Loading article...
The Department of Labor’s conflict of interest regulation package, re-defining who is an ERISA “investment advice fiduciary,” re-labels many relationships as “fiduciary” that, under current rules, aren’t. The new regulation includes a “sellers exception” for advice in connection with arm’s length transactions, generally available with respect to “institutional” advice recipients.
With respect to “retail” advice, including advice to plan participants, as part of the package, DOL also finalized a Best Interest Contract Exemption (BICE). The BICE allows Advisers receiving “conflicted payments,” and related Financial Institutions, to provide advice to plan participants (and to IRA holders and small plans), so long as certain conditions are met.
Under the new conflict of interest regulation, persons making investment recommendations (and recommendations about distributions and rollovers) to plans and plan participants will be fiduciaries. Persons advising plans/plan fiduciaries that meet certain requirements – “institutional” advice recipients – can use a “seller’s exception” to entirely avoid fiduciary status.
Persons (“Retail Advisers”) advising “retail” advice recipients (including plan participants and IRA owners) are fiduciaries under the new regulation. If such a Retail Adviser advises, e.g., a participant to make an investment with respect to which the Adviser receives compensation, the Adviser generally is engaging in an ERISA prohibited transaction (PT).
For Retail Advisers, DOL has, as part of the new regulation package, adopted a prohibited transaction exemption, the Best Interest Contract Exemption (“BICE”), which exempts certain Advisers, Financial Institutions and related entities from applicable prohibited transaction rules if certain conditions are met. Thus, the BICE, in effect, sets the rules for the marketing of retirement investments to retail consumers (including plan participants).
The BICE sets out to do two things:
Fundamentally change how Retail Advisers are compensated. Under the BICE, while Financial Institutions may provide products with, e.g., different profit margins, they may not provide incentives to Advisers (e.g., brokers) to “push” those more profitable products. As DOL puts it, the Financial Institution may not employ compensation policies that “operate to transmit firm-level conflicts of interest to the Adviser.” Most of the (very complicated) conditions of the BICE – including extensive new compensation and disclosure rules – are designed to make this policy a reality.
Fundamentally increase the transparency of the retail retirement investment market. The BICE requires a Financial Institution to maintain a website that provides significant information about its business model, conflicts, third-party incentives, compensation and incentive arrangements with Advisers and any payout or compensation grids. As the DOL states in the preamble:
The web disclosure is not limited to individual Retirement Investors with whom the Financial Institution has a contractual relationship, but rather is publicly available to promote comparison shopping and the overall transparency of the marketplace for retirement investment advice. Thus, financial services companies, consultants, and intermediaries may analyze the information and provide information to plan and IRA investors comparing the practices of different Financial Institutions.
As we discuss in our article on the new Conflict of Interest regulation, for plan sponsors, the new rules matter because sponsors are, in effect, consumers of advice. Either directly, when, for instance, a consultant advises them about which funds to put in a fund menu. Or indirectly, on behalf of participants, when, for instance, they retain persons (educators, investment advisers or even call center operators) to advise their participants.
With respect to the former case – sponsors as direct consumers of advice – the BICE is likely to matter only to very small employers/small plans. As discussed in our article on the new regulation, larger plans will be covered by the seller’s exception.
The BICE will matter for advice to plan participants. In that regard, with respect to advice on, e.g., asset allocation, the exception under the new regulation for investment education will often be available. And defaults, e.g., use of a target date fund as a qualified default investment alternative (QDIA), may help avoid a lot of asset allocation “mistakes.”
The area in which the rules under the BICE are likely to matter most for plan sponsors is rollovers and distributions, advice with respect to which is also covered by the new regulation. Advisers (in some cases including call center operators) who are (i) advising participants about whether to take a distribution, whether to roll a distribution over, or how to invest a rolled over distribution and (ii) receiving “conflicted payments” (e.g., a payment from the Financial Institution (such as a mutual fund) receiving the rollover distribution), will generally have to comply with the BICE.
Obviously, compliance with the BICE will be the responsibility (generally) of the Adviser and her related Financial Institution. But the new rules will affect how the Adviser interacts with plan participants and may affect the cost and availability of advice (some firms may balk at complying with the BICE and stop providing advice). Thus, while it is generally the Adviser’s world that will change because of these new rules, those changes will affect plan sponsors (and their participants) as consumers of advice.
In what follows we discuss the BICE in detail.
Imposing ERISA “fiduciary” status on broad new categories of “advice” and “advice providers” – including advisers, brokers and consultants – raises several issues under ERISA. As a preliminary matter, ERISA fiduciaries are generally subject to duties of loyalty and prudence. Further, under ERISA’s prohibited transaction rules, a fiduciary may not (i) engage in self-dealing, (ii) have, or act for a person who has, an adverse interest, or (iii) receive a “kickback.” Finally, a fiduciary is an ERISA “party in interest,” prohibited from dealing with a plan in many respects.
A fiduciary who receives “conflicted payments” – e.g., a payment from a financial institution (such as a mutual fund) interested in a transaction with the plan – may run afoul of several of these provisions, e.g., the prohibition on “kickbacks.” Commissions paid to brokers advising participants about investments, 12b-1 fees paid to consultants advising small plan sponsors, and even ordinary compensation paid to call center operators advising participants about whether to take a distribution and whether to roll it into an IRA, all may constitute conflicted payments to an investment advice fiduciary violating one or more of the prohibitions described above.
Persons providing advice to participants and receiving conflicted payments – e.g., those brokers, consultants and call center operators – will generally have to use the BICE to avoid a prohibited transaction.
Persons covered: The exemption generally covers Advisers, Financial Institutions, and their affiliates and related entities. An Adviser is an employee, independent contractor, agent, or registered representative of a Financial Institution. A Financial Institution generally is a regulated investment adviser, bank, insurance company or registered broker or dealer.
Advice covered: The BICE generally covers advice to (i) plan participants with authority to direct investments or take distributions, (ii) IRA owners and (iii) and Retail Fiduciaries. A Retail Fiduciary is a plan fiduciary that doesn’t qualify under the seller’s exception under the new conflict of interest regulation (see our article on the conflict of interest regulation for more detail on the distinction between “retail” and “institutional” fiduciaries).
The exemption generally does not apply (i) to in-house plans (e.g., the plan of a Financial Institution for its own employees), (ii) where the Adviser or Financial Institution was selected by a plan fiduciary who is not independent, (iii) to principal transactions, (iv) to robo-advice, or (v) where the Adviser has investment discretion.
In finalizing the BICE the DOL eliminated the contract requirement for Advisers to ERISA plan participants and ERISA plans. We discuss the contract requirement (still applicable to non-ERISA plans and IRAs) briefly below. But we begin with a (detailed) discussion of the BICE requirements applicable to Advisers and Financial institutions advising ERISA plan participants and smaller ERISA plans.
To qualify for the BICE, Advisers to ERISA plan participants and ERISA plans must satisfy the following conditions:
1. Acknowledgment of fiduciary status: The Financial Institution must state in writing that it and the Adviser are fiduciaries with respect to the advice (e.g., an investment recommendation).
2. Impartial conduct: The Financial Institution and its related Adviser must:
Best interest standard. Provide investment advice that is, at the time of the recommendation, in the best interest of the retirement investor, reflecting 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.
Reasonable compensation standard. Not recommend a transaction that will cause the Financial Institution, Adviser or affiliates to receive compensation that is in excess of reasonable compensation.
No misleading statements. Not make any materially misleading statements about a recommended transaction, compensation, conflicts or other relevant matters.
3. Policies and procedures: The Financial Institution must:
Written policies and procedures. Adopt and comply with written policies and procedures reasonably and prudently designed to ensure that its Advisers adhere to the impartial conduct standards.
Identify and monitor conflicts. Specifically identify and document conflicts; adopt measures reasonably and prudently designed to prevent them from causing violations of the impartial conduct standards; and designate a person who will be responsible for addressing conflicts and monitoring compliance with those standards.
No compensation practices intended to cause violations. Require that neither the Financial Institution nor any affiliate use or rely upon quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives that are intended to cause Advisers to violate the best interest standard.
The substance of the policies and procedures requirement
While differential payments are permitted, the differentials must reflect neutral factors, not the higher compensation the Financial Institution stands to gain by recommending one investment rather than another. (From the BICE Preamble.)
The policies and procedures requirement will constrain Financial Institutions that wish to use the BICE to conform their compensation practices to a new, DOL-prescribed norm. In the BICE Preamble, DOL states that:
The exemption’s goal is not to wring out every potential conflict, no matter how slight, but rather to ensure that Financial Institutions and Advisers put Retirement Investors’ interests first, take care to minimize incentives to act contrary to investors’ interests, and carefully police those conflicts that remain.
Putting this as plainly as possible: DOL intends (in the “retail”/non-institutional world and including with respect to advice to plan participants) to make it a violation of the rules for a Financial Institution to provide a broker or other adviser with an incentive to sell to her retirement investor client a product that “makes more money for the firm.” Thus, as DOL puts it, Adviser compensation must not “operate to transmit firm-level conflicts of interest to the Adviser.”
DOL devotes a significant piece of the BICE Preamble to explaining how the policies and procedures requirement enforces this result. DOL emphasizes that the BICE “does not mandate level fees.” But Financial Institutions will have a relatively hard time justifying differential compensation (e.g., different commissions on different products). Thus: “While differential payments are permitted, the differentials must reflect neutral factors, not the higher compensation the Financial Institution stands to gain by recommending one investment rather than another.”
At the end of this article, as an Appendix, we discuss (and quote at length) an example from the BICE Preamble illustrating just how far DOL believes a Financial Institution must go to prevent differential compensation from violating the requirements of the BICE.
The easiest way to comply with the policies and procedures requirement will be to provide the Adviser a level fee, e.g., as DOL suggests in a footnote, “commissions with no variation at all, regardless of the category of investment.”
Finally, note that the focus with respect to this condition is on what compensation is paid to the Adviser when there are firm-level conflicts of interest – that is, where the firm makes more money selling one product than it does selling another. As discussed below, there are separate, streamlined rules for firms using a “level fee” business model.
4. Disclosures: The Financial Institution must clearly and prominently, in a single written disclosure provided prior to or at the same time as the transaction:
State the best interest standard, describe the services it provides and how the retirement investor will pay for services.
Describe any conflicts; disclose any fees or charges the Financial Institution or its affiliates imposes; and state the types of compensation it expects to receive from third parties.
Inform the retirement investor of her right to copies of the Financial Institution’s written description of its policies and procedures.
Include a link to the Financial Institution’s website (see below).
Disclose whether the Financial Institution offers proprietary products or receives third party payments with respect to any recommended investments and any related limits on investment recommendations and on the universe of investments that the Adviser may offer.
Identify a contact person with whom the retirement investor can raise any concerns; and, if applicable, a statement explaining that the retirement investor can research the Financial Institution and its Advisers using FINRA’s BrokerCheck database or the Investment Adviser Registration Depository (IARD), or other database maintained by a governmental agency or instrumentality, or self-regulatory organization.
Describe whether Adviser and Financial Institution will monitor investments and alert the retirement investor to any recommended change.
Good faith correction; reliance on third party information. With respect to these and other BICE disclosure requirements, the BICE allows good faith compliance, a period to correct errors and good faith reliance on information from third parties, subject to certain conditions.
If the investment advice concerns an IRA or a non-ERISA plan, the foregoing requirements (acknowledgment of fiduciary status, impartial conduct, etc.) are generally incorporated in a contract that must be executed “prior to or at the same time as the execution of the recommended transaction.” For existing clients the contract can be executed by negative consent. As noted, under the final BICE, investment advice concerning ERISA plans (or, e.g., an ERISA plan participant) is not subject to this contract requirement.
The requirements for a contract (for non-ERISA plans and IRAs), written policies and procedures and disclosures (including the general disclosure requirement discussed above and the web- and transaction-based and DOL disclosures discussed below) do not apply to “Level Fee Fiduciaries,” defined as Advisers and Financial Institutions who only receive compensation “provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee.”
In addition to the foregoing, the Financial Institution must satisfy both transaction- and web-based disclosure requirements.
The Financial Institution must, prior to or at the same time as the investment transaction, provide a single written document that:
States the best interest standard and describes any conflicts.
Informs the retirement investor that he has the right to obtain copies of the Financial Institution’s written description of its policies and procedures, as well as specific disclosure of costs, fees and other compensation including third party payments with respect to recommended transactions.
Includes a link to the Financial Institution’s website.
The Financial Institution must maintain a website containing:
A discussion of the Financial Institution’s business model and associated conflicts.
A schedule of typical account or contract fees and service charges.
A model contract (if applicable).
A written description of the Financial Institution’s policies and procedures relating to conflict-mitigation and incentive practices.
To the extent applicable, a list of all product manufacturers and other parties with whom the Financial Institution maintains arrangements that provide third party payments with respect to specific investment products, a description of the arrangements, including a statement on whether and how these arrangements impact Adviser compensation, and a statement of any benefits the Financial Institution provides to the product manufacturers in exchange for the third party payments.
Disclosure of the Financial Institution’s compensation and incentive arrangements with Advisers including, if applicable, any incentives to Advisers for recommending particular product manufacturers, investments or categories of investments, and a full and fair description of any payout or compensation grids.
Where a Financial Institution limits (in whole or in part) Advisers’ investment recommendations to the institution’s products (“proprietary products”) or to those that generate third party payments, the BICE is satisfied if:
Prior to or at the same time as the transaction, the retirement investor is informed in writing (i) that the Financial Institution offers proprietary products or receives third party payments and of any limitations placed on the universe of investments that the Adviser may recommend and (ii) of any conflicts that the Financial Institution or Adviser have with respect to the recommended transaction.
The Financial Institution documents in writing (i) its limitations on the universe of recommended investments, (ii) the conflicts associated with any proprietary products or third party payments, and (iii) any services it will provide in exchange for third party payments. The Financial Institution must also (i) reasonably conclude that the limitations on the universe of recommended investments and conflicts will not cause it or its Advisers to receive compensation in excess of reasonable compensation, (ii) reasonably determine that these limitations and conflicts will not cause it or its Advisers to recommend imprudent investments, and (iii) document in writing the bases for its conclusions.
At the time of the recommendation, the amount of compensation and other consideration reasonably anticipated to be paid to the Adviser, Financial Institution or affiliates is not in excess of reasonable compensation.
The Adviser’s recommendation reflects 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; and the Adviser’s recommendation is not based on the financial or other interests of the Adviser or on the Adviser’s consideration of any factors or interests other than the investment objectives, risk tolerance, financial circumstances, and needs of the retirement investor.
The BICE also requires that the Financial Institution notify DOL in advance of its intent to rely on the BICE and maintain supporting documents for a period of six years.
The BICE is “effective” 60 days after publication in the Federal Register. It is not generally applicable until April 10, 2017 (the “Applicability Date”).
Grandfather rule: Generally, and subject to certain conditions, ERISA prohibited transaction rules do not apply to compensation resulting from investment advice (including advice to hold) in connection with the purchase, holding, sale, or exchange of securities or other investment property (i) that was acquired before the Applicability Date, or (ii) that was acquired pursuant to a recommendation to continue to adhere to a systematic purchase program established before the Applicability Date.
Transition rule: Finally, during the period between April 10, 2017 and January 1, 2018, much more limited conditions apply to the availability of the exemption, “to give Financial Institutions and Advisers time to prepare for compliance.”
***
As we said at the beginning, the BICE, together with the rest of the conflicts regulation package, is intended to fundamentally change how advice is provided to retail retirement investors, including plan participants. DOL’s focus is on: (1) changing compensation practices to ensure that advice is given because it is in the best interest of the retirement investor, not because it furthers the interest of the Financial Institution; and (2) increasing the transparency of the retail retirement investment market, via mandated web-based disclosures.
In some ways this will clearly be good for plan sponsors and participants: there will be less “bad” advice. Some argue that it will, however, change the advice market and may make advice less available and more expensive. That may not matter for in-plan asset allocation, where participant education and defaults can produce appropriate outcomes. The crunch will come when a participant terminates employment.
The question for sponsors raised by the new rules is: Will there be persons – advisers – prepared to coach terminating participants on the wisdom of rollovers or of leaving their retirement assets in the qualified plan system? We will have to wait to see if advisers emerge to respond to this need under DOL’s new rules.
We will continue to follow this issue.
***
DOL provides five examples “intended to illustrate some possible approaches that Financial Institutions could take to managing Adviser incentives.” Example 4, Commissions and stringent supervisory structure, is probably as good an illustration as any of how difficult paying differential compensation will be under the BICE. We provide the following (very lengthy) quotation to give readers a feel for how much DOL expects broker compensation practices to change:
Example 4: Commissions and stringent supervisory structure. The Financial Institution establishes a commission-based compensation schedule for Advisers in which all variation in commissions is eliminated for recommendations of investments within reasonably designed categories. The Financial Institution establishes supervisory mechanisms to protect against conflicts of interest created by the transaction-based model and takes special care to ensure that any differentials that are retained are based on neutral factors, such as the time or complexity of the work involved, and that the differentials do not incentivize Advisers to violate the Impartial Conduct Standards or operate to transmit firm-level conflicts of interest to the Adviser (e.g., by increasing compensation based on how much revenue or profits the investment products generate for the Financial Institution). Accordingly, the Financial Institution does not provide an incentive for the Adviser to recommend one mutual fund over another, or to recommend one category of investments over another, based on the greater compensation the Financial Institution would receive. But it might, for example, draw a distinction between variable annuities and mutual funds based on the additional time it has determined is necessary for client communications and oversight with respect to these annuities. The Financial Institution adopts a stringent supervisory structure to ensure that Advisers’ recommendations are based on the customer’s financial interest, and not on the additional compensation the Adviser stands to make by recommending, for example, more frequent transactions or products for which greater compensation is provided. Examples of components of a prudent supervisory structure include:
Establishment of a comprehensive system to monitor and supervise Adviser recommendations, evaluate the quality of the advice individual customers receive, properly train Advisers, and correct any identified problems. Particular attention is given to recommendations associated with higher compensation and recommendations at key liquidity events of an investor (e.g., rollovers).
Systems to evaluate whether Advisers recommend imprudent reliance on investment products sold by or through the Financial Institution.
The use of metrics for behavior (e.g., red flags), comparing an Adviser’s behavior against those metrics, and basing compensation in part on them.
Penalizing Advisers and supervisors (including the branch manager) by reducing compensation based on the receipt of customer complaints or indications that conflicts are not being carefully managed.
Appointment of a committee to assess the risks and conflicts associated with new investment products, determine the prudence of the products for retirement investors, and assess the adequacy of the Financial Institution’s procedures to police any associated conflicts of interest.
Ensuring that no Adviser nor any supervisor (including the branch manager) participates in any revenue sharing from a “preferred provider,” earns more for the sale of a product issued by a “preferred provider,” or earns more for the sale of a Proprietary Product over other comparable products, and ensuring that the Adviser discloses to customers the payments that the Financial Institution and its Affiliates have received from a preferred provider or for a Proprietary Product.
The Financial Institution periodically reviews, and revises as necessary, the policies and procedures to ensure that they are appropriately safeguarding proper fiduciary conduct, and that the factors used to justify any compensation differentials (e.g., time) remain appropriate, that they reflect neutral factors tied to differences in the services delivered to the investor (as opposed to differences in the amounts paid to the Financial Institution by different mutual fund complexes), and that they are neutral in application as well as selection. In this regard, the Financial Institution needs to take special care in defining the categories to ensure that they reflect the application of such neutral factors to genuine differences in the nature of the advice relationship.