What the 5th Circuit decision doesn’t do

By now, you have probably heard about the decision by the 5th Circuit Court of Appeals. In a nutshell, it threw out the fiduciary rule and the prohibited transaction exemptions that accompanied the rule (including the best-interest contract exemption, or BICE). You may have also heard that the consequence is that if the Department of Labor doesn’t contest the decision, the new fiduciary rule and exemptions are dead. It’s as if they never existed.

But you may not have heard that the court decision doesn’t apply to services. That means that investment management services for retirement plans, participants and IRAs will continue to be fiduciary activities. As a result, discretionary investment management of plans and participants — which are subject to ERISA — must comply with the prudent man rule and the duty of loyalty. And any compensation resulting from those services, other than a level advisory fee, is a prohibited transaction, for which very few exemptions are available.

For individual retirement accounts, though, it does not mean that the adviser is governed by the prudent man rule or duty of loyalty (which, in combination, are called the “best interest” standard of care). Instead, an adviser’s conduct is regulated by the SEC and securities laws. There is one exception to that, though, which is that the individual adviser and the registered investment adviser must comply with the prohibited transaction rules in the Internal Revenue Code. (For all practical purposes, the prohibited transaction exemptions in the code and ERISA are the same.) That means that the RIA and the individual adviser cannot use their fiduciary authority to cause additional compensation (above and beyond the level advisory fee) to be paid to themselves or to an affiliated or related party.

By the way, a nontechnical definition of a level advisory fee is one that does not include any payments from third parties and that is not directly affected by the adviser’s investment decisions. For example, additional transaction-based payment (like a 12b-1 fee) is prohibited. However, if the RIA offsets the third-party payment against its advisory fee on a dollar-for-dollar basis, that effectively restores the permissible level fee.

While most discretionary, or 3(38), advisers to retirement plans understand these rules and comply with them, many advisers to IRAs do not, usually because they don’t know the rules. Here are some examples.

If a discretionary manager of an IRA uses mutual funds that pay 12b-1 fees to the RIA or an affiliate in addition to the advisory fee, that is a prohibited transaction. Since BICE only provides relief for nondiscretionary investment advice, it would not be available (and in any event, if the 5th Circuit decision is the final word, BICE will also be thrown out). The DOL position is that there isn’t an exemption for those payments.

As another example, if an RIA works with a custodian that makes payments to the RIA based on the use of no-transaction-fee funds, and the adviser selects no-transaction-fee funds, the payments from the custodian would be prohibited transactions, for which there is not an exemption. Those payments would need to be placed in the IRA for the benefit of the investor or, alternatively, offset against the advisory fee on a dollar-for-dollar basis.

Also, if a discretionary investment adviser can determine the asset allocation for an IRA and charges different fees for different asset classes (for example, if the adviser gets a higher fee for equities than it does for fixed income), the adviser has discretion, which could result in higher compensation for the adviser, for example, the fees on the allocation to equities. That would be a prohibited transaction for which there is not an exemption.

The point of this article is that discretionary investment management is treated differently than nondiscretionary investment advice. The 5th Circuit decision about the fiduciary regulation only covered nondiscretionary investment advice. It did not change the rule that discretionary investment management is, and always has been, a fiduciary activity.

With the increased attention being focused on fiduciaries and financial conflicts of interest (that is, prohibited transactions), advisers — particularly advisers to IRAs — need to have a better understanding of the prohibited transaction rules. It seems almost certain that investors and their attorneys, and regulators, will be aware of these rules.

(More: How advisers can manage IRA rollover risk under the DOL fiduciary rule)

Fred Reish is a partner at the law firm Drinker Biddle & Reath.