United States: First State Charges Broker-Dealer In Connection With Violations Of DOL Fiduciary Rule

Last Updated: February 21 2018
Article by Hillel Cohn, Dylan Naughton and Lloyd S. Harmetz

On February 15, 2018, the Enforcement Section of the Massachusetts Securities Division (the "Division") of the Office of the Secretary of the Commonwealth charged a registered broker-dealer (the "Broker-Dealer") that operated in Massachusetts with violating its own internal policies designed to ensure compliance with the U.S. Department of Labor's (the "DOL") Fiduciary Rule.

The DOL Fiduciary Rule

The DOL Fiduciary Rule significantly expands the scope of persons who will be deemed fiduciaries when dealing with retail retirement accounts. Under the Rule, virtually any suggestion made by a financial intermediary to a retail retirement account regarding specific investments, investment strategies or investments advisers will result in the intermediary being deemed a fiduciary. Certain communications with retail retirement investors will not trigger fiduciary status. These communications include educational communications, and "hire me" communications that do not recommend a specific investment or investment strategy.

As a fiduciary, a financial intermediary is required to act in the best interest of its customer, without regard to the interests of the intermediary. A fiduciary is also prohibited from receiving commissions and other forms of transaction-based compensation, and the fiduciary may not act as a principal in transactions effected with its client. These prohibitions are particularly problematic for the broker-dealer industry, which was built on transaction-based compensation and often effects transactions on a principal basis. Recognizing these problems, the DOL adopted two new prohibited transaction exemptions that, subject to numerous conditions, would permit the receipt of commissions or engaging in principal transactions.

The DOL is continuing to evaluate the Fiduciary Rule and has delayed full implementation of the Rule and related prohibited transaction exemptions until July 1, 2019. However, on June 9, 2017, the basic requirements of the DOL Fiduciary Rule became applicable, as did the new Impartial Conduct Standards that must be met in order to receive commissions or other transaction-based compensation. In connection with the delay in full implementation, the DOL and IRS indicated they would refrain from bringing enforcement actions against firms that were in good faith attempting to implement the new standards.

Impartial Conduct Standards

The Impartial Conduct Standards require broker-dealers and other intermediaries who advise retirement accounts and receive transaction-based compensation to: (i) act in the "best interest" of the retirement investor, considering such investor's investment objectives, risk tolerance, financial circumstances and needs; (ii) avoid receiving unreasonable compensation; and (iii) ensure that disclosure about compensation, conflicts of interest and other matters relevant to an investor's decision is not misleading.

The Massachusetts Complaint

The Broker-Dealer in the Massachusetts case prepared to comply with the DOL Fiduciary Rule by including provisions in its brokerage and investment advisor compliance manuals, which stated that "the firm does not use or rely on quotas . . . contests, special awards or incentives that are intended or reasonably expected to cause associates to make recommendations that are not in the best interest of [r]etirement [a]ccount clients or prospective [clients]." The Division alleges that the Broker-Dealer failed to implement and enforce its own policy by running sales contests that rewarded associates for generating new net assets, including retirement assets. While the Division alleges a variety of "aggressive sales practices," the Complaint mainly discusses the use of such practices to gather assets, without necessarily specifying any instances where such sales practices influenced specific investment recommendations made to retirement investors. The Division also alleges that the Broker-Dealer failed to inform the customers of the conflicts arising from the sales contests. As a result, the Broker-Dealer was charged with violating the relevant provisions of the Massachusetts Uniform Securities Act.

In its Complaint, the Division seeks, among other things, a cease and desist order, disgorgement of illicit profits and an unspecified administrative fine. The Broker-Dealer has not yet responded to the Complaint.

Our Take-Aways

The Massachusetts action is a timely reminder that the basic requirements of the DOL Fiduciary Rule are in effect, and broker-dealers as well as other financial intermediaries need to ensure that their practices comply with these new standards. While the DOL may refrain from active enforcement prior to July 1, 2019, enforcement actions by state regulators and private civil actions may be predicated on violations of the fiduciary standards imposed by the DOL Fiduciary Rule.

In order to comply with the new standards, broker-dealers and other financial intermediaries need to review their internal compensation systems to eliminate any arrangements or practices that could reasonably be expected to incentivize brokers or other financial advisers to make recommendations that are not in the best interest of the retail retirement investor. Sales contests or quotas that reward brokers for pushing specific products or strategies that may not be in the best interest of a retail retirement investor are problematic and should not be utilized.

That said, the Massachusetts Complaint appears to focus on sales contests that were designed to reward brokers for bringing in new assets. Sales efforts focused on bringing in new accounts could fall within the "hire me" exception. The Complaint is not clear about the extent to which the "aggressive sales practices" included contests or other compensation arrangements that rewarded brokers for recommending specific products or for generating transaction-based commissions. In that sense, the Complaint reflects in large measure the regulator's view that broker-dealers who are now deemed fiduciaries under the DOL Fiduciary Rule may be charged with violations under the Massachusetts state securities laws to the extent that the broker-dealers fail to enforce policies adopted to comply with the new fiduciary standards.

In any event, to better ensure compliance with the DOL Fiduciary Rule, broker-dealers should implement the following measures:

  • meet with retail retirement investors on a regular basis and make sure they have an adequate understanding of the client's current circumstances an objectives;
  • conduct thorough diligence on all investment products offered to retail retirement investors;
  • document the basis for the agent's conclusion that a particular investment product is in the best interest of the customer;
  • evaluate internal compensation arrangements to ensure that they do not improperly incentivize sales agents to recommend products or strategies that are not in the best interest of the client;
  • train all sales agents and supervisors to comply with the new requirements and internal policies;
  • monitor account activity with a view to detecting potential deviations from the new best interest standard;
  • establish procedures for documenting the reasonableness of compensation received from transactions with retail retirement accounts;
  • establish and enforce procedures to identify, manage and disclose conflicts of interest; and
  • revisit distribution arrangements for new issues to ensure they comply with the new standards.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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