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Client Update: The DOL’s Final Conflict of Interest Rule, Part 4

The Best Interest Contract Exemption

August 5, 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 advisors understand, implement and remain compliant in the wake of this new rule. This fourth installment continues a series of updates focused on the Best Interest Contract exemption. Read our previous client updates here, here and here.

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 (“Code”). This Client Update considers the meaning of the Impartial Conduct Standards to which investment advice fiduciaries will need to adhere.

Background

A BIC is an important exemption to certain prohibited transaction provisions of ERISA and the Code in that many brokers and advisers would not be able to do business in many retirement accounts without it. The BIC allows investment advice fiduciaries, such as investment advisers, broker-dealers, and insurance companies to receive various forms of compensation, such as brokerage or insurance commissions, 12b-1 fees, and revenue sharing payments that would otherwise not be permitted under ERISA or the Code. 81 FR 21002 (April 8, 2016) (to be codified at 29 C.F.R. pt. 2550). The BIC was designed to allow investment advice fiduciaries under the rule and their agents and representatives to continue to provide advice to certain retail investors, including IRA owners, under conditions designed to safeguard those retail investors’ interests. Id. The Department of Labor’s (“DOL”) intent is that the investment advice fiduciaries rely on statutory exemptions or the BIC exemption to the extent they receive conflicted forms of compensation that would otherwise be prohibited. Id. at 21007.

Impartial Conduct Standards

As a condition of receiving compensation that would otherwise be prohibited under ERISA and the Code, the BIC exemption requires financial institutions to acknowledge the fiduciary status of itself and its advisers, and the financial institution and its advisers must adhere to certain standards of impartial conduct. 81 FR 21007. What are those standards? A financial institution and its advisers must:

  1. give prudent advice that is in the client’s best interest (i.e. prudent advice based on the client’s investment objectives, risk tolerance, financial circumstances, and needs, without regard to financial or other interests of the financial institution or adviser);
  2. avoid misleading statements about investment transactions, compensation, and conflicts of interest; and
  3. receive no more than reasonable compensation.

If advice is provided to an IRA investor or a non-ERISA plan, the financial institution must set forth the standards of fiduciary conduct and fair dealing in a contract and it will be enforceable against the financial institution. 81 FR 21008.

The fiduciary acknowledgement provision is necessary for the BIC exemption to apply. 81 FR 21025. The DOL states that the financial institution’s “role in supervising individual Advisers and overseeing their adherence to the Impartial Conduct Standards is a key safeguard of the exemption.” Id.

Best Interests Standard: The Best Interest Standard is based on concepts derived from both ERISA and the law of trusts and means advice that, at the time of the 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, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. 81 FR 21026-27.

The DOL notes that the BIC exemption and the Best Interests Standard do not require an ongoing, long-term advisory relationship. 81 FR 21029. Instead, the duration of the relationship will be governed by the contracts or other agreements or understandings between the parties. Id.

It appears the DOL intends this standard to be consistent with the prudent person standard set forth in Section 404 of ERISA. This section requires ERISA fiduciaries to discharge their duties “solely in the interest of the [plan’s] participants and beneficiaries” and for the exclusive purpose of “providing benefits to participants and their beneficiaries and defraying reasonable expenses of administering the plan.” 29 U.S.C. § 1104(a). This ERISA standard is objective and “focuses on the fiduciary’s conduct preceding the challenged decision—not the results of that decision.” Tussey v. ABB, Inc., 746 F.3d 327, 335 (8th Cir. 2014). In addition, a fiduciary’s conduct is viewed from the perspective of the fiduciary at the time of the challenged decision, rather than from a vantage point of hindsight. Roth v. Sawyer-Cleator Lumber Co., 16 F.3d 915, 918 (8th Cir. 1994). Thus, ERISA obligates fiduciaries “to investigate all decisions that will affect [a plan], and must act in the best interests of the beneficiaries.” Id. (internal quotations omitted). As firms draft their BIC agreements, they should be aware of the scope of duties owed by ERISA fiduciaries and how those duties may or may not fit within their business models, and how they will ensure (for example, through checklists, documentation/note requirements, client acknowledgement letters, etc.) their advisers are fulfilling those duties.

Avoiding Misleading Statements: This requirement applies to statements made about the recommended transaction, fees and compensation that are “materially” misleading “at the time they were made.” 81 FR 21031. ERISA cases find that fiduciaries must “disclose any material information that could adversely affect a participant’s interests.” Braden v. Wal-Mart Stores, Inc., 588 F.3d 585, 598 (8th Cir. 2009). The materiality of information is a “fact-intensive issue” and depends on the effect the information would have on a reasonable investor and how they decide to make investments. Id. In the ERISA context, this “may require a fiduciary to disclose latent conflicts of interest which affect participants’ ability to make informed decisions about their benefits.” Id. at 600.

Reasonable Compensation: The reasonable compensation requirement means that neither a financial institution or advisor can receive compensation for their services that is in excess of reasonable compensation within the meaning of ERISA section 408(b)(2) and Code section 4975(d)(2).” 81 FR 21029. The standard simply requires that “compensation not be excessive, as measured by the market value of the particular services, rights, and benefits” the financial institution or adviser is giving to the client. Id.

Compliance

To take advantage of the BIC exemption when advice is provided to an IRA investor or non-ERISA plan, investment advice fiduciaries will need to carefully draft contracts that acknowledge their fiduciary status, which will include adhering to the Impartial Conduct Standards discussed above. Those contracts should also include other important terms, such as the duration of the relationship between the financial institution and/or adviser and the client. Avoiding misleading statements and charging reasonable compensation based on market rates are seemingly straightforward requirements. Complying with the Best Interest Standard, however, will require more careful analysis of the facts, circumstances and the law. Indeed, the most fertile ground for potential litigation will likely be whether or not the financial institution or adviser complied with the Best Interest Standard when making the recommendation.

If you have questions about the rule, the BIC exemption and its implications, please contact any member of Greensfelder's Securities & Financial Services Group or your regular Greensfelder contact for additional information.