Mitigating Conflicts of Interest - Part 4

Mitigating Conflicts Through Technology

The SEC’s proposed Regulation Best Interest seeks to impose a duty on brokers to mitigate certain conflicts of interest. This series of articles will explore the various ways firms can effectively mitigate or eliminate conflicts of interest.

Part 1 – Introduction

Part 2 – Level fee

Part 3 – This Mistake Cost Merrill $9 Million

Last week, the SEC adopted Regulation Best Interest (“Reg BI”) which established a new standard of conduct for broker-dealers in retail relationships as well as other interpretive guidance related to the standard of conduct required of investment advisers under the Advisers Act.

The proponents of Reg BI appear to outweigh its detractors because the regulation is workable for b/d’s and doesn’t necessitate the type of wholesale business changes that a regulation like this could have, or as the advisory community thinks it should have, or that the now vacated DoL fiduciary rule would have. The regulation does put mandates on firms to put in place processes and procedures to comply with Reg BI, specifically to identify and mitigate conflicts of interest.

Much of the heavy lifting around Reg BI compliance will be accomplished through technology but most of what I’ve heard regarding technology has been centered around record-keeping to support disclosure or surveillance to identify conflicts. However, the real power of this technology is not to identify conflicts of interest or mitigate them. The power of the technology is its ability to eliminate conflicts of interest, and with that comes a beautiful degree of freedom and power; let me explain.

For some time, the use of technology has been relied upon in the ERISA space to eliminate conflicts of interest in the form of a computer (don’t call me a robo) model. A computer model that uses generally accepted investment theory to make impartial recommendations, without human intervention as to the final result, has been found to eliminate conflicts of interest and protect the fiduciary advisor and plan from a prohibited transaction.

SunAmerica Advisory Opinion -  In 2001, the DoL issued its SunAmerica advisory opinion which stated a fiduciary advisor can use a computer model developed by an independent financial expert to implement model asset allocation portfolios (offered on both a discretionary and non-discretionary basis), and that increased compensation to the fiduciary that resulted from the model asset allocation portfolio would not be a prohibited transaction under ERISA §406(b)(1) or (3). The reasoning and crucial take away is that if the model is recommending the asset allocation portfolios and is developed by an independent financial expert, the fiduciary would not be using any of the authority, control, or responsibility which makes that person a fiduciary to cause the plan to pay additional fees to fiduciary. The key was the relationship between the fiduciary advisor and the developer of the model (independent financial expert). There were many parameters outlined in the opinion that led to an inference of independence as between the fiduciary and expert. Some of these factors include the control and discretion of expert, lack of any affiliation between fiduciary advisor and expert, financial arrangements between the fiduciary advisor and expert, and proportion of expert’s revenue derived from fiduciary advisor. 

The Pension Protection Act, ERISA §408(g) and IRC 4975(f)(8) – The Pension Protection Act gave rise to a new prohibited transaction exemption in the spirit of SunAmerica, which leaned on the existence of a computer model to eliminate conflicts of interest. In almost identical regulations, ERISA §408(g) and IRC §4975(f)(8) allow  the developer and fiduciary to be affiliated or even the same entity, but require the model to be certified by an independent financial expert. This exemption allows the fiduciary advisor to recommend through the computer model proprietary products and products that pay the fiduciary advisor a commission.

So why am I talking so much about ERISA prohibited transactions when Reg BI has nothing to do with ERISA? It’s because an arrangement that passes muster under ERISA’s strict fiduciary prohibitions will most certainly pass muster under Reg BI. And by the way, a new fiduciary rule from the DoL is coming down the pike and while nobody expects it to be as disruptive as its predecessor, it could give brokers a reason to want to take on the fiduciary role. Technology that eliminates conflicts of interest means brokers can take on the fiduciary role with the plan and keep their indirect compensation with no prohibited transaction.

Firms should look to leverage technology to execute their investment process in a repeatable, documented, reliable, un-conflicted manner.  Doing so will allow brokers to service clients unfettered, at the highest standard of care, and with current compensation structures intact.



Cory Clark is Chief Marketing Officer at DALBAR, Inc., the nation’s leading independent expert for evaluating, auditing and rating business practices. Cory is also a practicing attorney licensed in Massachusetts. He resides near Boston with his wife and 3 children.

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