DOL Releases Anticipated Proposed Investment Advice Exemption
On June 29, 2020, the US Department of Labor (DOL) released a proposed prohibited transaction class exemption and associated guidance (the Proposed Exemption).1 If adopted, the Proposed Exemption will allow investment advice fiduciaries to IRAs and ERISA plans (and similar tax-favored accounts) to receive transaction-based and other variable compensation in connection with providing investment advice as a fiduciary, and to engage in certain principal transactions, without violating the prohibited transaction rules of ERISA and the Internal Revenue Code. However, the Proposed Exemption imposes additional requirements on financial institutions advising on rollovers in some circumstances. The Proposed Exemption is potentially applicable to banks, trust companies, insurance agents, broker-dealers, investment advisers, and other financial services firms that make investment products available to IRA, pension plan and other retirement account clients, and is DOL's intended replacement for its prior, controversial "fiduciary rule" (Vacated Fiduciary Rule) that was vacated by the courts in 2018.2
From a financial services industry perspective, there are several takeaways from DOL's proposal, some positive and some not.
- In line with recent SEC activity intended to protect retail investors (e.g., Regulation Best Interest (Reg BI)), the Proposed Exemption is focused on the retail marketing of products and services to IRA owners and ERISA plan participants.
- The compliance conditions of the Proposed Exemption are significantly less burdensome than those in the Vacated Fiduciary Rule. That said, the proposed conditions will still require financial institutions providing investment advice to IRAs and ERISA plans to implement material policies, procedures and compliance programs and may require changes to business models and compensation arrangements. Because many of the requirements are similar to the SEC's Reg BI, financial institutions that are subject to Reg BI may have already done some of this work.3
- DOL confirmed that fiduciary status is determined under the long-standing five-part test and, unlike the Vacated Fiduciary Rule, does not expand the regulatory definition of "fiduciary." However, as discussed below, the proposal includes some DOL commentary that is less favorable than in the past to those who may be providing investment advice as to how aspects of the five-part test should be interpreted.
- In unwelcome news to investment professionals, DOL overturned a prior DOL Advisory Opinion that had held that a financial institution did not, in most cases, act as a fiduciary in connection with rolling over ERISA plan or IRA assets to an account at the financial institution. As a result, many (but not all) rollover transactions now will be considered to involve fiduciary investment advice.
The Proposed Exemption
Historically, there has been a concern with investment advice fiduciaries receiving compensation that varied based on the advice provided by the fiduciary. As a result, business models that sought to receive variable compensation were typically structured to avoid meeting at least one of the prongs of the five-part test. The Vacated Fiduciary Rule negated this strategy by replacing the five-part test with a broad definition of "fiduciary" that included, among other things, most sales activities, but then provided an exemption that allowed fiduciaries to continue to sell products and services to IRAs and plans subject to cumbersome and complicated conditions. The Proposed Exemption clarifies that the five-part test continues to apply and expressly confirms that financial institutions acting as fiduciaries may receive variable compensation and engage in certain principal transactions, provided that the conditions of the Proposed Exemption are satisfied (if it is finalized). Of course, investment advisers must still comply with Section 206(3) of the Investment Advisers Act of 1940, as amended, which generally prohibits principal transactions unless specific conditions are met.
Under the five-part test, a person is an "investment advice fiduciary" if:
- the person renders advice as to the value of securities or other property or makes recommendations as to the advisability of investing in, purchasing or selling securities or other property;
- on a regular basis;
- pursuant to a mutual understanding;
- that the advice will serve as a primary basis for investment decisions with respect to the IRA or plan; and
- the advice will be individualized based on the particular needs of the IRA or plan.
The conditions that an "investment advice fiduciary" must satisfy to rely on the Proposed Exemption include:
- The financial institution must provide a written disclosure that acknowledges fiduciary status, describes, without being misleading, the services to be provided to the IRA or plan, and discloses all material conflicts of interest.
- The advice must satisfiy a "prudent expert" standard, be in the best interest of the retirement investor, and not place the interests of the financial institution (and related parties) ahead of the interests of the IRA or ERISA plan.
- The compensation received, directly or indirectly, by the financial institution (and related parties) must not exceed "reasonable compensation."
- The financial institution must maintain and enforce written policies and procedures that, among other things, are prudently designed to ensure that the financial institution complies with the impartial conduct standards of the exemption. The exemption states that policies and procedures are required to mitigate conflicts of interest to the extent that they, and the financial instituion's incentive practices, when viewed as a whole, are prudently designed to avoid misalignment of interests of the financial institution and its employees and the interests of the retirement investors.
- In the case of a rollover transaction, or advice to change account type (e.g., commission to asset-based fee), the financial institution must document why the transaction is in the best interest of the customer.
- The financial institution must conduct an annual, retrospective review of its compliance with the conditions of the exemption, and its policies and procedures, and then reduce the findings of the review to a written report that must be reviewed by its Chief Executive Officer.
- The financial institution's Chief Executive Officer must make specified annual certifications regarding the financial institution's compliance with the exemption.
Notable DOL Comments on the Five-Part Test
DOL commentary released with the Proposed Exemption includes discussion of DOL's view on how the five-part test should be interpreted in an attempt to restrict financial institutions from taking, or continuing to take, more narrow positions on the proper interpretation of the five-part test. For example, DOL takes the position in the commentary that the determination of whether there is a mutual agreement that the advice will serve as a primary basis for investment decisions should be based on the "reasonable understanding of each of the parties, if no mutual agreement or arrangement is demonstrated," which makes it somewhat easier for DOL or a plaintiff to establish that a mutual understanding exists. Similarly, DOL expresses the view that the "regular basis" prong can be satisfied in instances where the financial institution generally has, or the advice would establish, an ongoing relationship in which advice is provided from time to time, which makes it easier for DOL or a plaintiff to establish that the "regular basis" prong is satisfied. On the other hand, DOL helpfully admits that some one-time transactions, such as one-time sales of certain insurance products, do not satisfy the five-part test "even if accompanied by a recommendation that the product is well suited to the investor."
An aspect of the Proposed Exemption that is likely to have a material impact on the current practices of many financial institutions is DOL's reversal of its position on whether advice to take a distribution and rollover assets from an ERISA plan to an IRA is "fiduciary investment advice." In a 2005 Opinion Letter, DOL expressed the view that such advice generally was not fiduciary in nature.4 As a result, many financial institutions have historically taken the position that rollover transactions generally do not give rise to fiduciary status or associated self-dealing prohibited transaction concerns. DOL's commentary released with the Proposed Exemption expressly repudiates the 2005 Opinion Letter (and such advisory opinion has been withdrawn as of June 29, 2020) and instead takes the view that the five-part test applies to rollover transactions and that many such transactions will in fact satisfy the five-part test. Under DOL's new analysis, a financial institution advising a plan participant to take a distribution from the participant's ERISA plan and to roll over those assets to an IRA at the financial institution will need carefully to assess whether the five-part test is satisfied and, if so, address any accompanying prohibited transaction issues (such as by utilizing the new exemption). Further, if the rollover involves "fiduciary investment advice," the financial institution will be deemed to be a fiduciary of the ERISA plan and the financial institution will need to ensure that it complies with ERISA's substantive fiduciary obligations.
What to do Now?
It is no surprise that consumer groups and various Democratic lawmakers have already signaled dissatisfaction with the Proposed Exemption, taking the position that DOL's proposal is insufficiently protective of retirement investors. In response, we expect DOL to move to finalize these regulations quickly in order to avoid the risk that, if there is a change in administration as a result of the upcoming November election, the finalized rule could be overturned pursuant to the Congressional Review Act. DOL has asked for comments within 30 days of its issuance of this proposal.
Accordingly, financial institutions, particularly those not subject to Reg BI and who expect to utilize the Proposed Exemption when it is finalized, should start reviewing what changes may need to be made to their business models and policies, procedures and compliance programs to be ready if it is finalized quickly. The Proposed Exemption and related commentary are complex and this Advisory does not address all aspects or impacts of the Proposed Exemption. Please contact any of the authors to discuss how the Proposed Exemption may impact your business.
© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.
Department of Labor, Improving Investment Advice for Workers & Retirees.
For more information on the history of the Vacated Fiduciary Rule, see our previous Advisories: Department of Labor Adopts Sweeping Rules Regarding Fiduciary Investment Advice (April 2016); New Administration Moves Toward Repealing or Revising the Department of Labor's Fiduciary Rule (February 2017); DOL Proposes to Delay Implementation of the Fiduciary Rule by 60 Days(March 2017); DOL Delays Fiduciary Rule—But Significant Portions of New Rule Are Likely to Take Effect in June 2017 (April 2017); Fiduciary Rule to Become Applicable on June 9 (May 2017); DOL Proposes 18-Month Extension of Fiduciary Rule Transition Period (September 2017); DOL Extends Fiduciary Rule Transition Period Until July 1, 2019 (November 2017); DOL's Fiduciary Rule Vacated—But the Best Interest Concept Appears Here to Stay (July 2018).
For more information about Reg BI, see The SEC's "Regulation Best Interest," Form CRS, and Investment Adviser Interpretations: Does the New Framework Actually Protect the Best Interest of Customers and Clients?
DOL Advisory Opinion 2005- 23A (the Deseret Letter).