The Department of Labor’s proposed regulation package re-defining who is an ERISA ‘fiduciary’ as a result of the provision of investment advice (an ‘investment advice fiduciary’) would re-label many relationships as ‘fiduciary’ that, under current rules, are not so labeled. The proposed regulation includes a ‘seller’s carve out’ for incidental advice in connection with arm’s length transactions, but that carve out is generally only available with respect to ‘institutional’ advice recipients – basically, plans and sponsors of plans with 100 or more participants. It would not be available with respect to participants in those plans.
With respect to ‘retail’ advice, including advice to plan participants, as part of the package, DOL also proposed a Best Interest Contract Prohibited Transaction Exemption (PTE). The PTE would allow advisers receiving ‘conflicted payments’ and related financial institutions to provide advice to participants (and to IRA holders and non-participant-directed plans and plan sponsors with less than 100 participants), so long as certain requirements are met.
In this article we discuss the PTE in detail.
Outline of the article
Some of the discussion gets a little complicated – the following is an outline of the article:
- The prohibited transactions for which an exemption is necessary.
- The scope of the PTE – who is covered and what advice is covered.
- The contract requirement – the terms of the contract advisers and financial institutions must agree to in order to use the PTE.
- A detailed discussion of required policies and procedures (generally with respect to compensation) “reasonably designed to mitigate any harmful impact of conflicts.”
- A detailed discussion of the PTE’s disclosure requirements.
- Other requirements of the PTE, including the ‘range of options’ and data retention/production requirements.
- Provisions of the PTE with respect to insurance contracts and pre-existing transactions, enforcement, and the “streamlined alternative for high-quality low-fee investments.”
1. The prohibited transactions for which an exemption is necessary
Imposing ERISA ‘fiduciary’ status on broad new categories of ‘advice’ and ‘advice providers’ – including advisers, brokers, consultants, valuation firms and even call center operators – raises several issues under ERISA. As a preliminary matter, ERISA fiduciaries are generally subject to duties of loyalty (ERISA’s ‘exclusive benefit’ rule) 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 PTE to avoid a prohibited transaction.
2. The scope of the PTE
Persons covered: The PTE covers an investment advice fiduciary (the ‘Adviser’) who is an employee, independent contractor, agent, or registered representative of an investment adviser, bank or insurance company (the ‘Financial Institution’), provided the Adviser satisfies applicable licensing requirements. Plan sponsors, named fiduciaries and discretionary advisers are generally not eligible for the PTE.
Advice covered –
To whom: The PTE covers advice to (i) plan participants with authority to direct investments or take distributions, (ii) IRA owners and (iii) and sponsors of a non-participant-directed ERISA plans that have fewer than 100 participants.
About what: The PTE generally covers advice “in connection with the purchase, sale or holding of an Asset ….” For this purpose, a limited set of investments (including, e.g., mutual fund shares, bank collective funds, separate accounts, ETFs, agency debt, SEC registered bonds and exchange-traded securities) are considered ‘Assets.’
Futures and options are not ‘Assets,’ and thus advice with respect to them would not be covered by the PTE. Further, the PTE does not apply to advice about, e.g., services that are not provided in connection with the purchase/sale/holding of Assets or about whether to take a rollover distribution.
3. Contract requirement
To use the PTE (and avoid the prohibited transactions discussed in 1.), the Adviser and the Financial Institution must enter into a written contract with the advice recipient before the advice is given. That contract must include:
Commitment to basic standards of impartial conduct: These include commitments to (i) provide investment advice that is in the best interest of the retirement investor, (ii) charge only reasonable compensation, and (iii) make no misleading statements. For ERISA plans these commitments more or less track ERISA’s fiduciary requirements and thus duplicate obligations that come with the acknowledgment of fiduciary status. They provide, however, advice-recipients with a contractual remedy in addition to whatever remedy they might have under ERISA.
Compensation policies: A warranty by the Adviser and the Financial Institution “that they have adopted policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest.” The key target of this requirement is compensation policy, that is, how the Adviser is paid by the Financial Institution. (We discuss this requirement in detail in 4. below.)
Disclosure: A disclosure by the Adviser and the Financial Institution of “basic information on their conflicts of interest and on the cost of their advice.” The contract must: (i) identify all conflicts, (ii) inform the advice recipient of the right to obtain “complete information about all of the fees currently associated with the Assets,” and (iii) disclose “whether the Financial Institution offers proprietary products or receives third party payments with respect to the purchase, sale or holding of any Asset.” Finally, “the contract must provide the address of a webpage that discloses the compensation arrangements entered into by the Adviser and the Financial Institution….” (Disclosure requirements are discussed in more detail in 5. below.)
4. Policies and procedures reasonably designed to mitigate any harmful impact of conflicts
This ‘warranty’ with respect to policies and procedures, targeting compensation practice, is likely to be one of the two most controversial elements of the PTE (the other is its disclosure requirements, discussed below). To use the PTE the Financial Institution must state in the contract that:
It will not use “quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives to the extent they would tend to encourage individual Advisers to make recommendations that are not in the Best Interest of the Retirement Investor.”
In the preamble, DOL states:
Examples of compensation structures that “could help satisfy the contractual warranty regarding the policies and procedures” include: independently certified computer models; asset-based compensation; fee offset arrangements; differential payments based on neutral factors; and “alignment of interests” arrangements (e.g., compensation that is primarily asset-based, with bonuses to promote best interest advice).
In the preamble, DOL discusses at length the sorts of compensation policies and ‘situations’ it considers problematic. In this regard, Financial Institutions should consider:
(ii) monitoring activity of Advisers approaching compensation thresholds such as higher payout percentages, back-end bonuses, or participation in a recognition club, such as a President’s Club;
(iii) maintaining neutral compensation grids that pay the Adviser a flat payout percentage regardless of product type sold (so long as they do not merely transmit the Financial Institution’s conflicts to the Adviser); (iv) refraining from providing higher compensation or other rewards for the sale of proprietary products or products for which the firm has entered into revenue sharing arrangements;
(v) stringently monitoring recommendations around key liquidity events in the investor’s lifecycle where the recommendation is particularly significant (e.g. when an investor rolls over his pension or 401(k) account); and
(vi) developing metrics for good and bad behavior (red flag processes) and using clawbacks of deferred compensation to adjust compensation for employees who do not properly manage conflicts of interest.
Although it emphasizes that it is not dictating compensation policy, DOL clearly believes that certain practices are out-of-bounds and seems to favor a ‘flat fee’ approach.
In addition to the contract, the Adviser or Financial Institution must meet certain disclosure requirements. The major elements of the PTE’s disclosure regime are (i) a web page, (ii) point-of-sale disclosure and (iii) annual disclosure.
The web page
Any Financial Institution wishing to use the PTE must maintain a public web page disclosing, basically, all its compensation and pricing data. It is worth quoting the DOL at length on this:
The information provided by the webpage will provide a broad base of information about the various pricing and compensation structures adopted by Financial Institutions and Advisers. The Department believes that the data provided on the webpage will provide information that can be used by financial information companies to analyze and provide information comparing the practices of different Advisers and Financial Institutions. Such information will allow a Retirement Investor to evaluate costs and Advisers’ and Financial Institutions’ compensation practices.
Point of sale disclosure
In addition, before the execution of the relevant investment transaction, the Adviser must provide the advice recipient with a chart showing information about the investment’s ‘all-in cost’ and ‘anticipated future costs.’
This disclosure “is designed to make as clear and salient as possible the total cost that the plan, participant or beneficiary account, or IRA will incur when following the Adviser’s recommendation, and to provide cost information that can be compared across different Assets that are recommended for investment.” This information will “enable the Retirement Investor to discuss other (possibly less costly) alternatives with the Adviser prior to executing the transaction.”
“The required chart would disclose with respect to each Asset recommended, the ‘total cost’ to the plan, participant or beneficiary account, or IRA, of the investment for 1-, 5- and 10-year periods expressed as a dollar amount, assuming an investment of the dollar amount recommended by the Adviser, and reasonable assumptions about investment performance, which must be disclosed.” Total cost is: “acquisition costs, ongoing costs, disposition costs, and any other costs that reduce the asset’s rate of return, are paid by direct charge to the plan, participant or beneficiary account, or IRA, or reduce the amounts received by the plan, participant or beneficiary account, or IRA (e.g., contingent fees, such as back-end loads, including those that phase out over time, with such terms explained beneath the table).”
For each year, the Adviser or the Financial Institution must provide the advice recipient, within 45 days of year-end:
- A list identifying each Asset purchased or sold … and the price at which [it] was purchased or sold;
- A statement of the total dollar amount of all fees and expenses paid by the Plan, participant or beneficiary account, or IRA …; and
- A statement of the total dollar amount of all compensation received by the Adviser and Financial Institution … as a result of each Asset sold, purchased or held by the Plan, participant or beneficiary account, or IRA ….
Aside from the competitive issues (particularly with respect to the web page) that this sort of comprehensive disclosure presents, some question whether any provider would be able to pull together all the required information in any economically reasonable way.
6. Other requirements of the PTE
The PTE also requires that the Financial Institution:
Meet extensive data retention and production requirements. We will wait for comments from the investment community before we evaluate the practicality of these requirements; we note, however, that DOL reserves the right to make this data public.
Notify DOL in advance of its intent to rely on the PTE.
7. Other provisions of the PTE
Special rules for insurance contracts and pre-existing transactions: The PTE includes special provisions with respect to (i) the purchase of insurance and annuity contracts and (ii) the treatment pre-existing transactions.
Enforcement: The enforcement provisions of the PTE are a little unusual. The contract would be generally enforceable by the plans, plan sponsors and participants who are receiving advice and by DOL (except with respect to IRAs). Exculpatory clauses (disclaiming or limiting liability) would be prohibited. The contract could provide for arbitration, but the advice recipient’s right to bring a class action could not be waived. Some have suggested that DOL may see class actions – along the lines of the class action fee cases of the last 10 years – as a principle means of enforcing the PTE.
Streamlined alternative for high-quality low-fee investments: In the preamble to the PTE DOL also expressed a desire to propose a separate ‘streamlined exemption’ for certain ‘high-quality low-fee investments.’ DOL did not formally propose this streamlined exemption because it could not ‘operationalize’ it. DOL’s problem is, obviously, how to define/identify high-quality low-fee investments. If such investments could be identified, then an exemption for them could, according to DOL, be provided “subject to relatively few conditions.”
The Best Interest PTE is likely to be as controversial as the proposed regulation itself.
Some view the requirements of the PTE as onerous and unworkable. Those requirements would apply where an adviser is receiving a ‘conflicted payment’ from a financial institution. Independent (e.g., fee-for-service) advisers would be fiduciaries under the proposed regulation but (generally and absent no special facts) as long as they are not receiving conflicted payments would not have to comply with the requirements of the PTE. In other words: the PTE would force conflicted advisers/financial institutions to change their business model; it would not force independent advisers to change theirs.
The most significant questions with respect to the PTE will be: (1) Will conflicted advisers and related financial institutions accept the changes in their practice DOL is asking for or simply stop providing participant advice? (2) To what extent (if any) will DOL be willing to accommodate objections from those advisers and financial institutions?
We will continue to follow this issue.