Magazine

ERISA vista | PLANADVISER July/August 2016

Referrals Under the Final Fiduciary Rule

Questions advisers are asking

By Fred Reish and Joan Neri editors@assetinternational.com | July/August 2016
PAJF16_Article-Image-ERISA-Reish-and-Neri-Portrait_Tim-Bower.jpgArt by Tim BowerADVISER QUESTION: Is the recommendation of an investment adviser to an individual retirement account [IRA] owner a fiduciary act under the Department of Labor [DOL]’s final fiduciary rule?

ANSWER: If the person making the recommendation—the referrer—receives a fee for the recommendation, it will be a fiduciary act when the rule becomes applicable, on April 10, 2017. That means the referral fee may be a prohibited transaction.

The rule provides that recommending a fiduciary investment adviser to an IRA owner in exchange for a referral fee, such as a solicitor’s fee, is a fiduciary act. And, under the rule, virtually every adviser will be a fiduciary.

The DOL currently takes the position that recommending an adviser for a fee is a fiduciary act where the adviser is a discretionary investment manager and the recommendation is individualized and based on the particular needs of an IRA or plan. Once the rule applies, the recommendation of both discretionary and nondiscretionary fiduciary investment advisers to the IRA owner, plan or participant will be a fiduciary act, and regardless of whether the recommendation is individualized and based on the investor’s needs or not. This will have a significant impact on referrals of advisers, especially as some advisers, such as insurance agents and financial advisers, may not be fiduciaries under current law but will now have acquired that status.

Under the rule, a referrer’s recommendations will likely be prohibited transactions. That’s because the referrer will be able to use his fiduciary authority to increase his compensation—i.e., by recommending a fiduciary adviser who pays a referral fee.

One approach to avoid a prohibited transaction is for the referrer to charge a level fee for recommending a fiduciary adviser. However, that “solution” is inconsistent with current practice, where the IRA owner does not think in terms of being charged a fee for a referral—and may not, in some cases, even be aware of the payment.

As an alternative, a referrer could, in theory, use the best interest contract (BIC) exemption in order to avoid the prohibited transaction. However, that won’t work for practical reasons; it’s too cumbersome and expensive for the relatively small amounts involved. It may work, though, in situations where, for example, the financial advisers of a broker/dealer (B/D) refer clients to discretionary investment managers. In those cases, the payments may be large enough to justify the compliance costs, particularly where the broker/dealer is already using a BIC exemption for other payments.

Ways Around Referrals

Does this mean that referrals and solicitor’s payments are prohibited after April 9, 2017? Yes and no. They are prohibited as commonly done. But, hopefully, new arrangements will be developed that are compliant with the rule and the prohibitions. For example, it may be possible for a referrer to tell an IRA owner that he, the referrer, will charge a set fee—e.g., 20 basis points (bps)—to help find a good-quality investment adviser and will arrange for the adviser to pay that fee. Properly done, that would work.

On a practical level, it could mean that referrers will carefully investigate the capabilities of advisers and could have arrangements with several who would pay that level fee. Or other compliant approaches could be developed. Either way, change is coming.

Similar challenges will apply regarding referral of fiduciary advisers, for a fee, to Employee Retirement Income Security Act (ERISA) plan fiduciaries and plan participants. Under the rule, those recommendations will be considered a fiduciary act, subjecting the referrer to the ERISA prudent man standard of care and the same prohibited transaction issues. In addition, the referrer will be considered a covered service provider under the ERISA 408(b)(2) regulation. This means that the referrer will need to provide the plan fiduciaries with a written description of the referral service, fees and status reasonably in advance of the referral.

Referral arrangements should be evaluated in light of these considerations. It is likely that the rule, once it is applicable, will bring material changes to the way referral business is conducted.

Fred Reish is chair of the Financial Services ERISA practice at the law firm Drinker, Biddle & Reath. A nationally recognized expert in employee benefits law, Reish has written four books and many articles on the Employee Retirement Income Security Act (ERISA), Internal Revenue Service (IRS) and Department of Labor (DOL) audits, as well as pension plan disputes. Joan Neri, who has been associated with the firm since 1988, is counsel on the Employee Benefits and Executive Compensation Practice Group. Her practice focuses on all aspects of employee benefits counseling.