Interesting Angles on the DOL’s Fiduciary Rule #52


BICE, DOL, fiduciary, prudent, service providers

The Fiduciary Rule and Exemptions: How Long Will Our Transition Be?

This is my 52nd 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 fiduciary regulation that dramatically expanded the definition of fiduciary investment advice went into effect on June 9. As a result, virtually all advisers to plans, participants and IRAs are now fiduciaries, or will be as soon as they make the next investment recommendation to one of those qualified accounts. At the same time—June 9, the “transition” transaction exemptions were effective.

If viewed out of context, the fiduciary regulation, as currently written, will continue in effect for years to come. However, the transition exemptions will only apply until December 31, when the full exemptions will apply, with their many and demanding requirements. But, that’s out of context.

When viewed in context, the situation looks much different. For example, the Department of Labor will be publishing the Request for Information asking, among other things, about the potential impact of the fiduciary rule and changes that may be needed. Not to be outdone, the SEC has asked a series of questions about a possible fiduciary standard for all investment advice within its purview. The SEC and DOL have indicated that they will be working together to develop their respective fiduciary definitions (and, in the case of the SEC, a fiduciary standard of care) or, perhaps, they will develop an identical definition of fiduciary advice.

In addition, the DOL has asked for input concerning the structure and requirements of the prohibited transaction exemptions, including the two exemptions that impact most advisers . . . the Best Interest Contract Exemption (BICE) and Prohibited Transaction Exemption 84-24. Those exemptions are exceptions from the prohibited transaction rules, but come with strings attached. On the other hand, the SEC does not have a statutory basis for adopting similar prohibited transactions or, for that matter, exemptions from prohibited transactions. Because of those differences, it is likely that, even if the two regulatory bodies adopt a common definition of fiduciary advice (and a common standard of care), their treatment of conflicts of interest will vary.

As mentioned earlier, the transition period for the DOL’s exemptions is only until December 31. And, if I haven’t made clear, there isn’t any transition period for the fiduciary regulation; it is in full force and effect.

What does this mean in terms of timing? My view is that it will be virtually impossible for the DOL and SEC to collaborate on the development of a common, or at least compatible, definition of fiduciary advice and standard of care before December 31. Because of the Administrative Procedures Act, the final regulation would need to be published in early November, which means a proposed regulation would probably need to be published in early to mid-September. To hit those deadlines, the two regulatory bodies would need to develop a proposed regulation within that time frame. That seems almost impossible —partially because of the need for coordination and partially because the SEC hasn’t previously proposed guidance on these issues. In other words, even though the DOL has a basis for revising its regulation and exemptions, the SEC doesn’t.

As a result, my view is that the DOL will extend the transition period, perhaps for as much as a year. That would allow time for the two agencies to work together in a thoughtful manner and at a reasonable pace.

That is both good news and bad news to the regulated community, that is, for financial services companies. It is good news because it allows more time to fully adapt to the new rules and because the compliance requirements for the transition exemptions are not that difficult or burdensome. It is bad news—at least for those firms that strenuously object to the fiduciary rule, because, by a year from now, financial services companies will be in compliance with the fiduciary standard and fiduciary advice will have become the standard course of business. The training will have been done, products will have been developed, solutions will have been implemented, and so on. In other words, the fiduciary standard will have become the norm. As a result, it may be more difficult to change the fiduciary definition and standard of care. On the other hand, there will still be significant changes to the exemptions and, particularly, to the Best Interest Contract Exemption.

One way or another, I expect that we will hear, in August or September, that the transition period is being extended.

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 #51


BICE, broker-dealers, DOL, fiduciary, prudent

Recommendations to Transfer IRAs

This is my 51st 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 new fiduciary regulation includes, among its definitions of fiduciary advice, a recommendation to an IRA owner to transfer the IRA from another firm. As a result, the recommendation, if accepted by the IRA owner, will automatically result in a prohibited transaction. That is because, if the recommendation is accepted and the IRA is transferred, the adviser will obviously make more money than if it were not. That is a financial conflict of interest that is a prohibited transaction under the Internal Revenue Code.

Fortunately, there is an exemption, or exception, called the Best Interest Contract Exemption (BICE). However, BICE comes with conditions . . . the adviser and his or her supervisory entity (typically a broker-dealer or RIA firm) must comply with the Impartial Conduct Standards. There are three Impartial Conduct Standards:

  • The adviser (and the supervisory entity) must adhere to the best interest standard of care (which includes the duties of prudence and loyalty).
  • Neither the adviser nor the supervisory entity can receive more than reasonable compensation.
  • The adviser and the supervisory entity must not make any materially misleading statements.

This article looks at the requirement to engage in a best interest process.

The first step of a best interest, or prudent process, is to determine the information that is “relevant” to making a decision that is “informed.” In other words, what would a person who is knowledgeable about such matters, and who is unbiased and loyal to the IRA owner, want to review in order to develop a recommendation? Unfortunately, there aren’t any specific guidelines in the fiduciary regulation or BICE. However, it seems reasonable to conclude that, at the least, the following would be required in most cases:

  • The investments, services and expenses in the current IRA.
  • The investments, services and expenses available in the IRA that the adviser will recommend.
  • The needs, objectives, risk tolerance and financial circumstances of the IRA owner.

In the typical case, that may be enough. However, in some cases, there may be special circumstances that would require considerations of additional factors.

Once those considerations have been identified, the next step is to gather the information; that documentation should be retained in retrievable fashion in the event of SEC or FINRA examinations, IRS audits, or private claims.

The next step is to analyze the information. For example, if the investments and the expenses are similar for both the current IRA and a new IRA, the key is to consider the services in light of the needs and circumstances of the IRA owner. With that in mind, in this new fiduciary world, advisers and their supervisory entities should focus on the services that they will provide to retirement money, such as Individual Retirement Accounts. Generally speaking, the investment of retirement money (at least, based on guidance from the Department of Labor) involves considerations of generally accepted investment theories—such as modern portfolio theory, and of prevailing investment industry standards. Ordinarily, that would include strategies such as asset allocation, diversification among and within asset classes, portfolio construction, and so on. Those are “services” that are consistent with the best interest standard of care and that could justify a prudent, or best interest, recommendation to transfer an IRA.

The considerations listed in this article are not exclusive. There are many other factors that could reasonably be considered in developing a recommendation to transfer an IRA. The key, though, is that the appropriate documentation be gathered, a thoughtful analysis be made, and the recommendation be prudent and loyal.

The best interest fiduciary process is a new way of looking at everyday transactions and making recommendations about those transactions. It’s important for advisers to realize that it’s not just a compliance issue; instead, it’s a process . . . a thoughtful, documented, best interest process.

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


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers

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


408(b)(2), broker-dealers, DOL, fiduciary, prohibited transaction, prudent, registered investment advisers, service providers

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


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, prudent

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 #47


BICE, DOL, fiduciary

The “Real” Requirements of the Fiduciary Rule

This is my 47th 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.

I have seen articles and heard comments about the fiduciary rule and exemptions that are misleading. The purpose of this article is to clarify the requirements of the fiduciary rule and the related exemptions.

In order to discuss the “fiduciary package” of guidance, we need to divide it into two categories. The first is the transition rule, for the period from June 9 to December 31, 2017. The second category is the final set of the regulation and exemptions, which are scheduled to become applicable on January 1, 2018, and which are being reviewed by the DOL for changes.

The Transition Rules

The transition rules require, in essence, that advisers, and their supervisory entities, “adhere to” the following:

  • The Best Interest Standard of Care. The Best Interest standard of care is a combination of ERISA’s prudent man rule and duty of loyalty. The consequence is that advisers and their supervisory entities need to engage in a prudent process to develop their investment and insurance recommendations to plans, participants and IRA owners.
  • Reasonable compensation. “Reasonable compensation” is a market-based standard. In other words, what would a transparent and competitive market pay for the services of the adviser and his or her supervisory entity?
  • Misleading statements. The adviser cannot make materially misleading statements about the investments, fees, material conflicts of interest or other matters that would be material to the investment decision.

I used the phrase “adhere to” (as the guidance does) to emphasize that there is no contract or disclosure requirement. In other words, it is a conduct-based standard.

Think about it. Beginning on June 9, an adviser’s recommendations to plans, participants and IRAs has to be prudent and loyal; the adviser cannot mislead the retirement investor; and the adviser and supervisory entity’s compensation must be reasonable. The question is, are these reasonable requirements?

However, on January 1, 2018, the full Best Interest Contract Exemption (BICE) will apply. As currently written, it is disruptive of existing practices, and would be expensive to comply with. That is obviously a problem. However, it will likely be revised. Unfortunately, we don’t know what the changes will be. Hopefully, though, they will reduce the compliance burden while maintaining investor protections.

Notice, though, that I referenced needed changes to the Best Interest Contract Exemption, but not to the fiduciary rule. That’s not to say that the fiduciary rule cannot be improved . . . because it can. However, most of the objections are to the Best Interest Contract Exemption and not to the rule. Unfortunately, people put a label on the package of guidance and, when objecting to the fiduciary rule, their complaints are usually about the Best Interest Contract Exemption. That adds to the confusion about the fiduciary standard of care and its requirements, as opposed to the concerns about the conditions in the exemptions.

While there are some concerns about the fiduciary rule itself, for example, some broker-dealers argue that the Securities and Exchange Commission should write a single fiduciary rule for all investment accounts, including both qualified and non-qualified accounts. That raises the issue of whether there is, or should be, a distinction between accounts that are designed for producing retirement income and those that are intended for personal investing. If the answer is “yes,” then investment advice will be different for the two types of accounts, regardless of which agency writes the rules.

To further complicate matters, the main issue is the prohibited transaction rules, which are statutory, rather than regulatory. Neither the SEC, nor FINRA nor the DOL, can issue regulations that conflict with a statute. As a result, even if the standard of care is changed, the prohibited transaction exemptions will continue to be written by the Department of Labor. In other words, the SEC does not have the statutory authority to create exemptions from the prohibited transaction rules.

As concluding thoughts, while the fiduciary regulation and the transition rules for the exemptions will require changes in practices (for example, fiduciary training and documentation), those rules should not be overly burdensome or expensive to comply with. However, that changes on January 1, 2018 when the final exemptions will apply. Fortunately, the DOL will be reviewing the requirements of those exemptions and, hopefully, the requirements will be modified to be more reasonable in terms of the cost and burden of compliance.

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


BICE, DOL, fiduciary, prohibited transaction, prudent

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


BICE, broker-dealers, DOL, fiduciary, prohibited transaction, registered investment advisers

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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