United States: Implications Of The DOL Fiduciary Rule For Structured Products

On April 6, 2016, the Department of Labor ("DOL") issued its final conflict of interest regulations, which significantly expand who is considered a fiduciary when dealing with a retirement account. The new regulations, together with a number of amended and final prohibited transaction exemptions that were concurrently released, exceed 1,000 pages (the "Regulations"),1 and apply to IRAs and to pension and 401(k) plans that are covered by ERISA.2

The new Regulations sweep within the concept of "fiduciary" broker-dealers and other financial advisors who provide any investment recommendation to a retirement plan or an IRA. As a fiduciary, a broker-dealer would be required to act in the best interest of its customers and would generally be prohibited from receiving commissions or other variable compensation. In order to receive transaction-based compensation when dealing with a retirement account, a broker-dealer would need to fit the transaction within one of the exceptions or exemptions set forth in the Regulations. As discussed in this article, sponsors and distributors of structured products should review their structured product programs as well as related distribution and compensation arrangements in order to comply with the new Regulations. The Regulations will begin to become effective on April 10, 2017.

Background and New Rule

Under the current rules, which have been in place for more than 40 years, a party is considered a fiduciary only if it provides investment advice on a regular basis under a mutual agreement, arrangement or understanding. The advice must serve as the primary basis for investment decisions and must be individualized for the particular needs of the retirement investor.

The new Regulations remove the requirements that (a) the advice be given on a regular basis, (b) it be given under a mutual agreement or understanding or (c) it serve as a primary basis for the investment decision.

In addition, the new Regulations expand the scope of what is considered an investment "recommendation" and what is considered advice that is "individualized" to the needs of a plan or IRA. The Regulations revise the definition of "investment advice" to include:

  • recommendations to purchase or sell securities or other investment products (including rollover decisions),
  • recommendations regarding investment strategy,
  • appraisals of investments and
  • recommendation of other persons to provide investment advice.

The Regulations look to FINRA guidance as to what constitutes an investment recommendation. FINRA has stated that a communication that could reasonably be viewed as a "suggestion" that the client take certain action or refrain from taking certain action in relation to a security or investment strategy constitutes a "recommendation." See FINRA Notice to Members 11-02. Importantly, this broad definition could cover virtually all dealings between a broker-dealer and its customer, other than processing unsolicited orders.

The new Regulations provide that persons who provide such "investment advice" fall within the general definition of a fiduciary if they either (i) represent that they are acting as a fiduciary under ERISA or the Code or (ii) provide the advice under an agreement, arrangement or understanding that the advice is individualized or specifically directed to the recipient for consideration in making investment or investment management decisions regarding plan assets. These criteria for determining who is a fiduciary would generally cover most client account agreements.

A person's status as a fiduciary is critical. For a broker-dealer who has been categorized for the first time as a fiduciary, his or her duties have dramatically increased. Determining that an investment is "suitable" for a client would no longer be sufficient. Rather, the broker-dealer will need to act in a manner which it believes is in the best interests of its customers. In addition, the broker-dealer is required under ERISA to discharge his or her duties to the plan or IRA 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.

Furthermore, as a fiduciary, the broker-dealer has for the first time become subject to ERISA's self-dealing rules, which provide generally that a fiduciary acting in its fiduciary capacity (e.g., as the giver of advice) cannot cause itself or any of its affiliates to receive additional compensation. "Variable" compensation (e.g., commissions and similar transaction-based fees) are expressly prohibited unless there is an available exception or exemption. In the final Regulations, the Department of Labor provides three principal avenues for avoiding a self-dealing prohibited transaction from occurring: the seller's exception, the Best Interest Contract Exemption and the Principal Exemption. We discuss these provisions in more detail below.

Seller's Exception to Fiduciary Status

The seller's exception carves out from the new Regulations advice rendered to certain sophisticated clients or professionally managed plans. Under the final Regulations, a seller will not be deemed a fiduciary if, prior to the transaction, the seller provides advice to a person who is independent of the seller, and:

  1. the seller knows or reasonably believes that the person with whom it is negotiating is (i) a bank as defined in section 202 of the Investment Advisers Act of 1940 ("Advisers Act") or similar institution under state or federal law, (ii) an insurance carrier qualified in more than one state to perform the services of managing, acquiring or disposing of assets of a plan, (iii) an investment adviser registered under the Advisers Act or in some cases under state law, (iv) a broker-dealer registered under the Securities Exchange Act of 1934 or (v) an independent fiduciary that holds, or has under management or control, assets of at least $50 million (the seller may rely on written representations from the plan or independent fiduciary as to (v));
  2. the seller knows or reasonably believes that the independent fiduciary of the plan or IRA is capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies (the person may rely on written representations from the plan or independent fiduciary to satisfy this paragraph (B));
  3. the seller fairly informs the independent fiduciary that the person is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, in connection with the transaction and fairly informs the independent fiduciary of the existence and nature of the person's financial interests in the transaction;
  4. the seller knows or reasonably believes that the independent fiduciary of the plan or IRA is a fiduciary under ERISA or the Code, or both, with respect to the transaction and is responsible for exercising independent judgment in evaluating the transaction (the person may rely on written representations from the plan or independent fiduciary to satisfy this paragraph (D)); and
  5. the seller does not receive a fee or other compensation directly from the plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner for the provision of investment advice (as opposed to other services) in connection with the transaction. In other words, the seller can still receive a fee or compensation from an entity or person other than the plan or IRA, such as an underwriting commission that is reduced from an issuer's net proceeds.

The Best Interest Contract Exemption (BICE)

The Best Interest Contract Exemption (BICE) creates an avenue for undertaking transactions on a commission basis with retail retirement clients who would not qualify for the seller's exception. BICE is available for transactions in all classes of securities; however, it only covers transactions effected on an agency or riskless principal basis. Principal transactions, which are defined to include purchases or sales on behalf of a broker-dealer's own account or the account of an affiliate, may not be effected under BICE.

The final Regulations expressly contemplate that proprietary products may be sold under BICE. Proprietary products are defined as products which are managed, issued or sponsored by the broker-dealer or an affiliate. The application of this definition to many types of structured products is not clear. In addition, given the potential inconsistency between the definition of prohibited "principal transactions" and "proprietary products," it is not clear if certain categories of proprietary products may not be sold under BICE because they would be deemed principal transactions. Market participants are expected to request the DOL to clarify these issues before the effective date.

What Are the Requirements to Comply with BICE?

The exemption requires that the IRAs enter into a written contract under which the financial institution acknowledges its and its individual advisers' fiduciary status. For plans covered by ERISA (e.g., an employer-sponsored 401(k) plan) there is no contract required, but the financial institution must still provide a written statement to the plan that acknowledges its fiduciary status. In addition, the contract or statement must warrant that:

  1. the adviser, financial institution and affiliates will adhere to basic standards of impartial conduct (including advice that is in the "best interest" of the advisee (see below));
  2. the financial institution has adopted written policies and procedures reasonably designed to mitigate the impact of material conflicts of interest and to ensure that its individual advisers adhere to the impartial conduct standards (see below);
  3. in formulating its policies and procedures, the financial institution has specifically identified material conflicts of interest and adopted measures to prevent them from causing violations of the impartial conduct standards and designated a person or persons, identified by name, title or function, responsible for addressing material conflicts of interest and monitoring their advisers' adherence to the impartial conduct standards;
  4. neither the financial institution nor (to the best of its knowledge) any affiliate uses quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differentiated 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 plan or IRA. The exemption provides that this requirement does not prevent the financial institution or its affiliates from providing advisers with differential compensation (including commissions) to the extent that the financial institution's policies and procedures and incentive practices, when viewed as a whole, are reasonably and prudently designed to avoid a misalignment of the interests of advisers with the interests of the plan or IRA. Differential compensation received by an adviser based on what product the adviser sells appears under the exemption to be limited to cases where objective neutral factors affect the amount of services the adviser has to give with respect to the different types of investments. For example, it is possible that the sale of a structured note that requires an adviser to provide greater explanations or guidance to the plan or IRA might justify a greater commission; however, no concrete examples were given by the DOL.
  5. the contract is prohibited from having (a) exculpatory provisions disclaiming or otherwise limiting the liability of the adviser or financial institution; (b) a provision under which the plan or IRA waives or qualifies its right to bring or participate in a class action or other representative action in court in a dispute with the adviser or financial institution; provided that, the parties may knowingly agree to waive the plan's or IRA's right to obtain punitive damages or rescission as a remedy to the extent such a waiver is permissible under applicable state or federal law; or (c) agreements to arbitrate or mediate individual claims in venues that are distant or that otherwise unreasonably limit the ability of the retirement investors to assert the claims safeguarded by this exemption. So, the contract cannot waive the plan or IRA's right to participate in a class action lawsuit, but can require arbitration of individual claims; provided that the forum for arbitration does not unreasonably limit the ability of the plan or IRA to assert its claim.3
  6. the contract or statement must state the best interest standard of care owed by the adviser and financial institution to the plan or IRA; inform the retirement investor of the services provided by the financial institution and the adviser; and describe how the plan or IRA will pay for services, directly or through third-party payments, such as revenue sharing or 12b-1 fees. Investment advice is considered in the "best interest" of the plan or IRA when the adviser and financial institution providing the advice 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 plan or IRA, without regard to the financial or other interests of the adviser, financial institution or their respective affiliates.
  7. the contract or statement must describe "material conflicts of interest" in connection with the fees received by the adviser or financial institution.4 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.
  8. the contract or statement must inform the plan or IRA that the investor has the right to obtain copies of the financial institution's written description of its policies and procedures, as well as the specific disclosure of costs, fees and compensation, including third-party payments, regarding recommended transactions, described in dollar amounts, percentages, formulas or other means reasonably designed to present materially accurate disclosure of their scope, magnitude and nature in sufficient detail to permit the plan or IRA to make an informed judgment about the costs of the transaction and about the significance and severity of the material conflicts of interest, and describes how the plan or IRA can obtain the information, free of charge, within 30 business days following the request, but always before the transaction occurs if the request was made before the transaction occurs.
  9. the contract or statement must include a link to the financial institution's website, and must inform the plan or IRA that: (a) model contract disclosures updated as necessary on a quarterly basis are maintained on the website, and (b) the financial institution's written description of its policies and procedures adopted in accordance with the exemption are available free of charge on the website.
  10. the contract or statement must disclose to the plan or IRA whether the financial institution offers proprietary products or receives third-party payments with respect to any recommended investments, and to the extent the financial institution or adviser limits investment recommendations, in whole or part, to proprietary products or investments that generate third-party payments, notify the plan or IRA of the limitations placed on the universe of investments that the adviser may offer for purchase, sale, exchange or holding by the retirement investor.
  11. the contract or statement must provide contact information (telephone and email) for a representative of the financial institution that the plan or IRA can use to contact the financial institution with any concerns about the advice or service they have received, and, if applicable, a statement explaining that the plan or IRA can research the financial institution and its advisers using FINRA's BrokerCheck database or the Investment Adviser Registration Depository (IARD), or another database maintained by a governmental agency or instrumentality, or self-regulatory organization.
  12. the contract or statement must describe whether or not the adviser and financial institution will monitor the plan or IRA's investments and alert the plan or IRA to any recommended change to those investments, and, if so monitoring, the frequency with which the monitoring will occur and the reasons for which the plan or IRA will be alerted.

What Are the Impartial Conduct Standards?

The impartial conduct standards that the financial institution and its representatives must adhere to, are the following:

  1. when providing investment advice to plan or IRA, the financial institution and the adviser(s) provide investment advice that is, at the time of the recommendation, in the best interest of the retirement investor. As noted above, this 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, based on the investment objectives, risk tolerance, financial circumstances and needs of the plan or IRA, without regard to the financial or other interests of the adviser, financial institution or any affiliate or other party.
  2. the recommended transaction will not cause the financial institution, adviser or their affiliates to receive, directly or indirectly, compensation for their services that is in excess of reasonable compensation within the meaning of ERISA's service provider exemption.
  3. statements by the financial institution and its advisers to the plan or IRA about the recommended transaction, fees and compensation, material conflicts of interest and any other matters relevant to the plan or IRA will not be materially misleading at the time they are made.

Additional Requirements for Proprietary Products and Third-Party Payments

If a financial institution restricts advisers' investment recommendations, in whole or part, to proprietary products or to investments that generate third-party payments, to rely on BICE it must:

  1. prominently notify the plan or IRA in writing of such fact, as well as the existence of any material conflicts of interest prior to or at the time of execution of the recommended transaction;
  2. document in writing:
  1. its limitations on the universe of recommended investments and the material conflicts of interest associated with any contract, agreement or arrangement providing for its receipt of third-party payments or associated with the sale or promotion of proprietary products;
  2. any services that it will provide to plans or IRAs in exchange for third-party payments, as well as any services or consideration it will furnish to any other party, in exchange for the third-party payments;
  3. that it will reasonably conclude that the limitations on the universe of recommended investments and material conflicts of interest will not cause the financial institution or its advisers to receive compensation in excess of a reasonable amount and
  4. that it will reasonably determine that these limitations and material conflicts of interest will not cause the financial institution or its advisers to recommend imprudent investments, and the bases for its conclusions,
  1. adopt, monitor, implement and adhere to policies and procedures and incentive practices that meet the terms of the exemption.


1 http://www.dol.gov/ebsa/regs/conflictsofinterest.html. Prior to the issuance of the final regulation, the DOL had issued proposed regulations on October 21, 2010, which were withdrawn on September 19, 2011, and then revised substantially and re-proposed on April 20, 2015.

2 The Employee Retirement Income Security Act of 1974.

3 One liberalization of the final exemption over the proposed exemption is that for existing clients, the written contract requirement is met if the financial institution delivers the proposed contract amendment complying with BICE, and does not hear back from the IRA investor within 30 days; provided that the contract amendment does not impose any new contractual obligations, restrictions or liabilities on the IRA.

4 Although not clearly stated in the Regulations, we believe disclosure of material conflicts of interest in offering documents timely delivered to the retirement investor should suffice for this purpose.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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