Mitigating Conflicts of Interest - Part 2

In Part 1 of this series on mitigating conflicts of interest, I discussed the SEC’s proposed Regulation Best Interest and the potential significance of the mitigation requirements for financial incentives.  The mitigation requirement would appear to be one area where broker/dealers and their reps could be responsible for some significant changes.

When tackling conflicts of interest, it’s helpful to look to a place where disclosure has never been a sufficient remedy; employer-sponsored retirement plans. ERISA is perhaps the strictest regulatory regime related to financial services and under ERISA, an advisor’s conflict of interest is always a prohibited transaction (subject numerous potential exemptions).  Even those not familiar with ERISA parlance can surmise that a prohibited transaction is bad news. However, there are two well established methods of avoiding prohibited transactions in ERISA that serve as a good starting point to neutralizing conflicts of interest in the broker community. Those two methods are (1) fee leveling and (2) the use of a computer model. Fee leveling is the subject of this Part 2 article. Subsequent parts to this series will discuss the use of computer models and other financial technology as a means for elimination and mitigation of conflicts.  

Fee leveling is not the same as fee-only and does not require a shift to a wholly new business model; it simply implies an offsetting arrangement to avoid variable compensation. The distinction between fee leveling and fee-only is an important one.  First, shifting to a model where fees are deducted directly from the client’s account could be disruptive to some client relationships.  Second, shifting to a truly fee based compensation structure and no longer relying on commissions, markups, and markdowns would constitute “special compensation,” in which case the broker may magically morph into an investment adviser with respect to that client.

Regulators have been consistent that when compensation cannot be increased by the advisor, there is no conflict of interest. The Department of Labor stated in a landmark advisory opinion known as the Frost Letter that when fees are passed through to the investor, the advisor is not being benefited. Congress would later codify the concept of level fee in the Pension Protection Act when it created a new level fee exemption for advisors under ERISA §408(g). The SEC specifically mentioned the option of an offsetting arrangement in its Regulation Best Interest proposal.

Fee leveling does more than mitigate conflicts of interest, it eliminates them. Firms should explore the possibility of eliminating some conflicts altogether because in some cases it may be the only appropriate action. The SEC noted that the nature of the conflict, its inherent lack of transparency involved, and the level of sophistication of a particular investor are all factors which may lead to a determination that disclosure and mitigation are insufficient. In these cases, elimination will be the firm’s only viable option. Nonetheless, fee leveling will often be over and above what is required to mitigate a financial incentive, but serves as a preemptive strike against the continuous cost of procedures designed to police lingering incentives. It may pay long term to simply cut the head off the snake and eliminate financial incentive completely through fee leveling or other methods.


     Cory Clark is a Director at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices, where he has worked since 2006. Cory holds a law degree from New England Law |Boston where he graduated Cum Laude and earned his Bachelor of Arts degree in Economics from the University of Massachusetts, Amherst. Cory resides near Boston, Massachusetts with his wife and 3 children.

These articles are provided for general information only, and does not constitute legal advice, and cannot be used or substituted for legal advice.