United States: US Department Of Labor’s New Fiduciary Conflict Of Interest Proposal Remains Controversial

Last Tuesday, the US Department of Labor (DOL) released its 120-page notice of proposed rulemaking to revamp the Employee Retirement Income Security Act's (ERISA) fiduciary conflict of interest rules, along with 246 pages of proposed prohibited transaction exemptions and amendments to existing exemptions. Even before their issuance, the proposed rules drew harsh criticism from the investment community, which recognized that the proposed rules would turn many financial professionals into ERISA fiduciaries and change how they could be compensated and the way they do business.

Given the vocal opposition to the new rules, the ultimate scope and fate of their specific provisions is yet to be determined. But the ongoing debate over how investment advisers should operate in the face of potential conflicts of interest is unlikely to leave the current status quo in place. At stake is not just what standards will apply to the investment advisory community, but who within the federal government will establish those standards.

Fiduciaries under existing law

Under the Employee Retirement Income Security Act of 1974 (ERISA), "fiduciaries" as defined in ERISA are subject to prescribed standards of conduct, and to specific prohibitions on certain transactions. Standards of conduct include the familiar rules that fiduciaries must act solely in the interest of plan participants and beneficiaries, for the exclusive purpose of providing benefits to participants and beneficiaries and defraying the reasonable expenses of the plan, and with care, skill, prudence and diligence that a prudent person familiar with such matters would use in the conduct of an enterprise of like character and with like aims. Prohibited transactions include most dealings between a plan and its fiduciaries and other parties in interest, though there are many statutory and regulatory exceptions. For fiduciaries, the prohibited transactions include specific mandates not to deal with the assets of a plan for the fiduciary's own interest or for his or her own account, not to act in any capacity adverse to the interests of the plan, and not to receive any consideration for his or her personal account from any party dealing with the plan in connection with a transaction involving the assets of the plan.

Although ERISA does not regulate individual retirement accounts (IRAs) or annuities, similar prohibited transaction rules appear in the Internal Revenue Code, which prescribes an excise tax for violation, and the US Department of Labor (DOL) has general authority to define who is a fiduciary for that purpose as well.

A fiduciary is defined by statute to include someone who provides investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of a plan. DOL regulations dating back to 1975 effectively set out five criteria that had to be met for a person who did not have discretionary authority over plan assets to be considered an ERISA fiduciary by reason of investment advice. The person had to provide advice:

  • On the value of securities or other property or recommendations on the plan's investment, purchase or sale
  • On a regular basis
  • Pursuant to an agreement with the plan
  • That would serve as the primary basis for investment decisions
  • That would be individualized based on the particular needs of the plan

Background for change

In 2010, the DOL proposed new regulations to create a far more expansive definition of "fiduciary." The proposed regulations would have made many brokers, dealers and other financial advisers into fiduciaries even though they had carefully avoided meeting the five-part test from the 1975 regulations. Those proposed regulations thus ran into a firestorm of criticism from the investment community, which pointed out, among other things, that under the proposed regulations they could not maintain their customary business and compensation structures, would be potentially liable for investments that performed poorly, and therefore were likely to stop giving investment advice altogether to the ultimate detriment of plan participants and IRA owners.

Of course the DOL was fully aware of the effect of the proposal on advisers' business structures, but in its view the old 1975 rules permitted inherent conflicts of interest that resulted in poorer investment returns costing plans and IRAs—depending on whose figures one wants to believe—some US$17 billion per year in total.

Now the DOL has tried again. The structure of the new rules is a new definition of "fiduciary" that, like the 2010 proposal, sweeps up most investment advisers and many others into the general definition. But the arena in which the regulations will operate is narrowed in two ways: first, by a series of specific exceptions, or "carve-outs," in the regulations for situations in which, if certain conditions are met, the strictures of being an ERISA fiduciary will not apply; and second, by proposed prohibited transaction class exemptions.

The most significant proposed class exemption is a proposed "best interest contract" exemption. This would allow broker-dealers, insurance agents and financial institutions—who would be considered fiduciaries under the proposed regulations through giving investment advice in the retail investor market (for example, to 401(k) plan participants, IRA beneficiaries and small plans)—to maintain existing commission and similar compensation arrangements, but only if a long list of specific conditions are met.

The proposed new definition

Under the proposed regulations, a person is a fiduciary if person gives advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is individualized to, or is specifically directed to, the recipient for consideration in making investment or management decisions with respect to securities or other property of the plan or IRA; and the advice is rendered for a direct or indirect fee or other compensation, and falls into is one of four categories:

  •  Recommendations on the advisability of acquiring, holding, disposing of or exchanging securities or other property, specifically including advice on the investment of property distributed from a plan or IRA
  • Recommendations on the management of securities or other property, again specifically including property being distributed from a plan or IRA
  • An appraisal, fairness opinion or similar statement, whether verbal or written, on the value of securities or other property in connection with a specific transaction involving the acquisition, disposition or exchange of securities by a plan or IRA
  • Recommendations of a person to give any of the first three forms of advice for a fee other compensation

A person will also be a fiduciary by reason of giving investment advice if the person gives one of those types of advice for a fee or other compensation and represents or acknowledges that the person is a fiduciary. In other words, if the person claims to be a fiduciary with respect to the advice, it is irrelevant whether there is an agreement, arrangement or understanding on the nature of the advice.

The new proposed definition is significantly broader than the existing definition. The advice would not have to be provided on a regular basis, would not have to be provided by agreement with the plan, and would not have to be the primary basis for plan investment decisions. All of those limitations were part of the 1975 definition. Also of note, the DOL is explicitly targeting advice on taking distributions from plans (or IRAs) and investing the distributed proceeds, even though the assets are no longer held by the plan or IRA.

The kind of "agreement, arrangement or understanding" to provide individualized advice that is referred to in new proposed definition is rather vague. The new proposed regulation perhaps avoids the concern raised by the investment community respecting the 2010 proposed regulations that general remarks on talk shows or speeches might make the speaker an ERISA fiduciary. But the new proposed definition could encompass stray remarks on the prospects of an investment that are actually directed to a plan or participant. The new proposed definition is certainly intended to reach persons who advertise that they provide individualized investment advice, even if they disclaim those services in their actual written agreements.


The new proposed regulation contains a number of exceptions, referred to as "carve-outs," describing limited circumstances in which a person will not be a fiduciary despite providing advice covered by the general definition. The breadth of the general definition makes it vital to come within the terms of a carve-out if one is available. However, the carve-outs are not available to a person who admits to being an ERISA fiduciary.

Three of the carve-outs are relatively straightforward. One covers employees of the plan sponsor who provide advice to a plan fiduciary for no compensation other than their regular pay from the sponsor. A second covers platform providers who identify investment alternatives and make them available for individual participant selection. This includes assistance in identifying whether an investment alternative meets objective criteria, either investment or financial, provided the person discloses in writing to the plan fiduciary that it is not undertaking to provide impartial investment advice or give advice in a fiduciary capacity.

A third carve-out covers persons who provide financial reports and valuations to either:

  • A collective investment fund in which more than one unaffiliated plan has an interest
  • A plan or fiduciary for the purpose of completing required reports, such asset value information reported on Form 5500
  • An employee stock ownership plan (ESOP) on the value of employer securities

The last situation is a retreat by the DOL from the 2010 proposed regulations, which would have specifically made fiduciaries out of ESOP appraisers. But the DOL may return to ESOP appraisal issues in other ways.

The other two carve-outs are less simple. One is a carve-out for counterparties in transactions with the plan. The general aim of this carve-out is to let people selling investments to a plan tout the virtues of the investment without thereby becoming fiduciaries. But this carve-out only applies if one of three alternative conditions is met:

  •  The first alternative applies where the plan has fewer than 100 participants (which limits it to he retail market), an independent plan fiduciary confirms that fact to the counterparty in writing and also gives the counterparty a written representation that the plan fiduciary is not relying on the counterparty to act in the best interests of the plan or provide impartial advice or give advice in a fiduciary capacity; and the counterparty informs the plan fiduciary of the existence and nature of the person's financial interest in the transaction.
  • The second alternative applies if there is an independent plan fiduciary who manages at least US$100 million in employee benefit plan assets (which limits it to plans that presumably have sophisticated plan managers), and the counterparty informs the fiduciary that the person is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity.
  • The third alternative covers a counterparty who is a regulated swap or security swap dealer, and the plan has an independent plan fiduciary who gives a written representation to the swap dealer that the fiduciary is not relying on recommendations provided by the dealer.

Satisfying either of the first two of those conditions additionally requires that the counterparty not receive a fee other compensation directly from the plan or plan fiduciary for providing investment advice.

Another carve-out is for investment education, stated in the regulation to cover information about the plan, general financial investment and retirement information, asset allocation models and interactive investment materials. Each of these categories is defined in detail and must meet specified conditions. Overall, the definition of investment education for this carve-out is not too dissimilar from existing guidance on when investment education will not be fiduciary advice. But one change is that the investment education materials may not include advice or recommendations as to specific investment products, specific investment managers or the value of particular securities or other property.

Finally, although not described as a carve-out, the proposed regulation stipulates that a registered broker or dealer, or a bank, does not become a fiduciary by executing trades directed by an independent plan fiduciary that specify the security to be bought or sold, a price range, a time span of no more than five days for the trade and minimum or maximum amounts of securities to be bought or sold.

The "best interest contract" proposed prohibited transaction exemption

A major criticism of the 2010 proposed regulations was that the intersection of the broader definition of fiduciary with the existing prohibited transaction rules would prohibit brokers, dealers and financial institutions from receiving compensation for fiduciary investment advice in the form of commissions, so-called 12b-1 fees from mutual funds and other revenue-sharing arrangements, based on the plan's investment choices in response to that advice.

Although the proposed regulation itself does not address this, the DOL has authority to create administrative exemptions to the prohibited transaction rules and used this authority to propose a new class exemption to those rules. The DOL calls this the "best interest contract" exemption. Essentially, this would allow broker-dealers and insurance agents who are fiduciaries by reason of investment advice to continue to receive the traditional forms of compensation based on the plan's investment choices while giving fiduciary investment advice, but only when acting in the retail investment market and only if they agree to act in the best interest of the advice recipient and meet other stringent conditions.

The exemption applies when the transaction with respect to which the fiduciary receives compensation is a result of the adviser's advice to a "retirement investor," defined to include a plan participant, an IRA beneficiary or owner, and a plan sponsor-fiduciary of a plan with fewer than 100 participants and no participant investment direction. It does not apply to trades generated by "robo-advice," advisers trading for their own account, or advisers with discretionary authority over the plan assets involved in the transaction.

The DOL believes that the "best interest contract" exemption provides broad and flexible relief from the prohibited transaction restrictions on certain compensation, and that in contrast to most other exemptions its conditions are "principles-based" rather than prescriptive. It is unclear that the investment community will actually view the proposed exemption as broad and flexible. The proposed exemption contains a plethora of specific conditions that must be met, designed to mitigate the conflicts of interest that the DOL sees as inherent in such compensation arrangements.

  • Contract requirements: There must be a written contract; it must state that the adviser and/or financial institution are fiduciaries under ERISA or the Internal Revenue Code; and it must state that the adviser will provide investment advice that is in the best interest of the retirement participant and will not recommend an investment if the investment would produce unreasonable commissions or other compensation for the adviser. The agreement must warrant (among other things) that the financial institution involved in the transaction has established written policies and procedures to mitigate material conflicts of interest (which means that the institution must adopt such policies conforming to the requirements of the class exemption). In addition, the contract must disclose material conflicts of interest, fee and compensation arrangements, and may not include certain provisions, like a class action waiver.
  • Disclosure requirements: Required disclosures (in addition to what must be disclosed in the contract) include transactional disclosure of the compensation to the adviser and financial institution in a prescribed format (the proposed exemption contains a model chart for this purpose), and stipulated annual disclosures. The financial institution must maintain a web page on which the compensation it receives with respect to each asset (or asset class) that a plan, participant or IRA might purchase through the institution is publicly disclosed.
  • Assets available: A financial institution involved in the transaction must offer a broad range of assets for investment, unless the institution satisfies additional requirements of exemption for making a more limited class available.
  • Disclosure and recordkeeping: Financial institutions must notify the DOL in advance that they are relying on the exemption, and maintain data and records for six years after any transaction. Those records and data must be available for review not only by the government but also by any participant or beneficiary of a plan that engaged in a transaction covered by the exemption.

Apart from those conditions for "best interest contracts," the proposed "best interest contract" exemption contains a simpler exemption for purchases of insurance and annuity contacts from an insurance company that is already a service provider to the plan or IRA. Subject to certain conditions, it will also exempt transactions that predate the applicability date of the proposed exemption (which is contemplated to be eight months after publication of the final exemption).

But even for advisers and financial institutions that undertake the many compliance duties and disclosures necessary to come within the "best interest contract" exemption, in the end, the exemption only exempts the person from the prohibited transaction rules, including potential excise taxes for IRAs under the Internal Revenue Code. Unlike the carve-outs in the regulation itself, the exemption does not exempt a person, such as an adviser who becomes a fiduciary under the proposed rules, from the general fiduciary duties under ERISA to act solely in the interest of participants and beneficiaries, or from potential civil liability to make up any loss to the plan resulting from a breach of those duties.

Other prohibited transaction exemption amendments

Separately from the "best interest contract" exemption, the DOL is proposing an exemption for advisers to sell debt instruments to plans and IRAs directly from their own inventory, subject to the contract requirements of the "best interest contract" exemption and additional conditions relating to price. The DOL is also proposing to amend a number of existing class exemptions, largely to incorporate features form the "best interest contract" exemption, or to require persons previously able to rely on those exemptions to rely instead on the "best interest contract" exemption.

The affected exemptions include amendments to the long-established 1975 exemption for securities transactions involving broker-dealers, banks, plans and IRAs; a 1984 exemption for transactions involving mutual fund shares or insurance or annuity contracts sold to plans or IRAs; and a 1986 exemption allowing fiduciaries who render investment advice to receive fees from a plan or IRA for effecting securities transactions as agent. Persons or institutions that have relied on those exemptions will have to take careful note of the changes proposed as part of this regulatory package.

The proposed regulations are proposed to become applicable eight months after publication of the final regulations, a period which the DOL believes will help effect an orderly transition. Meanwhile, the comment period on the proposed regulations will be open for 75 days following publication of the proposed regulations on the Federal Register, expected to occur on April 20, 2015. In light of the controversy over the proposed regulations, it can be expected that comments will be heavy. But for the same reason, little else about the proposed package or its ultimate effect when issued can be predicted at this time.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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