This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”). My previous blog posts can be found here.
The DOL’s Regulatory Impact Analysis, states:
… traditional compensation sources – such as brokerage commissions, revenue shared by mutual funds and funds’ asset managers, and mark-ups on bonds sold from their own inventory – can introduce acute conflicts of interest.
… the Department found that conflicted advice is widespread, causing serious harm to plan and IRA investors, and that disclosing conflicts alone would fail to adequately mitigate the conflicts or remedy the harm.
In order to address these conflicts and the resulting harm to investors, the DOL has introduced the DOL Fiduciary Rule (“DOL FR”) and the Best Interest Contract Exemptions (“BICE”), which I have discussed in my previous posts.
Shifting the Burden of Proof
One remarkable facet of the DOL FR is that under the BICE, if violations are alleged, the burden of proof is on the defendants. The DOL writes:
Moreover, inclusion of the standards in the exemption’s conditions adds an important additional safeguard for ERISA and IRA investors alike because the party engaging in a prohibited transaction has the burden of showing compliance with an applicable exemption, when violations are alleged. In the Department’s view, this burden-shifting is appropriate because of the dangers posed by conflicts of interest, as reflected in the Department’s Regulatory Impact Analysis and because of the difficulties Retirement Investors have in effectively policing such violations. (Emphasis added)
This language is reiterated by the DOL elsewhere in the BICE:
… Advisers and Financial Institutions bear the burden of showing compliance with the exemption and face liability for engaging in a non-exempt prohibited transaction if they fail to provide advice that is prudent or otherwise in violation of the standards. The Department does not view this as a flaw in the exemption, as commenters suggested, but rather as a significant deterrent to violations of important conditions under an exemption that accommodates a wide variety of potentially dangerous compensation practices. (Emphasis added)
Meeting the Burden of Proof
Shifting the burden of proof from plaintiffs to defendants will introduce a new dynamic in securities litigation and arbitrations. In my experience, brokerage firms and their registered representatives are not prepared to meet this burden.
I have been involved in many cases where brokers will testify that it is their “business practice” to not take notes during client meetings and calls. Furthermore, this paucity will frequently extend to their research habits. For instance, despite making hundreds of recommendations to a client over a multi-year period, a registered representative will not produce one document that evidences any research or due diligence for any recommendation.
These practices will immediately fail under a fiduciary standard. As discussed in a previous post, under the BICE, there is an explicit requirement to undertake rigorous due diligence, document that due diligence, share the results of the due diligence with the client, and to supervise the process.
With the burden of proof residing with defendants, the documentation and supervision of the due diligence process will have high salience in any litigation.
Due Diligence and the Firm
A number of news articles have highlighted a surge in business for compliance software in the wake of the DOL FR passage. While technological solutions can be helpful, broker-dealers and their registered representatives should not confuse them with actual due diligence.
For instance, having registered representatives cycle through a check-the-box screen before making a recommendation will be a failure if the actual due diligence has not been done. Firm supervisors will need to insure that:
- Rigorous and professional due diligence has been undertaken that meets the Prudent Expert Standard;
- A fiduciary-quality conclusion has been reached, and;
- Evidence of the entire process has been archived.
Failure to undertake any of these steps will likely result in liability, should a violation be alleged.
Due Diligence and the Registered Representative
Under the fiduciary standard, the client has reposed trust and confidence in their registered representative to look after their interests. This means the registered representative is charged with carrying out the fiduciary obligations to the client. These obligations cannot be outsourced.
One of the primary obligations is that of due diligence into investments before a recommendation is made. Independent due diligence by registered representatives is required to meet the fiduciary standard. This does not mean that third party resources cannot be used, however, they cannot be the primary means of due diligence.
Conflicted sources of research should be discounted heavily, if not ignored. Traditionally, one of the most conflicted sources of research has been the brokerage firms at which registered representatives work. If a brokerage firm is offering a product and will earn a commission from its sale, then the firm is conflicted and its research should be viewed with great skepticism.
Indeed, the offering itself should be viewed with great skepticism by the firm’s own registered representatives.
As will be discussed in greater detail in subsequent blog posts, independent research requires a great deal of work, including: close reading of offering documents, talking with issuers, modeling assumptions, and comparing offering risk, reward, and pricing, to other similar options.
 Department of Labor; Fiduciary Investment Advice: Regulatory Impact Analysis; April 14, 2015; 9.
 Federal Register; Vol. 81, No. 68; April 8, 2016; Best Interest Contract Exemption; 21033. Also see: Fish v. GreatBanc Trust Company; No. 12-3330; (7th Cir. 2014); at 27. Under ERISA, the burden of proof is on a defendant to show that a transaction that is otherwise prohibited under § 1106 qualifies for an exemption under § 1108.
 Id. at 21060.
 Indeed, they frequently fail under a suitability standard.
 All offerings that involve commissions should be viewed with great skepticism by both firms and their registered representatives.
To learn more about fiduciary expert Jack Duval, click here.