financial planning, even if we have to do it for free through our pro-bono program. It’s not that we’re a charity, we still make a good profit, and our high net-worth prospects appreciate our mission and are more likely to hire us and refer us their friends.”

XY Planning Network: Monthly retainer, no asset minimums

A relatively newer but rapidly growing organization of fee-only, fiduciary advisors is the XY Planning Network. All of its advisors offer monthly retainer services and none of them require asset minimums. Many of the XY Planning Network’s members also offer consultations for hourly fees or fixed fees.

A typical example of XY Planning Network’s members is Ben Wacek, a fee-only, Certified Financial Planner who provides financial and investment advice online and through phone calls. In addition to a 30-minute free phone call “to get to know each other and see if I can help,” Ben provides hourly financial advice for only $80 an hour. He also offers ongoing financial and investment advice through a monthly retainer that starts at only $50 per month. With seven years experience, Ben says that he “loves working as a financial planner because of the opportunity that he has to make a difference in people’s lives.”

Robo-advisors: Badly named but there for the little guy

Several recently formed firms offer investment advisory services through a combination of automated services and/or human interactions. They build and manage low-cost portfolios at a fraction of what investors typically pay human advisors. These firms, incorrectly but commonly called “robo-advisors,” apply technology to bring efficiencies to the investment advisory process. Given that the Internet and technology in general has led to wholesale disintermediation in many different industries, it is no surprise that such firms have arisen in the online investment advisory space.

One of the largest of these new offerings is from nonprofit, low-cost mutual fund provider The Vanguard Group. However, its Vanguard Personal Advisor Services currently has a $50,000 minimum. Under this platform Vanguard now manages billions and billions of assets for individual investors.

Perhaps more representative of the new type of fee-only, fiduciary online advisory services is investment advisory online firm Wealthfront Inc. Wealthfront does not charge an advisory fee on the first $10,000 of assets under management. On amounts over $10,000, Wealthfront charges a monthly advisory fee based on an annual fee rate of 0.25%. Hence, the annual investment advisory fee on a $10,000 account is only $250. The only other direct cost clients incur is the very low fee embedded in the annual expense ratio of the exchange traded funds it recommends; Wealthfront states that these fees average only 0.12% a year. With over $2.4 billion in assets under management in just a relatively short period of time, Wealthfront stands ready to provide investment solutions to hundreds of thousands, if not millions, of potential small IRA customers. Other online investment advisory firms exist, with several more currently in the process of forming.

What do the Wall Street threats really mean?

Wall Street’s large firms have often made threats to abandon smaller investors as regulators contemplate changes to rules governing their conduct. For example, in 2005-2007, during the Financial Planning Association’s successful litigation in overturning the SEC’s ill-fated “fee-based accounts rule,” several firms stated that they would be unable to serve investors if they were forced to switch the fee-based brokerage accounts to investment advisory accounts. Of course, this was largely an empty threat, as the end of fee-based brokerage accounts saw many, if not most, of these fee-based brokerage accounts transformed into investment advisory accounts governed by the Advisers Act’s fiduciary standard.

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If the Department of Labor’s rules are finalized, then changes to the delivery of investment advice will occur for some IRA account owners. But these changes will be a great positive, as small IRA investors would then be provided investment advice by fiduciary advisors who possess a legal obligation to both control and account for investment fees and costs. In most instances, not only will the advice received by these small investors be lower-cost, but the advice will also be better, far more objective, and much more comprehensive.

This begs the question: Why do the members of SIFMA and FSI threaten to not serve small IRA account owners under the DOL’s fiduciary standard?

One might conclude a more logical explanation exists. Simply put, without the free rein provided by FINRA’s scandalously weak “suitability standard” to recommend high-cost, expensive investment products that pay broker-dealer firms and their registered representatives inordinately high fees (including many pay-to-play and similar back-door payments), what Wall Street really means is that it cannot afford to still serve such investors under its current business model if it cannot continue to reap inordinately high rents from unsuspecting consumers.

Time to stop feeding the beast

To Wall Street’s empty threats I would reply as follows. Small IRA investors deserve trusted advice, from expert investment advisors, for reasonable fees. They don’t deserve to be sold costly investment products that a huge body of academic research has concluded deprives individual investors of a significant portion of the returns the capital markets have to offer.

Nor do the regulators need to permit this abuse by Wall Street firms of individual investors to continue. Part of the duty of both the DOL and the SEC is to protect capital formation, which is highly dependent upon the trust placed in financial intermediaries by individual investors. The DOL and SEC also serve to protect investors, both large and small. Nothing in their charters requires either to preserve an archaic, abusive business model of Wall Street in which perhaps a hundred billion dollars (or more) are diverted each year from individual investors as a means to fuel Wall Street firm’s extraordinary levels of compensation, bonuses, and profits.

The simple truth is that Wall Street’s sell-side, high-expense model is not desired by knowledgeable small IRA investors. More importantly, a vast array of better alternatives exist to serve the small IRA investors. If Wall Street actually were to carry out its threat to abandon small IRA investors should the DOL finalize its proposed rules which largely prohibit most of the conflicts of interest Wall Street firms currently embrace, I say let these firms so depart the marketplace! There are many, many investment advisory firms willing to provide trusted advice for reasonable fees to these small IRA investors without the huge conflicts of interest that cause so much harm to investors.

As to Wall Street’s conflict-ridden, enormously expensive (for consumers) business model in which excessive rents are extracted, what should occur? Wall Street’s broker-dealer firms are dinosaurs, like the genetically modified monster in the recent Jurassic World movie. And, unwilling to adapt their standards of conduct for the benefit of our fellow Americans and America itself, Wall Street’s firms dinosaurs that well deserves their own mass extinction event.

Let us embrace the U.S. Department of Labor’s proposal to eliminate most of Wall Street’s perverse conflicts of interest, as these rules when implemented will usher in a new era in which both small IRA and large IRA investors are able to save and accumulate far greater amounts for their own personal financial security.

VII. ON THE BIC EXEMPTION, GENERALLY.

“All other things being equal, the smaller a fund’s expense ratio, the better the results obtained by its stockholders … But the burden of proof may reasonably be placed on those who argue the traditional view –that the search for securities whose prices diverge from their intrinsic values is worth the expense required.” - Sharpe, William F. 1966. “Mutual Fund Performance.” Journal of Business, vol. 39, no. 1 (January):119–138.

I am most appreciative of the U.S. Department of Labor’s efforts to provide an exemption for brokers and insurance agents to permit the sale of products using commission-based compensation and other product-provided

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compensation. This represents a noble effort to accommodate a large (but ever-declining) segment of the industry that provides investment advice to plan sponsors and to individual clients.

However, I believe the current BIC exemption could be misconstrued, in several respects, so as to permit over time institutionalization of perverse economic incentives and conflicts of interest that continue to apply to many financial services providers today and which cause so much harm to individual investors. Hence, below I undertake recommendations for modifications to the BIC exemption that will strengthen the requirements of the exemption in order to better protect consumers.

It must be remembered that ERISA mandates a “sole interests” fiduciary standard of conduct, which is further augmented by prohibited transaction rules. The DOL possesses the authority to provide exemptive relief, provided it is the interests of consumers. The BIC exemption must be carefully constructed to ensure that the interests of individual investors are protected, and that it is not interpreted incorrectly.

A. ON THE DIFFICULTIES PRESENTED BY DIFFERENTIAL COMPENSATION.

The BIC exemption permits a wide variety of compensation methods, including but not limited to commissions, 12b-1 fees, payment for shelf space arrangements, and other forms of revenue sharing, at the brokerage firm level and/or insurance agency level. It is not necessarily the fact of how these payments are made, but the fact that such payments may be different depending upon the investment product (or insurance product) recommended, that creates the first significant hurdle for firms bound by the fiduciary standard of conduct, and the agents of those firms.

Why Level Compensation, for Both the Adviser and the Firm, is So Important to Adhering to a Fiduciary Standard.

Fixed compensation, agreed-to in advance with the client, is much preferred in fiduciary-client arrangements. As Professor Laby explained: “It can be difficult ex post to determine the wisdom of an investment recommendation at the time it was made. A decision to recommend one investment over another is based on many factors; one can seldom know if self-interest was a motivating force. The imposition of the fiduciary duty of loyalty and the regulation of conflicts are ways to control the risk that an investment recommendation will not be objective.”64

As Professor Laby observed above, it must be recognized that it can take many years of investment manager performance to be able to test for a fund manager’s skill. As recently observed by David Blake:

Our final conclusion is that, while ‘star’ fund managers do exist, all the empirical evidence – including that presented here – indicates that they are incredibly hard to identify. Furthermore, it takes a very long time to do so: Blake and Timmermann (2002) showed that it takes 8 years of performance data for a test of a fund manager’s skill to have 50% power and 22 years of data for the test to have 90% power. For most investors, our results show that it is simply not worth paying the vast majority of fund managers to actively manage their assets.65

The principle that Professor Arthur Laby summarized above has long been observed by the courts of our country. As Hallgring explained nearly a half-century ago:

The courts have consistently held that this inflexibility is essential to its effective operation … First, the courts have acknowledged that it is difficult, if not impossible for a person to act impartially in a matter in which he has an interest…Secondly, the courts have realized that fiduciary relationships lend themselves to exploitation … Finally, the courts have made much of the fact that disloyal conduct is hard to detect.66

As Fred Reish and Joseph Faucher more recently expounded:

64 Arthur B. Laby, Fiduciary Obligations Of Broker-Dealers and Investment Advisers, 55 Villanova L.Rev. 701, 739 (2010).

65 David Blake et. al., New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods (2014) at p.19. 66 Hallgring, R., The Uniform Trustees’ Powers Act and the Basic Principles of Fiduciary Responsibility. 41 WASHINGTON LAW REVIEW 808–11 (1966).

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Conflicts of interest adversely affect the integrity of the private retirement system. At the least, the appearance of impropriety calls into question fiduciaries’ loyalty to participants. At worst, a conflict of interest can have a direct adverse impact on the plan and its participants. For instance, a conflict of interest, gone unchecked, can result in the plan paying more than reasonable compensation to service providers or result in fiduciaries offering mediocre and overly expensive investment options when superior products are available at equal or less expense. Conflicts of interest, therefore, can adversely affect the benefits available to participants at retirement – the exclusive purpose for which retirement plans exist.67

The BIC exemption (and the Principal Transaction Exemption) addresses the problems posed by differential compensation by requiring that both financial institution and adviser affirmatively agree to provide investment advice that is in the best interest of the retirement investor “without regard to the financial or other interests” of the financial institution, adviser, or other party.” While the intent of this language appears clear on its face, FINRA in its July 17, 2015 comment letter to the DOL on the proposals suggests three possible interpretations. FINRA’s third (and correct) interpretation is that under the BIC exemption “investment advice may be deemed in the customer’s best interest as long as, among other matters, the amount of compensation earned was not a factor in the recommendation.” Yet, in the sentence thereafter, FINRA states: “It is unclear how a financial institution or adviser would demonstrate that the amount of compensation was not a factor in the recommendation.”

The clarity FINRA seeks is provided by the DOL itself, in its issuing release for the BIC exemption:

[B]oth ERISA section 404(a)(1)(A) and the trust-law duty of loyalty require fiduciaries to put the interests of trust beneficiaries first, without regard to the fiduciaries' own self-interest. Accordingly, the Department would expect the standard to be interpreted in light of forty years of judicial experience with ERISA's fiduciary standards and hundreds more with the duties imposed on trustees under the common law of trusts …

Example 3: Fee offset. The Financial Institution establishes a fee schedule for its services. It accepts transaction-based payments directly from the plan, participant or beneficiary account, or IRA, and/or from third party investment providers. To the extent the payments from third party investment providers exceed the established fee for a particular service, such amounts are rebated to the plan, participant or beneficiary account, or IRA. To the extent third party payments do not satisfy the established fee, the plan, participant or beneficiary account, or IRA is charged directly for the remaining amount due

Other examples are provided by the U.S. Department of Labor. However, the “fee offset” example appears to provide the best mechanism for brokers and insurance companies to ensure adherence that the amount of compensation was not a factor in the recommendation. I hope this reminder serves to provide FINRA, which seems completely unable to understand what a true fiduciary standard requires (despite its acknowledgement, in the early 1940’s, that brokers forming relationships of trust and confidence with their clients would possess such fiduciary duties), with the clarity FINRA seeks.

Higher Compensation = Higher Investment Product Costs = Lower Returns for the Client.

The impact of additional differential compensation on the individual investor should not be underestimated. The compensation arrangements permitted under the BIC exemption, paid by product providers, include commissions (front-end sales loads), deferred contingent sales charges (DCSC), 12b-1 fees (approximately 80% of which are paid by mutual funds to brokers), payment for shelf space (typically paid by a fund’s investment adviser, out of a portion of the management fees charged to the fund, resulting in economic incentives to keep management fees high), brokerage commissions paid by funds to brokers (including the insidious payment of higher commissions as “soft dollar” compensation), and other forms of revenue-sharing arrangements.

These forms of compensation result in higher-cost investment products (as additional compensation paid by product providers to brokers and insurance agents must be recouped through higher-cost products). Yet, the academic research is compelling in support of the proposition that investment products with higher fees and costs result, in average, in lower returns for investors, especially over the long term.

67 C. Frederick Reish and Joseph C. Faucher, The Fiduciary Duty to Avoid Conflicts of Interest in Selecting Plan Service Providers (Feb. 2009).

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1) The Market as a” Zero-Sum Game.”

William F. Sharpe, in his Nobel laureate-winning paper, "The Arithmetic of Active Management," posited that the stock market was a “zero-sum game.” Following is an extended excerpt form this important paper:

If "active" and "passive" management styles are defined in sensible ways, it must be the case that

(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

Of course, certain definitions of the key terms are necessary. First a market must be selected -- the stocks in the S&P 500, for example, or a set of "small" stocks. Then each investor who holds securities from the market must be classified as either active or passive.

A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 per cent of the value of the securities in the market, a passive investor's portfolio will have 3 per cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market.

An active investor is one who is not passive. His or her portfolio will differ from that of the passive managers at some or all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change relatively frequently, such managers tend to trade fairly frequently -- hence the term "active."

Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights3. Each passive manager will obtain precisely the market return, before costs4. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.

This proves assertion number 1. Note that only simple principles of arithmetic were used in the process. To be sure, we have seriously belabored the obvious, but the ubiquity of statements such as those quoted earlier suggests that such labor is not in vain.

To prove assertion number 2, we need only rely on the fact that the costs of actively managing a given number of dollars will exceed those of passive management. Active managers must pay for more research and must pay more for trading. Security analysis (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders, specialists and other market-makers.

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

This proves assertion number 2. Once again, the proof is embarrassingly simple and uses only the most rudimentary notions of simple arithmetic.68

68 William F. Sharpe, The Arithmetic of Active Management, The Financial Analysts Journal (January/February 1991) (Vol. 47, No.1, pages 7-9).

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2) The Race Horse Analogy.

Another way of explaining the success of low-cost investment management is by focusing on the burden of fees and costs. Generally (but not always), passively managed funds have lower fees and costs than actively managed funds.

What is the consequence of high fees and costs? It requires outperformance simply to “break even,” and even more outperformance to “pull ahead.”

For example, imagine a racehorse in a race. In nearly all horse races the combined weight of the jockey, saddle and other tack is the same. Lower-weight jockeys must place weights in locations near the saddles to make it a fair race.

Now imagine that one racehorse is given an extra 25 pounds of weight, relative to all other race horses. Will that racehorse be unable to win in a relatively short race, lasting just 3/4ths of a mile? Not necessarily – that racehorse may have a favorable starting position, an excellent start, or indeed may have better performance. The likelihood that such racehorse will win is only marginally lower.

But now imagine that the races get longer, and longer. The added 25 pounds of weight begins to take its toll. It becomes harder and harder for the racehorse with the added weight to prevail in these longer races. Not impossible, but just much harder.

And so it is with the added fees and costs of active management. In such instance, the longer the race (i.e., the greater the number of years surveyed), the ongoing fees and costs take their toll, and the higher-fee stock mutual fund or ETF is unlikely to prevail, and often may struggle to even survive.

3) The Academic Research Prior to 2012.

Many investors are willing to pay higher fees with the hope of earning a higher return. However, the academic research prior to 2012 generally supports the conclusion that higher-fee, actively managed mutual funds are bested, on average, by low-cost passively managed funds:

• Sharpe (1966)69 and Jensen (1968)70 first showed that the average mutual fund underperformed relative to their indexes.

• “Eugene Fama, William Sharpe and Jack Treynor were some of the first researchers to note the apparent lack of skill by mutual fund managers. Economist Michael Jensen provided his view in 1967, that “mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance.”71

• Actively managed funds tend to underperform their benchmarks after adjusting for expenses, and the probability of earning a positive risk-adjusted return is inversely related to expense ratios. (Haslem et al., 2008).72

• Although a small number of early studies find that mutual funds having a common objective (e.g., growth) outperform passive benchmark portfolios, Elton, Gruber, and Blake (1996)73 argue that most of these studies would reach the opposite conclusion if survivorship bias and/or adjustments for risk were properly taken into account.

69 Sharpe, William F. 1966. Mutual fund performance. Journal of Business 39, 119-138. 70 Jensen, Michael C. 1968. The performance of mutual funds in the period 1945-1964. Journal of Finance 23, 389-416. 71 Ferri, R.A., Benke, A.C., 2013. A Case for Index Fund Portfolios. Technical Report. Available at: http://www.rickferri.com/WhitePaper.pdf. (Last retrieved July 1, 2015.) 72 Haslem, J.A., Baker, H.K., & Smith, D.M. (2008). Performance and characteristics of actively managed retail equity mutual funds with diverse expense ratios. Financial Services Review, 17, 49-68. 73 Elton, Edwin J., Martin J. Gruber, and Christopher R. Blake (1995), ‘Fundamental Economic Variables, Expected Returns, and Bond Fund Performance’, Journal of Finance, 50, 1229-1256.

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• Expense ratios and turnover are negatively correlated with return. (Carhart, 199774; Dellva & Olson, 199875; O’Neal, 2004).

• Loads are also negatively associated with fund performance (Carhart, 199776; Dellva & Olson, 199877).

• Load funds underperform no-load funds by an estimated 80 basis points (bps) per year (Carhart, 1997).78

• Transaction costs also decrease the potential benefit of active management (Carhart, 1997).79

• Opportunity costs exist due to cash holdings by funds. Hence, part of this underperformance is because actively managed mutual funds have higher liquidity needs for frequent purchases and redemptions. (O’Neal, 2004).

• Lower performing funds have higher fees, and high-quality funds do not charge comparatively higher fees. (Gil-Bazo & Ruiz-Verdu, 2008).80

• Mutual funds on average underperform benchmarks by approximately the amount of fees and expenses. (Fama and French, 2008).81

• After correcting for false discoveries in positive alpha, lucky mutual fund managers, most funds do not deliver positive alpha net expenses. Skilled managers are disappearing, finding skilled managers in 1996 but almost none by 2006. (Barras et. al., 2010).82

• Evidence collected over an extended period on the performance of (open-ended) mutual funds in the US (Jensen, 196883; Malkiel, 199584; Wermers et al., 2010)85 and unit trusts and open-ended investment companies (OEICs) in the UK (Blake and Timmermann, 199886; Lunde et al., 1999)87 has found that on average a fund manager cannot outperform the market benchmark and that any outperformance is more likely to be due to luck rather than skill.

74 Carhart, M.M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. 75 Dellva, W.L., & Olson, G.T. (1998). The relationship between mutual fund fees and expenses and their effects on performance. The Financial Review, 33, 85-104. 76 Carhart, M.M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. 77 Dellva, W.L., & Olson, G.T. (1998). The relationship between mutual fund fees and expenses and their effects on performance. The Financial Review, 33, 85-104. 78 Carhart, M.M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. 79 Carhart, M.M. (1997). On persistence in mutual fund performance. Journal of Finance, 52(1), 57-82. 80 Gil-Bazo, J., & Ruiz-Verdu, P. (2008). When cheaper is better: Fee determination in the market for equity mutual funds. Journal of Economic Behavior & Organization, 67, 871-885. 81 Fama, E.F., & French, K.R. (2008). Mutual fund performance. 82 Barras, L., O. Scaillet, and R. Wermers. 2010. False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas. Journal of Finance 65:179-216. 83 Jensen, M.C., 1968. The performance of mutual funds in the period 1945-1964. Journal of Finance 23, 389-416. 84 Malkiel, B.G., 1995. Returns from investing in equity mutual funds 1971 to 1991. Journal of Finance 50, 549–72. 85 Wermers, R., Barras, L., Scaillet, O., 2010. False discoveries in mutual fund peformance: measuring luck in estimated alphas. Journal of Finance 65, 179-216. 86 Blake, D., Timmermann, A., 1998. Mutual fund performance: evidence from the UK. European Finance Review 2, 57-77. 87 Lunde, A., Timmermann, A., Blake, D., 1999. The hazards of mutual fund underperformance: a Cox regression analysis. Journal of Empirical Finance 6, 121-52.

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• As a result of lower expenses, broad index funds tend to outperform actively managed funds with equivalent risk. Therefore, the best way for most investors to improve performance is to have a broad index fund with minimal costs (Malkiel, 2003).88

• As stated in a 2011 paper, using data on active and passive US domestic equity funds (the sample included a total of 13817 funds while the CRSP Mutual Fund Database) from 1963 to 2008, the authors observed: “Similar to others, we first show that fees are an important determinant of fund underperformance – that is, investors earn low returns on high fee funds, which indicates that investors are not rewarded through superior performance when purchasing ‘expensive’ funds. We explore a number of hypotheses to explain the dispersion in fees and find that none adequately explain the data. Most importantly, there is very little evidence that funds change their fees over time. In fact the most important determinant of a fund’s fee is the initial fee that it charges when it enters the market. There is little evidence that funds reduce their fees following entry by similar funds or that they raise their fees following large outflows as predicted by the strategic fee setting hypothesis. We also do not find evidence that higher fees are associated with proxies for higher service levels provided to investors. Overall, our findings provide little evidence that competitive pricing exists in the market for mutual funds.”89 (Emphasis added.)

• The finding that active mutual fund managers underperform their benchmark, net of fees, on average, is generally robust for other developed and emerging market equity managers (e.g., Otten and Bams 200290, Standard & Poor’s 200991).

4) More Recent Academic Research.

• Vidal et. al., 2015: High Mutual Fund Fees Predict Lower Returns. “[We confirm the negative relation between funds´ before fee performance and the fees they charge to investors. Second, we find that mutual fund fees are a significant return predictor for funds, fees are negatively associated with return predictability. These results are robust to several empirical models and alternative variables.” Marta Vidal, Javier Vidal-García, Hooi Hooi Lean, and Gazi Salah Uddin, The Relation between Fees and Return Predictability in the Mutual Fund Industry (Feb. 2015).

• Sheng-Ching Wu, 2014: High-Turnover Funds Have Inferior Performance. “[F]unds with higher portfolio turnovers exhibit inferior performance compared with funds having lower turnovers. Moreover, funds with poor performance exhibit higher portfolio turnover. The findings support the assumptions that active trading erodes performance….]92

• Blake, 2014 (UK): Average Fund Manager in UK Unable to Deliver Outperformance Using Either Selection or Market Timing. “[U]sing a new dataset on equity mutual funds [returns from January 1998–September 2008] in the UK … [we] find that: the average equity mutual fund manager is unable to deliver outperformance from stock selection or market timing, once allowance is made for fund manager fees and for a set of common risk factors that are known to influence returns; 95% of fund managers on the basis of the first bootstrap and almost all fund managers on the basis of the second bootstrap fail to outperform the zero-skill distribution net of fees; and both bootstraps show that there are a small group of ‘star’ fund managers who are able to generate superior performance (in excess of operating and

88 Malkiel, B.G. (2003). The efficient market hypothesis and its critics. Journal of Economic Perspectives, 17(1), 59-82. 89 Michael Cooper, Michael Halling and Michael Lemmon, Fee dispersion and persistence in the mutual fund industry (March 2011). 90 Otten, Roger, and Dennis Bams. 2002. European Mutual Fund Performance. European Financial Management 8, no. 1: 75–101. 91 Standard & Poor’s. 2009. Standard & Poor’s Indices versus Active Funds Scorecard, Midyear 2009. 92 Sheng-Ching Wu, Interaction between Mutual Fund Performance and Portfolio Turnover, Journal of Emerging Issues in Economics, Finance and Banking (JEIEFB) 2014 Vol: 3 Issue 4.

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trading costs), but they extract the whole of this superior performance for themselves via their fees, leaving nothing for investors.”93

• Ferri and Benke (2012). Using the “CRSP Survivor-Bias-Free US Mutual Fund Database … maintained by the Center for Research in Security Prices (CRSP®), an integral part of the University of Chicago Booth School of Business … In all portfolio tests, there was some benefit to using low-cost actively managed funds, but not as much as we expected, given the reported impact that fees have on individual fund performance. The probability of outperformance by the all index fund portfolios remained above 70% in all scenarios … We speculate that filtering actively managed funds may shift the probability curve closer to an all index fund portfolio as in the low-expense example, but we are not convinced that any filtering methodology will significantly alter the balance in favor of all actively managed funds. This may be an area for future research … A diversified portfolio holding only index funds in all asset classes is difficult to beat in the short-term and becomes more difficult to beat over time. An investor increases their probability of meeting their investment goals with a diversified all index fund portfolio held for the long term.”94

• SPIVA Scorecard (For Period Ending 12/31/2014). The S&P Dow Jones SPIVA® U.S. Scorecard is an extensive report that’s published semiannually at mid-year and year-end. SPIVA divides mutual fund return data into category tables covering different asset classes, styles, and time periods. There’s also a measure of survivorship bias and style drift for every category over each period. This accounts for funds that are no longer in existence or have had a change in investment style. The SPIVA® U.S. Scorecard Year-End 2014 has data going back 10 years. Excerpts from this report follow:

• “It is commonly believed that active management works best in inefficient environments, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA Scorecard. The majority of small-cap active managers have been consistently underperforming the benchmark over the full 10-year period as well as each rolling 5-year period, with data starting in 2002.”

• “Funds disappear at a meaningful rate. Over the past five years, nearly 24% of domestic equity funds, 24% of global and international equity funds, and 17% of fixed income funds have been merged or liquidated. This finding highlights the importance of addressing survivorship bias in mutual fund analysis.”95

Hence, to the extent investment advisers believe, under the BIC exemption, that they can recommend higher-cost products that pay their firm more than substantially similar low-cost investments, with no harm to the client, these investment advisers are not acting as expert advisers with the due care required of a fiduciary. The academic evidence is compelling that higher-cost products possess a heavy burden which, on average, negatively affects returns.

Divided Allegiance and Loyalties = Inability to Instill a True Fiduciary Culture Within a Firm.

I would also observe that some commentators have been stating, publicly, that suitability is “97% of the way there” to the fiduciary standard of conduct. This could not be further from the truth. Even with the relaxation of the sole interests standard under the BIC exemption to the best interests standard, as proposed, there remains a key distinction – i.e., whom does one represent? There is a huge gulf between representing a brokerage firm and/or product manufacturer, versus representing the client. The mindset of the adviser is completely different, as are the adviser’s loyalties.

93 David Blake et. al., New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods (2014). 94 Ferri, R.A., Benke, A.C., 2013. A Case for Index Fund Portfolios. Technical Report. Available at http://www.rickferri.com/WhitePaper.pdf. Last retrieved July 1, 2015. 95 SPIVA® U.S. Scorecard Year-End 2014, available at http://www.spindices.com/documents/spiva/spiva-us-year-end-2014.pdf.

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Moreover, SIFMA’s and FINRA’s recent attempt to re-define “best interests” standard as a different version of suitability, discussed in a previous section of this comment letter, clouds the issues even further and risks further confusion for both individual advisers and their clients.

While the BIC exemption proposed by the U.S. Department of Labor seeks to levelize the compensation to the individual adviser, the brokerage firm or insurance company is still permitted to possess higher, differential compensation for the sale of some products relative to other similar products which might be available. Yet, under a fiduciary standard, both the investment adviser and the firm possess broad fiduciary duties toward the client.

While the fiduciary duty of loyalty also extends from the investment adviser to the firm, when the fiduciary duty of loyalty to the client also exists the duties are ordered. In other words, the interests of the client are paramount, and the duty of loyalty owed by the investment adviser to the firm are subordinate to the duty of loyalty owed to the firm. The client’s best interest can, and should, remain paramount in the eyes of both the firm and the individual adviser.

Is it realistic to believe, as required under the BIC exemption, that firms will not seek to influence their advisers to sell investment products which result in higher compensation to the firm (but not to the adviser)? The long history of fines on various brokerage firms and other product providers who repeatedly push propriety products suggests that brokerage firms are unlikely to put forth pressure on advisors, whether explicit or by other means.96 It is easy to surmise that some brokerage firms view such fines as a “cost of doing business” and are likely to continue to put pressure, directly or indirectly, on their sales representatives, especially given the substantial economic incentives for the firms resulting from the sale of higher-cost products.

Modifications to the BIC Exemption are Recommended in Order to Increase Consumer Protections.

Given the DOL’s relaxation of the sole interests requirement and prohibited transaction rules under the BIC exemption, and the inherent difficulties in determining whether the fiduciary has been improperly motivated by his, her, or the firm’s own economic self-interest in recommending a higher-cost product over a lower-cost product, I suggest several modifications which might be undertaken to the BIC exemption in order to strengthen same, in the sections that follow.

B. EXPRESSLY PLACE THE BURDEN OF PROOF, TO DEMONSTRATE COMPLIANCE WITH

FIDUCIARY DUTIES, ON THE ADVISER AND HIS OR HER FIRM.

Given the extensive academic evidence in support of the proposition that higher-fee investment products result in lower-returns, and given the academic evidence in support of the proposition that the skill of an outperforming investment manager cannot be judged accurately until decades of performance history exist, the availability of the BIC exemption should be questioned, to the extent such exemption permits higher compensation for brokerage firms and insurance companies.

Differential compensation to the firm creates, as expressed above, a perverse economic incentive for the firm. While not a per se violation of a “best interests” fiduciary standard, given all of the academic evidence in support of the proposition that higher-fee investment products are highly likely to underperform lower-fee investment products with the same characteristics (e.g., the same asset class), the bar for receipt of higher compensation should be set high. Given the foregoing, the standard of due care should be expressly set forth, and the burden of proof for adherence to such standard should rest, in any legal (judicial or arbitration) proceedings, with the firm and the adviser.

96 See, e.g., Nathaniel Popper, “Wall Street Banks’ Mutual Funds Can Lag on Returns,” New York Times (April 12, 2015); also see Randall Smith, “Banks Face Tension Over Sales of In-House Products,” New York Times (September 8, 2014); also see Jed Horowitz, “Ex-Fidelity brokers claim sales pressure,” InvestmentNews (Apr 3, 2009).

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It must be noted that an ERISA fiduciary is held to the standard that a prudent person “acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims”, 29 U.S.C. §1104(a)(1)(B). As such, the investment adviser and his or her firm are effectively held to the standard of a “prudent expert.” The U.S. Department of Labor should make it clear that this “prudent expert” standard is applicable under the BIC exemption.

Furthermore, I recommend that the U.S. Department of Labor adopt, under the BIC exemption, that for any proceedings brought against the adviser and/or the firm, that the adviser and firm bear the burden of proof that both procedural and substantive due diligence were followed in the selection of the investment products.

While broker-dealer firms and insurance companies may complain that such shifting of the burden of proof is unwarranted, I believe sufficient academic evidence, as well as logical principles, exists to warrant the conclusion that the burden of proof should be shifted whenever differential compensation arrangements for the adviser or his or her firm exist.

The U.S. Department of Labor may desire to restrict the application of this shifted burden of proof to cases where differential compensation exists. It is relatively easy for firms to adopt a level-compensation methodology, thereby eschewing the perverse economic incentives that result from differential compensation arrangements. For example, in the release of the proposed BIC Exemption, Example 3 illustrates fee offsets. Of course, other requirements must still be met, including the “best interests” requirement within the Standards of Impartial Conduct, as well as the requirement that the compensation be reasonable, as well as the other requirements set forth in the exemption.

C. ESTABLISH THE STANDARD FOR THE ADMISSIBILITY OF EVIDENCE

In addition, I recommend that U.S. Department of Labor expressly state that Daubert standard of reliability (for the admission of expert testimony) is applicable to all proceedings (including but not limited to arbitration) in which either party seeks to address whether or not the fiduciary duties of the firm and/or the adviser has been met.

In this regard, purely qualitative assessments of investment products are inherently speculative and would not meet the requirement of the adviser and firm to act as a prudent expert.

Rather, the selection of the investment product, when differential compensation arrangements exist, should be undertaken on the basis of either extensive back-testing, or commonly accepted academic evidence, or both, under the Daubert standard.

D. HIGHLIGHT THE REQUIREMENTS OF THE FIDUCIARY DUTY OF LOYALTY, WHEN A

CONFLICT OF INTEREST IS PRESENT

The DOL should highlight what its “best interests” fiduciary standard requires when a conflict of interest is present. The receipt of additional compensation, beyond that which would be secured under the lowest-compensated available, where differential compensation is permitted, is perhaps the most egregious of the possible conflicts of interest. If, as the BIC Exemption permits, such differential compensation is to be permitted, then investment advisers and their firms should be cautioned, by the DOL, on the steps required to properly manage such a conflict of interest.

These steps include, when a conflict of interest is present:

First, disclosure of all material facts, which by definition include disclosure of any and all conflicts of interest, and which also includes disclosure of the existence of alternative products that are available, either through the investment adviser or in the marketplace, which would result in lower compensation to the fiduciary;

Second, that communication to the client must take place to ensure that the client understands the material facts, including the conflict of interest and its ramifications for the client, that such communication must be affirmative (not simply providing access to certain documents), and that the adviser has taken reasonable steps to ensure that the client has understood the material facts (including ramifications for the client);

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Third, that the client must provide informed consent to any conflict of interest that are not avoided, recognizing the fundamental principal that no client would ever consent to be harmed (and, as a best practice, it is wise to secure the client’s informed consent in writing);

Fourth, that even with informed consent, the proposed transaction must be and remain substantively fair to the client.

I further believe that the DOL should require that the foregoing methodology for properly managing conflicts of interest be included in each firm’s Code of Ethics, and that annual training around this all-important methodology be required for any individual adviser who relies upon the BIC exemption.

E. THE DOL SHOULD PROVIDE EXAMPLES OF UNREASONABLE COMPENSATION.

The issue of what constitutes “reasonable compensation” is a complex one. For example, over the past 15 years asset-based fees charged by brokers (under wrap accounts) and by registered investment advisers (when charging as a percentage of assets under management) have generally fallen. Further competition in the marketplace as more fiduciary advisers appear, as well as the continued application of technology and increased ease of receipt of investment advice through the internet, will likely continue to drive down asset-based fees. Hence, what is “reasonable” compensation in one era may not be “reasonable” in a future era.

Additionally, the scope of the services provided can be quite different. Many fiduciary investment advisors bundle a range of financial planning services, and even concierge services and tax return preparation, into asset-based fees charged for investment advisory services.

And, of course, the size of the account, in terms of dollar amounts, can affect the amount charged. It is quite common for larger accounts to not pay the same percentage fee as smaller accounts do, under asset-based compensation arrangements with fiduciary investment advisers, due to the economies of scale present.

Hence, while I do not believe that the U.S. Department of Labor should declare what constitutes “reasonable compensation,” it would be proper for the DOL to provide examples of unreasonable compensation.

For example, suppose a qualified retirement plan participant seeks to rollover a $500,000 401(k) account into an IRA account. The fiduciary adviser, under the BIC exemption, seeks to charge a commission. If a single family of mutual funds were to be recommended, due to breakpoints on the commissions paid on “A” class shares, falls to 2% for a $500,000 investment.97

However, no breakpoint discounts are typically provided on sales of many variable annuity products, nor for nearly all equity indexed annuities and fixed annuities. This provides an economic incentive to a broker-dealer firm and/or insurance company to recommend these products over mutual funds. These economic incentives are powerful, as evidenced by the substantial sales of these products despite their often-high fees and costs or other unfavorable characteristics (see discussion below).

It would be easy for the U.S. Department of Labor to illustrate that a 5% commission on a $500,000 variable annuity sale, in conjunction with a rollover into an IRA account, amounting to $25,000, would be “unreasonable.” (It should be noted that many variable annuities and other types of annuities pay much higher commissions than set forth in this example. I have encountered certain equity indexed annuities with surrender fees – an indication of the size of the commission paid – of 10% and higher, and even as high as 25% in one instance.)

While variable annuity products are complex, as discussed in a later section, the product-specific due diligence on investment products recommended by a firm and its advisers is often undertaken at the firm level, resulting in the

97 (Per Nov. 2014 prospectus, Growth Fund of America). See also Report of the Joint NASD/Industry Task Force on Breakpoints (07/22/03) at: http://www.finra.org/industry/mutual-fund-breakpoint-information-investors#sthash.8e9iAGG1.dpuf, stating: “sales loads on equity funds typically start anywhere from 4% to 5.75% for purchase amounts up to $49,999. Typically, the sales load percentage applied to purchase amounts between $50,000 and $99,999 may decline by 0.5% to 1.0%; similar discounts may exist for purchases at $100,000, $250,000 and $500,000. Generally, purchases of $1 million or more are not charged any sales load.”

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ability to spread out the costs of such due diligence over many, many clients. While time required to explain an variable annuity to a client in order to adhere to the obligation to ensure client understanding of material facts may involve several hours of more time for the investment adviser, this also would not justify an extraordinarily higher commission. Fiduciary advisors deserve to be compensated as expert professionals, and such professional-level compensation must be at all times reasonable.

As seen, one of the problems with commissions is that, when the amounts involved are large, the up-front compensation for the services provided can easily become unreasonable. For example, for the sale of a variable annuity product, in which product-specific and client-specific due diligence has been undertaken, the services might also include the preparation of an investment policy, the selection of funds within the annuity to meet the terms of that investment policy, and the completion of paperwork necessary to attend to the IRA rollover and the making of the investment. Yet, again, these services would clearly not justify the receipt of a $25,000 commission in the $500,000 IRA rollover example above.

Under a fiduciary standard, for compensation to be reasonable the timing for the receipt of such compensation should also be tied to when the professional services are rendered. Compensation should not be made for services to be rendered at some distant point in the future (such as years into the future, for continued rebalancing of the portfolio or other investment advice or services). This is because there is no assurance that the advisor-client relationship will continue, nor is there any assurance that a product once acquired will not be quickly disposed of by the client (due to changed circumstances of the client or other factors).

Hence, continuing the example above, a 5% commission paid upon the rollover of a $500,000 401(k) plan balance into an IRA variable annuity, or $25,000 commission, would result in unreasonable compensation. This is especially so since, in all likelihood, trailing fees are likely to be paid to the selling firm on an annual basis (typically from 0.05% to 0.80% annually), for at least several years, if not indefinitely.

Other examples can be provided by the DOL. I suggest that the DOL empanel an advisory board, consisting of fiduciary investment advisers, to develop further examples of unreasonable compensation. And, the caveat should be stated that just because the percentage amount of compensation provided under the BIC exemption does not arise to the level of the examples which are illustrated does not mean that the compensation is reasonable; each instance in which reasonableness of fees is challenged will require a fact-based analysis to compare the circumstances then existing, including the amount of services provided, to the compensation received.

It should also be noted that if the fiduciary investment adviser and/or his or her firm is receiving ongoing compensation, in the nature of 12b-1 fees or trails on annuity fees, then continued services should be provided. Otherwise, the receipt of additional compensation, without the provision of substantial advisory services, would result in unreasonable compensation.

For example, merely acting as custodian, and providing monthly statements as well as annual reports and semi-annual reports to the client, without more, would be insufficient to support a 0.25% annual compensation structure. There are fiduciary investment adviser firms that provide full investment management services, including portfolio rebalancing and tax loss harvesting, as well as ongoing due diligence of the investment products the clients hold (which ongoing due diligence is required of a fiduciary advisor through periodic re-examination of the products and competing products), for a 0.25% annual fee.98

Where the adviser-client relationship is terminated, but custodial services are still provided, it is far more reasonable in such instances for a flat annual account administration fee to be paid by the customer; any compensation received by the broker/custodian which exceeds a reasonable account administration flat fee should be rebated to the customer.

98 Because investment advisory fees are I.R.C. §212 expenses, a retirement account's ongoing investment advisory fee can be paid directly from the account without being treated as a taxable distribution, under Treasury Regulation 1.404(a)-3(d). See also PLR 201104061, addressing wrap account fees and investment advisory services in connection therewith.

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Some broker-dealer firms and insurance companies might take the position that during the first year of a client engagement much higher compensation is allowed under the BIC exemption, if financial planning services (such as tax planning, estate planning recommendations, reviews of property and casualty insurance, etc.) are undertaken. Certainly more work is required in the first year to structure and implement the investment portfolio for the client and to explain the investment strategy and the characteristics of the investment products. However, it must be remembered that we are dealing with IRA accounts and qualified retirement accounts under the BIC exemption. While fees for investment advice can be deducted (directly by the investment adviser, or indirectly via the product provider) from such accounts, there is no provision in the law that permits fees to be paid from those accounts for other services such as financial planning.99

As seen above, the receipt of commissions by fiduciary investment advisers raise a number of issues relating to unreasonable compensation. However, fiduciary advisers can shop for products that pay lower commissions, or as many variable annuity contracts now provide utilize fee structures that provide an ongoing investment advisory fee to the firm and its investment adviser rather than an up-front sales load or commission.

F. SUNSET THE BIC EXEMPTION AFTER FIVE YEARS.

I believe that the DOL has made a good faith effort to ensure clients continue to receive advice, in an investment advisory industry where half or more of investment advice is delivered in association with the sale of investment products, rather than in an advisory context where no substantial third-party compensation is received by the investment adviser.

However, given the existence of non-level compensation arrangements under the BIC exemption, economic incentives exist that will result in non-adherence to all the requirements of the exemption. And efforts will likely be made, such as SIFMA’s “best interests” proposal recently advanced, to re-define the scope of fiduciary duties as far lesser obligations.

In a July 14, 2015 article, “Fees vs. Commissions: Why An Old Debate Is New Again,” appearing at AdvisorPerspectives, long-time and highly respected industry commentator Bob Veres observed:

[Recent changes in the securities industry] are forcing us to revisit the ancient fees versus commissions debate. New data and new circumstances have changed the debate in powerful ways.

How? Let’s start with the middle market. Historically, defenders of commissions have persistently asserted that it’s impossible to deliver investment advice, profitably, to middle-market consumers if you only charge fees for your services …

If you sell a small [e.g., approximately $5,000] annuity and pocket a $300 commission, how is that more efficient than receiving a $300 check from the client for your recommendation of comparable mutual funds or ETFs?

Meanwhile, advisors all around the country have been refuting this argument for decades through their normal business practices. The Garrett Planning Network and Alliance of Comprehensive Advisors have been working with non-wealthy clients for years on a fee basis. More recently, the XY Planning Network of advisors has been charging subscription fees to younger Gen X/Y clients who have far more credit card debt than investible assets. This, at least, suggests that fee compensation is compatible with the middle market and even with those who have assets at all.

99 See Michael Kitces, “Deducting Financial Planning And Retainer Fees, And The (Tax) Problem With Bundled AUM Fees,” Nerd’s Eye View (blog), May 20, 2015, stating: “While IRAs are allowed to pay their own expenses – thus why an investment management fee for an IRA can be deducted directly from that IRA without a taxable event – and doing so effectively makes the management fee pre-tax (since it was deducted directly from a pre-tax account), an IRA should only pay for its own expenses. When an IRA’s assets are used for other non-IRA expenses, it is deemed to be a distribution from the account. And when IRA assets are used in particular to pay personal expenses on behalf of a ‘disqualified person’ (including the IRA owner themselves), it may be treated as a prohibited transaction under IRC Section 408(e)(2) and IRC Section 4975, which causes the entire account to lose its tax-qualified status and be deemed as distributed at the beginning of the tax year. Thus, using IRA assets to pay the personal financial planning expenses of the IRA owner would be a deemed distribution of that dollar amount at best, and at worst a prohibited transaction triggering distribution of the entire account.” Available at https://www.kitces.com/blog/deducting-financial-planning-and-retainer-fees-and-the-tax-problem-with-bundled-aum-fees/.

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But even granting the validity that sales is somehow more efficient than fee-compensated advice when both are delivered face-to-face, we now have a plethora of online advice platforms that are willing to deliver relatively sophisticated investment services to non-wealthy customers on an AUM- (that is, pure fee) basis. Middle market consumers can get investment services from Betterment, Wealthfront or one of the competitors that are sprouting up like mushrooms after a warm summer rain.

This is a game-changer. You can no longer argue that someone has to charge commissions in order to provide services to the vast majority of Americans …

Today, it’s possible to look back over 35 years and see that there has, indeed, been a visible migration among advisors and planners from commissions to fees … The number of fee-only planners has grown from fewer than 100 during the tax-shelter limited-partnership days to roughly a fifth of all advisors registered with the SEC, according to the latest data compiled by Tiburon Associates.

Many dually-registered reps are now primarily compensated by an AUM revenue model, and every independent broker-dealer has its own asset management platform to serve them. According to the various broker-dealer surveys in the industry magazines, fees represent the fastest-growing segment of broker-dealer revenues, virtually across the board …

The point here is that it is finally possible to identify a clear trend from commissions to fees in the profession. Before, those on the commission side of the debate might have challenged the idea that commissions are on the decline as a component of advisor compensation, and argued that fees are not the future of the profession. They can’t make that argument any more …

[There still exist] advisors who are happily getting paid to recommend investment and insurance solutions that, if those products stopped paying commissions, they would never recommend as the optimal solution to their clients.

That is the pernicious effect that sales commissions are having on our profession: the quality gap between what consumers are getting when they pay commissions, and what they would get if they pay for advice directly …

Can you name any other profession that routinely allows its practitioners to accept sales commissions for the sales of products? 100

As Bob Veres alludes to, the provision of investment advice has been in a state of transition for several decades. In just the past decade the transition away from product sales to fiduciary relationships in which fees are paid directly by the client has accelerated dramatically. New deployments of technology have aided advisors serve the middle class, and the increased competition among fee-only investment advisers continues to drive down the level of compensation. All of these ARE is an extremely important, and powerful, developmentS that better secure the retirement security of Americans.

The DOL’s new proposed definition of “fiduciary” will further accelerate the already rapid change away from commissions and other third-party compensation to client-paid, professional compensation arrangements.

However, the BIC exemption, which as stated above permits differential compensation and hence provides an economic incentive to maintain product sales, and the potential under pressure from the industry for re-definition of important terms utilized in the BIC exemptions’ requirements, could slow down this evolutionary process.

While the BIC exemption is necessary at the present time in order to not disrupt the availability of advice to Americans, and while the BIC exemption is workable in its current form, the U.S. Department of Labor should not make the BIC exemption permanent. With sufficient advance notice, product providers can and will change the structures of their products in order to eliminate the many conflicts of interest that firms and their representatives might otherwise possess, and both firms and advisors can adjust to these changes.

100 Available at http://www.advisorperspectives.com/newsletters15/29-fees-vs-commissions-why-an-old-debate-is-new-again.php.

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Additionally, certain product-based compensation arrangements, such as 12b-1 fees, possess troubling aspects. For one, such fees are often (if not nearly always) received for services which are advisory in nature; as a result 12b-1 fees are “investment adviser fees in drag” and are subject to legal challenge as non-permitted “special compensation” under the broker-dealer exception to the definition of investment adviser found in the Investment Advisers Act of 1940.

In addition, 12b-1 fees continue to apply even if the adviser-client relationship is terminated. Moreover, such fees are incapable of negotiation in many cases, and it could be argued that such fees act as an impermissible restraint of trade. FINRA’s cap on 12b-1 fees could be seen as a de facto industry agreement on fees to be paid; in other fiduciary contexts, such as fees established by statute for certain legal services, such laws and/or regulations have been overturned as unreasonable restraints of trade.

Consumer confusion abounds with regard to 12b-1 fees. And, 12b-1 fees no longer serve their original purpose.

Hence, necessary evolution is required in the product manufacturing industry to eliminate 12b-1 fees. The SEC has recently stated that it is again studying the issue of 12b-1 fees.

In summary, many concerns exist that the BIC exemption will wind up being diminished by industry pressure to interpret terms, such as “best interests,” in some new manner. In addition, the receipt of differential compensation leads to perverse economic incentives. Accordingly, I STRONGLY recommend that the U.S. Department of Labor automatically sunset the BIC exemption, in order that ERISA’s sole interests standard and prohibited transaction rules are then applied (barring the application of some other existing prohibited transaction exemption), on December 31st of a year which is 5-6 years following the effective date of any final rule.

This 5-6 year period will permit an adequate period of time for both the investment product manufacturers, broker-dealer firms, and individual advisors to adjust their compensation arrangements in order that ERISA’s sole interests requirement can be applied.

As stated above, the fiduciary standard acts as a restraint upon greed. There is no need for the government to permanently modify ERISA’s “sole interests” fiduciary standard of conduct in order to fit the existing business models of broker-dealer firms and insurance companies. However, the BIC exemption can be justified as a temporary transitional standard for those advisers unable at the present time due to the numerous often-hidden flows of revenue from product providers to product sellers.

In no event, however, should the BIC exemption become permanent, as the economic incentives for differential compensation provided by the BIC exemption, even with the changes recommended above, will eventually lead to the BIC exemption becoming the rule, and not the exception. Hence, an automatic sunset of the BIC exemption is essential.

VIII. ON THE SALE OF VARIABLE ANNUITIES UNDER THE BIC EXEMPTION.

As a professor teaching undergraduate classes in both insurance and investments, I have often reviewed variable annuity contracts with my students. Different contracts often use different terminology for the same concepts. The array of available riders and choices inside a variable annuity also contribute to their complexity. As a result, much time is spent analyzing different variable annuity contracts, in order to secure for the students an appropriate foundation for the analyses they will undertake in the future.

What I have also seen is the sale of variable annuities by many agents/registered representatives who fail to understand the product itself – its fees, costs, potential benefits, and limitations. For example, a common broker-sold variable annuity contract I encounter contains a guaranteed minimum withdrawal benefit rider. With this rider, the annual expenses of the annuity range from 3% to 4%, and perhaps higher. This is broken down as follows, for the series of the variable annuity that does not possess an up-front and substantial commission (paid via a deferred contingent sales charge, or DCSC). A product that lacks a DCSC is more appropriate for a fiduciary advisor, given the requirement of reasonable compensation):

1.80% Annual mortality & expense charges (decreases to 1.3% after 9 years)

0.15% Annual administration charge

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1.10% Annual expense percentage for the spousal highest daily lifetime income rider, a very popular feature when this annuity is sold. Since this charge is assessed on the greater of the actual account value or the “protected withdrawal value,” when the actual account value falls below the protected withdrawal value the effective annual expense percentage would be greater than 1.1%. Additionally, the insurance company can raise this annual charge to as high as 2.0% a year.

0.79% to 1.59% The annual expense ratios for the funds are: 0.79%, 0.85%, 0.87%, 0.88%, 0.92%, 0.91%, 0.92%, 0.94%, 0.94%, 0.95%, 0.99% 1.02%, 1.03%, 1.05%, 1.07%, 1.11%, 1.12%, 1.14%, 1.21%, 1.46%, and 1.59%. These fund annual expense ratios assume the spousal highest daily lifetime income rider is chosen, as noted above. When the rider is chosen, the fund selection is limited by the terms of the contract; 10% must be allocated to the fixed income account and the remaining 90% must be allocated to the insurance company’s selected mutual funds, rather than the much larger universe of funds permitted under the annuity contract if no lifetime income rider is chosen. The interest rate on the fixed income account is determined by the insurance company each year, based upon several factors, including the returns of the insurance company’s general account. Each optional living benefit also requires the contract owner’s participation in a predetermined mathematical formula that may transfer the account value between the VA’s permitted sub-accounts and a proprietary bond fund. It is assumed that the insurance company generates revenue for itself on its fixed income account equal to the lowest annual expense ratio of the available sub-accounts, for purposes of this analysis. Most of these funds are “funds of funds” and include balanced funds (with equity and fixed income allocations) or tactical asset allocation strategies.

0.2% Each mutual fund (i.e., sub-account) pays brokerage commissions (for certain stock trades) and principal mark-ups and mark-downs for bond trades. In addition, stock trades incur other transaction costs in the form of bid-ask spreads, market impact, and opportunity costs due to delayed or cancelled trades. In addition, fees are paid to an affiliate of the fund out of a portion of any securities lending revenue. In addition, cash held by a fund results in a different kind of opportunity cost. There is no method to estimate the impact of these “hidden” fees and charges and costs, from publicly available information. However, it is likely that these fees and charges and costs vary from a low of perhaps 0.2% to a high of 1.0% (or even higher). For purposes of this analysis, it is assumed that these fees and charges amount to only 0.2%.

---- Some states and some municipalities charge premium taxes or similar taxes on annuities. The amount of tax will vary from jurisdiction to jurisdiction and is subject to change. The current highest charge (Nevada) is 3.5% of the premiums paid. Often this premium tax, if assessed, is deducted by the insurance company from the premium payment. However, for purposes of this analysis it is assumed that there is no premium tax assessed.

Given the limited asset allocation choices that are mandated by the insurance company if the spousal lifetime benefit rider is chosen, it is likely that the gross returns (before any fees and expenses) within the variable annuity would average 7.5% annually, over the very long term, based upon long-term historical average returns of the asset classes included in such funds. Yet, after deduction of fees of 4% (or greater) (decreased to 3.5% or greater after the first 9 years), the net return to the investor is likely to be only 3.5% over the long term, and perhaps even less. However, for the first ten years of the annuity contract, the annuity contract offers a “roll-up rate” of 5% (compounded) for the “protected value” – the value if annuitization takes place. However, this 5% roll-up rate is terminated if lifetime annuitization takes place during the first ten years.

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While the annuity offers a “guarantee” in the sense that, if lifetime annuitization is elected at a future date, the highest daily value of the annuity will be used when applying the annuitization rate, it is obvious that, given the high fees and costs of this variable annuity it is highly unlikely that the variable annuity will reach a high principal value over the long term. There simply exist too much extraction of rents – fees and costs – for the sea encompassed within this variable annuity to ever reach a good “high water mark” in most long-term market environments. In fact, over a period of 20 years or longer, there is only a very small probability that the variable annuity value, against which lifetime annuitization is based, will exceed the rates of return on a balanced portfolio of low-cost stock and bond funds (even assuming investment advisory fees and fund fees for such a balanced portfolio totaling 1% a year). Hence, for longer-term investors, the “guarantee” is often illusory.

Additionally, the annuitization rate offered by the insurance company is quite low, compared to the rates for immediate fixed income annuities from insurance companies with excellent financial strength on the marketplace today. This is true even though annuitization rates offered today are quite low, relative to those historically offered, due to the low interest rate environment of today. Here’s a comparison:

Age of Younger Spouse

The Annuity Reviewed Above: Spousal (100%) Lifetime

Annuitization Rates (Per Prospectus Supplement

dated July 15, 2015)

Comparable Single Premium Immediate Annuities:

Spousal (100%) Lifetime Annuitization Rate (per January 2015 survey by www.annuityshopper.com)

ACGA Suggested Charitable Gift Annuity Rates –

Spousal (100%) (as of April 2015)

60 3.4% 4.0% to 4.4% 3.9% to 4.2% (depending on age of

older spouse)

65 4.4% 4.3% to 4.8% 4.2% to 4.5%

70 4.4% 5.0% to 5.4% 4.6% to 4.9%

75 4.4% 5.9% to 6.3% 5.0% to 5.6%

As seen in the table above, the client would typically be far better off shopping for a single premium immediate annuity in the marketplace. Even purchasing a charitable gift annuity, in which the American Council on Gift Annuities targets a residuum (the amount realized by the charity upon termination of an annuity) of 50% of the original contribution for the gift annuity, would usually be better. And, as noted above, if annuitization is to occur in the future, it is highly likely that today’s extremely low interest rate environment would moderate, resulting in even higher annuitization rates at that time.

Given this substantial limitations of this variable annuity product, it is difficult to see how any fiduciary investment adviser who, after performing due diligence on variable annuities such as this one, would recommend it to a client with a long-term investment time horizon. Other investment strategies and solutions exist which are highly likely to generate outcomes much more favorable to the client over the client’s lifetime.

Even more rare is the client who understands the variable annuity he or she has purchased. In fact, for broker-sold variable annuities, in all my years of practice I never met a client who, having already been sold a variable annuity with these or similar features, came close to fully understanding the features of the variable annuity, and the often-illusory nature of the “guarantee” provided. Most clients assume that the guaranteed value will be available if the full amount is withdrawn in full; hardly any clients realize that the variable annuity must be annuitized, over lifetime, at a relatively low annuitization rate. And none of the clients I met understood the high level of fees and charges assessed against the annuity account value (or, worse yet, the higher protected value, as to some of the percentage fees charged).

It is the obligation of the fiduciary investment adviser to understand the product he or she is selling, and to fully explain all material aspects of the contract to the client. Hence, I suggest that the U.S. Department of Labor, in its issuing release, remind investment advisers of their fiduciary obligation of due care when dealing with variable annuities. The investment adviser should be able to comprehend, and be able to effectively explain to the client in a

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manner which ensures client understanding, many concepts relating to variable annuity products, including but not limited to the following:

1) there is no tax advantage for holding a variable annuity in a traditional IRA, Roth IRA, 401(k), or other qualified retirement plan;

2) the client should normally not purchase a variable annuity with funds that the client will likely need for current (or near-term) expenses;

3) that withdrawals from the annuity before the client attains age 59-1/2 may be subject to a 10% federal penalty tax [and ways to avoid such penalty, such as 72(t) elections, rollovers to qualified retirement plans possessing age 55 withdrawal rights without penalty, etc.];

4) the computational methods utilized in determining any guaranteed amounts which might be available either upon the death of the annuitant(s) or upon annuitization, and the nature of each guarantee and any limitations on when the guaranteed amounts are secured;

5) the annuity’s various fees and expenses, including but not limited to annual mortality and expense charges (and whether fees/costs vary), annual administration expenses, contingent deferred sales charges, expenses associated with any riders (enhanced death benefit, GMWB, etc.) provided under the contract, the annual expenses of the variable annuity’s sub-accounts, and their composition, including management fees, administration fees, and 12b-1 fees; the brokerage commissions paid (due to transactions occurring within the funds) by any subaccounts recommended to the client, as a percentage of the average net asset value of the subaccount, and whether such brokerage commissions are paid to the insurance company or its affiliates and/or to any firm associated with the investment adviser or affiliates of such firm, and whether such brokerage commissions include any soft dollar compensation; securities lending revenue obtained by such subaccount and the extent to which the gross security lending revenue is shared with the investment adviser or any other service provider and whether such service providers are affiliated with the insurance company or the investment adviser’s firm or any of their affiliates; additional transaction and opportunity costs resulting from securities trading within the fund, the subaccount’s annual turnover rate (computed as the average of sales and purchases within the fund divided by average net asset value of the fund); the percentage of cash holdings of the subaccount over time and the likely resulting opportunity costs arising therefrom;

6) the financial strength of the insurance company and the importance of such financial strength, especially during a period of annuization;

7) the rate of return of the variable annuity’s fixed account, the exposure of fixed account assets to the claims of the general creditors of an insurance company upon default; whether state guaranty funds likely protect against a default by the insurance company and if so to which extent; whether different annuities should be purchased – from different companies – to better protect against the risks of insurance company default; the likelihood of insurance company default on a historical basis given the starting financial strength of the company as measured by the various rating agencies; the Comdex score for the insurance company;

8) the impact of fees and costs of the variable annuity contract on the account value of the variable annuity, and the availability of and any limitations on the various guarantees offered by the insurance company either as a core of the policy or as a rider;

9) an estimate of the likely long-term rate of return of the variable annuity contract, as structured by the investment adviser, versus the likely long-term rate of return of alternative investment strategies and alternate products (including alternate variable annuity products), and an estimate of the likelihood that the protected value of the annuity will be higher than the returns of non-guaranteed products, over various time periods;

10) the annuitization rates offered under the annuity contract, whether those rates are guaranteed, how these rates may change over time, how these rates compare to similar single premium lifetime annuity rates in

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the marketplace, and the negative or positive effective rate of return the client(s) will receive during the annuitization period assuming death of the client(s) occur at various ages.

11) any options existing for spousal lifetime annuitization and/or term certain, or any combination thereof, and how these options should be considered given the medical history of the clients and their family members;

12) whether, during annuitization, the client would be better served by annuitization of a portion of the client’s portfolio, whether an annual inflation increase would better serve the client in terms of providing needed lifetime income, whether there exist optimal ages or times (from the date of purchase of the annuity contract) to consider undertaking annuitization, and whether a ladder of annuitized investments undertaken over time, at various ages, would better serve the client;

13) for nonqualified annuities: the taxation of withdrawals from the annuity contact, the lack of long-term capital gain treatment, the lack of stepped-up basis upon the death of the account holder(s), and the withdrawals mandated by heirs of the annuitant(s) and the combined estate tax / federal income tax / state income tax consequences of income in respect of a decedent; and how withdrawals from such nonqualified annuity contract might be undertaken to take advantage of any lower marginal income tax brackets (both during lifetime of the annuitants, and as to beneficiaries); and the impact of withdrawals on related income tax planning issues for a client including taxation of social security retirement benefits, the amount of Medicare premiums paid, and alternative minimum tax computations; and the taxation of principle and income upon annuitization of the nonqualified variable annuity contract; the lack of foreign tax credit availability to the client when foreign stock funds are utilized as subaccounts of the variable annuity;

14) the impact of any cash withdrawals upon any guarantees or features of the variable annuity contract;

15) the various risks attendant to the investments in any fixed income account or the subaccounts in the variable annuity; and

16) the understanding that higher cost investments nearly always result in lower returns for investors over the long term, relative to lower cost investments that are substantially similar in composition and risk exposures.

IX. ON THE SALE OF EQUITY INDEXED ANNUITIES UNDER THE BIC EXEMPTION

I recommend that the prohibited transaction relief for the receipt of sales commissions has been available under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary” insurance advisors of equity indexed annuities (EIAs) to ERISA plans and to IRAs be repealed, not modified. I further recommend that the BIC exemption apply to the sale of equity indexed annuities, but that the BIC exemption be modified to reflect that disclosure of the costs of the EIA cannot be undertaken with any accuracy, and instead that the compensation to the fiduciary investment adviser be disclosed with particularity. This recommendation is undertaken as a means of consolidating the regulatory regime and providing further guidance and instruction to insurance agents over time (as, no doubt, cases and notices will be published regarding the BIC exemption over time). Additionally, while the insurance industry will argue that equity indexed annuities are “insurance products” (in the sense that they are not regulated as securities), from the consumer perspective such equity indexed annuities are an “investment” – similar to the consumer perception that a bank-issued certificate of deposit is also an investment.

In addition, equity-indexed annuities (EIAs), also known as fixed indexed annuities, are another product that, in my experience, many investment advisers and the clients who purchase them do not fully comprehend.

The fiduciary investment adviser should be able to understand EIAs, and be able to effectively explain the many features of these products to the adviser’s client. This includes, but is not limited to, the following:

We have observed that most purchasers of EIAs gain little understanding of many of the material facts surrounding these products. A fiduciary advisor must not only disclosure these material facts, but must also ensure client understanding of them. These include:

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1) That the EIA imposes a penalty, similar to a surrender charge, for early withdrawals from the annuity, whether any portion of the funds can be withdrawn from the EIA each year without a penalty, the amount of the surrender charge and when it disappears, and that withdrawals from the EIA are best undertaken at particular points during each contract year.

2) That investments in an EIA are not meant for funds which are likely to be utilized by the client to address short-term financial needs.

3) That the dollar value of the annuity shown on the client’s statement is not the “market value” of the annuity as it relates to the client, but rather the “surrender value” (unless these are separately stated and appropriately marked on each statement).

4) That the amount of the credit provided to the client during any period for index returns during each period does not include dividends which would have been received by an index fund tied to that index and which would otherwise have been be reinvested in that index; how the dividend rates for the index have fluctuated over time; the current dividend rate for the index; and if in the future dividend payout rates are higher due to changes in U.S. federal income tax policy, or due to other factors (such as shareholder demand for payment of dividends, versus retention thereof), the percentage of index total returns the client receives could be significantly impaired by the fact of the exclusion of dividends.

5) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by a cap on the index returns; that this cap limits the amount of interest credited to the client’s annuity contract; the current cap and the cap in recent years; whether the insurance company has lowered the cap since the inception of the annuity contract (for any purchaser thereof) and when; and that the insurance company reserves the right to lower such caps, which would negatively affect the client’s returns;

6) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by the participation rate; the current level of the participation rate; the past levels of the participation rate; and that the insurance company reserves the right to lower the participation rate, which would negatively affect the client’s returns.

7) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by market value adjustments, which should be able to be described with particularity, and that such market value adjustments may negatively affect the client’s returns;

8) That the amount of the credit provided to the client during any period in which the client elects to tie returns to those of an index is further limited by is further limited by the imposition (annually) of “administrative charges,” whether the insurance company reserves the right to increase the administrative charges; whether such administrative returns are capped; the current level and historical level of the administrative charges, and that such administrative charges negatively impact the client’s returns;

9) That the funds placed with the insurance company are part of the insurer’s general account and subject to the general claims of the insurance company’s creditors; unlike a mutual fund or variable annuity sub-account your annuity funds are not segregated and therefore the client’s funds are not protected in the event of insolvency of the insurance company; the financial strength ratings of the insurance company including its Comdex score; whether any state guaranty funds exist to safeguard investors and the extent of such guarantees; whether such state guaranty funds would apply should the client’s state of residence be changed; and the fact that state guaranty funds exist at this discretion of the states’ legislatures.

10) The default rate, over the past 10, 20, 30, 40 and 50 years or more, of insurance companies, based upon their initial financial strength rating;

11) That various tax proposals exist which, if they were to be enacted, could adversely affect the commercial viability of many life insurance and annuity products, which in turn could significantly impair the ability of

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many insurance companies to meet their obligations to their present insurance policy holders and annuity contract owners;

12) That for nonqualified EIAs any withdrawals from the annuity of gains within the annuity will be taxed at the client’s ordinary income tax rates, that gains are distributed prior to the return of principal (unless annuitization occurs); that the client will not receive the more favorable long-term capital gain treatment that would have been available through a tax-efficient or tax-managed stock mutual fund; and that no stepped-up basis exists upon the death of the annuitant (and the consequences of same, to heirs);

13) That for EIAs held in IRA accounts, tax deferral is already provided by the IRA account possessed, and hence is not a benefit of this annuity contract; similarly, for EIAs held in Roth IRA accounts, tax-free growth of principal is a feature of the account and not of the annuity contract.

X. ON THE SALE OF FIXED ANNUITIES UNDER THE BIC EXEMPTION

Over 20 years ago I was approached by a client who had his entire qualified retirement plan balance (approximately $400,000) rolled over into a fixed tax-deferred IRA annuity. The client requested my opinion regarding the safety of the investment. After conducting an investigation into the financial strength of the insurance company that issued the fixed annuity, I determined that the fixed annuity was issued by a very low-rated insurance company, that state guarantees at the time were insufficient to protect the client’s investment in the annuity contract, and that the client should withdraw a significant portion of the annuity (and incur a significant surrender fee, then 9% of the amount withdrawn) in order to better safeguard the client’s hard-earned retirement savings.

Unfortunately, lower-rated insurance companies often offer higher commissions to insurance agents to sell their insurance products, including annuities. As a result, the insurance agent often possesses an economic incentive to recommend not among the best of the fixed annuity products available, but among the worst. The application of fiduciary duties, along with other measures I recommend herein, under the BIC exemption, should go a long way to counter these perverse economic incentives.

I recommend that the prohibited transaction relief for the receipt of sales commissions has been available under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary” insurance advisors of fixed insurance products to ERISA plans and to IRAs be repealed, not modified. I further recommend that the BIC exemption apply to the sale of fixed annuities, but that the BIC exemption be modified to reflect that disclosure of the costs of the fixed annuity cannot be undertaken with any accuracy, and instead that the compensation to the fiduciary investment adviser be disclosed with particularity. This recommendation is undertaken as a means of consolidating the regulatory regime and providing further guidance and instruction to insurance agents over time (as, no doubt, cases and notices will be published regarding the BIC exemption over time). Additionally, while the insurance industry will argue that fixed annuities are merely “insurance products” (in the sense that they are not regulated as securities), from the consumer perspective such fixed annuities are an “investment” – similar to the consumer perception that a bank-issued certificate of deposit is also an investment.

Similar to EIAs above, the investment adviser should be aware of the risks of insurance company default, the financial strength ratings of the insurance company, the presence of state guaranty funds and the limits and effect of a client’s change of residence, and more. In addition, the investment adviser should be able to compare the rate of return of the fixed annuity to other fixed income vehicles, weigh the varying risks and returns of different forms of fixed income vehicles, and determine whether diversification of fixed annuities among highly rated insurance companies as a best practice given the client’s situation.

In addition, the fiduciary investment adviser should be able to examine, and to explain to the client: the benefits of a fixed annuity with an annual CPI increase during annuitization; the impact of inflation upon the client’s purchasing power; whether laddering of annuities over time presents a valid strategy; the liquidity (or lack of liquidity) characteristics of the annuity either before or after annuitization; and the effective rate of return for the client of an product annuitized over one’s lifetime given the client’s attainment of certain ages.

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XI. ON THE REGULATION OF IRA ROLLOVERS BY INDEPENDENT ADVISERS

When undertaking a rollover from an ERISA plan to an IRA account, a great deal of care must be undertaken. This requires any fiduciary adviser to possess a great deal of knowledge of the many factors and tax rules which come into play, in order to ensure maximum benefits to the individual client. In addition, a rollover into an individual IRA account often involves a much higher level of service provided to the individual investor, during and following the rollover process; as a result of this differing level of service and the lack of economies of scale which are often present in the defined contribution space, the compensation for individual accounts is higher. Accordingly, this results in a potential prohibited transaction, even for fee-only independent registered investment advisers.

Any fiduciary adviser providing advice on an IRA rollover should fully understand, and be able to apply, the often-complex tax and other considerations that may affect the decision, including but not limited to:

(1) the availability under many qualified retirement plans (QRPs) to undertake distributions commencing at age 55, rather than the age 59½ requirement imposed upon IRAs;

(2) the existence and best methods for undertaking a series of substantially equal periodic payments from traditional IRA accounts using the 72(t) election;

(3) the 2-year-from-inception restriction on distributions from SIMPLE IRA accounts;

(4) the ability to distribute appreciated employer stock from certain QRPs and receive long-term capital gain treatment upon its later sale, under the technique commonly referred to as “net unrealized appreciation”;

(5) the most tax-efficient manner to design, implement and manage a client’s entire portfolio, which might consist of QRPs, traditional IRAs, Roth IRAs, nonqualified annuities, life insurance cash values, taxable accounts, 529 college savings plans accounts, HSA accounts, and other types of accounts, generally, in order to best secure for the client the likely attainment of the client’s objectives;

(6) the ability to undertake due diligence on the investment options within a QRP account, including but not limited to the potential availability of guaranteed investment accounts (and the risks and characteristics of same, including the reduced exposure to interest rate risk which might be present);

(7) the restrictions which exist on the availability of foreign tax credits and/or deductions for foreign stock funds held in certain types of accounts;

(8) the best manner to minimize future potential income tax liability for both the clients and the client’s potential heirs, including the role of stepped-up basis;

(9) the availability of tax-managed or tax-efficient stock mutual funds in taxable accounts;

(10) the marginal rates of tax (federal, state and local) which might be imposed upon ordinary income and long-term capital gain income, and qualified dividend income, both in the current year and in future years;

(11) the ways to avoid realization of short-term capital gains and long-term capital gains;

(12) the harvesting of losses in accounts and how such losses may offset either various types of capital gains or ordinary income (up to certain annual limits);

(13) whether Roth IRA conversions should be considered, and if so when and to what extent, whether separate Roth IRA accounts might be established during conversions for different investment assets, and whether re-characterizations might take place thereafter;

(14) whether distributions might be undertaken to generate additional ordinary income, in order to mitigate the effect in any year of the alternative minimum tax;

(15) the increased amount of premiums for Medicare Part A which might result should the client’s/clients’ modified adjusted gross income exceed certain limits;

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(16) the effect of additional income resulting from QRP or IRA distributions, or from other investment-related income, on the taxation of social security retirement benefits;

(17) the interplay between the timing of taking social security retirement benefits, income tax itemized vs. standard deduction strategies, the receipt of various forms of income, and the taking of QRP or IRA distributions, given the various marginal income tax rates the client is likely to possess, then and in the future, for both federal and state tax purposes;

(18) the ability to take investment advisory fees from certain types of accounts, the best methods to allocate fees and pay them from various types of accounts, the potential for deductibility of fees when paid from certain types of accounts, and avoidance of prohibited transactions which might otherwise result if fees for non-investment advisory services are incorrectly paid from QRP or IRA accounts;

(19) the ability to delay QRP distributions past age 70½ in certain circumstances, for certain clients;

(20) the availability of lifetime annuitization options for a portion of any QRP or IRA, both inside the QRP and in a rollover IRA, including an evaluation of the single life, spousal (with and without reduced benefits to the survivor), term certain, and combinations of the foregoing, and including further an evaluation of the possible use of CPI adjustments in the annuity contract to keep pace with increased spending needs, and including further the possible use of a staggered approach to annuitization, and including further the available of deferred annuities with payouts commencing at later ages, and including further the risks and return characteristics of certain annuities, the costs and fees associated with same, the possible applicability of premium taxes, the various riders which might be employed and their costs and benefits and limitations; and

(21) the best method to ensure asset protection of the rollover IRA, such as by segregating it from contributory IRA accounts.

As to broker-dealers, dual registrants, and insurance agents, the DOL’s requirements for the BIC exemption (with modifications, as suggested above) seem wholly appropriate. The DOL might seek, in its issuing release, to remind fiduciary advisers of the need for a high degree of competence when planning for IRA rollovers and the extensive knowledge required to provide advice on proper structuring of investment portfolios to best secure the client’s retirement income needs over the long term or to meet other objectives of the client.

However, for independent registered investment advisers, who are not affiliated with any broker-dealer and who receive no third-party compensation (i.e., compensation from providers of investment products or insurance products), the requirements of the BIC exemption (especially as to the requirement of no discretion) seem inapplicable. These “fee-only” registered investment advisers already agree to adhere to the tough “sole interests” standard found under ERISA and the prohibited transaction rules when providing ongoing investment advice. The conflict of interest that occurs is only in whether to undertake a rollover to an IRA, where the fees paid by the client will be higher than those in the qualified retirement plan account, such higher fees reflective of a higher level of service provided.

Hence, I suggest that the DOL promulgate a new prohibited transaction exemption for advice provided with respect to rollovers from an ERISA-covered retirement plan to an IRA account. This prohibited transaction exemption would be applicable only to independent registered investment advisers who receive no cash payments from any broker-dealer or insurance company. Under this prohibited transaction exemption the following requirements would be imposed, over and above the fiduciary requirements already imposed under ERISA and the various requirements of the SEC and state securities administrators:

1) That the independent investment adviser fully disclose to the client the difference in the amount the client would pay in the estimated total fees and costs if client continued in the client’s current qualified retirement plan account versus the recommended rollover IRA, expressed both as a percentage of the amount invested and as a dollar amount (estimated in good faith);

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2) That the independent investment adviser fully disclose to the client that the client has other options, including self-managed IRA accounts, and that some options will possess lower fees and costs; and

3) That the independent investment adviser fully disclose to the client that the higher the total fees and costs associated with investments and the delivery of investment advice, the lower the return of the investor, on average, and that such lower returns can significantly affect the size of the investment portfolio over the long term.

Again, this exemption would be limited to independent fee-only registered investment advisers – i.e., those who receive no payments from broker-dealer firms, insurance companies, or investment product manufacturers. Upon the sunset of the BIC exemption, as suggested above, it would be anticipated that all providers of rollover IRA advice would be able to adhere to the “sole interests” requirements of ERISA and its prohibited transaction rules, under this new proposed prohibited transaction exemption.

Since this would be a new PTE, and it is relatively straightforward, I believe that this PTE could be proposed and finalized under the normal timeline for agency rulemaking. There would be no need to delay the rulemaking process for the DOL’s Conflicts of Interest Rule and for the BIC exemption and other exemptions the DOL has proposed, simply as a result of the promulgation of this new, simple and limited exemption.

XII. ON THE SELLER’S EXCLUSION FOR LARGE RETIREMENT PLANS.

The DOL has proposed an exemption for non-fiduciary investment providers from the definition of fiduciary for large retirement plans. In examining this proposed exclusion, attention should be given to the effectiveness of large retirement plans to embrace the best investment products.

As discussed earlier in this comment letter, there exists a compelling body of academic research that low-cost funds, such as passive investment vehicles (including but not limited to index funds and index ETFs), outperform higher-cost funds, on average. The longer the time horizon the greater the frequency, and amount, of the outperformance.

One would expect that large pension funds, armed with savvy investment advisers, would flock to passive investing. Yet, as reported in early 2015 by The Wall Street Journal:

More individuals are pouring money into so-called passive investing or index funds, which aim to match the performance of the main stock and bond markets, but larger institutions like pension funds and endowments have been slower to follow suit, despite the potential for higher returns and lower fees.

These bigger institutions still tend to rely on an army of asset managers and consultants who charge higher fees but promise better returns through so-called alternative investments like private equity and hedge funds. But many of these investments do no better — or even worse — than index funds, opponents say.101

How good are these consultants? Not very – they fail to add value. As reported by The Economist in March 2015:

Many pension funds and endowments hire investment consultants to help them choose fund managers (one estimate is that 82% of US pension plans use such services, and consultants advise on $25 trillion of assets). The consultants employ highly-educated workforces, have decades of experience and charge hefty fees. But an academic paper, which was awarded the 2015 Commonfund prize, concluded:

we find no evidence that these (the consultants') recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless

… The first point is how important these consultants are: the top 10 have an 82% market share worldwide and are seen by most fund managers as the gateway to clients. Despite this, there is very little data on how good the consultants are at their jobs. For people who demand a lot of numbers

101 Randall Smith, “Pension Funds Trail Individuals in Embracing Index Funds,” The Wall Street Journal (March 3, 2015), retrieved July 3, 2015.

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from the fund management profession, they release very little information themselves. However, Greenwich Associates have conducted a survey of the consultants' recommendations of American long-only equity funds from 1999 to 2011.The surveys contain an annual list of fund managers showing what proportion of consultants recommend each manager; it also asks the consultants why they do so.

Interestingly, the consultants do not merely chase past returns. This is not too surprising; they are smart people and know the limitations of the data. They look at soft factors such as investment style (is performance consistent with the stated philosophy? can the manager explain trading decisions?) or service provision. Despite all this, they conclude that

the portfolio of all products recommended by investment consultants delivered average returns net of management fees of 6.31% per year (7.13% before fees). These returns are, on average 1.12% lower than the returns obtained by other products available to plan sponsors, which are not recommended by consultants.

… So if they can't pick winners, why do the consultants favour active managers at all? After all, fees are higher than on passive products and clients are more likely to switch managers on a regular basis, an activity that tends to reduce returns.

The authors suggest that

Consultants face a conflict of interest, as arguably they have a vested interest in complexity. Proposing an active US equity strategy, which involves more due diligence, complexity, monitoring, switching and therefore more consultancy work, drives up consulting revenues in comparison to simple cheap solutions.102

As indicated, the view that larger ERISA retirement plan sponsors don’t need the protection of the fiduciary standard of conduct, and its imposition of a duty of due care as well as, through the duty of loyalty, the avoidance of conflicts of interest, is highly suspect.

Indeed, an ERISA plan sponsor and/or its independent investment adviser would, if truly educated and informed, would require any provider of investment recommendations to be a fiduciary.

Simply because an investment adviser to a larger plan sponsor is “independent” does not, in and of itself, assure that the investment adviser possesses adequate expertise to advise upon the selection of investment options for the plan.

Accordingly, I recommend that this proposed exemption be dropped from consideration.

Alternatively, I recommend that educational requirements be established for the independent adviser to the plan, who will be engaged in the selection of investment products offered by non-fiduciary providers. Rather than specify a particular designation, I suggest that a minimum number of hours of education, acquired through either college-level (undergraduate or undergraduate) course work, or via certification programs or seminar attendance, be required. Specifically:

An independent investment adviser should possess a minimum of 90 hours of education from college-level (or higher) course work, acquired through university, college, certification/designation training, or other seminars for which continuing education credit in the area of investments is provided by either the CFP Board of Standards, Inc., the AICPA, the IMCA, or the CFA Institute, in which the following subjects are covered: (1) discerning the fees and costs of investment products, including but not limited to the impact of sales loads, transaction costs relating to securities transactions occurring within a fund, and various opportunity costs which may be present; (2) Modern Portfolio Theory; (3) the Efficient Markets Hypothesis; (4) variable, equity-index and fixed deferred and immediate annuities, their fees and costs, and their benefits and limitations, and understanding the various guarantees and riders available; (5) the structure, characteristics, and fees and costs of publicly traded REITs; (6) multi-factor investment strategies, including but not limited to discussions of the value, small-cap, and profitability factors; (7) ERISA and regulations

102 Buttonwood, Buttonwood's notebook (Financial markets), “Nobody knows anything,” The Economist (March 3, 2015), retrieved March 10, 2015.

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promulgated thereunder; and (8) the requirements of the fiduciary standard of conduct (of which a minimum of 10 hours of instruction in this area, out of the total hours, must be devoted).

XIII. ON THE INTEGRATION OF DOL’S FIDUCIARY STANDARD WITH OTHER STANDARDS.

Various objections to the DOL’s proposal have been raised in the public sphere that differing fiduciary standards may exist, between providing advice to accounts covered by the Conflicts of Interest Rule and other types of accounts, and that compliance with differing standards would prove too difficult. This is patently false and non-sensible. It has long been understood by providers of services under two different standards of conduct that the easiest path to ensure compliance is to simply apply the higher standard to the entirety of the relationship.

Indeed, the SEC staff in 2011, following in the footsteps of the Certified Financial Planner Board of Standards, Inc.’s professional rules of conduct, explained that the federal fiduciary standard applies to a fiduciary adviser’s “entire relationship” with clients and prospective clients.103 In this regard, it must be understood that “contract law concerns itself with transactions while fiduciary law concerns itself with relationships.”104

While the DOL cannot, through its own regulations, mandate the fiduciary standard applicable to non-ERISA and non-IRA accounts, any “dilemmna” posed by the existence of differing standards is easily solved, as set forth above. The highest standards applicable to any account should govern the entirety of the relationship. This is likely the perception the client will possess, and this solution follows upon accepted common law that fiduciary status attaches to relationships, not accounts.

One must wonder why FINRA, in existence for over 75 years, has not incorporated into its conduct rules for brokers the requirements of a fiduciary standard, and acknowledge that under certain circumstances (e.g., when a relationship of trust and confidence is formed, when de facto discretion exists, etc.) that brokers can (and have been, repeatedly) held to be fiduciaries under state common law. If FINRA is concerned about the “confusion” that might exist among brokers and their registered representatives about varying standards of conduct, the solution for FINRA’s concern is very apparent: (1) simply copy into FINRA’s conduct rules the fiduciary standards of conduct under DOL (or other) regulatory regimes; (2) specify when such fiduciary standards of conduct apply (easily discernible from the DOL’s proposals, and guided by established law in other areas); and (3) instruct the broker and its registered representatives to simply apply the highest standard of conduct imposed upon any account or any aspect of the relationship to the entirety of the relationship.

Adherence to the highest standard imposed, when differing standards exist, isn’t rocket science. FINRA’s protests (and those of the broker-dealer industry associations such as SIFMA and FSI, and those of many broker-dealers themselves) should be dismissed as meritless and mere attempts to deny to Americans the important fiduciary protections they deserve.

XIV. IN CONCLUSION

Again, I generally applaud the U.S. Department of Labor’s effort to better secure for our fellow Americans their retirement security, and in so doing result in lesser burdens upon government in the future, which in turn will assist with future economic growth.

I hope that the suggestions included herein will aid the DOL as it seeks to finalize the Conflicts of Interest rule and the various new and modified PTEs associated therewith.

103 Securities and Exchange Commission Staff, Study on Investment Advisers and Broker-Dealers 22 (2011). 104 Rafael Chodos, Fiduciary Law: Why Now! Amending the Law School Curriculum, 91 Boston U.L.R. 837, 845 (and further noting that “Betraying a relationship is more hurtful than merely abandoning a transaction.”)

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Should the U.S. Department of Labor, I am more than happy to discuss these recommendations in person, to further elaborate upon them, and/or to provide other assistance which may be desired as the DOL continues down the path to provide a better future for all Americans.

Yours truly,

Ron A. Rhoades, JD, CFP® Director, Financial Planning Program Asst. Professor – Finance Gordon Ford College of Business Western Kentucky University Bowling Green, Kentucky Contact information:

E-mail: [email protected] Phone: 352.228.1672 (cell)

Additional sources for Ron’s writings and observations:

Blog on fiduciary issues: www.ScholarFP.blogspot.com Blog on college student success: www.TriumphInCollege.com LinkedIn: www.linkedin.com/in/WKUBear Twitter: @140ltd Published articles in RIABiz, Financial Planning, AdvisorPerspectives, and other industry publications.

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