The DOL “Fiduciary Rule,” FAQ 14: Disclosure of Conflicts of Interest

This series focuses on the DOL’s new fiduciary “rule”, which was effective on February 16. This, and the next several, articles look at the Frequently Asked Questions (FAQs) issued by the DOL to explain the fiduciary definition and the exemption for conflicts of interest.

Background

The DOL’s prohibited transaction exemption (PTE) 2020-02 (Improving Investment Advice for Workers & Retirees) allows investment advisers, broker-dealers, banks, and insurance companies (“financial institutions”), and their representatives (“investment professionals”), to receive conflicted compensation resulting from non-discretionary fiduciary investment advice to retirement plans, participants and IRA owners (“retirement investors”). In addition, in the preamble to the PTE the DOL announced an expanded definition of fiduciary advice, meaning that many more financial institutions and investment professionals will be fiduciaries for their recommendations to retirement investors and, therefore, will need the protection provided by the exemption.

In April, the DOL issued FAQs that explain the fiduciary interpretation and the conditions of the exemption.

This article discusses FAQ 14, a DOL question and answer about the disclosure requirements for conflicts of interest:

Q14. What information about conflicts of interest must be disclosed to retirement investors?

Before engaging in a transaction under the exemption, a financial institution must give its retirement investor customer a written description of the financial institution’s and investment professional’s material conflicts of interest arising out of the services and any recommended investment transaction. The disclosure must be accurate and not misleading in all material respects. Financial institutions must disclose, for example, conflicts associated with proprietary products, payments from third parties, and compensation arrangements for both the financial institution and individual investment professional. Disclosures with material omissions will be considered inaccurate and will not satisfy the exemption.

To satisfy the exemption, this disclosure cannot be merely a “check-the-box” activity. The disclosure should be designed to allow a reasonable person to assess the scope and severity of the financial institution’s and investment professional’s conflicts of interest. Financial institutions must engage in a careful analysis to identify their material conflicts so that they and their investment professionals can provide meaningful information that retirement investors need to make decisions about their investments. The disclosure requirement is principles-based and intended to allow flexibility to apply to a wide variety of business models and practices.

Some broker-dealers and investment advisers may contemplate using their Forms CRS for this purpose. However, those forms can disclose only a limited number of conflicts and thus may not satisfy the requirement to disclose all material conflicts of interest related to the recommendations.

In some cases, broker-dealers have modified their Reg BI conflicts disclosures for this purpose. Those disclosures can be a good starting point for the 2020-02 disclosures, but more may be required. The same can be said of Form ADV disclosures.

For example, a recommendation to transfer an IRA from another firm will be a conflict of interest that should be disclosed. Similarly a recommendation to roll over assets from a retirement plan to an IRA will be a conflict of interest that must be disclosed. As a result, firms should revisit their current conflicts disclosures to ensure that they capture all of the ways in which they make money if a recommendation to a plan, participant or IRA owner is accepted. Also, Reg BI does not apply to recommendations to retirement plans, so the disclosures will likely need to be augmented if there are any additional conflicts associated with recommendations to plans.

The language “The disclosure should be designed to allow a reasonable person to assess the scope and severity of the financial institution’s and investment professional’s conflicts of interest” is interesting in the sense that it suggests that the disclosures must be specific enough to allow a retirement investor to at least approximate the dollar amount of the conflict…and then to assess the “scope and severity” of the conflict. Unfortunately, that is a relatively vague standard that doesn’t tell us the level of specificity that is required. Hopefully, the DOL will provide additional guidance about how detailed the disclosures should be. But, if it doesn’t, it could be helpful to look at the DOL’s guidance under the 408(b)(2) disclosure requirements—which serve a similar purpose.

Similarly, the statement that compliance will not be a “check-the-box” activity suggests that the disclosures must inform the retirement investor of the conflicts associated with a particular recommendation or, at least, that the retirement investor will be given enough information to know which parts of the disclosures apply to recommendations to him or her.

To be clear, though, the disclosure requirement is only one of the conditions of PTE 202-02. Notwithstanding the disclosures, the other conditions have to also be satisfied, including the requirement that the recommendation has to be in the best interest of the retirement investor. A disclosure that the recommended investment is more expensive than an alternative will not satisfy the best interest standard unless the more expensive (or more highly compensating) alternative is in the investor’s best interest.

Concluding thoughts

It would be easy for broker-dealers and investment advisers to assume that their current conflict disclosures are adequate for this purpose, for example, the Forms CRS, the Reg BI conflicts disclosures and the ADV conflicts disclosures. However, my experience in reviewing the current disclosure documents of broker-dealers and investment advisers is that those materials have not covered all of the conflicts or, alternatively, the disclosures have been so general that they do not “allow a reasonable person to assess the scope and severity of the financial institution’s and investment professional’s conflicts of interest”.

December 21 will be here before we know it, and with so many changes needed to comply with 2020-02, it could be a mistake to assume that current conflicts disclosures are adequate. Financial institutions should, at the least, go through their current disclosures to make sure that they cover all of the potential conflicts and whether the disclosures are specific enough to allow a reasonable person to identify which conflicts apply to recommendations to that person and to determine whether the disclosures are specific enough to allow a reasonable person to assess the scope and severity of the conflicts.

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

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