Locke Lord Article: The Best Interest Contract Exemption

Locke Lord LLP
April 8, 2016

In connection with publication of final regulations (the Rule) on the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974, as amended (ERISA) and the Internal Revenue Code of 1986, as amended (IRC), the United States Department of Labor (the Department) issued two new prohibited transaction class exemptions and amendments to several existing prohibited transaction class exemptions.  Because the Rule will expand the universe of financial service providers that are subject to ERISA’s fiduciary duties, these new exemptions and revisions to existing exemptions are necessary to provide relief from the prohibited transaction provisions of ERISA and the Code for conflicts that may result. 

One of the most anticipated exemptions is the Best Interest Contract Exemption (the BIC Exemption).  Generally, this exemption allows entities, such as registered investment advisers, broker/dealers, and insurance companies and their agents and representatives, that are ERISA or Code fiduciaries by reason of the provision of investment advice, to receive compensation that could create a conflict of interest (such as commissions, sales loads, 12b-1 fees, revenue sharing, and other payments from third parties) if certain conditions are met.

During the comment period relating to the proposed BIC exemption, the Department received a large number of comments, many from industry participants raising significant concerns about substantive and procedural items contained in the proposal.  Below, we have outlined a number of the most significant issues raised in the comment process and the Department’s response in the final exemption.

Terminology and Overview:

The Department defined the parties to a typical transaction which would be covered by the Rule and BIC Exemption: 

  • Financial Institution:  The entity that employs, or otherwise retains, the Adviser and is either a registered investment adviser, a bank or savings association, an insurance company, a registered broker/dealer, or a is granted status as a Financial Institution through an individual exemption issued by the Department of Labor.  
  • Adviser:  Any individual who is a fiduciary of a plan or IRA solely by reason of the provision of investment advice with respect to a recommended transaction, and is an employee (or otherwise retained by) a Financial Institution.  
  • Retirement Investor:  A participant in an ERISA governed plan who has the authority to direct the investment of assets in his or her plan account or take a distribution, or the beneficial owner of an IRA acting on behalf of the IRA.

Essentially, the BIC Exemption requires that Financial Institutions and Advisers who render investment advice to Retirement Investors adhere to Impartial Conduct Standards, including the Best Interest Standard, as well as provide certain disclosures about their business model, conflicts of interest, and fees to Retirement Investors.  

Impartial Conduct Standards:
The BIC Exemption has revised the Impartial Conduct Standards.  To comply with the BIC Exemption, the Financial Institution must state that both it and its Advisers shall comply with, and such parties must in fact comply with, the following:
  • The Financial Institution and Adviser must provide advice that, at the time of such recommendation, is in the Best Interest of the Retirement Investor;
  • Such recommended transaction would not result in the Financial Institution, Adviser, or their Affiliates receiving aggregate compensation for their services in excess of reasonable compensation; and
  • Any statements made by the Financial Institution and the Adviser to the Retirement Investor about matters relevant to the Retirement Investors investment decisions are not materially misleading at the time they are made.

The change made in the final BIC Exemption makes the Impartial Conduct Standards more attainable for Financial Institutions and Advisers.

The BIC Exemption also provided a more robust definition of when an investment recommendation is in the Best Interest of the Retirement Investor.  The Financial Institution or Adviser will provide recommendations which are in the Best Interest of the Retirement Investor when they:

“act 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 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.” (Emphasis added).

Although this definition of “Best Interest” would seem to prohibit the recommendation of certain Proprietary and Third Party Payment Products (defined below), the BIC Exemption provides a means by which Financial Institutions and Advisers may recommend such products. We discuss this safe harbor.

Contract Requirement:
The proposed BIC Exemption released for comment in April 2015 required that the Financial Institution and the Adviser enter into a written contract with the Retirement Investor.  A significant change is that generally the final BIC Exemption only requires a written contract for IRA accounts (not ERISA plans) and the IRA contracts only need to be between the Financial Institution and the Retirement Investor.  The proposed BIC Exemption had required that the Adviser also be signatory to such contract. By requiring that only the Financial Institution and Retirement Investor be parties to the contract, the Department avoided the difficulties identified by many commenters regarding whether a new contract would be needed every time that a different employee of the Financial Institution engages with the Retirement Investor.

As a result of removing the Adviser as a signatory to the contract, the Department has included additional representations and warranties that the Financial Institution is required to make in the contract.  This includes representations that both the Financial Institution and Adviser will adhere to the Impartial Conduct Standards as well as warranties that the Financial Institution has adequate policies and procedures in place.  Although many commenters requested additional guidance as to the contents of these policies and procedures, the Department has provided no such guidance.

Contract Timing:
In the proposed BIC Exemption, the Department required that a contract be entered into with the Retirement Investor prior to, or contemporaneously with, the delivery of any investment advice.  Given the broad interpretation of “investment advice” under the Rule, there were significant concerns that this requirement would prove impractical as it would require Retirement Investors to enter into formal contracts before they decided whether to engage the investment adviser. The Department responded to this concern by by stating that the contract must be executed to at the time of, or prior to, the entering into any transaction. This will make it easier for Advisers to communicate with Retirement Investors as they will not be required to initially ensure that a contract has been entered into before providing even basic information.  It should be noted that when a contract is entered into, the BIC Exemption requires that the contract treat all advice provided to the Retirement Investor (even that given before the contract is signed) as subject to the Impartial Conduct Standard.

When the proposed BIC Exemption was released, there were considerable concerns that several of the required disclosures would be impossible to fulfill without violation of Federal or state securities or insurance law for those advisers which are subject to such laws. The Department has responded by removing such disclosures from the BIC Exemption.  The Department also responded to concerns about the significant amounts of required disclosure by streamlining the amount and type of information to be provided to Retirement Investors under the BIC Exemption.  Nonetheless, Financial Institutions seeking to comply with the BIC Exemption will have a substantial disclosure burden.

With each contract, the Financial Institution must include several disclosures, including a statement that its Advisers will adhere to a Best Interest standard of care; a description of material conflicts of interest; any fees charged by the Financial Institution; and information about, and links to, where the Retirement Investor can find additional detailed information These disclosures must be provided at the time of, or prior to, the execution of any recommended investment transaction.  Much of this information will be required to be maintained on a website which must be reviewed and updated quarterly. The information that must be disclosed on the website includes a discussion of the Financial Institutions business model, material conflicts of interest, typical account or contract fees, model contracts, and written descriptions of the Financial Institutions policies and procedures that summarize the key components of such policies and procedures. In addition, the Financial Institution must make copies of the complete policies and procedures, as well as other information, available to Retirement Investors upon request.  Because of this last element, the Department has in reality only slightly reduced the disclosure burden of the Financial Institution. However, it has provided the Retirement Investor with a more manageable way to deal with the information.

Proprietary and Third Party Payment Products:
The Rule has incorporated a quasi-safe harbor for Advisers to recommend proprietary products and products for which the Financial Institution receives third party payments (the Proprietary and Third Party Payment Products).  We view this as only a quasi-safe harbor because the BIC Exemption expressly permits advisers to recommend Proprietary and Third Party Payment Products if it meets certain requirements. Instead of providing very objective and commonly understood requirements, the Proprietary and Third Party Payment Products quasi-safe harbor contains requirements that the Financial Institution adopt and adhere to “policies and procedures and incentive practices” that reflect the somewhat imprecise Impartial Conduct Standards.  The Department did, however, more specifically define how to meet the Best Interest standard of the Impartial Conduct Standards in the context of Proprietary and Third Party Payment Products.  Aside from this, the Department has not provided guidance on what such policies, procedures, and incentive practices must contain in order to meet this standard.  Unlike in other areas of the BIC Exemption, the Department did not provide for the protection of good faith deviations in the policies, procedures, or incentive practices.  As long as there is uncertainty on this point, Financial Institutions will incur some amount of risk in relying on this quasi-safe harbor.

The BIC Exemption permits grandfathering of relationships which were in existence prior to April 10, 2017 (the Applicability Date).  Essentially, the BIC Exemption permits the receipt of compensation from contracts which had been entered into prior to the Applicability Date, provided that the advice was rendered prior to the Applicability Date or the transaction was made in accordance with a systemic purchase program put in place prior to the Applicability Date.  Any compensation that the Financial Institution receives from such accounts will still be subject to a reasonableness standard, but provided that the compensation is not unreasonable, would not be subject to the prohibited transaction restrictions.  Any advice that that Adviser renders to a grandfathered  Retirement Investor after the Applicability Date would need to conform to the Best Interest Standard.

An account will lose the benefit of its grandfathered status if additional investments are made in the account after the Applicability Date. However, the exemption will apply to recommendations to exchange investments within a mutual fund family or variable annuity contract (where the right to do so was established prior to the Applicability Date).

The Department has created a phased in approach to the conditions necessary for compliance with the BIC Exemption. The Department intended for the fiduciary rule and all exemptions, including the BIC Exemption, to become fully effective 8 months after the publication of the rule. The final BIC Exemption is instead to be implemented in stages, with an abbreviated version of the BIC Exemption being put into place on April 10, 2017 and the full BIC Exemption being effective January 1, 2018.

In the final BIC Exemption, the Department adopted many of the proposed changes and addressed many of the comments that were made during the notice and comment period.  Although many of the comments from industry have been incorporated into the BIC Exemption, there are still some issues outstanding that may require additional guidance from the Department. We will continue to monitor the development of the fiduciary rule and the BIC Exemption, and will provide future client updates.

If you would like more information on the matters discussed here, please contact the authors. For more information see Locke Lord QuickStudy: Department of Labor Publishes New Fiduciary Rule Affecting Retirement Account Advisers.