Client Update: The DOL’s Final Conflict of Interest Rule, Part 5

Drafting and Implementing Policies Designed to Mitigate Conflicts of Interest

September 6, 2016

The Department of Labor’s much-anticipated Final Conflict of Interest Rule is the most significant regulatory undertaking by the DOL since the enactment of ERISA. Greensfelder is releasing a series of client updates to assist broker-dealers and registered investment advisers understand, implement and remain compliant in the wake of this new rule. This fifth installment continues a series of updates focused on the Best Interest Contract exemption. Read our previous client updates: part onetwothree and four.

The Best Interest Contract ("BIC") exemption is an important exemption to the prohibited transactions provisions of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code. Section 2(d) of the BIC exemption requires firms to warrant to customers that they have written policies and procedures “reasonably and prudently designed to ensure that its Advisers adhere to the Impartial Conduct Standards.” This client update focuses on those policies and procedures.

Policies and procedures
Section 2(d) of the BIC exemption requires policies and procedures reasonably designed to ensure that advisers follow the impartial conduct standards. However, the regulations do not specify exactly what these policies and procedures must contain. Instead, they set out “overarching standards,” allowing each financial institution to develop policies and procedures that are effective for its unique business but that still ensure that its advisers remain in compliance. The regulations stress that financial institutions are not expected to guarantee perfect compliance. Rather, they must take reasonable proactive steps to ensure that advisers comply with impartial conduct standards and that compensation is not structured in such a way to incentivize advisers against acting in the best interests of their clients. Thus, the BIC exemption encourages firms to first minimize incentives for advisers to act contrary to clients’ best interests and then to carefully police the conflicts that remain. The substance of these required policies and procedures is aimed at two primary subsets of requirements: compensation structure and supervisory structure. 

Compensation structure
The regulations are clear that there is no one-size-fits-all policy that can be adopted by all financial institutions. Instead, each institution must tailor its policies to its own business model and the particular conflicts it may face. Still, the regulations emphasize that incentive-based compensation and differential compensation for different categories of investments are permitted as long as the institution creates safeguards against conflicts potentially caused by those compensation arrangements. Although the regulations do not prescribe any one compensation structure, they do discuss a variety of example approaches that financial institutions may choose to take in complying with the exemption’s requirements. Additionally, institutions are free to pick and choose among these compensation arrangements, using several in conjunction. Among the non-inclusive list of possible compensation arrangements, the regulations list:

  • Allowing independently certified computer models to make investment recommendations for clients. Under this approach, advisers could receive any form or amount of compensation as long as the advice given adheres strictly to the computer model’s recommendations.
  • Compensating advisers on the basis of a percentage of the dollar amount of assets invested by a client. The adviser would earn the same percentage on the same payment schedule regardless of how a client’s assets are allocated among investments.
  • Establishing a fee schedule for services and accepting transaction-based payments from individuals or third-party investment providers. Any third-party investment provider payment that exceeded the established service fee would result in a rebate to the individual, while third-party payments lower than the set fee would require the individual to be charged directly for the remaining amount due.
  • Creating a commission-based system with a stringent supervisory structure. This structure would eliminate variations in commission within categories of investments and ensure that any differentials retained would be based upon neutral factors, such as the time or complexity of the work involved. 
  • Designing a compensation structure that rewards advisers for providing advice that complies with the impartial conduct standards. 

Supervisory structure
In order to ensure that advisers comply with the impartial conduct standards, firms must implement a supervisory program to monitor adviser conduct. The regulations provide various examples of components of a prudent supervisory structure, including:

  • Establishing a comprehensive system to monitor and supervise adviser recommendations, evaluate the quality of the advice clients receive, properly train advisers, and correct any identified problems.
  • Creating systems to evaluate whether advisers recommend imprudent reliance on investment products sold by or through the financial institution.
  • Using metrics for behavior, comparing advisers’ behavior to those metrics, and basing compensation on those metrics.
  • Penalizing advisers and supervisors by reducing compensation on the basis of customer complaints about their behavior and other information suggesting that conflicts have not been carefully managed.
  • Appointing a committee to assess the risks and conflicts associated with new investment products and to assess the adequacy of the financial institution’s procedures to police any associated conflicts of interest arising from those products.
  • Ensuring that advisers and supervisors do not participate in any revenue sharing from any preferred provider, earn more for the sale of a product issued by a preferred provider, or earn more for the sale of a proprietary product. 
  • Ensuring that advisers disclose to clients any payments that the financial institution and its affiliates have received from a preferred provider or proprietary product.
  • Reviewing and revising policies and procedures related to conflicts of interest periodically to ensure that the financial institution is safeguarding fiduciary conduct and that the factors used to justify compensation differentials are neutral in substance and in application.

Importantly, in addition to implementing written policies and procedures, Section 2(d)(2) of the BIC exemption requires firms to designate an individual responsible for addressing conflicts of interest and monitoring adviser compliance. Section 2(e)(4) of the BIC exemption requires firms to draft a summary of the policies and procedures intended to mitigate conflicts of interest and make it available to investors on request as well as on their websites. 

In sum, crafting written policies and procedures necessary to take advantage of the BIC exemption is a process that requires a case-by-case analysis based upon the specific needs of each financial institution and its respective products and business models.

If you have questions about the rule or would like assistance drafting policies and procedures related to compensation and supervision that will allow your institution to utilize the BIC exemption, please contact any member of Greensfelder's Securities & Financial Services Group or your regular Greensfelder contact for additional information.