United States: The Department Of Labor's 2016 Final Fiduciary And Conflict Of Interest Regulations: The Principal Transactions Exemption

This post continues our examination of the Department of Labor's suite of final fiduciary and conflict of interest regulations. Our prior posts discussed the newly expanded definition of " investment advice fiduciary" and the " best interest contract" (or BIC) exemption. In this post we explain the suite's second new prohibited transaction class exemption entitled: "Class Exemption for Principal Transactions in Certain Assets between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs". This exemption generally permits the trading of debt instruments in principal and riskless principal transactions involving Employee Retirement Income Security Act (ERISA)-regulated retirement plans and Individual Retirement Accounts (IRAs).


On April 8, the U.S. Department of Labor published a suite of final regulations governing the fiduciary status of, and prescribing conflict of interest rules that apply to, persons who provide investment advice to ERISA-covered retirement plans and IRAs and owners. (For a list of and links to these final regulations, please see our April 11, 2016 post.) The Department refers to these investors collectively as "retirement investors."

The new fiduciary and conflict of interest rules vastly expand the definition of an "investment advice fiduciary" to include financial advisors of all stripes (e.g., broker-dealers/registered representatives, Registered Investment Advisors (RIAs) and insurance agents and brokers who advise retirement plans and IRAs). At the same time, the Department issued a series of new and amended prohibited transaction class exemptions, which together preserve many of the commission-based compensation arrangements that would otherwise be imperiled under the new fiduciary standard.

The Department's efforts to address fiduciary conflicts of interest take as their starting point the variety of ways in which an advisor's advice might be biased. Advisers are sometimes paid substantially more if they recommend investments and transactions that are highly profitable to the financial industry, even if they are not in investors' best interests. Commission-based compensation is the most obvious but certainly not the only form of conflicted advice. For example, advisers often are paid more for selling, or executing larger or more frequent trades of, some securities rather than others. In the case of principal transactions, the Department is particularly concerned about conflict of interest issues involving liquidity, pricing, transparency and the fiduciary's possible incentive to "dump" unwanted assets.

Both ERISA and the Internal Revenue Code (the "Code") prohibit a fiduciary from dealing with the assets of a plan or an IRA investor in his or her own interest or for his or her own account. ERISA further prohibits a fiduciary from, in his or her individual or any other capacity, acting in any transaction involving the plan on behalf of a party (or representing a party) whose interests are adverse to the interests of the plan or the interests of its participants or beneficiaries.

Existing law already exempts some principal transactions. Blind transactions, i.e., purchasing or selling a security on an exchange when the buyers and sellers have no knowledge of each other's identity, are generally not considered to be prohibited. There is also statutory relief for principal transactions that qualify as "Eligible Investment Advice Arrangements" under the Pension Protection Act of 2006. This exemption allows fiduciary investment advisers to receive compensation from investment vehicles they recommend if either:

  • The investment advice they provide is based on a computer model certified as unbiased and as applying generally accepted investment theories, or
  • The adviser is compensated on a "level-fee" basis (i.e., fees do not vary based on investments selected by the participant).

There is, finally, a 1975 prohibited transaction class exemption, Part II(1) of PTE 75-1 that permits broker-dealers to engage in principal transactions with ERISA-covered plans and IRAs. This exemption applies, however, only where the broker-dealer exercises no discretionary authority or control (except as a directed trustee). It is not available where the advisor renders investment advice to the plan or IRA.

Principal Transactions

Oversimplifying, securities transactions are typically made on either a principal or an agency basis.

Principal transactions involve the sale of a security by a financial institution out of its inventory or proprietary account or the purchase of a security by a financial institution from its customer for its inventory or proprietary account. In a principal transaction the financial institution transacts on its own behalf. In contrast, an "agency" transaction is one in which the financial institution transacts as an agent on behalf of its customer. A broker-dealer typically acts as a "dealer" in principal transactions and as a "broker" in agency transactions. In a principal trade, the dealer uses its own inventory fill a client's order. For example, investor X wants a particular bond, and if the dealer that X does business with has the bond in its inventory, the dealer can act as the counterparty and sell X the bond from its inventory. In an "agency" transaction, a broker arranges on behalf of a client for the transfer of securities that the broker does not own. The broker must identify the appropriate market and locate a counterparty wishing to enter into the transaction. Agency trades are more commonly encountered in liquid, mature markets.

When acting in a principal capacity, the broker-dealer is generally compensated for executing the transaction by charging a "mark-up" or "mark-down" on the market price of the security being bought or sold. In the case of a sale, a mark-up is the difference in price between the price for the security the dealer pays (or receives) in its transaction with the market and the price the dealer receives (or pays) in its transaction with the investor. In the case of the purchase (sale) by the customer, the market price of the security is increased (reduced) by an amount that the dealer charges for effecting the transaction, which is referred to as a "mark-up" ("mark-down"). The Department was concerned that an advisor's ability to reap price spreads from principal transactions that may bias their recommendations.

Principal transactions occur not only in transactions with broker-dealers, but also transactions with other types of financial institutions. For example, principal transactions occur when an investment adviser acting as principal for its own account buys securities from or sells securities to its advisory client.

Under the final fiduciary regulations, broker-dealers and their representatives will be acting in a fiduciary capacity when they engage in principal transactions with ERISA-covered plans and IRA investors. A recommendation to enter into a principal transaction would, as a consequence, result in a prohibited transaction in the absence of an exemption. Conceding the usefulness of principal transactions in general, the Department provided the principal transactions exemption. But in a manner similar to the BIC exemption, the principal transaction exemption imposes significant new protections for investors.

The Principal Transactions Exemption

The principal transactions exemption allows individual investment advice fiduciaries—i.e., advisors and the institutions that employ or contract with them—to engage in principal transactions and riskless principal transactions involving certain investments, with plans, participant and beneficiary accounts, and IRAs.

  • A "principal transaction" is a transaction in which an adviser or financial institution is purchasing from or selling to the plan, participant or beneficiary account, or IRA an asset for the account of the financial institution or any affiliate.
  • A "riskless principal transaction" is defined as a transaction in which a financial institution, after having received an order from a plan or IRA investor to buy or sell a principal traded asset, purchases or sells the asset for the financial institution's own account to offset the contemporaneous transaction with the plan or IRA investor.

Riskless principal transactions are the functional equivalent of agency transactions. As such, they are also covered under the Best Interest Contract exemption. This means that riskless principal transactions can proceed under either exemption, thereby resulting in "some overlap between the Best Interest Contract exemption and the principal transaction exemption." The Best Interest Contract exemption, however, provides broader relief for all recommended purchases.

Summary of Exemption Requirements

To qualify for the relief afforded by the principal transactions and riskless principal transactions exemption, financial institutions must do the following:

  • Acknowledge fiduciary status with respect to any investment advice regarding principal transactions or riskless principal transactions;
  • Adhere to "Impartial Conduct Standards" requiring them to:
    • Give advice that is in the plan's or IRA investor's best interest (i.e., prudent advice that is based on the investment objectives, risk tolerance, financial circumstances, and needs of the plan or IRA investor, without regard to financial or other interests of the adviser, financial institution or any affiliates or other parties);
    • Seek to obtain the best execution reasonably available under the circumstances with respect to the transaction; and
    • Make no misleading statements about investment transactions, compensation, and conflicts of interest;
  • Implement policies and procedures reasonably and prudently designed to prevent violations of the Impartial Conduct Standards;
  • Refrain from giving or using incentives for advisers to act contrary to the customer's best interest; and
  • Make additional disclosures (summarized below).

Advisers relying on the exemption must comply with the Impartial Conduct Standards when making investment recommendations regarding principal transactions and riskless principal transactions.

The Impartial Conduct Standards

The Impartial Conduct Standards form the core of the exemption's consumer protections. These standards require that advisers and financial institutions (i)provide investment advice regarding the principal transaction or riskless principal transaction that is in plan's or IRA investor's best interest, (ii)seek to obtain the best execution reasonably available under the circumstances with respect to the transaction (FINRA members may satisfy existing FINRA rules to satisfy this requirement), and (iii) not make misleading statements to the plan or IRA investor about the recommended transaction. A financial institution and adviser act in the best interest of a plan or IRA investor when they provide investment advice that reflects:

"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, any affiliate or other party."

Contractual and Annual Disclosures

As a condition of the exemption, financial institutions must make certain contractual disclosures to retirement investors. In the case of IRAs and non-ERISA plans, the disclosures must be provided prior to or at the same time as the recommended transaction either as part of the contract or in a separate written disclosure. For ERISA plans, the disclosures must be provided prior to or at the same time as the execution of the recommended transaction. The disclosure may be provided in person, electronically, or by mail.

Financial institutions must, in addition, provide certain written information in a single written disclosure on an annual basis. The annual disclosure must include, among other things, a list identifying each principal transaction and riskless principal transaction executed during the applicable period, the date and price at which the transaction occurred, and statements relating to compliance with certain requirements of the final regulation.

The final exemption includes a good faith compliance provision under which the financial institution will not fail to satisfy it disclosure requirements because it, acting in good faith and with reasonable diligence, makes an error or omission in disclosing the required information or if the Web site is temporarily inaccessible, provided that the following conditions are satisfied:

  • In the case of an error or omission on the Web, the financial institution discloses the correct information as soon as practicable, but not later than 7 days after the date on which it discovers or reasonably should have discovered the error or omission; and
  • In the case of other disclosures, the financial institution discloses the correct information as soon as practicable, but not later than 30 days after that date on which it discovers or reasonably should have discovered the error or omission.

Principal traded assets

The exemption provides relief for advisors and financial institutions to enter into principal transactions and riskless principal transactions in "principal traded assets" with plans and IRAs. What constitutes a principal traded asset depends on who is selling and who is buying:

  • The principal traded assets that are permitted to be purchased by plans, participant and beneficiary accounts, and IRAs include CDs, interests in UITs, and debt securities—i.e., "corporate debt securities offered pursuant to a registration statement under the Securities Act of 1933; treasury securities; agency securities; and asset backed securities that are guaranteed by an agency or government sponsored enterprise." This list may be expanded, without amending the class exemption, under future individual exemptions.
  • In the case of the sale of principal traded assets by plans and IRAs, the term "principal traded asset" includes "securities or other investment property." It therefore includes a broad range of assets including assets for which a plan or IRA investor might be unable to obtain a reasonable price from a third party.

Exclusions—items not covered by the principal transactions exemption

Advisors and financial institutions may not take advantage of relief under the principal transactions exemption to engage in principal transactions and riskless principal transactions if they (i)have or exercise discretionary authority or discretionary control with respect to management of the assets of a plan, participant or beneficiary account, or IRA; (ii)exercise any discretionary authority or control respecting management or the disposition of the assets; or (iii)have any discretionary authority or discretionary responsibility in the administration of the plan, participant or beneficiary account, or IRA.

The principal contract exemption is not available for transactions involving an ERISA-covered plan if the adviser or financial institution (or an affiliate) is the employer of employees covered by the plan. Nor is the exemption for a principal transaction entered into as part of a rollover from such a plan to an IRA under these circumstances, where the principal transaction is being executed by the plan and not the IRA. But this exclusion does not apply to an IRA. In the Department's view, "the decision to open an IRA account or obtain IRA services from the employer is much more likely to be entirely voluntary on the employees' part than would be true of their interactions with the retirement plan sponsored and designed by their employer for its employee benefit program."

Lastly, the principal contract exemption is unavailable if the adviser or financial institution is a named fiduciary or plan administrator with respect to an ERISA plan, or an affiliate thereof, that was selected to provide advice to the plan by a fiduciary who is not independent of them.

Conditions of the Exemption

Enforceable Right to Best Interest/IRAs, and other non-ERISA plans

In the case of IRAs, and other non-ERISA plans (e.g., Keogh plans), the financial institution and IRA investor must enter into an enforceable written contract that includes items summarized above. The enforceable written contract must be entered into prior to or at the same time as the execution of the recommended transaction, and the contract's terms must cover the prior recommendations. Unlike the proposed rule, only the financial institution is required to be a party to the contract. The contract may be incorporated into other documents to the extent desired by the financial institution, and it may be a master contract covering multiple recommendations (i.e., there is no need for a new writing prior to each additional recommendation).

The contract must include the financial institution's acknowledgment of its fiduciary status and that of its advisers; the financial institution's agreement that it and its advisers will adhere to the Impartial Conduct Standards, including the Best Interest standard; the financial institution's warranty that it has adopted and will comply with certain policies and procedures, including anti-conflict policies and procedures reasonably and prudently designed to ensure that advisers adhere to the Impartial Conduct Standards. The financial institution's disclosure of information about material conflicts of interest may be provided in the contract or in a separate single written disclosure.

With respect to new contracts, the regulation specifically permits electronic execution as a form of customer assent. The exemption requires that a copy of the applicable (model) contract be maintained on a Web site accessible to the IRA investor. For existing customer relationships, existing contracts may be brought into compliance using negative consent, provided the amended contract includes no new obligations, restrictions or liabilities. Any attempt by the financial institution to impose additional obligations, restrictions or liabilities must receive affirmative consent from the IRA investor. The financial institution is permitted to treat the IRA investor's silence as consent after 30 days.

Ineligible contract provisions

The contract must not include any of the following "ineligible provisions:"

  • Exculpatory provisions disclaiming or otherwise limiting liability of the adviser or financial Institution for a violation of the contract's terms;
  • A waiver of a retirement investor's right to bring or participate in a class action or other representative action in court in a dispute with the adviser or financial institution, or in an individual or class claim, an agreement to liquidated damages (although the parties may agree to waive the retirement investor's right to punitive damages or rescission); and
  • 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 the exemption.

ERISA-covered plans

In the case of ERISA-covered plans, a written contract is not required, but advisers and financial institutions must nevertheless acknowledge their fiduciary status, adhere to the adhere to Impartial Conduct Standards, provide warranties concerning their implementation of policies and procedures reasonably and prudently designed to prevent violations of the Impartial Conduct Standards, refrain from giving or using incentives for advisers to act contrary to the customer's best interest, and make the disclosures described above.

Sales incentives and anti-conflict policies and procedures

The final fiduciary and conflict of interest rules for the most part leave intact a large swath of commission-based compensation arrangements common in the securities industry—but at a cost. To continue to receive commissions and commission-based compensation, advisors and financial institutions must abide by the Best Interest standards, which include certain anti-conflict policies and procedures; and financial institutions must avoid offering incentives that might cause advisors to violate these standards.

To qualify for principal transactions exemption, a financial institution must adopt a written policies and procedures, and establish an accompanying supervisory structure, to ensure that its advisers adhere to the Impartial Conduct Standards. The policies and procedures must identify and document material conflicts of interest associated with principal transactions and riskless principal transactions; adopt measures reasonably and prudently designed to prevent such conflicts from causing violations of the Impartial; and designate a person or persons, identified by name, title or function, responsible for addressing conflicts and monitoring advisers' adherence to the Impartial Conduct Standards. A conflict is "material" for this purpose 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.

In the case of IRAs and other non-ERISA plans, financial institution must, in their written contract, make a warranty regarding their policies and procedures, thereby giving the financial institutions a strong incentive to avoid conflicts. No such warranty is required in connection with ERISA-covered plans, for which a separate warranty is unnecessary. These plans, and the Department, have an enforcement mechanism under ERISA.

The financial institution must provide a summary of its policies and procedures, copies of which must be made available free of charge upon request and on the financial institution's Web site. The written description must accurately describe or summarize key components of the policies and procedures relating to conflict-mitigation and incentive practices. The full set of policies and procedures must be made available to clients and to the Department upon request.

The policies and procedures must require that, neither the financial institution nor (to the best of its knowledge) any affiliate uses or relies on quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differential compensation or other actions or incentives that are intended or would reasonably be expected to cause individual advisers to make recommendations regarding principal transactions and riskless principal transactions that are not in a client's best interest. The preamble to the principal transactions rule emphasizes that differential compensation is permitted provided that the incentive practices giving rise to the commission, 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 investor.

The financial institution's written policies and procedures must address credit risk and liquidity assessments standards that are established elsewhere in the rule. Under that standard, a debt security that is purchased by a plan, participant or beneficiary account, or IRA must possess at the time of purchase no greater than moderate credit risk and sufficiently liquidity that it can be sold at or near its carrying value within a reasonably short period of time.


The remedial scheme under the principal transactions exemption mirrors that established under the BIC exemption. When financial institutions or their advisers breach their obligations under the principal transactions exemption thereby causing losses to retirement investors, the investor is provided a remedy to redress the injury. In the case of IRAs and non-ERISA plans, the exemption's enforceable contract requirement provides retirement investors with a right of action under the contract. While financial institutions generally remain free to require arbitration for individual claims, the principal transactions exemption confers on IRA investors the right to pursue class action claims in the courts.

Financial institutions and advisers may not rely on the principal transactions exemption if they include contractual provisions in their contracts with retirement investors disclaiming liability for compensatory remedies or waiving or qualifying retirement investors' right to pursue a class action in court. The exemption does, however, permit financial institutions to include contractual provisions waiving the right to punitive damages or rescission as contract remedies to the extent permitted by other applicable laws. As a consequence, the retirement investor is limited to "make-whole relief," which puts the investor in roughly the same place as the ERISA investor, since ERISA too denies access punitive damages, rescission, and other forms of "extra-contractual" relief.

Effective Dates, Applicable Dates and Grandfathering

The principal transactions rule is effective as of June 7, 2016. Recognizing that it will take some time for financial institutions to come into compliance, however, the Department has provided a grandfather rule under which the new standards will apply to "transactions occurring on or after April 10, 2017." The Department refers to this as the rule's Applicability Date. Among other things, investments made on or after April 10, 2017, or under a systematic purchase program established before that date based on advice given before that date, are grandfathered. As a consequence, the receipt of compensation related to the advice is not treated as a prohibited transaction. In contrast, ongoing (e.g., advice to hold) and new advice provided under grandfathered arrangements is subject to the new requirements. Grandfather status also lapses prospectively with the expiration of the contract under which the grandfathered advice is being provided.

Grandfathered relief for compensation associated with investments made prior to the regulation's Applicability Date is further extended in the case of the principal transactions exemption to the period between the Applicability Date and January 1, 2018, subject to more limited conditions. During this period, firms and advisers must adhere to the impartial conduct standards; seek to obtain the best execution reasonably available under the circumstances; refrain from making misleading statements; and provide notice to their retirement investors that, among other things, acknowledges their fiduciary status and describes their material conflicts of interest, and designates a person responsible for addressing material conflicts of interest and monitoring advisers' adherence to the impartial conduct standards. Full compliance with the principal transactions exemption will be required as of January 1, 2018.

* * * * *

Next week's installment will examine the changes made by the Department's final fiduciary and conflict of interest rules to the existing prohibited transaction exemption (PTE 84-24) covering insurance agents and brokers

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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Alden J. Bianchi
Steve Ganis
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