Category Archives: Prohibited Transaction

Interesting Angles on the DOL’s Fiduciary Rule #63

Policies and Procedures: The Fourth BICE Requirement

This is my 63rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

On August 31, the Department of Labor (DOL) issued its proposal to extend the transition period for three prohibited transaction exemptions until July 1, 2019. Those exemptions are the Best Interest Contract Exemption (BICE), the 84-24 exemption (for sale of annuities and insurance products), and the Principal Transactions Exemption. In all likelihood, the DOL will finalize that extension within the next 60 days.

The practical effect will be to both delay the applicability date of the final exemptions until July 1, 2019 and to extend the transition versions of those exemptions until June 30, 2019.

However, the DOL is not proposing to extend the applicability date of the fiduciary rule. The full fiduciary regulation applied earlier this year–on June 9, 2017. In other words, advisors to “qualified” accounts (i.e., plans, participant accounts and IRAs) already are fiduciaries. And, where the advisor or the advisor’s supervisory entity (for example, a broker-dealer) receives payments from third parties (such as insurance commissions or 12b-1 fees), or where the advice increases their compensation, those payments will be prohibited transactions. As a result, those advisors and entities will need the protection of a prohibited transaction exemption.

BICE is the exemption that will be used for most transactions. In order to comply with BICE, the supervisory entity and the advisor must satisfy the three Impartial Conduct Standards: the best interest standard of care; no more than reasonable compensation; and no materially misleading statements.

It is commonly believed that BICE requires satisfaction of only those three conditions. However, that is not the case. There is a fourth, and less well-known, requirement. As stated in the DOL’s August 31 guidance:

During the Transition Period, the Department expects financial institutions to adopt such policies and procedures as they reasonably conclude are necessary to ensure that advisers comply with the impartial conduct standards. During that period, however, the Department does not require firms and advisers to give their customers a warranty regarding their adoption of specific best interest policies and procedures, nor does it insist that they adhere to all of the specific provisions of Section IV of the BIC Exemption as a condition of compliance. Instead, financial institutions retain flexibility to choose precisely how to safeguard compliance with the impartial conduct standards, whether by tamping down conflicts of interest associated with adviser compensation, increased monitoring and surveillance of investment recommendations, or other approaches or combinations of approaches.(Emphasis added.)

As a result, supervisory entities, such as broker-dealers and RIAs, need to ensure that their practices, policies and procedures, and supervision are adequate to protect retirement investors from the conflicts arising from advisor compensation that could incent an advisor to make recommendations that are not in the best interest of a retirement investor. While the conflict can arise in any situation involving commissions or similar transactional payments, there are other, less obvious, areas where the conflict can be significant and where, therefore, the policies and practices may need to be strengthened. For example, when an advisor recommends that a participant take a distribution and roll it over to an IRA, that recommendation typically results in higher compensation for the advisor. And, where the rollover amount is large, the additional compensation can be significant. As a result, financial institutions, such as broker-dealers and RIAs, need to have compliant processes in place to ensure that inappropriate rollover recommendations are not made. In addition, those recommendations need to be supervised to ensure compliance with the best interest standards. This is an area where a conservative approach is good risk management.

The same concept applies to other types of recommendations where significant increases in compensation to advisors could result, as well as to bonus and recruiting arrangements. Any arrangement that materially increases advisor compensation should be closely vetted. That vetting should occur at three levels. The first is the design of the compensation system; the second is the development of policies and procedures to oversee that fiduciary recommendations are in the best interest of retirement investors; and the third is the supervision of those policies and procedures. Now is the time to review practices, policies and supervision in light of the DOL’s expectations.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #56

The Department of Labor has reversed its position on the issues discussed in the article below. Angles article #58 explains the changes.

Recommendations of Contributions as Fiduciary Advice

This is my 56th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor’s Request for Information on the fiduciary rules and exemptions focuses on a number of issues that became apparent as financial institutions and advisers work to comply with the new requirements. One of these, which is addressed in the RFI, but which has not been generally discussed, is that a recommendation of a contribution, or of increased contributions, to plans and IRAs is a fiduciary act. As a result, if the recommended contribution causes higher compensation to be paid to the adviser (or the adviser’s financial institution), the recommendation would result in a prohibited transaction.

The problems are obvious. Even though there is a potential conflict of interest where an adviser could make a little more money because of the increased contributions, the benefits to participants of increasing their retirement savings in plans and IRAs are meaningful. In that regard, it seems that public policy would favor increased contributions to IRAs and plans, even though there may be some minor benefit to the person making the recommendation.

With that in mind, the Department of Labor’s RFI asked:

Contributions to Plans or IRAs

Should recommendations to make or increase contributions to a plan or IRA be expressly excluded from the definition of investment advice? Should there be an amendment to the Rule or streamlined exemption devoted to communications regarding contributions? If so, what conditions should apply to such an amendment or exemption?

The first question is whether a recommendation to make those contributions should be viewed as a fiduciary act. My view is that it should not. The benefits of increased contributions are so obvious, and the potential conflict is so small, that the easiest, and most direct, solution would be for the DOL to conclude that a recommendation to make or increase contributions is not fiduciary advice.

However, if the DOL doesn’t do that, it should follow through with a favorable response to the second question. In its essence, the DOL’s second question is whether there should be a streamlined exemption for contribution recommendations. A truly streamlined exemption might work. However, usually exemptions have conditions. If those requirements are more than di minimus, the rules would likely create a trap for the unwary. In saying that, I mean that many advisers might not be aware of those additional requirements when recommending that a retirement investor save more in his or her IRA or plan.

Hopefully, the DOL will conclude that recommendations to a participant or IRA owner to increase their retirement contributions is not a fiduciary act. If they conclude otherwise, a recommendation to make or increase contributions would result in a prohibited transaction . . . and an exemption will be necessary. Unless it is an exemption without conditions (which is rare, but possible), there will undoubtedly be inadvertent violations.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #53

The Fiduciary Rule and Discretionary Investment Management

This is my 53rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

In recent conversations I have learned that many broker-dealers and RIAs do not understand how the prohibited transaction rules and exemptions (and, particularly, the Best Interest Contract Exemption) apply differently to discretionary accounts and non-discretionary accounts. This article discusses some of those differences.

One similarity, though, is that ERISA’s prudent man rule and duty of loyalty apply for both discretionary and non-discretionary advice to retirement plans and participants.

However, ERISA does not generally govern investment advice to IRAs. As a result, absent the need for a prohibited transaction exemption, advisers to IRAs will not be governed by fiduciary/best interest standard of care. For example, where an adviser (and his or her supervisory entity) provides discretionary or non-discretionary investment advice to an IRA on a “pure” level fee basis, the adviser and the entity are subject to the fiduciary standards under the securities laws, but are not covered by the new fiduciary rule. That is because, where an adviser is providing advice for a reasonable level fee, it is not a prohibited transaction. As a result, an exemption is not needed. (By the way, a “pure” level fee is compensation that does not vary based on the advisory decisions or recommendations and that is not paid by third parties, e.g., 12b-1 fees, insurance commissions, etc. Also, the fee must be level across all related and affiliated parties.)

However, where there is a financial conflict of interest for non-discretionary or discretionary investment advice to an IRA, a prohibited transaction results. That includes, for example, where the adviser or supervisory entity (or any affiliated or related party) receives compensation in addition to the level fee. Examples of those additional, and conflicted, payments are: 12b-1 fees; insurance commissions and trails; proprietary products; asset-based revenue sharing; and payments from custodians.

Where conflicted payments are received, and a prohibited transaction occurs, the adviser and the supervisory entity will need an exemption. If the adviser provides non-discretionary investment advice, the Best Interest Contract Exemption (BICE) is available, if its conditions are satisfied. BICE requires only that the adviser and the supervisory entity comply with the Impartial Conduct Standards during the transition period (the transition period is from June 9 to December 31, 2017, but will likely be extended). The Impartial Conduct Standards are that the adviser and entity adhere to the best interest standard of care, receive no more than reasonable compensation for their services, and make no materially misleading statements. The entity–-the broker-dealer or RIA firm-–also needs to have procedures and practices to ensure that the conflicts do not result in advice that is not in the best interest of the retirement investor.

However, BICE cannot be used for prohibited transactions that result from discretionary investment management. In fact, there are only a few exemptions for discretionary investment management, and none as broad as BICE. For example, there is an exemption for the use of proprietary mutual funds.

As a result, many—and perhaps most—financial conflicts (that is, prohibited transactions) that result from discretionary investment management decisions are absolutely prohibited, because there are not exemptions for the conflicted payments.

The moral of this story is that RIA firms and broker-dealers need to distinguish between discretionary investment management and non-discretionary investment advice. For the time being, at least, most conflicts of interest for nondiscretionary advisers are permissible, if the Impartial Conduct Standards are satisfied. However, for discretionary investment management, there are few exemptions and most financial conflicts will be prohibited without any available exemptions. To the extent that the prohibited transaction rules are being inadvertently violated for managed IRAs, now is the time to correct the errors.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #50

The Fourth Impartial Conduct Standard

This is my 50th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

When the Department of Labor announced that the fiduciary rule and the transition exemptions would apply on June 9, it also issued a non-enforcement policy and a set of Frequently Asked Questions (FAQs) and Answers. The FAQs are titled “Conflict of Interest FAQs (Transition Period).”

For the most part, the FAQs are benign and helpful. However, FAQ 6 raises some significant issues for broker-dealers and RIA firms. In relevant part, FAQ 6 states:

During the transition period, the Department expects financial institutions to adopt such policies and procedures as they reasonably conclude are necessary to ensure that advisers comply with the impartial conduct standards. During that period, however, the Department does not require firms and advisers to give their customers a warranty regarding their adoption of specific best interest policies and procedures, nor does it insist that they adhere to all of the specific provisions of Section IV of the BIC Exemption as a condition of compliance. Instead, financial institutions retain flexibility to choose precisely how to safeguard compliance with the impartial conduct standards, whether by tamping down conflicts of interest associated with adviser compensation, increased monitoring and surveillance of investment recommendations, or other approaches or combinations of approaches. For example, some firms have indicated that they intend to rely upon or build on existing regulatory compliance structures to monitor their advisers’ sales practices and recommendations, document the bases for those recommendations, and ensure that the impartial conduct standards are met (e.g., by subjecting transactions involving conflicts of interest to heightened scrutiny and surveillance).

As a general rule, the Best Interest Contract Exemption (BICE) requires only that broker-dealer and RIAs comply with the Impartial Conduct Standards. The Impartial Conduct Standards are:

  • The best interest standard of care.
  • No more than reasonable compensation.
  • No materially misleading statements.

However, the quoted language from FAQ 6 has the effect of adding a fourth requirement. It is that RIAs and broker-dealers, as financial institutions, adopt the policies and procedures “as they reasonably conclude are necessary to ensure that advisers comply with the Impartial Conduct Standards.”

That language should not be ignored. That is because, among other reasons, the non-enforcement policy requires that financial institutions, such as broker-dealers and RIAs, make a “diligent and good-faith” effort to comply with BICE. Since this additional requirement is imposed as a condition of BICE, it seems difficult to imagine that the non-enforcement policy would be available to a broker-dealer or RIA who did not adopt appropriate policies, procedures, practices and supervision.

Then, the question is, what is “appropriate”? The quoted language provides several alternatives. Those are:

  • Review and determine that existing policies, procedures and supervision is adequate for ensuring that the impartial conduct standards are met.
  • Review and revise existing policies, procedures and supervision, as needed.
  • Adjust adviser compensation to reduce and/or to otherwise manage the effects of conflicts of interest that arise from varying levels of compensation.
  • Heightened scrutiny, surveillance and supervision of transactions involving conflicts of interest.
  • Monitoring advisers’ sales practices and recommendations, including documenting the basis for recommendations.
  • A combination of the above and/or possibly other reasonable practices.

As I read this requirement, a good approach is for a financial institution to review its existing policies, procedures, compensation practices and supervision, and document why they will “ensure that advisers comply with the Impartial Conduct Standards.” No particular approach is required for doing that, but appropriate steps should be taken. (By the way, I specifically mention documentation of the decision because financial institutions may be required to demonstrate that they complied with this requirement. Also, under ERISA, the DOL has specifically stated that documentation is an integral part of a prudent process, and it appears likely that those requirements will apply to fiduciary services under BICE, as well.)

During the transition period, it is possible, perhaps even likely, that the DOL will accept any reasonable efforts to comply with this requirement. In other words, the DOL will probably apply a “reasonable efforts” standard, rather than a “strict compliance” standard. However, the attorneys who represent investors—most likely in arbitrations—will probably push for a higher standard. With that in mind, the broker-dealers and RIAs need to think about the policies, procedures, compensation practices and supervision that will appropriately manage the risk in that more demanding scenario.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #49

The Requirement to Disclose Fiduciary Status

This is my 49th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

When the new fiduciary rule applies on June 9, it will convert most non-fiduciary advisers into fiduciaries.

While there is not a disclosure requirement for new fiduciary advisers to IRAs, there is for these newly minted fiduciary advisers to plans. But it’s not part of the new regulation. Instead the requirement is found in the 408(b)(2) regulation which was effective in 2012.

As background, that regulation required that service providers to ERISA-governed retirement plans, including advisers, make written disclosures to plan fiduciaries of their services, compensation and “status.” The status requirement was that service providers disclose if they were fiduciaries under ERISA and/or the securities laws (e.g., RIAs). The regulation describes the status disclosure as follows:

If applicable, a statement that the covered service provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services pursuant to the contract or arrangement directly to the covered plan…as a fiduciary…; and, if applicable, a statement that the covered service provider, an affiliate, or a subcontractor will provide, or reasonably expects to provide, services pursuant to the contract or arrangement directly to the covered plan as an investment adviser registered under either the Investment Advisers Act of 1940 or any State law.

(The reference to “subcontractor” includes representatives of broker dealers who are independent contractors.)

For the most part, broker-dealers, and insurance agents and brokers, have taken the position that they were not fiduciaries and therefore did not make the fiduciary disclosure. And, if they were not in fact fiduciaries, those disclosures worked from July 1, 2012 until June 9, 2017, when the new definition will make them fiduciaries.

Technically, that last sentence is not absolutely correct. Let me explain. First, the new regulation requires that, to be considered a fiduciary, the adviser (and the supervisory entity) must make an investment recommendation. And, until the first investment recommendation is made, the adviser and entity are not fiduciaries. However, the definition of investment recommendation is so broad that it may be best to treat June 9 as the day they became fiduciaries. For example, a recommendation is a “suggestion” that the plan fiduciaries select, hold or remove investments; that the fiduciaries use a fiduciary adviser to give advice on investments or to help participants with investments; that the fiduciaries include certain specified policies in the IPS; and so on.

In other words, under the new rules it’s hard for an adviser to work with a plan without being a fiduciary.

So, accepting that virtually all advisers to plans become fiduciaries on June 9, what does that mean for disclosure of fiduciary status?

The 408(b)(2) regulation generally provides that, after the initial notice is provided, no subsequent disclosures are required until there is a change in the information initially provided. But, of course, where the first notice was silent about fiduciary status, the transition to fiduciary status is a change. Here’s what the regulation says about changes:

A covered service provider must disclose a change to the information…as soon as practicable, but not later than 60 days from the date on which the covered service provider is informed of such change, unless such disclosure is precluded due to extraordinary circumstances beyond the covered service provider’s control, in which case the information must be disclosed as soon as practicable.

In other words, the service provider (e.g., the broker dealer and adviser) must make a written disclosure of the change to fiduciary status to the “responsible plan fiduciary” within “60 days from the date on which the [broker dealer/adviser] is informed of such change.” Unfortunately, there isn’t any guidance on when a service provider is “informed” of the change to fiduciary status under these circumstances. For example, was it the day that it was finally determined that the fiduciary regulation would be applicable on June 9? Or, will it be on June 9? Or, will it be the first day that the adviser makes the first post-June 9 recommendation?

In the absence of clear guidance, a conservative approach may be advisable. So, my suggestion is that the change notice be sent in June. That’s not my conclusion about the outer limit; instead, it’s a conservative position.

The consequence of the failure to make 408(b)(2) disclosures is that compensation paid the broker-dealer and the adviser is prohibited.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #48

The Last Word: The Fiduciary Rule Applies on June 9

This is my 48th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

The Department of Labor has announced that it will not further delay the application of the fiduciary rule. As a result, the new fiduciary definition and the “transition” exemptions will apply to investment and insurance advice to plans, participants and IRA owners (“Retirement Investors” of “qualified accounts”) on June 9.

When the DOL announced its decision, it also issued additional guidance, in the form of FAQs and a non-enforcement policy.

For the most part, the FAQs were helpful.

For example, they clarify that certain types of information and conversation are educational, rather than fiduciary. However, FAQ #6 appears to have increased the compliance burden on “Financial Institutions,” such as broker-dealers, RIAs, banks and insurance companies. While the general rule for conflicted advice is that the Financial Institution and adviser must adhere to the Impartial Conduct Standards (see below), that Q&A said that Financial Institutions have additional responsibilities to manage conflicts so that variable compensation does not influence advisers to make recommendations that are not in the best interest of Retirement Investors.

The non-enforcement policy (Field Assistance Bulletin [FAB] 2017-02) provides that the DOL will not enforce the fiduciary standard or the exemptions during the transition period (from June 9 to December 31), so long as the Financial Institution is making diligent and good faith efforts to comply. However, the failure to make diligent and good faith efforts to comply will result in the loss of the benefit of the non-enforcement policy. Also, the IRS and Treasury will not enforce the fiduciary advice prohibited transactions during the transition period, so long as the requirements of the DOL non-enforcement policy are met.

What does this mean?

It means that, beginning on June 9, recommendations of investment or insurance products or services to qualified accounts must be evaluated two ways.

1.   Is the recommendation prudent and loyal?

Recommendations to ERISA-governed retirement plans and participants (including rollover recommendations) are subject to ERISA’s prudent man rule and duty of loyalty. ERISA protections apply and claims can be asserted based on breaches of the fiduciary rule.

However, IRAs (other than SEPs and SIMPLEs) are not governed by ERISA and, therefore, the fiduciary standard does not automatically apply (but see the prohibited transactions discussion below).

2.  Does the recommendation result in a prohibited transaction and, if so, are the conditions of an exemption satisfied?

Simply stated, any fiduciary recommendation that results in a payment from a third party (such as a mutual fund or an insurance company) or increases the compensation of the adviser or Financial Institution is a prohibited transaction. As a result, an exemption will be needed. The two most common exemptions are 84-24 (which applies to annuities and insurance products) and BICE (which applies to all types of investments and services, including insurance products). Both require that the adviser adhere to the Impartial Conduct Standards. (However, 84-24 has other requirements, including disclosure compensation and written approval by the Retirement Investor.)

This article focuses on transition BICE, since that exemption will be used in most cases.

As explained above, BICE requires that the Financial Institution and adviser adhere to the Impartial Conduct Standards. There are three such standards:

  • The Best Interest standard of care (which is, in its essence, a combination of ERISA’s prudent man rule and duty of loyalty).
  • The Financial Institution and the adviser can receive no more than reasonable compensation.
  • The adviser and Financial Institution cannot make materially misleading statements.

Since one of the conditions of BICE is that the Financial Institution and the adviser adhere to the Best Interest standard of care, the exemption effectively imposes a fiduciary standard of care. In other words, if the Financial Institution and adviser do not satisfy the fiduciary standard, the exemption will be lost and any compensation paid to the Financial Institution and adviser must be restored to the investor’s account. As a result, even though IRAs are not subject to ERISA’s prudent man rule, the exemption has the same effect as if advice to IRAs were subject to ERISA.

Financial Institutions (including broker-dealers, RIAs, banks and trust companies, and insurance companies) need to institute policies and procedures for compliance with these rules, including training of their representatives about how to satisfy the duties of prudence and loyalty.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #46

How Does an Adviser Know How to Satisfy the Best Interest Standard?

This is my 46th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

Beginning on June 9, the new “transition” exemptions will apply to investment and insurance (e.g., annuities) recommendations for IRAs. If an adviser and his supervisory entity (the “financial institution”) are “pure” level fee fiduciaries, there will not be a prohibited transaction under the Internal Revenue Code (so long as the fees are reasonable). Two consequences flow from that. First, the adviser and entity will not need to use the Best Interest Contract Exemption (BICE), which means that they will not be bound by the best interest standard of care. Second, their services to the IRA will be regulated by the securities laws, and not by these new rules.

But, if there is a financial conflict of interest (that is, a prohibited transaction, or PT), the adviser and entity (e.g., broker dealer) will need to use an exemption in order to be paid. The most likely exemption is BICE, and one of the conditions is that the adviser and entity adhere to the “best interest standard of care.” But, what is the best interest standard of care? In essence, it is a combination of ERISA’s prudent man rule and duty of loyalty. Literally, it is:

Investment advice is in the “Best Interest” of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

While advisers to retirement plans are familiar with those concepts, many advisers to IRAs are not. That raises the question, how can those advisers know what is required? The answer is that fiduciary training and education are needed . . . and needed immediately in light of the June 9 applicability date.

What is the basis for the training? Answer: The fiduciary requirements in ERISA. The DOL made that clear in the preamble to BICE:

“The Best Interest standard set forth in the final exemption is based on longstanding concepts derived from ERISA and the law of trusts. It is meant to express the concept, set forth in ERISA section 404, that a fiduciary is required to act “solely in the interest of the participants . . . with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” Similarly, both ERISA section 404(a)(1)(A) and the trust-law duty of loyalty require fiduciaries to put the interests of trust beneficiaries first, without regard to the fiduciaries’ own self-interest.”

As a result, broker-dealers and others should look to training and education materials based on ERISA’s provisions, DOL regulations and guidance, and ERISA litigation. Those materials should cover the broad concepts and principles, but should also provide detailed education about the information to be reviewed and the processes to be followed, on a step-by-step basis.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #45

The DOL Fiduciary “Package”: Basics on the Prohibited Transaction Exemptions

This is my 45th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

My last post (Angles #44) discussed the requirements of ERISA’s prudent man rule and of the best interest standard of care for IRAs and plans. This article outlines the requirements of the two prohibited transaction exemptions that will apply to recommendations of investment products and services and insurance products to plans, participants and IRAs (“qualified accounts”). Those two exemptions are:

  • Prohibited Transaction Exemption 84-24 (which covers recommendations of insurance products, including annuities and life insurance policies). This “transition” 84-24 has been amended to cover all types of annuities (group and individual, variable, fixed rate and fixed index) and applies to the period from June 9, 2017 through December 31, 2017.
  • The Best Interest Contract Exemption (BICE) which can be used for sales of any investment products and services or any insurance products (including those covered by 84-24) during the transition period.

Before discussing the general requirements of those exemptions, I should point out that not all advisory services require the use of an exemption. For example, if an adviser provides investment services to a plan, participant or IRA for a pure level fee, there is not a conflict of interest, in the sense that the adviser’s compensation remains the same regardless of the investments that are recommended. By “pure level fee,” I mean that neither the adviser, nor any affiliate nor related party (including the adviser’s supervisory entities, e.g., broker-dealer), receives any additional compensation or financial benefit.

If, however, the adviser, or any affiliated or related party, does receive additional compensation, that would be a financial conflict of interest, which is a “prohibited transaction” under ERISA and the Internal Revenue Code. In that case, the adviser would need to take advantage of one of the exemptions: BICE or 84-24. (I should point out that neither 84-24 nor BICE is available where the adviser has discretion over the investments in the plan, participant’s account or IRA. As a result, discretionary investment management must be for a pure level fee or a different exemption must be found.)

Here are some examples of compensation that constitutes a prohibited transaction: commissions; 12b-1 fees; trailing payments; asset-based revenue sharing; solicitor’s fees; proprietary investments; and payments from custodians. If any of those payments, or any other financial benefits (such as trips, gifts, or marketing allowances), are received by the adviser, or any affiliated or related party, partially or entirely as a result of an investment or insurance recommendations, that would be a prohibited transaction.

The most common exemption will be the Best Interest Contract Exemption. During the transition period, that exemption, BICE, requires only that the adviser (and the adviser’s Financial Institution, e.g., the RIA firm or broker-dealer) “adhere” to the Impartial Conduct Standards (ICS). There are three requirements in the ICS. Those are:

  • Best interest standard of care (which, in its essence, consists of the prudent man rule and duty of loyalty).
  • The receipt of only reasonable compensation.
  • The avoidance of any materially misleading statements.

The use of the word “adhere” means only that the adviser and Financial Institution must comply with those requirements. There is not a requirement to notify the plan, participant or IRA owner of those requirements, nor is there a requirement during the transition period to enter into a Best Interest Contract.

On the other hand, 84-24 does impose some written requirements. For example, the insurance agent or broker must disclose his initial and recurring compensation, expressed as a percentage of the commission payments. And, the plan fiduciaries or IRA owners must, in writing, acknowledge receipt of that information and affirm the transaction. On top of that, though, the agent must also “adhere” to the Impartial Conduct Standards.

It is my view that Financial Institutions (such as broker-dealers and IRA firms) should, between now and June 9, focus on the fiduciary processes that will be implemented by the home offices (for example, which mutual fund families and insurance products can be sold to “qualified” accounts such as IRAs plans). In a sense, the Financial Institutions will be co-fiduciaries with the advisers and, therefore, share responsibility for the recommendations that are made to the qualified accounts. As a result, Financial Institutions need to have protective policies, procedures and practices in place.

In addition, the home offices of Financial Institutions need to focus on the training of their advisers to comply with the prudent process requirement imposed by the fiduciary rules, including documentation of those processes. While part of a prudent process will be similar to what is currently required under the suitability and know-your-customer rules, these new fiduciary standards place greater emphasis on certain factors, for example, the costs of investments and the quality of the investment management (as well as the financial stability of an insurance company).

With regard to the reasonable compensation requirement, the burden of proof is on the person claiming that the compensation was reasonable. In other words, the burden of proof will be on the broker-dealer, the RIA firm, and the agent or insurance adviser. As a result, advisers and Financial Institutions should have data in place to support their compensation for each investment category that they recommend to plans, participants and IRA owners.

Finally, with regard to 84-24, the required disclosure and consent forms need to be developed and agents need to be educated on the use of the forms, including the disclosure and consent requirements.

Unfortunately, in a short article like this one, I can only discuss some of the requirements. Obviously, there is more than this, but this is a good starting point for understanding the rules and working on compliance with the new requirements.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Interesting Angles on the DOL’s Fiduciary Rule #44

The Basic Structure of the Fiduciary Package (June 9)

This is my 44th article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

This article focuses on the fiduciary rule; next week I will discuss two of the exemptions, the Best Interest Contract Exemption and 84-24.

As we all know by now, the DOL’s new fiduciary definition applies on June 9. As a result the following recommendations will be fiduciary acts on and after June 9:

  • Recommendations of investments, investment strategies, insurance and annuities, investment managers, other fiduciaries, distributions and rollovers, and IRA transfers;
  • Recommendations to ERISA plans, participants or IRA owners.

Fiduciary recommendations to plans and participants (including rollover recommendations) will be subject to ERISA’s prudent man rule and duty of loyalty and, therefore, any breaches can be enforced as ERISA claims.

The same is not true for recommendations to IRAs, because the law does not establish a prudent man and duty of loyalty standard of care for advice to IRAs.

However, that is not the end of the story.

Where an adviser provides fiduciary services to an IRA for a level fee (for example, 1% per year and no other benefits or compensation is received), the adviser will be subject to the standard of care established by the securities laws.

But, if the adviser (or his supervisory entity, e.g., a broker-dealer) receives compensation that is a prohibited transaction (e.g., commissions, 12b-1 fees, asset-based revenue sharing, etc.), the adviser and entity will need the protection of a prohibited transaction exemption.

For the rest of this year–the “transition period,” most firms will use the Best Interest Contract Exemption. However, it is not the BICE you have been hearing about over the past year. Instead, it is “transition BICE.” Transition BICE requires that the entity and the adviser only comply with the Impartial Conduct Standards (ICS). The ICS has 3 components: the best interest standard of care, only reasonable compensation, and no materially misleading statements.

In effect the best interest standard of care brings the ERISA prudent man rule and duty of loyalty to IRAs. As a result, advisers and their supervisory entities need to educate themselves on the requirements of a prudent process with a duty of loyalty to the IRA owner. The suitability and know-your-customer requirements are a part of that, but only part.

Some other things to consider are:

  • The DOL has historically taken the position that a prudent process must be documented. How will advisers be doing that?
  • It is clear that under ERISA, advisers to plans must consider the costs of the investments. That is likely to be extended to IRAs under the best interest standard. How will advisers to IRAs evaluate the expense ratios of recommended mutual funds and the expenses imbedded in annuities? Will the entities (e.g., broker-dealers) be specifying which software is to be used for that purpose?
  • It is also clear under ERISA that the quality of the mutual funds must be considered, quantitatively and qualitatively. What will that process look like for IRAs? How will it be documented? What software will be used for that purpose? Some broker-dealers are limiting the mutual fund families that can be recommended to “qualified” accounts.

These are just some examples. There are others.

But, for the moment, the message is that, beginning on June 9, advisers and their supervisory entities must understand and apply these concepts.

Since the deadline is right around the corner, these are high priority issues.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #43

BICE Transition: More Than the Eye Can See

This is my 43rd article about interesting observations concerning the Department of Labor’s fiduciary rule and exemptions. These articles also cover the DOL’s FAQs interpreting the regulation and exemptions and related developments in the securities laws.

As we all know by now, the new, and greatly expanded, definition of fiduciary advice becomes applicable on June 9. That means that almost any investment or insurance recommendation to a plan, participant, or IRA will be a fiduciary act. (The definition of investment recommendations is also very broad, including referrals to investment managers, recommendations to take distributions from plans, and recommendations to transfer IRAs.)

As a result, investment and insurance recommendations to participants and plans must be prudently developed and must be loyal to the plan or participant. But, recommendations to IRAs will not be subject to the prudent man standard of care. Instead, they would be subject to the SEC fiduciary duty for RIAs, FINRA’s suitability and know-your-customer standards for broker-dealers, and state law standards of care for both RIAs and broker-dealers.

However, this story does not end there. When investment recommendations cause a third party to pay compensation to the adviser (for example, commissions or 12b-1 fees), that is a prohibited transaction. Also, when the adviser makes a recommendation that causes the adviser to receive additional compensation (for example, a commission on a securities transaction), that is a prohibited transaction. Because of those prohibited transactions (for recommendations to plans, participants and IRAs), an adviser must satisfy the conditions of an exemption.

During the period from June 9 to December 31, the likely exemption will be “transition” BICE, that is, the transition rule under the Best Interest Contract Exemption. Fortunately, those conditions should be fairly easy to satisfy. In fact, there is only one condition, but it has three parts. The condition is that the adviser (and the adviser’s Financial Institution) comply with the Impartial Conduct Standards (ICS). The three parts of ICS are: (1) The best interest standard of care; (2) no more than reasonable compensation; and (3) no materially misleading statements.

Focusing on the best interest standard of care, that means that the adviser and the Financial Institution must engage in a prudent process to develop investment recommendations and must act with a duty of loyalty to the plan, participant or IRA owner.

However, the purpose of this article is to discuss requirements that aren’t obvious on the face of the ICS. In other words, there is more to the rule than meets the eye. That’s because, in the DOL’s final regulation extending the applicability date of the fiduciary rule, the Department said:

Also note that even though the applicability date of the exemption conditions have been delayed during the transition period, it is nevertheless anticipated that firms that are fiduciaries will implement procedures to ensure that they are meeting their fiduciary obligations, such as changing their compensation structures and monitoring the sales practices of their advisers to ensure that conflicts in interest do not cause violations of the Impartial Conduct Standards, and maintaining sufficient records to corroborate that they are adhering to Impartial Conduct Standards.

In other words, while the explicit compensation requirement of the ICS is that advisers and Financial Institutions cannot receive more than reasonable compensation, the DOL is saying that a Financial Institution’s compensation structures cannot promote investment recommendations that are not in the best interest of the investor. Think about that. One possible interpretation is that, even though the compensation of the adviser can vary, both for similar products (e.g., mutual funds) and among product categories (e.g., mutual funds vs. variable annuities), the variation cannot be so great as to unreasonably promote advice that is inconsistent with the best interest standard of care.

That raises the obvious question, how much is too much?

It’s difficult, if not impossible, to answer that question. Having said that though, I think that the answer will be somewhat like the famous Supreme Court position . . . “You know it when you see it.”

In any event, broker-dealers, RIA firms, and other Financial Institutions should evaluate their compensation practices and consider whether they align with the quoted language.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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