DOL Conflict of Interest Rule and its Impact on Investment Advisers

By:  Jaqueline M. Hummel, Managing Director, IACCP, AIFA Hardin Compliance Consulting LLC and Elizabeth L. Cope, Managing Member, CPA, CSCP, CIPM Focus 1 Associates, LLC

 May 4, 2016

The Department of Labor’s (“DOL”) “Conflict of Interest Rule” (the “Rule”), also known as the Fiduciary Rule, was issued in final form on April 6, 2016.  The good news is that the new rule does not go into effect until April 10, 2017, and even better, compliance with the exemptive relief (best interest contract and principal transactions) is extended until January 1, 2018.   The bad news is that it will impose fiduciary obligations on a larger segment of the financial services industry, including broker-dealers and insurance agents.  Investment advisers already have a fiduciary duty to their clients, but ERISA’s fiduciary standards are stricter than those under the Advisers Act, so compliance with the rule will require additional documentation.  Advisers that offer products and services in addition to investment management, such as capturing 401(k) rollovers, acting as a broker-dealer, and selling insurance products, will have additional compliance burdens of disclosure and documentation specifically tailored to retirement investors.

General Effect on Investment Advisers

The Rule requires fiduciaries to retirement plans, plan participants, and IRA owners to act impartially and provide advice that is in their clients’ best interest.  Under ERISA, this means these fiduciaries are not permitted to receive payments that create a conflict of interest with their clients without meeting a prohibited transaction exemption.  In order for an adviser to receive such compensation, the firm must meet the conditions of the Best Interest Contract Exemption (“BICE”).

By comparison, under the Adviser’s Act, fiduciaries are required to act in their clients’ best interests but can still engage in activities that might be considered to be a conflict of interest, as long as the client has received full disclosure and, in some cases, provided consent.  As a result of the Conflicts of Interest Rule, investment advisers providing advice to plans subject to ERISA and IRAs cannot count on disclosure and consent to mitigate conflicts of interest.  They must also meet the conditions of an exemption like BICE.

At the end of the day, the Rule and accompanying exemptions should be familiar territory to most investment advisers.  Advisers deal with conflicts of interest every day, and have developed ways to ensure that decisions affecting clients are made without regard to actual and potential benefits to the adviser.  Best execution, restrictions on personal trading, and proxy voting policies are prime examples.  Decisions in these areas are driven by a process that excludes consideration of benefits to the adviser.  Accountability is also part of the process, since regulators require documentation of how decisions were made.

Moreover, advisers already have an obligation to disclose conflicts of interest to clients and potential clients in Form ADV and other documents, such as prospectuses and private placement memoranda.  The DOL’s new Rule requires some greater granularity for disclosures related to retirement investors, as well as specific details regarding fees and any compensation received by the adviser.  This is no small task, as advisers continue to struggle with providing adequate disclosures.  A great example is the SEC’s case against The Robare Group, Ltd, where the various parties to an agreement had difficulty with determining whether the fees being paid to the advisers were commissions, 12b-1 fees, or some other type of direct payment.

Background

Back in 1975, at the time ERISA was initially passed, the DOL enacted regulations imposing fiduciary liability on advisers for managing assets subject to ERISA if the adviser provided individualized investment advice for compensation on a regular basis that was intended to serve as the primary basis for investment decisions with respect to plan assets.  The advice also had to be provided pursuant to an agreement.  Over time, the DOL discovered that this was a pretty high bar to reach and made it difficult for regulators to impose fiduciary liability on investment advisers and broker-dealers providing investment services to ERISA plans and IRAs.

Scope of the Rule

The Rule applies to advisers who provide investment advice to ERISA plans and IRAs.  The DOL has specified what it considers “advice” with respect to ERISA plan assets and IRAs.  Specifically, “advice” means:

1. Recommendations on the advisability of acquiring, holding, disposing of, or exchanging securities or other investment property or how to invest after a rollover, transfer, or distribution from a plan or IRA; or
2. Recommendations as to management of securities or other investment property.

But the definition does not end there.  The DOL expanded the concept to include any communication that, “based on its content, context and presentation, would reasonable be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.”

Changes for Advisers

What is different for registered investment advisers under this Rule? Most significantly, the Rule extends ERISA fiduciary responsibilities to IRAs, which were previously not subject to ERISA.  The Rule also covers advisers providing “fiduciary investment advice” to other non-ERISA plans, including defined contribution plans, health savings accounts (“HSAs”), certain 403(b) plans, Keoghs, Savings Incentive Match Plans for Employees (“SIMPLEs”), SIMPLE‐IRAs, and Simplified Employee Pensions (“SEPs”).  These assets will now be subject to the DOL’s scrutiny, which may result in advisers being held to an even stricter fiduciary standard than that imposed by the SEC (although, we expect the SEC will continue to hold its own in this arena).

Another change is that advisers providing additional services and products, such as insurance and annuity contracts, will now have to meet the specific conditions of BICE.   This can no longer be overcome by disclosure to the client, as allowed currently under the Advisers Act.    Even advisers that typically receive flat fees or a fee based on a fixed percentage of assets under management may need to comply with BICE, in the event they provide advice with respect to rollovers from employer-sponsored retirements plans to IRAs.  The DOL specifically addressed these situations by allowing “Level Fee Fiduciaries” to comply with a streamlined version of BICE (discussed later in this article).

Perhaps most significantly, the Rule now requires investment advisers providing advisory services to retirement investors to comply with ERISA’s standards of conduct.  This includes compliance with general fiduciary provisions, prohibitions against self-dealing, and prohibitions against dealings with parties in interest.

Advisers to Private Funds

The impact of the Rule on private fund managers accepting ERISA Plan or IRA investments is not clear, since the DOL did not provide a specific exemption for investments in private funds.  It could be argued that offering an investment in a private fund is not “a recommendation” as contemplated under the Rule, since it is not based on meeting the particular investment needs of a client.  To bolster this argument, a fund manager should consider including representations in the subscription agreement stating:

• the owner understands and agrees that the fund manager is not offering impartial fiduciary advice
• the owner has sufficient financial expertise to make the decision to invest
• the owner understands and agrees that fund manager is not providing specific advice or a recommendation as to whether the owner should invest in the fund

Private fund advisers could rely on BICE (as described below).  There may be challenges specific to private fund managers  due to the requirement to “exercise special care when assets are hard to value, illiquid, complex or particularly risky”   and “give special attention” in their oversight of the policies and procedures “surrounding such investments.”

Best Interest Contract Exemption

The Rule creates a new Prohibited Transaction Class Exemption, the “Best Interest Contract Exemption.” BICE will allow firms to continue to receive commissions and revenue sharing so long as they meet the conditions of the exemption, which includes a commitment to putting their client’s best interest first and disclosing any conflicts that may prevent them from doing so.  Compliance with BICE will also allow advisers to recommend proprietary products and investments that generate third party payments, such as 12b-1 fees, sales loads, and commissions.

Investment advisers should be familiar with the conditions imposed by BICE since they mirror many of the disclosure requirements of the Form ADV.

The DOL defines best interest in BICE stating that an investment adviser acts in the “Best Interest” of a retirement investor when it provides investment advice acting with:

“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 investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investors, without regard to the financial or other interest of the [investment adviser, its affiliates or related parties.”

This is more commonly known as the “prudent person” standard.

Impartial Conduct Standards

The underpinning of BICE are the Impartial Conduct Standards, which a fiduciary must satisfy in order to rely on the exemptive relief.  The Impartial Conduct Standards requires that the fiduciary meet the following conditions relevant to ERISA plans and IRAs:

1. Provide prudent investment advice;
2. Charge only reasonable compensation; and
3. Avoid misleading statements.

BICE Conditions

There are three versions of BICE.  “Full blown” BICE for IRAs and non-ERISA plans, “Disclosure BICE” for ERISA plans, and “Streamlined BICE for Level Fee Fiduciaries.”   The conditions of Full Blown BICE and Disclosure BICE are substantially similar, with the exception that Full Blown BICE requires the adviser to enter into a contract with the IRA owner.   For ERISA plans, the disclosures, representations and warranties included in the contract with IRA owners must be provided in a separate document.  Here is a summary:

1.  Written contract or separate document. An adviser providing fiduciary investment advice with respect to IRAs and other non-ERISA plans (e.g., HSAs, certain 403(b) plans, Keoghs, SIMPLEs, SIMPLE‐IRAs, and SEPs) must have a written contract with the retirement investor that includes the provisions outlined below.  Although a contract is not required under the Rule for an ERISA plan, the adviser must provide disclosures regarding these same provisions.  Specifically, the contract or separate disclosure document must:

• Acknowledge Fiduciary Responsibility. The adviser must provide the retirement investor with an affirmative statement of fiduciary responsibility under ERISA.
• Compliance with Impartial Conduct Standards (defined above). The adviser must affirmatively state that it will comply with the Impartial Conduct Standards.
• Adoption of Policies and Procedures. The adviser has to adopt policies and procedures to (i) ensure compliance with Impartial Conduct Standards, (ii) identify and document material conflicts of interest and designation of a Chief Conflicts Officer, (iii) prohibit compensation (bonuses, sales contests, awards) that would reward employees not acting in the retirement investors’ best interest.  The adoption of these policies must be affirmed in either the written contract or separate document.
• Additional Information. Additionally, the contract or separate document may not limit the financial institution’s liability for a violation of contract terms, force arbitration of individual claims in remote venues or in a manner that unreasonably limits enforcement of the contract, or limit the retirement investor’s ability to bring class action claims in court.

2.  Required Disclosures. The adviser must provide disclosure to retirement investors (either in the contract or other document) that describes:

• the “Best Interest” standard;
• any material conflicts of interests; all fees or charges to be paid by the retirement investor, and any compensation expected to be generated in connection with the recommended transaction;
• the right of the investor to receive copies of the firm’s policies and procedures that ensure adherence with the Impartial Conduct Standards;
• how to access the adviser’s website, which includes some of these disclosures;
• adviser’s use of any proprietary products or receipt of payments from third parties with respect to recommended investments, whether the adviser limits advice to proprietary products, and any limitations placed on the universe of investments offered;
• how to contact the adviser (telephone number and email) with any concerns; and
• the extent to which the adviser monitors the recommended investments.

3.  Maintenance of a web site: Advisers will also have to maintain a website, updated quarterly, that contains:

• a description of the adviser’s business model and the material conflicts of interest associated with that business model;
• a schedule of typical account or contract fees and charges;
• a model contract including all required disclosures;
• a list of all parties with whom the adviser maintains third-party payment arrangements; and
• compensation and incentive arrangements available to employees and representatives (including payout or compensation grids).

4.  Transaction Disclosure. Before or at the time the recommended investment in an investment product is made, the adviser must provide to the retirement investor:

• a statement of any material conflicts of interest and a statement of the best interest standard of care owed to the investor;
• a notice of the right to obtain copies of the adviser’s written description of its policies and procedures and the costs, fees, and compensation paid with respect to the transaction;
• a link to the financial institution’s website and a statement that certain model contract disclosures or notices and the institution’s policies and procedures are maintained on the institution’s website.

The transaction disclosures do not need to be repeated for subsequent recommendations by the adviser of the same investment product within one year of providing the disclosures in a contract or separate document, unless there are material changes to the disclosure.

5.  Notification to DOL. Advisers that want to rely on BICE must notify the DOL of their intent, in writing, via email to e-BICE@DOL.gov. This applies to advisers relying on Full Blown BICE and Disclosure BICE.

Streamlined BICE for Level Fee Fiduciaries

The DOL granted special relief from the BICE conditions for “Level Fee Fiduciaries.”  Level fees are defined as fees or compensation “provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee.”  Level Fee Fiduciaries do not have to have a written contract, adopt written policies and procedures to ensure compliance with BICE, maintain a website with the information described above, or provide transaction-based disclosures.  To qualify for this exemption, the adviser has to disclose the fee in advance to the retirement investor, acknowledge its fiduciary status in writing, and comply with the Impartial Conduct Standards (with the exception of the contract requirement).

Level Fee Fiduciaries must also document why a rollover from an employer-sponsored ERISA plan to an IRA, or from a commission-based IRA to a fee-based IRA, is in the best interest of the retirement investor. The documentation must include consideration of the retirement investor’s alternatives (e.g., leave the money in the current plan) and the relative fees and expenses associated with the old and new investment options (e.g., previous employer pays for the fees related to the plan). The documentation must address the services that will be provided for the new fee-based IRA.  The DOL did not mandate any particular format or method for creating and retaining documentation. Firms should develop a process (such as developing a checklist) that is practical for proving that they compared all of the pertinent factors and acted in the client’s best interest.

Exemption for Sales of Insurance Products

The DOL also amended Prohibited Transaction Exemption 84-24, which has traditionally permitted advisers to receive commissions in connection with the purchase and sale of insurance products and mutual fund shares by plans and IRAs.  The exemption has been narrowed to only cover “fixed rate annuity contracts” and “insurance contracts.” Purchases by a plan or IRA of variable annuity contracts, indexed annuity contracts, or similar contracts are now covered by BICE.  This particular exemption is applicable on April 10, 2017.

The general requirements of Prohibited Transaction Exemption 84-24 did not change and are similar to those imposed by BICE.  In order for an investment advisory representative to receive a commission on the sale of an insurance contract, the investment advisory representative must acknowledge in writing that he/she is a fiduciary and must agree to adhere to the best interest standard of care.

As noted by Fred Reish, a recognized expert on ERISA and a partner at Drinker Biddle & Reath, this means that “the recommendation of a particular insurance company must be prudent and the recommendation of the particular insurance contract must also be prudent.”  The exemption also requires that both the adviser’s compensation and the commission received by the investment advisory representative must be reasonable and disclosed to the client.  Like BICE, statements made with respect to the insurance product cannot be materially misleading.  Finally, the required disclosures must be delivered to the ERISA plan fiduciary of the IRA owner in writing and acknowledged.  The retirement investor must also approve of the transaction in writing.

12b-1 Fees, Referral Payments, and Use of Proprietary Products

An investment adviser or its affiliates typically cannot receive 12b-1 fees or revenue sharing payments from mutual funds in addition to its advisory fee with respect to ERISA plan assets.  Additionally, an investment adviser cannot receive a fee for advising an ERISA plan to invest in a mutual fund advised by the adviser and also receive an advisory fee from the mutual fund with respect to the ERISA plan’s investment in the fund.  This is considered double dipping, and the adviser has to rebate the advisory fee charged in connection with its advice to invest in the mutual fund.

Under BICE, such fees are permitted, if certain conditions are met.   Advisers using proprietary products and recommending products that generate third-party payments must comply with all the conditions of Full Blown BICE, with a few extra twists.  The written disclosure provided to the retirement investors regarding the transaction must:

• state that the adviser offers proprietary products and/or receives third-party payments with respect to certain investments;
• describe the “limitations placed on the universe of investments” that the adviser may recommend; and
• describe the material conflicts of interest that the adviser (and the investment advisory representative) has with respect to the transaction.

Preparing for the New Rule:  Compliance with BICE

Transition Period

There is a transition period for advisers to prepare.  Advisers to IRAs and other non-ERISA plans may receive compensation from third parties in connection with advice from April 10, 2017 through January 1,2018 if they meeting the following conditions:

1. The adviser meets the Impartial Conduct Standards (stated above);
2. The adviser provides a written statement of fiduciary status and conflict disclosures (either electronically or via email); and
3. The firm designates a Chief Conflicts Officer (or BICE Compliance Officer).

For the transition period, advisers do not have to have compliance policies or other disclosures required under Full Blown BICE.

Drafting Policies and Procedures Addressing Conflicts of Interest:

Advisers should consider whether their current policies and procedures already address the “Impartial Conduct Standards” discussed in BICE.

Advisers will probably need to make some refinements to existing procedures that address conflicts of interest in order to comply with the BICE conditions.

1.   Written Record of Material Conflicts of Interest. As discussed in the Adopting Release of Rule 206(4)-7 of the Advisers Act, an adviser is expected to identify any material conflicts of interest and design policies and procedures to address them.  BICE requires advisers to address and document “Material Conflicts of Interest,” which exist when an adviser 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.  As a practical matter, investment advisers are already expected to disclose these conflicts in the Form ADV.

Advisers should review  their process for identifying any conflicts of interest (as required under Rule 206(4)-7)  and how they are addressed.  This process should include:

• identifying any affiliated service providers, such as broker-dealers, custodians, consultants, or administrators;
• listing payments made and received by the firm and its affiliates, including referral fees, revenue sharing, 12b-1 payments, shareholder servicing fees, and recordkeeping fees;
• identifying other benefits received, such as access to educational seminars related to current products and industry issues; and
• considering sales events, conferences, and programs held by mutual fund distributors.

2.  Adopt Policies and Procedures Mitigating the Effect of the Material Conflicts of Interest. Once the conflicts have been identified, the adviser must adopt measures “reasonably and prudently designed to prevent these conflicts.”

• No special incentives. The policies and procedures must specifically prohibit any incentives or rewards that might encourage employees from acting in the best interest of the retirement investor.  Make sure the firm’s compensation policy is based on neutral factors tied to the differences in the services delivered to retirement investors and not the amount of payment received in connection with a specific investment recommendation.
• Use processes already in place. The SEC has made it clear that advisers are expected to “make a  reasonable inquiry into the client’s financial situation, investment experience and investment objectives, and to make a reasonable determination that the advice is suitable in light of the client’s situation, experience and objectives.”   Most advisers already have a procedure for gathering information about clients, such as a questionnaire, to determine a client’s financial and family circumstances, investment objectives and restrictions, and risk tolerance.  After reviewing this information, the firm should have a standard method for providing investment recommendations consistent with the client’s circumstances, expectations, objectives, and risk tolerance.
• Incorporate required disclosures into the client on-boarding process. Advisers are already required to provide disclosures like the Form ADV Part 2A brochure and a privacy notice at the beginning of the client relationship.  BICE disclosures should be included as part of this process.

3.  Appoint a Chief Conflicts Officer. BICE requires the designation of a person “responsible for addressing Material Conflicts of Interest and monitoring the adviser’s adherence to Impartial Conduct Standards.”  Firms should designate a “Chief Conflicts Officer” whose job it is to keep the written record of the material conflicts and to monitor compliance.  This could, and most likely will, be the adviser’s Chief Compliance Officer.

4.  Update Books and Records Policies. BICE requires advisers to maintain records providing evidence that they have met the conditions of BICE for a period of six years.

5.  Identify Retirement Investor Clients. Advisers should develop a way to identify ERISA and retirement investor clients on their systems. These clients require special treatment.  For example, retirement investor client accounts should be excluded from cross trading among client accounts.

6.  Perform benchmarking. Advisers will need evidence that their fees are reasonable, which can include comparisons with fees charged by comparable firms.  Advisers are required to disclose their fee schedules on the Form ADV; therefore, advisers can access fees charged by their competitors using the  Investment Adviser Public Disclosure Website (IAPD).

7.  Draft Disclosures and Set up the Webpage. BICE requires extensive disclosures regarding fees, conflicts of interest, the best interest standard, descriptions of policies and procedures meant to mitigate conflict, and third-party payment arrangements.  The disclosures have to be provided in writing to retirement investors and on the firm’s website.  Advisers should develop a game plan for drafting the various disclosures and a process for ensuring that they are reviewed and updated at least quarterly.  Assign responsibility to areas within the firm for drafting, updating, reviewing, and overseeing this process.  The process should ensure that all required disclosures, whether on the website or in account opening documents, are consistent.

8.  Revise investment management contracts and send out negative consent letters. The contract requirement set forth in BICE applies to existing retirement investor clients as well as new clients.  BICE allows advisers to comply with this condition by sending a negative consent letter, describing the required contract amendments, to existing retirement investors.  The client has 30 days to object; otherwise, the amendments to the contract become effective.  This notification is an important communication, and therefore, client services, sales, and marketing teams should be involved in its drafting and distribution.  Legal and/or compliance professionals should review to ensure the notification contains the language required by BICE, but those with direct client contact should be aware of this notice and be prepared to respond to client questions.

9.  Document Rollover Recommendations. Advisers recommending that clients roll over their assets from an employer-sponsored 401(k) plan to an IRA managed by the adviser will need to document the reasons why the rollover was considered to be in the retirement investor’s best interest.  The documentation should:

• compare fees and expenses of 401(k) plan and IRA;
• determine whether the employer pays some or all of the plans’ administrative expenses;
• compare the levels of services and investments available under each option; and
• take into account the individual needs and circumstances of the retirement investors.

Similarly, if an adviser is recommending a switch from an IRA where the fees are based on commission, to an IRA where the fees are based on a percentage of assets under management, it must document the reasons the arrangement would be in the retirement investor’s best interest, including the services that are being provided for the fee.

10.  Special Disclosures for Proprietary Products and products that generate third-party payments.  Under BICE, advisers may recommend proprietary products and products that generate third-party payments but will need to develop disclosures and standards for recommending such products in order to ensure that such recommendations are in the best interest of retirement investors.  So advisers should have a documented process to show why a recommendation of its proprietary products is in the best interest of its retirement investors clients.  This process needs to address why the proprietary products have been selected, that the adviser will receive only reasonable compensation, and that the adviser’s recommendation is based on the best interest of the client.

Additionally, for advisers that receive 12b-1 fees, for referral payments or other payments in connection with products sold to retirement plan investors, the firm should document the services provided in connection with those fees and evaluate the fees for reasonableness.

Legal Consequences of the Rule

This new rule brings with it new potential areas of regulatory action and litigation.  Even prior to the adoption of this Rule, the DOL and the IRS had the authority to conduct audits of employee benefit retirement plans.  DOL audits focus on compliance with ERISA and can result in civil actions against advisers for fiduciary breaches. The Internal Revenue Service (IRS) has concurrent authority to impose excise taxes on advisers for these breaches. Traditionally, the IRS also has had enforcement authority over IRAs, and generally has not focused its enforcement energies in this area.

Failure to meet BICE conditions could result in significant penalties for investment advisers.  For example, failure to provide appropriate disclosure to a retirement investor could result in a “prohibited transaction” under ERISA, resulting in a right of rescission of the transaction by the retirement investor, a “first tier” 15%-per-year excise tax and a “second tier” 100% excise tax, and a 20% civil penalty on any amounts recovered through DOL action.

Because BICE requires that advisers include a provision in their advisory contracts with retirement investors (including IRA clients) acknowledging their fiduciary status, these clients will have a right to sue the adviser for breach of fiduciary duty.  Under Section 206 of the Advisers Act, there is no private right of action, which means that clients cannot sue their advisers damages incurred for Advisers Act violations.  Clients generally have the right to sue for breach of the investment advisory agreement, but it remains to be seen whether this new right of action will result in more lawsuits against advisers.