DOL's Proposed Best Interest Contract Exemption Could Require Dramatic Changes for Financial Institutions

The U.S. Department of Labor (DOL) has proposed a new “Best Interest Contract” prohibited transaction exemption, which is a standards-based exemption that applies to the receipt of compensation by advisers and their financial institutions as a result of investment advice provided to retail “Retirement Investors.” Many registered investment advisers, banks, insurance companies and registered broker-dealers may be forced to rely on this exemption if the definition of an investment advice fiduciary is expanded as has been proposed by the DOL. The requirements for satisfying this proposed exemption could result in dramatic changes in the practices and operations of these financial institutions.

We previously published a legal update, "Proposed Fiduciary Definition Regulations Will Impact Investment Adviser Practices" that provided a general overview of (i) the DOL’s proposed regulations that would broaden the fiduciary definition under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (Code) to include a much wider array of persons who provide investment advice or recommendations to employee benefit plans, plan fiduciaries, plan participants/beneficiaries or Individual Retirement Account (IRA) owners, and (ii) the DOL’s proposed two new prohibited transaction exemptions and amendments of several existing exemptions. (Note that the DOL recently extended the comment period for the new rules by 15 days, to July 20, 2015.) This legal update takes a more in-depth look at the requirements of the Best Interest Contract Exemption (BIC Exemption) and some of the implications for financial institutions.

Scope of Proposed BIC Exemption

The proposed exemption would allow Advisers (brokers, insurance agents and other individuals who are fiduciaries by reason of the provision of investment advice) and their associated Financial Institutions and affiliates to receive compensation in connection with the purchase, sale or holding of an Asset by a plan or IRA as a result of the Adviser’s and Financial Institution’s advice to a Retirement Investor. “Financial Institutions” are registered investment advisers, banks, insurance companies and registered broker-dealers that employ Advisers, or retain Advisers as independent contractors, agents or registered representatives. “Retirement Investors” are plan sponsors of ERISA plans with less than 100 participants, plan participants and beneficiaries, and IRA owners. “Assets” include bank deposits, certificates of deposit (CDs), mutual fund shares, bank collective funds, insurance company separate accounts, exchange-traded REITs, exchange-traded funds (ETFs), registered corporate bonds, government agency debt securities, insurance and annuity contracts, guaranteed investment contracts (GICs), and exchange-traded equity securities. However, under the proposed exemption, Assets would not include any equity security that is a security future or a put, call, straddle or other option contract, and would not include limited partnership interests or other equity securities that are not publicly traded (although the DOL has invited comment on investments excluded from the Asset definition). In other words, the BIC Exemption would not be available with respect to compensation received in connection with the purchase, sale or holding of these excluded types of investments.

The cornerstone of the BIC Exemption is the requirement of a written contract with the Retirement Investor in which the Adviser and the Financial Institution do all of the following:

• Acknowledge their fiduciary status
• Commit to basic standards of impartial conduct, which generally incorporate an ERISA fiduciary standard of care for prudence and loyalty
• Warrant that the Financial Institution has adopted written policies and procedures designed to mitigate conflicts of interest and ensure adherence to standards of impartial conduct (which includes not authorizing compensation or incentive systems that would tend to encourage recommendations not in the best interest of the Retirement Investor)
• Warrant compliance with applicable federal and state laws
• Disclose material conflicts of interest (e.g., whether offering proprietary products or receiving third party payments) and information about fees
• The contract may not include certain prohibited contract provisions, such as disclaimers or limitations of liability for violations of the contract, or a waiver of the Retirement Investor’s right to participate in class action litigation (although agreement to binding arbitration with respect to individual contract claims would be permissible)

In addition, the Financial Institution would be required to give advance notice to the DOL of reliance on this exemption and report certain data requested by the DOL.

Financial Institution’s Policies and Procedures

Note that the BIC Exemption is applicable to retail investor situations (e.g., small plans, plan participants and IRA owners) for which the “seller’s carve-out” under the DOL proposed regulations is unavailable. The point of the BIC Exemption is to ensure that advisers to these retail Retirement Investors act in the best interests of the Retirement Investor and do not provide biased advice.

As part of the contractual warranty on policies and procedures required for the BIC Exemption, the Financial Institution must state that in formulating its policies and procedures it specifically identified material conflicts of interest and adopted measures to prevent those material conflicts of interest from causing violations of the impartial conduct standard. Furthermore, the Financial Institution must state that neither it nor (to the best of its knowledge) any affiliate will use “quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives” to the extent they would tend to encourage individual Advisers to make recommendations that are not in the best interest of the Retirement Investor. No particular compensation or employment structures are required, but the DOL expects Financial Institutions to monitor carefully whether its policies and procedures are, in fact, working to prevent biased advice.

The preamble to the proposed BIC Exemption provides five examples of broad approaches to compensation structures that could help satisfy this requirement:

• Any form or amount of compensation, if the advice is rendered in strict accordance with an unbiased computer model created by an independent third party
• Asset-based compensation that does not vary based on the type of investments
• Offsets of transaction-based payments against an established service fee schedule, with any excess rebated to the plan, participant account or IRA
• Differential payments based on neutral factors, such as a reasonable assessment of the time and expertise necessary to provide prudent advice on the product (e.g., annuities versus mutual funds)
• Variable compensation that is aligned with providing advice that is in the Retirement Investor’s best interest

The DOL notes that these examples are not exhaustive, and other arrangements may satisfy the contractual warranties.

In addition, the DOL lays out the following components that Financial Institutions could consider in establishing effective policies and procedures relating to an Adviser’s compensation:

• Avoid creating compensation thresholds that enable an Adviser to increase his or her compensation disproportionately through an incremental increase in sales
• Monitor activity of Advisers approaching compensation thresholds such as higher payout percentages, back-end bonuses or participation in a recognition club, such as a President's Club
• Maintain neutral compensation grids that pay the Adviser a flat payout percentage regardless of product type sold (so long as they do not merely transmit the Financial Institution's conflicts to the Adviser)
• Refrain from providing higher compensation or other rewards for the sale of proprietary products or products for which the firm has entered into revenue sharing arrangements
• Stringently monitor recommendations around key liquidity events in the investor's lifecycle where the recommendation is particularly significant (e.g., when an investor rolls over his or her pension or 401(k) account)
• Develop metrics for good and bad behavior (red flag processes) and use clawbacks of deferred compensation to adjust compensation for employees who do not properly manage conflicts of interest

Obviously, these requirements could have a dramatic impact on a Financial Institution’s operating procedures and the compensation arrangements maintained for Advisers. The DOL has requested comments on all aspects of these sorts of policies and procedures, and in particular whether the exemption should be more prescriptive or provide more detailed examples of acceptable policies and procedures. 

Disclosure Requirements

Another requirement of the BIC Exemption is disclosure to the public and to Retirement Investor clients. Public disclosure is to be provided through a website, and client disclosure is to be provided as a point-of-sale disclosure, an annual disclosure and a potential limited-range-of-investment-options disclosure. 

The website, freely accessible to the public, must provide three items:

• Direct and indirect material compensation provided in connection with each Asset that is available and has, in fact, been purchased, held or sold within the last 365 days through the Adviser or Financial Institution
• The source of the compensation
• How the compensation varies within and among Assets

The DOL provided a model disclosure chart. The website chart must also be machine readable, and the DOL has requested comments on the format and data fields for this chart. A Financial Institution cannot refuse to provide any of the website disclosure on the basis of trade secret or privileged commercial or financial information. 

The point-of-sale disclosure to the client must also be provided as a chart. The point-of-sale chart discloses the Total Cost for an Asset expressed as a dollar amount over a one-, five- and 10-year period. Again, the DOL provided a model disclosure chart. The model disclosure chart would be deemed to meet the disclosure requirement. “Total Cost” is the sum of the acquisition costs, ongoing costs, disposition costs and other costs (each as defined in the exemption). (Note that projections of some ongoing costs and disposition costs that are asset-based would require investment performance projections, but the proposal gives no guidance how that might be done.) Financial Institutions are expected to produce, according to a DOL estimate, 43.5 million point-of-sale disclosures each year. The DOL has requested comments on the chart and included a long list of specific questions regarding design, feasibility, impact (including a request whether a benchmark could be crafted) and an alternative “cigarette warning”-style disclosure that could read:

Investors are urged to check loads, management fees, revenue-sharing, commissions, and other charges before investing in any financial product. These fees may significantly reduce the amount you are able to invest over time and may also determine your adviser’s take-home pay. If these fees are not reported in marketing materials or made apparent by your investment adviser, do not forget to ask about them.

The annual disclosure would be provided to clients within 45 days after the end of the applicable year and include three items for the applicable period:

• A list of each Asset purchased or sold and the price at which it was purchased or sold
• Fees and expenses, as a dollar amount, paid by the Retirement Investor, directly or indirectly, for each Asset purchased, held or sold
• Compensation, as a dollar amount, received by the Adviser and Financial Institution, directly or indirectly, for each Asset purchased, held or sold

A limited-range-of-investment-options disclosure may be required if the Financial Institution limits available Assets, for example, based on whether the Assets are proprietary products or generate third party payments. If that is the case, the Adviser or Financial Institution, before giving investment recommendations, must give written notice to the Retirement Investor “of the limitations placed on the Assets that the Adviser may offer.” The DOL is explicit that the “[n]otice is insufficient if it merely states that the Financial Institution or Adviser ‘may’ limit investment recommendations based on whether the Assets are Proprietary Products or generate Third Party Payments, or for some other reasons, without specific disclosure of the extent to which recommendations are, in fact, limited on that basis.” If a business model limits investment options and the Financial Institution plans to rely on the BIC Exemption, then the extent of that limitation must be disclosed in writing before investment recommendations can be given. 

Data Reporting to DOL

In addition to the public and client disclosures, another condition of the proposed BIC Exemption would require Financial Institutions to maintain certain data for six years and make the data available to the DOL upon request. The required data includes transaction data and investment return data. 

First, for each transaction (purchase, holding and sale), the following information must be maintained at the Financial Institution level: 

• Aggregate number and identity of shares/units involved
• Aggregate dollar amount involved and cost to the Retirement Investors
• Revenue received by the Financial Institution and any Affiliate for each Asset involved
• Identify of each revenue source and the reason the compensation was paid

Second, for each Retirement Investor, the following information must be maintained at the Retirement Investor level:

• The identity of the Adviser
• The beginning-of-the-quarter value of the portfolio (including plan and IRA assets)
• The end-of-the-quarter value of the portfolio (including plan and IRA assets)
• Each external cash flow to or from the portfolio during the quarter and the date on which it occurred

The DOL would have the right to publicly disclose the quarterly return information, aggregated at the Adviser level. 

The preamble to the BIC Exemption provides that these data retention requirements are “consistent with data retention requirements made by the SEC and FINRA” and that the records are “generally kept as regular and customary business practices.” Despite these statements, the DOL requests comment on the scope and definitions of the data to be gathered and whether the data will assist the DOL in assessing the effectiveness of the BIC Exemption.

Conclusion

The requirements for satisfying the proposed BIC Exemption could result in dramatic changes in the practices and operations of many financial institutions. Financial institutions would need to examine, and some might need to modify, their compensation arrangements. Financial institutions that seek the protection of the BIC Exemption would need to satisfy significant new data collection, recordkeeping and disclosure requirements. The required disclosure could foster a level of transparency that invites comparison shopping, and also would provide a wealth of data for the DOL and other third parties to compare financial institutions.