By: Richard J. Schulman, Partner, Duval & Stachenfeld LLP
Will you be happy if, in the not-too-distant future, you’re served with a summons and complaint accusing you of failing to act in a retirement investor’s best interest by recommending the purchase of shares in a non-traded REIT? Doubtful! Can you do anything now to lower and possibly avoid any litigation risk? Yes, you can! Let me explain.
Unless you’ve been hiding under a rock, you know that on April 6, 2016 the Department of Labor issued a “final” rule that extends a fiduciary standard to financial institutions and advisers who give investment advice concerning “retirement accounts” (a term used here to refer to employee benefit plans under ERISA as well as IRAs and other non-ERISA plans covered by §4975(e)(1) of the IRC). Although DOL’s fiduciary rule is currently being challenged in the courts and may receive legislative and/or regulatory attention after a new President and Congress are in place, prudence recommends that financial institutions and advisers plan for now on its becoming effective and prepare accordingly.
Assuming the governing standard for financial institutions and advisers escalates, in the case of retirement accounts, from one of recommending “suitable” investments to that of recommending investments which are in the “best interest” of a customer, this will create an increased risk of litigation for financial institutions and advisers. Disgruntled retirement investors may well claim that certain recommended investments, even if arguably suitable, are simply not in their best interest. Or, that DOL’s fiduciary rule has otherwise been violated.
In light of this risk, what might you do to neutralize (and hopefully overcome) any such claims? Addressing that question in advance may head off litigation later. Even if litigation eventuates, thinking ahead may reduce if not eliminate any liability exposure.
Nowhere is the need for advance planning more necessary than for those who want to recommend the purchase of direct marketed financial products such as non-traded REITs. Despite the benefits they offer for certain portfolios, it is well understood in the market that: non-traded REITs are generally illiquid – they must pay sales commissions and professional management fees – they may pay distributions from offering proceeds or from borrowings – they can be difficult to value – and they are subject to conflicts of interest due to their external management structure.
These risks presumably contributed to DOL, in its proposed fiduciary rule, omitting non-traded REITs from the list of assets that could be included in retirement accounts. Notably, in the final rule, DOL chose not to identify specific investments that could or could not be included in retirement accounts. Nevertheless, DOL has expressed continuing concern about various attributes of the financial products (like non-traded REITs) not previously listed in the proposed rule as assets permissibly included in retirement accounts. These attributes, among other reasons, may well prompt retirement investors to complain at some point that any recommendations to purchase shares in non-traded REITs for their retirement accounts are not in their “best interest.”
Fortunately, DOL’s fiduciary rule does not become effective until April 2017; and certain of the disclosure and contract provisions do not become fully effective until January 2018. That allows time to consider and take appropriate steps to moderate the potential risks associated with recommending non-traded REITs under a fiduciary standard for inclusion in retirement accounts.
Here are some thoughts on courses of action that can or should be taken, as applicable, in anticipation of the need to comply with DOL’s fiduciary rule.
1. Financial institutions should complete the preparatory steps mandated by DOL’s fiduciary rule. Most importantly, they should adopt and implement written anti-conflict policies and procedures, as dictated by DOL’s fiduciary rule. In addition, they should establish a comprehensive supervisory structure to monitor adviser recommendations, and assure compliance with the anti-conflict policies and procedures adopted.
2. Financial institutions should fine tune any account and investment documents to better protect against potential liability. If a non-traded REIT will be recommended in connection with a commission-based retirement-related account – as opposed to a level-fee account, which has a more streamlined set of requirements – have counsel prepare and retirement investors assent to a “best interest contract” (BIC) that’s compliant with DOL’s fiduciary rule – to take advantage of that rule’s “best interest contract exemption.” Any BIC should be entered into, in a manner provided by DOL’s fiduciary rule, prior to execution of a recommended non-traded REIT investment. Importantly, it should make the disclosures prescribed by DOL’s fiduciary rule, and include a link to the financial institution’s website, where certain prescribed information is available – including a copy of the retirement investor’s BIC, and necessary updates to any disclosures in the BIC.
In a separate transaction-related document, provided at or before any transaction is executed, make the several disclosures mandated by DOL’s fiduciary rule. None of these is more important than the disclosure of any material conflicts of interest which may exist (such as the nature, amount and source of any compensation or fees to be paid in connection with the sale of any shares; the proprietary nature of the non-traded REIT sold, if that is the case; and so forth).
If deemed advisable, and permitted under state law, the account documents may also provide for mandatory arbitration of individual claims – as long as arbitration is not required to take place at an unreasonably distant location, and that provision does not unreasonably limit the retirement investor’s ability to assert particular claims safeguarded by the exemption.
While the best interest contract exemption cannot be claimed if the BIC includes certain disclaimers and waivers, there is no restriction on having a retirement investor waive the right to punitive damages or rescission as contract remedies (so long as this is permitted under applicable state or federal laws). Such a waiver should therefore be included, if possible.
3. Financial institutions should prepare advisers to make recommendations, subject to a fiduciary standard, for retirement accounts. financial institutions should implement training programs focused on the requirements of DOL’s fiduciary rule, so that advisers are fully familiar with the new standards under which they will need to operate. Additionally, those training programs should familiarize advisers with the processes to be followed in determining whether an investment (for example, in a non-traded REIT) can prudently be recommended to a retirement investor as one that’s in his or her best interest. And, they also should instruct advisers how to document the processes followed and the bases relied upon for determining that a particular investment recommendation is in a retirement investor’s best interest.
4. Establish and follow a reasonable process to determine if a recommendation to invest in a non-traded REIT will be in a retirement investor’s best interest. At minimum, that process should require an adviser to consider a retirement investor’s investment objectives, risk tolerance, financial circumstances, and relevant individual needs – without regard for the financial or other interests of the financial institution or adviser – and, upon weighing these several factors, to determine whether a recommendation to purchase shares in a non-traded REIT represents prudent advice that’s in the retirement investor’s best interest at the time. After assessing the retirement investor’s individual situation, for example, the adviser should be able to conclude that a retirement investor’s best interest will be served by including in his or her retirement account a real estate related investment which provides a regular stream of income, presents the potential for appreciation, and is generally less volatile than publicly traded securities – even if it’s necessary to hold the investment until a liquidity event occurs or liquidation is otherwise allowed.
5. Identify and recommend those non-traded REITs that have reduced the risks attendant to such an investment. Some sponsors are restructuring non-traded REITs to reduce the risks attendant to such investments. By way of illustration, they are setting shorter time frames for: selling the properties purchased by the REIT, making a public offering, or otherwise engaging in a liquidity event. Or, they are developing a structure that periodically allows for liquidation. In addition, they are determining net asset values on a frequent (and, in some cases, daily) basis. They are also adopting new pricing structures (for example, by creating a class of new shares that reduces upfront fees, and provides instead for trailing commissions); are moving toward performance-driven compensation; or are reducing or eliminating certain fees. While it’s unclear whether these measures will prove sufficient, it makes sense, where there’s a choice, to recommend non-traded REITs that have reduced the attendant risks.
6. Use any meetings and other communications with a retirement investor as an opportunity to make sure he or she knows what’s involved when investing in a non-traded REIT, and believes such an investment to be in his or her best interest. Advisers should be prepared beforehand for any meetings or other communications in which investment recommendations are made to retirement investors. Counsel and/or compliance officers should prepare (or approve) training materials with regard to potential sales of non-traded REITs. They should also prepare (or approve) sales scripts as well as answers to frequently asked questions about potential investments in non-traded REITs, which dove-tail with any offering documents.
Any conversation that occurs with a prospective purchaser can then be used, in a planned way, to explain: the nature and features of non-traded REITs; the reasons for investing in one, and specifically in the non-traded REIT being recommended; and what’s involved when purchasing shares in such a REIT.
Any discussion should additionally be used to develop information that indicates an investment in a non-traded REIT is in the customer’s best interest. During that discussion, the adviser should explain why it’s believed the best interest of the retirement investor will be served by purchasing shares in a non-traded REIT – and specifically in the non-traded REIT being recommended – as a component of the retirement investor’s portfolio. The adviser should also try to tease out statements by the retirement investor that he or she appreciates the nature and features of a non-traded REIT, understands all of the requisite disclosures made about it, is aware of the advantages and risks attendant to such an investment, is desirous of proceeding, and believes it will be in his or her best interest to acquire shares in a non-traded REIT as a component of his or her portfolio.
Importantly, notes of any such discussions should be recorded electronically in customer relationship management records or, if unavailable, in handwritten notes which are retained. Alternatively or in addition, after advising a retirement investor in advance what you are going to do, engage in any telephone conversations on a recorded line, and then preserve such recording(s).
7. Inform potential purchasers of the most advantageous reasons for investing in a non-traded REIT. Doing this presumably will demonstrate to retirement investors why it’s in their best interest to acquire shares in non-traded REITs, and why such an investment is competitive with if not superior to other possible investments. Highlight, for example, that non-traded REITs provide higher and steadier rates of return than many other investment possibilities – a benefit of particular importance in a low interest environment – while at the same time presenting a potential for appreciation. Emphasize as well that non-traded REITs allow retirement investors access to high-quality investment managers otherwise available only to ultra-high-net-worth investors. Remind investors too that non-traded REITs can help them avoid the volatility of traded stocks (strongly qualified, of course, by the admonition that this is part and parcel of the drawback of limited liquidity).
8. Establish and follow a procedure for documenting the fact that a recommendation to invest in a non-traded REIT is in the retirement investor’s best interest. It is critical to document (a) the financial institution’s relevant anti-conflict policies and procedures (including those designed to mitigate the harmful impact on advice provided to retirement investors, that may flow from material conflicts of interest), and compliance with these policies and procedures; (b) the manner in which it was determined that a recommendation to purchase shares in a non-traded REIT, as a component of the retirement investor’s portfolio, was prudent, consistent with professional standards, and in the retirement investor’s best interest; (c) the reasons for specifically recommending investment in a non-traded REIT, both generally and as concerns the particular non-traded REIT suggested; and (d) the conclusion that such a recommendation satisfied the “impartial conduct standards” detailed in DOL’s fiduciary rule.
Ideally, if and to the extent permitted by state securities regulators, have retirement investors acknowledge and represent in writing that, after considering the attendant advantages and risks, they affirmatively believe the purchase of shares in a non-traded REIT – and specifically shares in the non-traded REIT recommended – for their retirement account(s) is not only consistent with their investment objectives but also in their best interest.
This documentation should be saved for at least six years, in case it becomes necessary at some point to demonstrate the steps taken to evaluate whether the recommendation to invest in a non-traded REIT was consistent with the retirement investor’s best interest.
Because it is so important, counsel and/or qualified compliance officers should establish the documentation process, and monitor for adherence to it on an ongoing basis.
9. Arrange for the active involvement of competent conflicts and conduct officers. DOL’s fiduciary rule requires the designation (by name, title or function) of one or more persons responsible for addressing and monitoring the process established to prevent conflicts of interest from violating the “impartial conduct standards” described in DOL’s fiduciary rule. Financial institutions may well designate compliance officers to fulfill this responsibility. Assuming this is what occurs, compliance officers should be made available as a general matter to answer any questions by, and provide necessary guidance to, advisers who require assistance in satisfying a fiduciary standard.
Importantly, compliance officers should monitor any sales of non-traded REITs – to make sure advisers comply with prescribed anti-conflict policies and procedures; to reasonably assure that any recommendations given satisfy the “impartial conduct standards;” and to be certain there is appropriate documentation setting out the reasons for recommending an investment in a non-traded REIT, as well as the processes followed in determining whether it was prudent to make that recommendation.
It would also seem advisable for compliance officers to approve any sale, before it is executed. Such approval should be given only after confirming that the adviser properly assessed whether an investment in a non-traded REIT was arguably in the best interest of a retirement investor; after making an independent “best interest” assessment based on available information; or both.
It would seem wise as well to have compliance officers monitor the compensation and other consideration received from the sale of any non-traded REITs to make sure the amounts (a) are not in excess of “reasonable” compensation as measured by the market value of the particular services, rights, and benefits being received by the retirement investor; (b) do not incentivize an adviser to make recommendations that are at odds with the best interest of a retirement investor; and (c) are consistent with any disclosures made on the subject.
They should also monitor for any material conflicts of interest that may arise.
In addition, because DOL believes certain investments (like non-traded REITs) will likely require further guidance to protect a retirement investor’s interests, it expects financial institutions to agree to monitor such investments or, alternatively, to recommend that a retirement investor arrange for ongoing monitoring. To better guard the financial institution against unforeseen developments, and to bolster the “reasonableness” of any commission received, the smarter course is probably to have compliance officers, on an ongoing basis, monitor any non-traded REIT purchased by a retirement investor – to make sure it is performing as described and without issue; and to furnish the retirement investor with related disclosures about this undertaking, notices of any significant developments regarding the investment and, as appropriate, recommendations concerning any changes to that investment.
Lastly, compliance officers should become involved if and when there is any indication of a potential problem, to help avoid litigation from ensuing.
10. Purchase insurance to cover any legal claims that may relate to DOL’s fiduciary rule. The purpose in doing this is to protect against significant liability exposures, and substantially if not completely cover the costs of defending against most claims, should litigation be commenced.
If you believe it important, negotiate a right to select counsel of your choice. Otherwise, the insurer may reserve a right under the policy to appoint counsel – who may be selected for reasons other than a particular familiarity with non-traded REITs or special knowledge of DOL’s fiduciary rule and its related legal issues.
11. Identify counsel you might call upon if and when litigation arises. While it may seem premature, it is better to know beforehand whom you can and should call upon to represent you in the event a lawsuit is commenced. There usually is a finite window of time to appear and answer after a legal proceeding is started. It’s a stressful time, so conduct your search for litigation counsel before then.
The article is for general information purposes and is based upon the status of DOL’s fiduciary rule as of the date of preparation. The information presented is not intended to be, and should not be taken as, legal advice. How any particular financial institution or adviser addresses potential liability exposures will turn on individual circumstances. It’s therefore important to consult with counsel of your choice regarding how best to proceed.
The opinions in the preceding article are those of the author alone and do not necessarily reflect the views of The DI Wire.