DOL Major Changes to Fiduciary Investment Adviser Definition and Prohibited Transaction Exemptions – Part 3

The Best Interest Contract Exemption and Level-Fee Fiduciaries

By Darcy Norville and Jessica Morgan

On April 6, 2016, the U.S. Department of Labor (the “DOL”) issued final regulations expanding the definition of who is a fiduciary and what constitutes fiduciary advice to ERISA-covered employee benefit plans, as well as a new fiduciary adviser definition and related prohibited transaction exemptions. This Tonkon Tip, the third in a series of tips, addresses the new Best Interest Contract Exemption, which includes a streamlined exemption that can be used by “Level-Fee Fiduciaries.”

Prohibited Transaction Exemptions

ERISA and the Internal Revenue Code (the “Code”) prevent fiduciaries to plans and IRAs from receiving compensation that varies based on their investment advice unless a prohibited transaction exemption applies because of the conflict of interest inherent in such arrangements. Fiduciaries are also prohibited from receiving compensation from third parties in connection with their advice. In creating new exemptions and modifying existing prohibited transaction exemptions, the DOL’s goal was to balance protecting retirement accounts from conflicts of interest without being too disruptive to existing business models. To accomplish this, it used a principles-based approach to exempt a variety of transactions and compensation models from the prohibited transaction restrictions, so long as certain conduct standards are followed and disclosures are made. The DOL adopted the Best Interest Contract Exemption (BIC exemption or “BICE”), which allows advisers who satisfy its requirements to receive variable compensation based upon the investment product selected and third party payments. BICE also provides an exemption that can be utilized by investment advisers who charge only “level-fees.”

Best Interest Contract Exemption

BICE was issued with the Final Rule to permit investment advice fiduciaries to receive customary forms of compensation when ERISA plans, plan participants and beneficiaries, and IRA owners purchase, hold, or sell investment products recommended by those fiduciaries. Firms that qualify for the BIC exemption will be allowed to receive reasonable compensation – commissions, trailing commissions, 12b-1 fees, etc. – that would otherwise be prohibited under ERISA. The financial institution must notify the DOL of its intent to rely on the BIC exemption before receiving compensation.

BICE Requirements

Under BICE, financial institutions and advisers must adhere to enforceable standards of fiduciary conduct and fair dealing with respect to their advice. The mechanism available for the investor to enforce these requirements differs significantly depending on whether the advice is rendered to a plan, participant or beneficiary in a plan covered by Title I of ERISA (an “ERISA plan investor”), or to an IRA owner or non-ERISA plan (such as a non-qualified deferred compensation plan):

  • ERISA plans: ERISA plan investors may bring an action to enforce the BICE requirements directly under ERISA.
  • IRAs and Non-ERISA Plans: When advising IRA owners and non-ERISA plans (e.g. non-qualified deferred compensation plans), the financial institution must enter into an enforceable “best interests” contract that contains specified representations and warranties.

ERISA Plan Advice

Under BICE, advisers and financial institutions may receive reasonable compensation for providing investment advice to ERISA Plans, if the following conditions are satisfied:

  • Fiduciary status is acknowledged in writing;
  • The financial institution affirmatively states that it and its advisers will, and they do in fact, comply with “impartial conduct standards” (described below);
  • The financial institution adopts and complies with policies and procedures designed to
    • ensure that its advisers adhere to the impartial conduct standards;
    • prevent “material conflicts of interest” (described below); and
    • avoid compensation or incentives that are intended or could be expected to cause advisers to make recommendations that are not in the best interests of the ERISA plan.
  • Compensation and other fee information is disclosed.

IRAs and Non-ERISA Plan Advice

Under BICE, advisers and financial institutions may receive reasonable compensation for providing investment advice to IRA owners and Non-ERISA Plans, if the following are satisfied:

  • A written contract is entered into with the retirement investor before, or at the same time as, the execution of the recommended transaction;
  • Fiduciary status is acknowledged in the contract;
  • Impartial conduct standards are complied with;
  • The financial institution adopts and complies with impartial conduct standards policies and procedures;
  • Material conflicts of interest are disclosed; and
  • Compensation and other fee information is disclosed.

BICE will be unavailable if the written contract contains the following provisions:

  • Disclaimer or limitation of the liability of an adviser or financial institution;
  • Waiver of rights and remedies of the plan, IRA, or retirement investor (including their right to participate in a class action in court); or
  • Arbitration, if the venue is distant or the provision otherwise unreasonably limits the ability of the retirement investor to assert claims safeguarded by BICE.

Timing and Execution of Best Interest Contracts

A financial institution must enter into a written contract prior to, or at the same time as, execution of a recommended transaction. The terms of the contract may appear in a stand-alone document, or may be incorporated into an investment advisory agreement or other agreement.

  • New contracts between financial institutions and investors must be signed by the investor, by handwritten or electronic signature.
  • Financial institutions may amend existing contracts with current clients by negative consent, whereby the investor is informed of the new terms, and failure to terminate the contract within 30 days is deemed assent to the new terms.
  • If an adviser and a financial institution provide advice that satisfies the conditions of BICE, but the financial institution is unable to enter into a contract with the retirement investor due to circumstances outside of its control, BICE may still be available in certain circumstances.

Disclosure Requirements

Transaction Disclosure

Prior to, or at the same time as, the execution of the recommended transaction, BICE requires disclosure of:

  • The “best interest” standard of care owed to the investor;
  • The services to be provided and fees to be charged, including the applicable payment mechanism;
  • Material conflicts of interest;
  • The investor’s right to obtain written descriptions of the financial institution’s impartial standards policies and procedures and detailed fee and cost information;
  • Whether the financial institution offers proprietary products or receives third party payments with respect to any recommended investments;
  • Whether the financial institution and adviser will monitor the investor’s investment – and if so, how frequently – and the reasons for which the investor will be alerted; and
  • Contact information for use if an investor has concerns about service or fees.

Website Disclosure

BICE requires financial institutions to maintain a website that is freely accessible to the public and updated at least quarterly, which contains specified information about the financial institution’s business model, material conflicts of interest, schedule of typical account or contract fees and service charges, model contract or notice of model contract terms, policies and procedures relating to conflict mitigation, compensation and incentive arrangements, a list of product manufacturers and providers of third-party payments, and other matters.

BICE Lite: Level-Fee Fiduciaries

The BIC exemption provides streamlined conditions for “level-fee fiduciaries,” sometimes referred to as “BICE lite”:

  • A financial institution is a “level-fee fiduciary” if the only fees or compensation received by the financial institution, adviser, and any affiliate in connection with the investment advice is a level-fee that is disclosed in advance to the retirement investor.
    • “Affiliate” is broadly defined for purposes of the exemption.
  • A “level-fee” is a fee or compensation that is provided based on a fixed percentage of the value of the assets managed, or a set fee that does not vary with the particular investment recommended.

Level-fee fiduciaries do not have to enter into a best interests contract but must:

  • Give the investor a written statement of the adviser’s fiduciary status prior to, or at the same time as, when the recommended transaction is executed;
  • Adopt in writing and comply with impartial conduct standards.
  • In the case of a recommendation to rollover from an ERISA plan to an IRA, the financial institution must document the specific reasons why the recommendation was considered to be in the best interest of the retirement investor. The documentation must specifically address:
    • The alternatives to rollover, including leaving the money in the employer’s plan, if permitted;
    • The fees and expenses associated with the plan and the IRA;
    • Whether the employer pays some or all of the fees and expenses associated with the plan;
    • The different levels of services available under the plan and the IRA options; and
    • The different investments available under the plan and the IRA options.
  • In the case of a recommendation to roll over from one IRA to another IRA, or to switch from a commission-based account to a level-fee-based account, the financial institution must document the specific reasons why the recommendation was considered to be in the best interest of the retirement investor. The documentation must specifically address the services that will be provided for the fee.

The “level-fee fiduciary” exemption is not available if the adviser, financial institution or any affiliate receives any commission, transaction-based payment or other remuneration (e.g., revenue sharing, 12b-1 fees) beyond the level fee.

“Impartial Conduct” Standards

The impartial conduct standards require that financial institutions and advisers:

  • Provide advice that is in the client’s “best interest”;
  • Ensure that recommended transactions will not cause the financial institution, adviser, or their affiliates or related entities to receive, directly or indirectly, compensation for their services that is not “reasonable.”
  • Avoid making materially misleading statements about the recommended transaction, fees and compensation, material conflicts of interest or other matters relevant to the retirement investor’s decisions.

“Best Interest” Standard

To meet the “best interest” standard, advice must:

  • Reflect 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;
  • Be based on investor’s investment objectives, risk tolerance, financial circumstances, and needs;
  • Be made without regard to the financial or other interests of the adviser, financial institution, or any affiliate, related entity, or other party.

“Reasonable Compensation” Standard

Reasonableness of compensation is based on several factors which include the market pricing of the services, benefits and rights provided, and other facts and circumstances, such as the complexity of the products recommended, the scope of monitoring of investment performance and other factors provided.

“Material Conflicts of Interest

A “material conflict of interest” exists when an adviser or financial institution has a financial interest that a reasonable person would conclude could affect the exercise of its best judgment as a fiduciary in rendering advice to a retirement investor.

Record-Keeping Requirements

The financial institution must keep, and make reasonably available for six years, records necessary to determine whether the conditions of the exemption have been met, including:

  • Records about the financial institution’s incentive and compensation practices for advisers;
  • Policies and procedures and the documentation governing applicability of the policies and procedures;
  • Contracts with retirement investors;
  • Disclosure documentation; and
  • Documents prepared for proprietary products and third party payments.

Applicability Date and Transition Rules

The new fiduciary adviser definition and the Best Interest Contract Exemption become effective April 10, 2017. However, fiduciary advisers are relieved from sanctions under ERISA and the Code during a transition period between April 10, 2017 and January 1, 2018, if certain of the requirements are met. Relief is available during the transition period if:

  • The financial institution and adviser provides investment advice that is in the best interest of the retirement investor;
  • The recommended transaction does not cause the financial institution, the adviser, or its affiliates or related entities to receive, directly or indirectly, compensation for services that is in excess of reasonable compensation;
  • Statements by the financial institution and its advisers about recommended transaction, fees and compensation, material conflicts of interest, and any other relevant matters are not materially misleading;
  • The financial institution provides the retirement investor, before or at the time of execution of the recommended transaction, a single written notice of its fiduciary status, that it will comply with the impartial conduct standards, and will disclose its material conflicts of interest;
  • The financial institution designates a person responsible for addressing material conflicts of interest and the adviser’s adherence to impartial conduct standards (BICE Officer); and
  • The financial institution complies with record-keeping requirements under BICE.

For more information about the final regulations, please contact a member of Tonkon Torp’s Financial Services practice group.

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