Department of Labor Adopts Sweeping Rules Regarding Fiduciary Investment Advice
On April 6, 2016, the Department of Labor (DOL) issued regulations that redefine who is a “fiduciary” of an employee benefit plan subject to the Employee Retirement Income Security Act (ERISA) or an Individual Retirement Account (IRA) and similar accounts subject to Section 4975 of the Internal Revenue Code (the Code). DOL also adopted new exemptions, and changes to existing exemptions, from rules that otherwise prohibit certain forms of compensation paid to “fiduciaries” (and related persons) under the revised definition. The new rules will be phased into effect beginning on June 7, 2016 (60 days after publication in the Federal Register) and ending on January 1, 2018. This phase-in period, described further below, is intended to be more workable than the eight-month period that DOL originally proposed.1
The new rules expand the types of firms and individuals that are deemed to be “fiduciaries,” and, as DOL has emphasized, whether a firm is acting as a “fiduciary” is based upon what a reasonable investor would have believed and will depend on the totality of the facts and circumstances in each case. The new rules’ preamble indicates that actions and statements of the firm and its affiliates in various contexts can be considered in this analysis. This standard may make it difficult to comfortably rely on a position that a firm is not acting as a fiduciary in making investment products available to IRA customers, unless a specific exemption is clearly applicable. The risk this creates is substantial: under the new rules, investors may pursue individual and class actions for alleged breaches of fiduciary duties. Market providers generally will need to conform their services and product offerings to meet the rules’ detailed requirements; create new disclosures; alter services, product offerings and fee structures; implement new policies, procedures and controls; and train personnel. The changes are sweeping, controversial, and may be tested in court.
I. Summary of the New Regulations
Under ERISA and the Code, a “fiduciary” may not engage in transactions that present conflicts-of-interest unless an exemption applies. Thus, a fiduciary may not receive compensation that varies based on its investment advice, or receive compensation from third parties in connection with that advice unless an exemption applies.
Under the newly published DOL rules, subject to specific exceptions, a “fiduciary” is any person who, for a fee or other compensation (whether direct or indirect):
(1) Provides either of the following types of advice to a plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner:
(a) Recommendations as to the advisability of acquiring, holding, disposing of, or exchanging, securities or other property, or a recommendation as to how securities or other investments should be invested after they are rolled over, transferred, or distributed from a plan or IRA; or
(b) A recommendation as to the management of securities or other property, including recommendations on investment strategies, portfolio composition, selection of advisers, selection of account arrangements (e.g., brokerage versus advisory); or recommendations as to rollovers, transfers, or distributions; and
(2) Directly or indirectly (e.g., through or together with affiliates), either:
(a) Represents or acknowledges that they are acting as a fiduciary;
(b) Renders the advice under a written or verbal agreement or understanding that the advice is based on the particular investment needs of the recipient; or
(c) Directs the advice to a specific recipient as to the advisability of a particular investment or management decision.
The new rules include examples of communications that would not be deemed “recommendations” and that would not implicate fiduciary requirements. These include providing platforms of investment alternatives for plan fiduciaries and related selection and monitoring assistance, providing educational materials, and general communications such as newsletters or presentations at conferences.
Further, certain types of activities will not be considered to involve providing investment advice, even if they include making “recommendations,” unless the person represents or acknowledges that they are acting as fiduciary. Thus, absent a fiduciary acknowledgement, these activities alone will not implicate fiduciary status. These activities involve:
- Advice Provided by Independent Fiduciaries with Financial Expertise. Provision of advice to an independent fiduciary of a plan or IRA in respect of an arm’s length transaction involving a plan or IRA where the independent fiduciary is a regulated professional (such as a broker-dealer, registered investment adviser, bank or insurance company) or is a fiduciary that holds, or has assets under management of, at least $50 million, provided that certain conditions are met.
- Swap Transactions. Provision of advice to an employee benefit plan by certain professional swap entities that are counterparties to swap transactions with the plan.
- Employee Activities. Provision of advice by employees of a plan, a plan sponsor or related parties so long as the employees, sponsor or related parties do not receive additional compensation.
In a change from its original proposal, DOL has determined that all appraisals and valuations, and not just those for Employee Stock Option Plans, should, at least for now, be excluded from the new rules. Accordingly, DOL has reserved all appraisal issues for a future rulemaking.
II. Best Interest Contract Exemption
The new rules include a new “Best Interest Contract (BIC) Exemption” from the prohibitions on advisory transactions, which allows fiduciaries to receive otherwise prohibited compensation, including compensation that varies based on the advice provided, if a number of conditions are met. The BIC Exemption’s conditions include the following:
- In the case of an IRA, the firm must enter into an enforceable written contract (i) subjecting the adviser to a fiduciary standard of care, and (ii) that may not include any provisions that purport to limit or waive an investor’s right to participate in a class action, or that require arbitration or mediation of individual claims in locations that are distant or that otherwise unreasonably limit the ability of the investor to assert claims under the contract.
- In the case of a plan subject to ERISA, the firm must provide the plan with a written statement as to the fiduciary status of the firm and adopt certain policies and procedures.
- The adviser and the firm must also:
- Commit to adhere to certain standards of impartial conduct;
- Not receive, directly, or indirectly (including affiliates), more than reasonable compensation;
- Provide multiple disclosures, including descriptions of charges, of compensation received from third parties, and any of material conflicts of interest;
- Warrant that they have adopted policies and procedures designed to ensure compliance and to prohibit sales quotas, bonuses, or other incentives that may lead to misaligned interests;
- Ensure that statements about a recommended transaction, compensation, material conflicts of interest, and other matters will not be materially misleading.
- The firm must maintain a quarterly-updated website that presents highly detailed disclosures, generally including:
- A discussion of the firm’s business model and related conflicts of interest;
- A schedule of typical fees and service charges;
- Model contract terms;
- A description of its policies and procedures as to conflicts and incentive practices;
- A list of all product manufacturers and other parties with whom the firm maintains arrangements that provide third-party payments; and
A firm that restricts recommendations (in whole or in part) to proprietary products or to products that generate third-party payments is permitted to rely on the BIC Exemption. However, such firms and their advisers must comply with many additional standards, including specific disclosure requirements, and internal vetting to ensure that the limits on recommendations and related conflicts of interest will not cause the recommendation of imprudent investments.
A more streamlined version of the exemption is available for “Level Fee Fiduciaries,” who only receive compensation that is charged on the basis of a fixed percentage of the value of assets or a set fee that does not vary with the recommended investment. Commissions or other transaction-based fees are not “Level Fees.” A Level Fee Fiduciary must also provide the investor with a written statement as to its fiduciary status.
III. Other Exemptions
DOL has also adopted other new prohibited transaction exemptions (PTEs) and changes to existing PTEs. These include:
- A “Principal Transactions” exemption, which allows certain principal transactions between a fiduciary and a plan or IRA, subject to the satisfaction of certain conditions. The exemption applies to purchases of debt securities, certificates of deposit, and interests in Unit Investment Trusts, by a plan, participant, beneficiary account or IRA. For sales by such plans and investors, it applies to any securities or other property.
- Revisions to PTE 84-24 (which has to date permitted receipt of commissions when plans and IRAs purchase insurance and annuity contracts and investment company securities), so as to exclude (a) variable annuities, indexed annuities, and similar contracts, and (b) with respect to IRAs, purchases of investment company securities.
- An amendment to PTE 75-1 to permit certain fiduciaries to receive compensation when they extend credit to plans and IRAs to avoid failed securities transactions.
- Revocation of PTE 75-1, Part II(2), which provided relief for receipt of a commission or other compensation related to the purchase or sale by a plan of securities issued by a mutual fund where the fiduciary with respect to the plan was not a principal underwriter for, or affiliated with, the fund.
- Revocation of PTE 75-1, Parts I(b) and I(c), which provided relief for persons providing clearance, settlement or custodial services, and for persons providing advice under circumstances not giving rise to a fiduciary relationship. DOL has stated that it revoked the exemptions because it believes that they are duplicative of relief available under statutory exemptions.
- Partial revocation of, and changes to, PTE 86-128, which has to date permitted receipt of compensation by certain fiduciaries and their affiliates in connection with agency transactions. The amendments require investment managers relying on PTE 86-128 to adhere to best interest and impartial conduct standards, and revoke the exemption for certain fiduciaries with respect to IRAs.
- New requirements for compliance with certain best-interest and impartial conduct standards as conditions to the following PTEs:
- PTE 75-1, Part III, which permits a fiduciary to cause a plan or IRA to purchase securities from a member of an underwriting syndicate other than the fiduciary, when the fiduciary is also a member of the syndicate;
- PTE 75-1, Part IV, which permits a plan or IRA to purchase securities in a principal transaction from a fiduciary that is a market maker in such securities;
- PTE 77-4, which allows a plan’s or IRA’s purchase or sale of mutual fund shares where the fund’s investment adviser is also a fiduciary to the plan or IRA;
- PTE 80-83, which provides relief for a fiduciary causing a plan or IRA to purchase a security when the proceeds of the securities issuance may be used by the issuer to retire or reduce indebtedness to the fiduciary or an affiliate; and
- PTE 83-1, which permits the sale of certificates in an initial issuance of certificates by the sponsor of a mortgage pool to a plan or IRA, when the sponsor, trustee, or insurer of the pool is a fiduciary with respect to the plan or IRA assets invested in such certificates.
As noted above, the new rules will be phased in over a period beginning June 7, 2016 (60 days after publication in the Federal Register) and ending on January 1, 2018. The new “fiduciary” definition will apply beginning on April 10, 2017. From April 10, 2017 until January 1, 2018, a transition period will apply that will allow financial institutions, advisers, their affiliates and related parties to continue to receive otherwise prohibited compensation if certain conditions are satisfied, including that, among other things, the advice is in the best interest of the recipient, the firm provides to the investor a single written disclosure that states that the firm and individual adviser(s) act as fiduciaries and that notifies the investor of any limits placed on investments due to the firm’s offering of proprietary products or as to the receipt of third party compensation.
The new definition of “fiduciary” and the new and amended prohibited transaction class exemptions represent very significant changes to existing rules and will fundamentally alter the retirement investment market. The new rules will require substantial changes in the practices of firms and individuals who provide investment-related advice, and sell financial products, to ERISA plans and IRAs. The new regulations, new and amended exemptions, and associated DOL releases are extremely long and complex. Accordingly, this Advisory is necessarily general in nature.