Client Update: The DOL’s Final Conflict of Interest Rule, Part 3

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 help broker-dealers and registered investment advisors understand, implement and remain compliant in the wake of this new rule. This third installment begins a series of updates focused on the Best Interest Contract exemption. Read our previous client updates here and here.

The DOL’s new rule applies the “prohibited transaction” standard applicable to ERISA fiduciaries to those providing advice to IRAs and non-ERISA plan investors. Thus, generally, those that provide advice related to retirement assets may not receive certain transactional compensation, such as revenue sharing, commissions and 12b-1 fees. The Best Interest Contract exemption (BIC) is a statutory exemption that will allow this type of compensation if a firm enters into an agreement wherein it acknowledges, among other things, its fiduciary status and agrees to a contractually enforceable standard of fiduciary conduct and fair dealing when providing advice that is in the “best interest” of the client.

Importantly, the BIC does not allow firms or advisors to act on conflicts of interest to the detriment of a client. In addition, it only applies to investment advice given to a “retirement investor,” defined as: (1) A participant or beneficiary of a plan with authority to direct the investment of assets in his or her account or to take a distribution; (2) the beneficial owner of an IRA acting on behalf of the IRA; or (3) a fiduciary of a plan or IRA other than a bank, registered investment advisor, registered broker-dealer or a fiduciary responsible for the management of more than $50 million in assets.

Requirements for the Best Interest Contract Exemption

Required primary terms: To invoke the BIC, a financial institution must agree to certain terms in an enforceable contract with the client. In this way, the DOL intends for clients to have a claim for breach of contract if the provisions are breached. The written contract requirement does not apply to advice to clients regarding investments in plans that are covered by Title I of ERISA. The rule specifically sets forth terms that are required, and prohibited, in the BIC contract. There are four categories of required terms that require a firm to:

1. Acknowledge fiduciary status in writing;
2. Agree that the financial institution and its advisors will comply with basic impartial conduct standards, in particular giving prudent advice in the client’s best interest, avoiding misleading statements and receiving no more than reasonable compensation;
3. Provide warranties relating to the firm’s advice and implementation of policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest; and
4. Disclose certain information about the costs of the advice, material conflicts of interests and third-party payments. 

Future client updates will cover specific requirements for the impartial conduct standards, and identification and disclosure of conflicts, as well as other conditions such as record retention requirements, notice to the DOL before relying on the BIC, and recommended language to include in BIC agreements.

With respect to obtaining a new client’s agreement to a BIC, the required terms may be incorporated in the firm’s standard account agreement or other account opening documents. For existing clients, negative consent letters may be used. Finally, the BIC exemption does not require execution of the contract at the start of the client’s conversations with an advisor, as long as it is entered into before or at the time of the recommended investment transaction.

Prohibited terms: Financial institutions and advisors may not rely on the exemption if they include contractual provisions disclaiming liability for compensatory remedies or waiving or qualifying clients’ right to pursue a class action or other representative action in court. Further, the BIC agreement cannot contain arbitration or mediation provisions for venues that are distant or otherwise unreasonably limit the ability of the client to assert claims. However, a BIC agreement can include provisions waiving the right to punitive damages or rescission as contract remedies to the extent permitted by other applicable law.

Transaction disclosures: In addition to the BIC agreement, the exemption requires firms to provide written transaction disclosures at least annually, or more frequently if an advisor recommends a different investment product. A disclosure does not have to be repeated for subsequent recommendations of the same product within one year of the contract or transaction disclosure. The transaction disclosure must include:

1. A statement of the firm’s best interest standard of care with a description of any material conflicts of interests;
2. A statement informing clients that they have the right to obtain the firm’s written description of its policies and procedures designed to ensure compliance with impartial conduct standards and a disclosure of the firm’s costs, fees and other compensation, including third-party payments; and
3. A link to the firm’s website (as described below) with a statement that the client may access, free of charge, the firm’s model contract disclosures (updated quarterly) and its written description of its policies and procedures designed to ensure compliance with the impartial conduct standards.

Website disclosures: The BIC exemption also requires firms to maintain certain information on their websites and to update it at least quarterly. Although the information must be freely accessible, firms may limit access by using user names and passwords. The six required web disclosures are:

1. A description of the firm’s business model and the material conflicts of interests associated with that model;
2. A schedule of the firm’s typical account or contract/services fees;
3. A model BIC agreement or other notice of its primary contract terms (updated within 30 days of any changes to the model contract or notice);
4. A description of the firm’s policies and procedures designed to ensure compliance with the impartial conduct standards (with summaries of key components relating to conflict-mitigation and incentive practices);
5. A list of the firm’s product manufacturers and other sources of third-party payments, a description of the firm’s arrangements with those entities and how they impact an advisor’s compensation, and a statement on any benefits a firm provides to these entities in exchange for third-party payments; and 
6. Disclosure of the firm’s compensation arrangements (including cash or non-cash awards or incentives) with its advisors, including (1) incentives to recommend a particular product manufacturer, investment or category of investments; (2) incentives to transfer retirement assets to the firm from other locations, or to maintain such assets at the firm; and (3) a description of the firm’s payout or compensation grid. 

These website disclosures may be, but are not required to be, dollar-specific. Instead, firms may provide percentages, formulas, reasonable ranges of values or categories of investment products/classes, or other means reasonably calculated to accurately describe the arrangements to permit clients to make informed decisions about the significance of the firm’s compensation practices and conflicts.

‘BIC Light’ for level fee fiduciaries

The DOL’s new rule provides a less burdensome exemption for “level fee fiduciaries.” This applies to those advisors who charge a flat fee for advice, or a fixed percentage of the value of assets in the client’s account, which is disclosed in advance. This exemption does not require any specific contract, transaction disclosures, or website disclosures. Instead, they must provide a written statement of fiduciary status and comply with the standards of impartial conduct.

To meet this exemption when recommending a rollover, documentation is mandated. Thus, if a level fee fiduciary recommends a rollover from an ERISA plan to an IRA, a rollover from one IRA to another or movement of retirement assets from a low-activity commission-based account to a level fee arrangement, they should document the specific reasons why the recommendation is in the client’s best interest.

Best Interest Contract Exemption carve-outs

The DOL rule makes these specific exclusions to the BIC exemption:

1. In-house plans: The exemption does not apply to the receipt of compensation from a transaction involving an ERISA plan if the advisor, firm or affiliate is the employer of employees covered by the plan.
2. Principal transactions: The exemption does not apply to compensation earned in principal transactions in which the firm fills the client’s trade from its own account. Note that the sale of insurance, annuity contracts or mutual fund shares are not considered principal transactions. 
3. “Robo-advice”: Robo-advice providers are generally carved out of the BIC; however, level fee fiduciaries may rely on the level fee exemption with respect to advice to engage a robo-advice provider, provided that they meet the level fee exemption requirements. Hybrid programs, in which an advisor relies on or works with interactive material is not excluded from the rule (as there is a personal interaction). Note that ERISA includes an exemption for computer-generated investment advice that the DOL states will cover robo-advice if its conditions are satisfied. See 29 C.F.R. 2550.408g-1(b)(4).
4. Discretion: The exemption does not apply if an advisor has or exercises any discretionary authority or control with respect to the recommended transaction. 

Conclusion

The DOL’s new rule extends fiduciary status to many firms and advisors that were not previously treated as fiduciaries. The BIC exemption is designed to permit firms to continue using their existing compensation structures that would otherwise be prohibited, provided that a recommendation is in the client’s best interest. To take advantage of the BIC, firms must draft and implement substantial disclosures and review their current operations. Of course, failure to comply with the BIC’s various disclosure requirements could result in regulatory penalties and litigation.

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.

Greensfelder Attorneys at Law  |  St. Louis, MO |  Chicago, IL  |  Southern Illinois

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