Risks Lurk in DOL Rule Exemption for ‘Clean Shares’

Industry officials see the Labor Department moving forward in proposing a new, streamlined exemption for "clean shares" as part of its revised fiduciary rule, but warn that risks lie ahead in how Labor crafts such an exemption.

If Labor issues "too broad" a definition of clean shares, "the rule will bless conflicted payments in cases where they might be a problem," said Aron Szapiro, director of policy research at Morningstar, during a Friday panel discussion at the Consumer Federation of America's financial services conference in Washington. If the definition is "too narrow," the rule could "stifle innovation."

As it stands now, Szapiro added, the kind of innovation that DOL hoped would occur in promulgating its fiduciary rule "is flourishing."

Paul Roye, senior counsel for Capital Research and Management Company — which is the investment advisor for the American Funds — who spoke on the panel with Szapiro, opined that Labor "is going to fashion an exemption around clean shares" in any revised rule.

However, Roye, a former director of the Securities and Exchange Commission's Division of Investment Management, stated, "it's very easy to say 'clean share' exemption, but then you get into some of the issues … of what is 'clean'?"

Labor, through such an exemption, could end up "making decisions for investors and dictating winners and losers," Roye added. When regulators "try to decide what's best for investors, that stifles innovation and in my view is bad policy."

Labor announced Monday the official 18-month delay of its fiduciary rule's prohibited transaction exemptions. Micah Hauptman, the Consumer Federation's financial services counsel, who moderated the panel, stated that while the fiduciary rule "partially took effect" on June 9, the Labor Department, in delaying the exemptions, is "really stopping the rule from coming into effect."

It's "widely expected that DOL will revise or repeal the rule" in the interim, Hauptman added.

Clean Shares

Clean shares — which first came via T shares (or "transactional" shares) and then share class Z, or "clean" shares — were developed to allow level commissions that the broker could charge directly to the customer.

Szapiro noted in a recent Morningstar blog post that, as he's warned regulators, there's "promise and peril" in embracing clean shares.

The "industry and regulators generally agree that clean shares will not have front-end loads or 12b-1 fees, which are those used to pay for a mutual fund's distribution costs. So investors will pay an externalized fee for advice — that is, the broker or advisor charges it directly to a client," he wrote.

However, "there is disagreement about whether clean shares should include sub-transfer agency fees, or sub-TA fees, and other kinds of revenue sharing," he said. "A big part of the definition depends on what we expect clean shares to do and how much protection we think they give investors from conflicted advice on their own."

If regulators "assume that clean shares with sub-TA fees and other kinds of revenue sharing are the same as the cleanest shares without them, they will be endorsing products that can have embedded conflicts of interest," Szapiro added.

Michelle Kelley, senior vice president and associate counsel at LPL Financial, who spoke on the panel with Roye and Szapiro, noted that LPL will use the 18-month delay to fine-tune its fiduciary-friendly platform, which was released in April.

Through the platform, "we are standardizing compensation," Kelley said, adding that the "exercise has turned out to be the hardest in the mutual fund space" as "there are thousands of them and hundreds of fund companies and many different share classes those funds can sell."

The platform, which currently offers 20 fund families, allows for the payment of commission "that is level, so that no matter what the fund is, the [client] will know how much they pay."

The fiduciary-friendly platform "will have a single share class," she added. "We see that as the future, and that share classes will be streamlined."

Roye agreed that, "over time, you will see fewer share classes. We no longer offer B shares. We shut them down."

Added Szapiro: "I think most of the assets will flow to the clean shares."

— Check out 'Full Speed Ahead' With DOL Fiduciary Compliance Despite Delay on ThinkAdvisor.