In Part 1 of this series, we reported on recently proposed regulations issued by the U.S. Department of Labor amending the definition of the term “fiduciary” under the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code (the “Code”). This post will examine a key feature of the Department’s proposed regulatory scheme—the “Best Interest Contract” exemption—that allows advisers to small retirement plans and IRA investors to receive commission-based compensation without triggering a fiduciary breach or incurring excise tax exposure under rules governing prohibited transactions.

Background

The proposed regulations expand the class of investment professionals, advisers and other service providers who qualify as fiduciaries. Under current law, advisers who provide investment advice to small plans and IRAs investors and whose compensation is commission-based (e.g., who receive 12b-1 fees, revenue sharing payments, marketing fees, administrative fees, sub-TA fees, sub-accounting fees, and other third-party payments) are generally able to avoid fiduciary status based on the narrow “five-part” test (discussed in Part 1 of this series) that defines “investment advice” for purposes of fiduciary exposure. The proposed regulations, as currently drafted, would change this by replacing the five-part test with a much broader definition. Under the newly proposed definition, advisers who receive commission-based compensation would, in the vast majority of instances, be fiduciaries.

Under the prohibited transactions rules in both ERISA and the Code, a fiduciary cannot receive from any party, directly or indirectly, any fees (including commissions or other compensation) that vary depending on the investment option selected by a plan participant or beneficiary or IRA investor. By eliminating the protection previously afforded by the five-part test, the proposed regulations force advisers working on a commission-based fee arrangement to come under a prohibited transaction exemption or fit within one of the specific carve-outs provided in the proposed regulations.  The Department explains the issue as follows:

In particular, investment professionals typically receive compensation for services to retirement investors in the retail market through a variety of arrangements. These include commissions paid by the plan, participant or beneficiary, or IRA, or commissions, sales loads, 12b–1 fees, revenue sharing and other payments from third parties that provide investment products. The investment professional or its affiliate may receive such fees upon the purchase or sale by a plan, participant or beneficiary account, or IRA of the product, or while the plan, participant or beneficiary account, or IRA, holds the product. In the Department’s view, receipt by a fiduciary of such payments would violate the prohibited transaction provisions of ERISA section 406(b) and Code section 4975(c)(1)(E) and (F) because the amount of the fiduciary’s compensation is affected by the use of its authority in providing investment advice, unless such payments meet the requirements of an exemption.

While the proposed regulations include a sellers exemption (i.e., a carve-out for “statements or recommendations made to a ‘large plan investor with financial expertise’ by a counterparty acting in an arm’s length transaction”), the seller’s exemption applies only to investment advice provided to retirement plans with 100 or more participants or with $100 million in employee plan assets. It does not apply to small plans or IRAs, nor does it apply to ancillary services.

In the case of advisers to small plans and IRA investors, the Department has proposed a “Best Interest Contract” (or “BIC”) exemption. In the preamble to the proposed regulations, the Department of Labor explains that this exemption:

. . . was developed to promote the provision of investment advice that is in the best interest of retail investors such as plan participants and beneficiaries, IRA owners, and small plans. ERISA and the Code generally prohibit fiduciaries from receiving payments from third parties and from acting on conflicts of interest, including using their authority to affect or increase their own compensation, in connection with transactions involving a plan or IRA. Certain types of fees and compensation common in the retail market, such as brokerage or insurance commissions, 12b-1 fees and revenue sharing payments, fall within these prohibitions when received by fiduciaries as a result of transactions involving advice to the plan participants and beneficiaries, IRA owners and small plan sponsors.

The BIC Exemption

Under current rules, investment advisers in the retail space operate under a “suitability” standard prescribed by FINRA. Under that standard, an adviser is only obligated to attempt to obtain information about the customer’s age, other investments, financial situation and needs, investment time horizon, liquidity needs and risk tolerance. There is no bar on conflicts of interest, nor is there any obligation under the suitability standard to act in the customer’s best interest.

The Department is of the view that the suitability standard is inconsistent with the protections enacted by ERISA, taking the position that the suitability standard fails to foster the provision of investment advice in the best interest of retirement plan and IRA investors. It is particularly troubling to the Department that advisers in the retail environment often receive commission-based compensation that varies from product to product and that advisers are free to select products that pay higher commissions with impunity — regardless of whether the recommended product is suited to the particular investor receiving the advice.

In simplest terms, the BIC exemption attempts to preserve commission-based compensation arrangements while at the same time ensure that investment advice is provided with the best interest of retail investors, such as plan participants and beneficiaries, IRA owners, and small plans, in mind. If adopted, it would permit advisers and their firms to receive fees (including 12b-1 and revenue sharing fees) in connection with investment transactions made by plan participants, beneficiaries, IRAs and small plans—i.e., plans with plans with fewer than 100 participants or with less than $100 million in assets.

The benefits of the BIC exemption are conferred on and available to advisers who provide investment advice for a fee to a small plan or an IRA investor with respect only to certain “assets.” An adviser, for purposes of the rule, also includes an employee of a financial institution, e.g., a registered representative, or an affiliate of a financial institution. The term “asset” is limited to the following:

• Bank deposits and certificates of deposit (CDs)

• Shares or interests in registered investment companies

• Bank collective funds

• Insurance company separate accounts

• Exchange-traded REITs

• Exchange-traded funds

• Corporate bonds offered pursuant to a registration statement under the Securities Act of 1933

• Agency debt securities as defined in FINRA Rule 6710(l) or its successor

• S. Treasury securities as defined in FINRA Rule 6710(p) or its successor

• Insurance and annuity contracts

• Guaranteed investment contracts

• Exchange-traded equity securities

Specifically excluded from the definition are futures contracts, puts, calls, straddles and any other “option or privilege of buying an equity security from or selling an equity security to another without being bound to do so.”

For the BIC exemption to apply, the advice must be provided to a “retirement investor,” which means and includes:

• A participant or beneficiary in a plan subject to ERISA with the authority to direct the investment of assets in his or her account or to take a distribution,

• The beneficial owner of an IRA acting on behalf of the IRA, or

• A plan sponsor of a non-participant-directed plan that is subject to ERISA that has fewer than 100 participants, to the extent it acts as a fiduciary with authority to make investment decisions for the Plan.

Thus, the BIC exemption does not apply to advisers who advise on the selection on a menu of investment options.  As a result, advisors providing advice relating to the selection of an investment menu must either satisfy general fiduciary standards or, alternatively, qualify for a carve-out or fit within a prohibited transaction exemption in order to avoid fiduciary exposure. (A future post will examine the options available to advisers who assist plan fiduciary committees with selection of a menu of investment options.)

The BIC exemption provides relief from the prohibited transaction rules of ERISA and the Code in the case of the receipt of compensation by an adviser, financial institution, or an affiliate or other related entity, collectively referred to as “fiduciary advisers.” The types of compensation payments contemplated by the BIC exemption include:

• Commissions paid directly by the plan or IRA, as well as commissions, trailing commissions, sales loads, 12b–1 fees, and revenue sharing payments paid by the investment providers or other third parties to advisers and financial institutions; and

• Other compensation received by an adviser, financial institution, affiliate or related entitity as a result of an investment by a plan, participant or beneficiary account, or IRA (such as investment management fees or administrative services fees from an investment vehicle in which the plan, participant or beneficiary account, or IRA invests).

The exemption would require advisers and their firms to enter into a written contract with the plan/IRA investor. The contract would not be permitted to contain exculpatory provisions disclaiming or otherwise limiting liability of the fiduciary adviser and firm for violation of the contract’s terms.

Availability of the BIC exemption also requires the adviser to satisfy certain conditions, which include the following:

• The contract must state that the adviser and firm are fiduciaries, to the extent they make investment recommendations.

• The contract must provide that the adviser and firm will adhere to impartial conduct standards including: acting in the “best interest” of the plan/IRA investor, charging no more than reasonable compensation and not making misleading statements. (This requirement is referred to as the “Impartial Conduct Standard,” and it plays an important role in changes made to other, existing prohibited transaction class exemptions.)

• The adviser and firm must warrant in the contract that they will comply with applicable federal and state law related to the provision of advice and the investment transaction.

• The adviser’s firm must warrant in the contract that it has put in place policies and procedures to mitigate material conflicts of interest and to ensure compliance with the impartial conduct standards, including a warranty that the firm does not allow employment incentives that would encourage advisers to violate the best interest standard.

• Advice must reflect the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the investment objectives, risk tolerance, financial circumstances and needs of the plan or IRA investor, without regard to the financial or other interests of the adviser, firm, or any affiliate, related entity or other party.

• Financial institutions must disclose any limits on investment recommendations based on proprietary products, receipt of third party payments or other reasons and make a specific determination that such limitations do not prevent the adviser from providing investment advice that is in the best interest of the firm’s plan and IRA clients or otherwise adhering to the impartial conduct standards. The adviser must further notify the plan or IRA investor if the adviser does not recommend a sufficiently broad range of assets to meet the plan’s or IRA investor’s needs. Payments received by such firms must be reasonable in relation to a specific service rendered in exchange for the payment.

• Financial institutions must provide customers a chart with respect to the recommended investment before execution of the purchase. Among other things, the chart would show the total cost of the investment, including the acquisition cost (such as commissions), ongoing costs (such as revenue sharing), disposition costs and other costs that reduce the investment’s return. On an annual basis, the customer must receive a summary of the investments purchased or sold, and the adviser’s and financial institution’s total compensation as a result of the listed investments over the period.

• The fees and expenses related to a mutual fund must be disclosed in the fund’s prospectus.

The BIC exemption includes a supplemental exemption that gives more leeway to advisers when structuring a plan’s or IRA’s purchase of an insurance or annuity product. This supplemental exemption is necessary, according to the Department, because purchases of insurance and annuity products are often prohibited purchases and sales involving insurance companies that have a pre-existing party-in-interest relationship to the plan or IRA. In proposing this supplemental exemption, the Department of Labor assumes that the fiduciary that coordinates a plan’s or IRA’s purchase of an insurance or annuity product is not the insurance agent or his or her employer/insurance company. Rather, the fiduciary would be the plan sponsor or IRA owner, acting on the agent’s advice. While there is an existing exemption which would often cover these transactions (PTE 84–24), the Department is proposing to revoke that exemption in relevant part and replace it with the BIC exemption.

In order to take advantage of the insurance and annuity exemption under the proposed regulations, the transaction must be effected by the insurance company in the ordinary course of its business as an insurance company, the combined total of all fees and compensation received by the insurance company must not be not in excess of reasonable compensation under the circumstances, the purchase must be for cash only and the terms of the purchase must be at least as favorable to the plan as the terms generally available in an arm’s length transaction with an unrelated party. Relief under the proposed insurance and annuity exemption would not extend to a plan where the adviser/agent of the financial institution or affiliate is the employer of employees covered by the plan, or where the adviser/agent or financial institution is a named fiduciary or plan administrator.

Lastly, the proposal furnishes an exemption for receipt of prohibited compensation prior to the rule’s effective date (the so-called “applicability date”) related to services provided in connection with the purchase, sale or holding of an asset before the applicability date. This relief is needed, according to the Department, for investment professionals who provided advice prior to the applicability date but did not consider themselves fiduciaries. The relief also extends to advisers and financial institutions who were considered fiduciaries before the applicability date, but who entered into transactions involving plans and IRAs before the applicability date in accordance with the terms of a prohibited transaction exemption that has since been amended. (The proposed rule’s impact on existing prohibited transaction class exemptions will be the subject of a future post.)

Impact and Consequences

The BIC exemption is aimed at the retail market for investment advice, and its purpose is to continue to allow retail brokers to receive commission-based compensation. To get to this result, the Labor Department asserts that it has proposed a “principles-based” approach rather than “a set of highly prescriptive transaction-specific exemptions,” which has generally been the regulatory approach under prior prohibited transaction class exemptions. We are not so sure.

Conceptually, the BIC exemption makes a good deal of sense: start with a broad prohibition, and then establish a targeted exception that strikes an appropriate balance between continued use of wide-spread and settled industry compensation practices and protection of the interests of the retail investor. However, in our view, the BIC exemption fails to strike this balance.

While it could be improved with modification, the current problems with the BIC exemption include:

The exemption exposes advisers and financial institutions to class action claims based on required warranties, which may involve an unacceptable level of risk.

The retail financial services industry has long required customers to agree to arbitration of claims against advisers and institutions alike. The BIC exemption does not bar arbitration provisions as potential plaintiffs might have hoped, but it does ensure access to the courts for class actions. In the case of ERISA-covered retirement plans, this will likely mean access to federal court with limits on remedies. For claims involving IRAs, this will mean litigation based on state law, with all its attendant risk.

More troubling still is scope of the “Impartial Conduct Standard.” Might that standard imply that the an adviser for mutual fund A would be required to instead recommend mutual fund B of a competitor if the adviser, acting impartially, felt that mutual fund B was a better deal? Even if this is not what the Department of Labor intended, it’s a good place for the plaintiff’s class action bar to start.

The adviser must acknowledge, and will be subject to, fiduciary status. Accordingly, the adviser will be subject to ERISA-like standards, but remedies will not be limited in the case of IRAs.

Perhaps the most troubling aspect of this requirement, as it applies to IRAs, is that the Department of Labor is adding a fiduciary where Congress did not see fit to impose one.

The required disclosures are expansive and burdensome.

The costs of adopting and enforcing policies and procedures, modifying compensation grids (in the case of retirement plans and IRAs) and tracking and organizing annual disclosure data (including core data summarizing investments purchased or sold and the adviser’s and financial institution’s total compensation for the period) will require enormous effort and expense. The result might force all but the largest financial institutions to exit the retirement plan and IRA business.