Fiduciary Responsibilty Becomes Driving Force in Soft Dollar Debate


New York, NY – Since the SEC’s July 2006 release of its interpretive guidance on section 28(e) of the Securities Exchange Act of 1934, many in the financial services industry have eagerly awaited the regulators’s proposal on commission disclosure.

However, the Department of Labor’s Employee Benefits Security Administration (EBSA), the regulator of ERISA plans, has taken some of the thunder away from the SEC with its own proposal that would require the unbundling and separate valuation of brokerage and research services provided to pension funds.

In July, 2006, EBSA proposed new reporting requirements as part of its effort to convert to electronic filing of annual reporting requirements under ERISA.  Brokerage fees and commissions, which had previously been exempt, are required to be reported for each broker receiving more than $5,000 worth of compensation.

Further, indirect compensation paid on behalf of the plan (including soft dollars, 12b-1 fees, float income, among others) has to be disclosed.  EBSA states that plan sponsors need to pay attention to the soft dollars being spent by investment managers on the plan’s behalf:

“The Department believes that an annual review of such expenses is part of a plan fiduciary’s on-going obligation to monitor service provider arrangements with the plan. Requiring the reporting of such information should emphasize that monitoring obligation.”

As one might expect, representatives of the brokerage and money management industries (SIFMA and the ICI) voiced major concerns over the DOL proposal.  However, despite the industry’s protestations about EBSA’s proposal, there might be very little they can do about it as there has been growing regulatory and legislative momentum about a plan sponsor and pension fund manager’s fiduciary duty to control and account for investment expenses in the wake of numerous high profile lawsuits and scandals in the industry.

In fact, we would not be surprised if some brokerage firms and money managers reversed their previous reticence to promote commission disclosure and actively lobbied the SEC to address the issue more quickly than they might previously have done on their own.

After all, these industry participants might feel that an SEC proposal would be less onerous than one developed by the DOL.  Such a move would be quite similar to how the UK financial services industry responded to the topic of commission transparency and unbundling in the wake of the Myners Report.

The following article, written by Donald B. Trone, president of the Center for Fiduciary Studies, addresses the gathering momentum to deal with the fiduciary responsibility inherent in controlling and accounting for investment expenses (including commissions, 12b-1 fees, etc.).


Fees and expenses: It’s about fiduciary responsibility

By Donald B. Trone
March 26, 2007

One of the most pressing issues in the investment industry today is retirement plan fees and expenses. A lot of questions have been raised about them recently, all of which can be answered simply à la college basketball commentator Dick Vitale: “It’s about fiduciary responsibility, baby!”

Consider events of the past 12 months:

  • Class actions have been filed against a number of large 401(k) plan sponsors; the apparent failure of the plan sponsors to properly monitor fees and expenses being the primary basis for the suits.
  • Two large public plans have filed suits against their investment consultant for conflicts of interest (undisclosed compensation).
  • The Government Accountability Office has released the results of its examination of 401(k) fees and expenses, recommending that the financial industry be required to disclose more, including all conflicts of interest, and do so in simpler, easy-to-understand language.
  • The Department of Labor has announced that changes are forthcoming on how fees and expenses, and conflicts of interest, are to be reported to plan sponsors, particularly at the point of sale.
  • The Securities and Exchange Commission has announced tighter controls on the use of “soft dollars,” the source of several abuses by money managers and broker-dealers.
  • The Pension Protection Act of 2006 includes a provision that will require that a fiduciary adviser be compensated only on a “level comp,” or fee-neutral, basis unless a certified computer model is utilized.
  • The recent congressional hearings on the subject of 401(k) fees and expenses, which further validated Washington’s increased interest in doing more to safeguard and protect the nation’s retirement wealth – interest that long is overdue but largely welcomed just the same.

The central theme behind all of these events is the fiduciary’s duty to control and account for investment expenses, a fundamental responsibility of all investment fiduciaries – not just retirement plan sponsors.

Why is so much attention being focused on fees and expenses, and not on some of the other fiduciary duties, such as the fiduciary’s duty to select and monitor investment options prudently?

The answer is quite simple: It’s the source of the most abuse; it’s the easiest fiduciary breach to detect in an audit; corrective action can generate immediate relief; and it’s the easiest breach to argue before a judge and jury.

When examining this fiduciary duty, one should think in terms of three layers, as in peeling away the skin of an onion:

Layer 1: The fiduciary has a duty to control and account for all investment-related fees and expenses.

Layer 2: The fiduciary has a duty to identify every party that has been compensated from portfolio assets.

Layer 3: The fiduciary has a duty to demonstrate that a determination was made that the fees and expenses paid to each party were appropriate and reasonable, given the level of services rendered.

What are the investment adviser’s specific fiduciary duties related to fees and expenses (assuming that the investment adviser is serving in a fiduciary capacity)?

First, an investment adviser cannot parlay their position of trust for additional profits – for undisclosed compensation. “Pay to play” schemes (selling conference services to the same money managers the investment consultant is being paid to monitor), asset placement fees (fees paid to move large blocks of assets to a new money manager) and undisclosed soft-dollar arrangements (computer services and due-diligence “trips”) all are examples of this type of breach.

Second, an investment adviser has the fiduciary duty to inform clients of all forms of compensation, both direct and indirect. In the case of 401(k) plans, the investment adviser must disclose to clients all 12-b(1), revenue-sharing and sub-transfer-agent fees that may benefit the adviser.

Third, an investment adviser can be compensated only on a level-comp basis; there can be no variability in the adviser’s compensation based on which asset classes, fund groups, funds and/or share classes are selected.

The two most widely acceptable approaches to level comp are asset-based fees or project-based fees (a flat dollar amount).

I’m not aware of any fiduciary duty that hinges on whether commissions are included in the adviser’s revenue. In other words, an adviser could apply commissions to, or offset, the agreed-upon level-comp arrangement.

Keep in mind, however, that only registered representatives (brokers) can receive commissions, and most brokers do not acknowledge fiduciary status. But that does not prevent a regulator or court from determining that the actions of the broker gave rise to fiduciary status – in which case the broker would be held to the level-comp standard.

Fourth, the investment adviser has a fiduciary duty to demonstrate that the fees and expenses associated with a particular client’s investment strategy are appropriate, fair and reasonable.

For example, the adviser should be able to demonstrate that if an active manager were hired to implement a client’s large-cap-blend strategy, consideration was given to the use of an index fund with a lower expense, but the adviser believed the higher expenses of the active manager were appropriate for the client’s situation. The same could be said about the adviser’s decision on which custodian to use.

Opportunity seen

Questions have been raised by investment advisers as to whether greater fee transparency and disclosure will result in lower compensation. Advisers who have disclosed all their forms of compensation and have structured their services to be compensated on a level-comp or fee-neutral basis shouldn’t see any change – except for the opportunity to gain new clients from advisers who haven’t followed prudent fiduciary practices.

In addition, investment advisers who can articulate the scope of their value-added services will benefit significantly by attracting new clients who were never serviced properly by their former advisers.

Fees and expenses – a complex subject but one that easily can be summarized: It’s about fiduciary responsibility, baby!

Donald B. Trone is president of the Center for Fiduciary Studies and chief executive of Fiduciary360, both in Sewickley, Pa.


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