Comparing the DOL Proposal to the Broker-Dealer and RIA Standards of Conduct

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Our recent blog post compared the SEC’s standard of conduct for broker-dealers under Regulation Best Interest (Reg BI) with the standard of conduct for registered investment advisers (RIAs) under the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers (the RIA Interpretation). Here, we add a comparison of the Department of Labor’s (DOL’s) proposed prohibited transaction exemption, which includes in the preamble an expanded interpretation of who qualifies as an investment advice fiduciary under ERISA and the Internal Revenue Code (the DOL Proposal).

Terms Used in this Article

For purposes of this Article, the terms identified below have the following meanings:

Code – the Internal Revenue Code of 1986, as amended.

Code Fiduciary – an investment advice fiduciary for a Code Plan.

Code Plan – a non-ERISA tax-qualified plan (other than a governmental plan or non-electing church plan), IRA or other account subject to the prohibited transaction rules of Code Section 4975.

ERISA – the Employee Retirement Income Security Act of 1974, as amended.

ERISA Fiduciary – an investment advice fiduciary for an ERISA Plan.

ERISA Plan – a plan subject to the fiduciary and prohibited transaction rules of ERISA.

Overview

  1. The DOL Proposal – A Proposed Prohibited Transaction Exemption

    The DOL Proposal is a proposed prohibited transaction exemption (the Proposed PTE) to the ERISA and Code prohibited transaction rules. It would be available to a fiduciary who provides nondiscretionary investment advice that results in additional compensation to the fiduciary or an affiliate – i.e., a self-dealing transaction. In other words, it would be needed only if the broker-dealer, RIA or other Financial Institution (1) is a fiduciary under ERISA and/or the Code and (2) provides non-discretionary investment advice that results in a self-dealing transaction. As detailed in the chart below, the requirements of the Proposed PTE are modeled generally after Reg BI, but there are some differences.

  2. Implications of the New DOL Interpretation of Regular Basis

    Like the RIA Interpretation, the preamble to the DOL Proposal includes an interpretation component – namely, the DOL’s interpretation of investment advice fiduciary under the current 5-part test. Under the 5-part test, an investment advice fiduciary under ERISA and the Code is one who (1) provides advice about investments for a fee or other compensation (2) on a regular basis, (3) under a mutual understanding (4) that the advice will form a primary basis for the investment decision, and (5) that the advice is individualized based upon the investor’s particular needs. In its interpretation, the DOL greatly expands the scope of the 5-part test by providing a new interpretation of what constitutes a “regular basis.” The “regular basis” requirement is the part of the 5-part test that firms have commonly used to avoid fiduciary status. Under the DOL’s new interpretation, the “regular basis” requirement under the 5-part test exists if either:

    • The adviser had a preexisting advice relationship with the investor, regardless of whether the prior advice was given in connection with retirement assets subject to ERISA and/or the Code or to other assets; in other words, the preexisting relationship would exist for both a preexisting ERISA Fiduciary adviser relationship and a preexisting non-ERISA financial advisory relationship OR
    • The adviser establishes a new relationship that is the first step or is anticipated to be the first step in an ongoing advice relationship. (The DOL does acknowledge that merely executing a sales transaction at the customer’s request does not by itself confer fiduciary status unless an ongoing relationship is being established or is contemplated, e.g., an agent who receives trailing commissions for ongoing services with respect to an annuity.)

    As a result, a firm that previously avoided status as a fiduciary under the regular basis requirement could now be considered an ERISA or Code Fiduciary with the attendant rules that flow from that status (i.e., standard of care for ERISA Fiduciaries and application of the prohibited transaction rules for both ERISA and Code Fiduciaries). Also, under this new interpretation, plan rollover recommendations to plan participants would, in most cases, result in fiduciary status under ERISA for the firm subject to ERISA’s standard of care and prohibited transaction rules. This is because the fiduciary receives additional compensation (e.g., the IRA advisory fee, commissions) that the fiduciary would not have received absent the investor accepting the recommendation. In that case, the conditions of the Proposed PTE would need to be met.

  3. Current Impact of DOL Proposal

This new interpretation of “regular basis” in the preamble to the DOL Proposal is not a proposal of a new rule. Instead, it is the DOL’s interpretation of the 5-part test and is operative now.

On the other hand, the Proposed PTE is just that – a proposal. We do not know whether it will be adopted in its present form or significantly modified. The DOL is conducting hearings and one of our partners, Bradford Campbell, had the opportunity to testify at those hearings. During this interim period before the exemption is finalized, the DOL and the IRS currently have a Non-Enforcement Policy ( ) in effect for nondiscretionary investment advice that results in a self-dealing transaction, providing the investment advice fiduciary satisfies the Impartial Conduct Standards (i.e., a standard of care virtually identical to the ERISA standard of care, reasonable fee, no materially misleading statements). While this Policy is binding on the DOL and the IRS, it does not protect against private rights of actions that can be brought against plan fiduciaries under ERISA. As an alternative to the Non-Enforcement Policy, an investment advice fiduciary may rely on other available prohibited transaction exemptions, to the extent applicable, and those exemptions will continue to be available even if the DOL Proposal is adopted.

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  DOL Proposal Reg BI RIA Interpretation
Who is subject to the standard? Under the Proposed PTE, the standard would apply to investment advice fiduciaries (as determined under the DOL’s 5-part test applying the new interpretation of “regular basis”) who are Financial Institutions (an RIA, broker-dealer, bank, insurance company) and their representatives (an employee, independent contractor, agent or representative registered with the Financial Institution).
The Proposed PTE would not apply to others who give fiduciary investment advice, such as independent non-securities licensed insurance agents unless an insurance company undertakes to serve as the Financial Institution with respect to those agents.
Broker-dealers and natural persons who are associated persons of a broker-dealer (together referred to here as a “broker-dealer”). Both SEC- and state-registered investment advisers, as well as other investment advisers that are exempt from registration or subject to a prohibition on registration under the Investment Advisers Act, and their supervised persons.

Note that case law, statutes (such as ERISA) and state law may impose obligations on investment advisers as well.

What recommendations and/or advice are covered by the standard? Covered advice: The standard applies to non-discretionary investment advice provided to an ERISA Plan, Code Plan or participants of such plans, and to IRA owners about investing in, purchasing or selling securities or other property, as well as recommendations regarding investment policies or strategies, overall portfolio composition or diversification of investments. Covered advice includes recommendations to a plan participant to take a distribution from a plan and roll it over to an IRA and recommendations to transfer from one IRA to another. Covered recommendation: A covered recommendation occurs when a broker-dealer recommends to a retail customer any securities transaction or investment strategy involving securities.

Recommending an account type is considered to be recommending an investment strategy for this purpose. This means that in the rollover context, the standard applies to advice about whether a participant should roll over plan assets, the account type into which the assets should be rolled and how the assets should be invested. The standard also applies to recommending that a retail investor transfer assets to open an account with the broker-dealer, including a transfer from an existing IRA to an IRA with the broker-dealer.

Covered advice: The standard applies to the full range of investment advisory services provided to the client under the agreed-upon adviser/client relationship (e.g., advice about investment strategy, advice about account type, rollover advice, IRA transfer, ongoing portfolio management, etc.).
What is the scope and description of the standard? The Proposed PTE requires compliance with the Impartial Conduct Standards, which require (1) satisfaction of a best interest standard of care, which mirrors the ERISA prudence standard and duty of loyalty, (2) receiving not more than reasonable compensation, (3) making no materially misleading statements, and (4) seeking best execution.

Firms that currently serve as an ERISA Fiduciary are already subject to the ERISA standard of care described in (1) above. However, compliance with this standard of care will be new for Code Fiduciaries and firms that become ERISA Fiduciaries as a result of the DOL’s expanded interpretation of regular basis.

A broker-dealer must act in the best interest of the retail customer at the time the covered recommendation is made, without placing the financial or other interests of the broker-dealer ahead of the interests of the retail customer. The standard applies to all investment advice provided within the scope of the agreed-upon adviser/client relationship.

An investment adviser owes a duty of care and loyalty to the client; the overarching duty is to act in the best interest of the client. The investment adviser must have a reasonable belief that the investment advice it provides in carrying out the agreed-upon services is in the best interest of the client and must not subordinate the client’s interest to its own.

When does the standard apply? Under the Proposed PTE, the standard would apply if the covered advice results in a self-dealing prohibited transaction and the ERISA/Code Fiduciary is relying on the Proposed PTE in order to receive the otherwise prohibited compensation.

Note that ERISA Fiduciaries are always subject to a duty of prudence and loyalty with respect to fiduciary advice provided under the agreed-upon arrangement with the ERISA Plan and/or participant. The ERISA standards of care and loyalty do not apply to fiduciary advice to IRAs. However, the best interest standard in the Proposed PTE would create a similar duty for Code Fiduciaries to IRAs and non-ERISA private sector plans that are Code Plans.

The standard is transaction-based; it applies when a broker-dealer makes a covered recommendation. Investment advisers always have a best interest duty. The standard applies when the investment adviser enters into the client relationship and it is defined by the scope of the agreed-upon adviser/client relationship.
Does the standard apply to all clients? No.

The Proposed PTE standard applies to the ERISA Plan, Code Plan and/or plan participant to whom the covered advice was provided.

The standard does not apply to governmental plans, non-electing church plans, or the participants of such plans.

No.

It only applies to retail customers. A retail customer for this purpose is defined as any natural person who receives a recommendation from the broker-dealer and uses it primarily for personal, family or household purposes. It includes individual plan participants. It does not generally apply to workplace retirement plans or their representatives and service providers. Also, it does not apply to an employee seeking services for an employer or an individual who is seeking services for a small business. However, it does apply to a sole proprietor who decides service arrangements for a workplace retirement plan and participates in the plan to the extent such individual receives recommendations primarily for personal, family or household purposes.

Yes.

It applies to all clients, regardless of whether the client is an individual or institution.

Process Requirement
A. Process Requirement in General To satisfy the Impartial Conduct Standards, the ERISA/Code Fiduciary would need to consider all relevant factors and determine whether the advice is in the retirement investor’s best interest based on the investor’s investment objectives, risk tolerance, financial circumstances and needs, and not place its interest ahead of the investor’s interests. The broker-dealer needs to consider the potential risks, rewards and costs associated with the covered recommendation and determine whether those factors align with the services requested by the customer and the customer’s investment profile. In carrying out the agreed-upon services, the investment adviser must assess whether the advice is in the client’s best interest by considering the client’s investment objectives and profile. This includes consideration of the client’s financial situation, level of financial sophistication, investment experience and financial goals and other relevant factors, such as the client’s risk tolerance and the costs of the recommended investment or investment strategy.
B. Process for Rollover Advice ERISA Fiduciaries relying on the Proposed PTE would need to consider all relevant factors, including the investments available under the existing plan and the proposed IRA, the different levels of services, and the fees and expenses associated with both the existing plan and the IRA, including whether the employer pays for some of the plan’s expenses. The fiduciary would need to evaluate the relevant factors to determine whether recommending the rollover is appropriate based on the participant’s needs and circumstances. The requirement to review and evaluate plan, IRA and investor information appear to be similar to those in Reg BI.

Documentation: The DOL also says that the Financial Institution must document the specific reasons why the recommendation to roll over assets is in the best interest of the participant.

The broker-dealer needs to consider the investments, services and expenses under the plan and the IRA to determine whether the rollover recommendation aligns with the investor’s financial needs and objectives.

Documentation: Also, while the SEC does not require documentation, the SEC encourages broker-dealers “to record the basis for their recommendations, especially for more complex, risky or expensive products and significant investment decisions, such as rollovers and choice of accounts” as a potential way to demonstrate compliance with the best interest standard.

The best interest process for investment advisers in providing rollover advice is likely similar to the process specified by the SEC for broker-dealers, and investment advisers should consider those same factors.

Documentation: The SEC does not address whether documenting the basis for the advice is needed or encouraged. However, investment advisers should consider doing so given the fact that it is expressly addressed by the SEC in Reg BI.

C. Process for Recommending an Account Type The DOL does not specifically refer to “recommending an account type” in describing the scope of the Proposed PTE. However, the DOL explains that the Proposed PTE would apply to investment advice about rollovers of all types – plan to IRA, plan to plan, IRA to IRA – as well as recommending a transfer from one type of account to another (e.g., from a commission-based account to a fee-based account). Under the Proposed PTE, the best interest process in advising about an account type is likely similar to the process specified by the SEC for broker-dealers, and ERISA and Code Fiduciaries should consider those same factors. When recommending an account type, the broker-dealer needs to consider the services and products provided in the account (e.g., account monitoring services, access to products with break-points, etc.) the projected cost to the customer and the alternative account types available.

Note: Dual registrants need to consider the full spectrum of accounts offered – both brokerage and advisory – and recommend the one that is in the customer’s best interest. If the advisor is only registered as an associated person of a broker-dealer and can only offer brokerage accounts, the advisor needs to have a reasonable basis to believe that the recommended brokerage account is in the customer’s best interest.

 
Is reasonable compensation required? Yes. One of the requirements for compliance with the Impartial Conduct Standards of the Proposed PTE is that the compensation received by the Financial Institution and its affiliates for the covered advice not exceed reasonable compensation.

Note that ERISA and Code Fiduciaries are required to charge no more than reasonable compensation in order to avoid a prohibited transaction even absent the Proposed PTE.

It is not a specific requirement.

However, broker-dealers need to evaluate the costs of the recommended transaction in determining whether it is in the customer’s best interest. And, those costs would include the broker-dealer’s compensation.

It is not a specific requirement.

However, an investment adviser needs to evaluate all relevant factors in assessing whether the recommended investment or investment strategy is in the best interest of the client, including the costs of the recommended investment or investment strategy. Those costs would include any direct or indirect compensation of the adviser.

Is there a monitoring obligation? The scope of the fiduciary’s monitoring obligation is defined by the agreed-upon arrangement.

The DOL makes clear that the conditions of the Proposed PTE – including the best interest standard – do not establish a monitoring requirement and that the monitoring obligation can be established by the parties to the arrangement. However, the DOL points out that under the Impartial Conduct Standards, the fiduciary would need to “carefully consider” whether the recommended investment requires ongoing monitoring (e.g., complex and/or risky investments may require ongoing monitoring to protect the investor’s interests).

No, unless the broker-dealer agrees to provide monitoring services. Yes. An investment adviser’s duty of care includes the duty to monitor at a frequency that is in the best interest of the client, taking into account the scope of the agreed-upon relationship.

For an ongoing relationship, an investment adviser’s duty to monitor extends to all personalized advice provided to the client, including an evaluation of whether a client’s account or program type (for example, a wrap account) continues to be in the client’s best interest.

On the other hand, the adviser and the client can agree to a relationship with limited duration that does not include a monitoring obligation such as a one-time financial plan for a one-time fee. In that instance, the adviser is not likely to have a duty to monitor.

Mitigation of conflicts of interest. Under the Proposed PTE, mitigation of conflicts of interest must be addressed in the Financial Institution’s policies and procedures, as follows:

“Financial Institutions’ policies and procedures mitigate Conflicts of Interest to the extent that the policies and procedures, and the Financial Institution’s incentive practices, when viewed as a whole, are prudently designed to avoid misalignment of the interests of the Financial Institution and Investment Professionals and the interests of Retirement Investors in connection with covered fiduciary advice and transactions.”

Broker-dealers must establish, maintain and enforce written policies and procedures reasonably designed to mitigate conflicts of interests that create an incentive for the firm’s financial professional to place its interests or the firm’s interest ahead of the customer’s interest. Investment advisers do not need to mitigate a conflict of interest (i.e., modify practices to reduce) unless, absent mitigation, the conflict cannot be fully and fairly disclosed to a client in order for the client to provide informed consent.
Elimination of conflicts of interest. Under the Proposed PTE, the conflict of interest does not need to be eliminated so long as all of the conditions of the exemption are satisfied. Broker-dealers must eliminate sales contests, sales quotas, bonuses and non-cash compensation that are based on the sale of specific securities or specific types of securities within a limited period of time. Investment advisers do not need to eliminate a conflict of interest unless, even with mitigation, the conflict cannot be fully and fairly disclosed to a client in order for the client to provide informed consent.
Form CRS delivery obligation.

Comment: The Form CRS is intended to provide a succinct high-level overview of a firm’s services, fees, costs, standards of conduct, conflicts of interest and disciplinary history.

The DOL Proposal does not require delivery of the Form CRS; refer to the next two columns describing the obligation. The DOL Proposal does require an initial disclosure. Refer to the heading General Disclosure Obligation below. A broker-dealer must deliver the Form CRS to each retail investor, before or at the earliest of (1) a recommendation of an account type, a securities transaction, or an investment strategy involving securities or (2) placing an order for the retail investor or (3) the opening of a brokerage account for the retail investor.

Note that a retail investor for purposes of the Form CRS delivery obligation includes a retirement plan participant. A plan fiduciary seeking services for an employer plan is not a retail investor, except in the case of Keogh plans.

At or before entering into an investment advisory agreement, the adviser must deliver the Form CRS to retail investors.

Note: Dual registrants must deliver the Form CRS as of the earliest of the timing requirements noted in the preceding column.

General Disclosure Obligation
A. Scope and contents of the disclosure. The Proposed PTE requires a disclosure of fiduciary status (as a Code or ERISA Fiduciary, as applicable), a description of services and a description of any material conflicts of interest written in a manner that is accurate and not misleading in all material respects.

Firms that currently serve as ERISA Fiduciaries are already subject to the 408(b)(2) disclosure obligation so these additional disclosures can be included in that document. However, this disclosure obligation will be new for Code Fiduciaries and firms that become ERISA Fiduciaries as a result of the DOL’s expanded interpretation of regular basis. Such ERISA Fiduciaries would be subject to the 408(b)(2) disclosure obligation for the first time.

The broker-dealer’s disclosure should include a description of the type and scope of services to be provided, the fees and costs, limitations on the services and products, whether the broker-dealer agrees to provide monitoring services and a description of conflicts of interests (e.g., conflicts associated with proprietary products, payments from third parties and compensation arrangements). An investment adviser must provide a prospective client with a broad-based disclosure of the investment adviser’s business set forth in a brochure under Part 2A of Form ADV. The brochure must disclose all material facts relating to the advisory relationship and all conflicts of interest that might incline the adviser to render advice that is not disinterested. The disclosure must include, among other things, a description of its advisory business, fees and compensation, methods of analysis, investment strategies, risk of loss explanation, disciplinary information, code of ethics, brokerage practices, and ownership and affiliations.
C. Timing of initial disclosure. Under the Proposed PTE, the disclosure would need to be provided to the retirement investor prior to engaging in the transaction. Before or at the time of the recommendation, a broker-dealer or natural person who is an associated person of a broker or dealer must provide to the retail customer a written disclosure of material facts about the scope and terms of its relationship with the retail customer and conflicts of interest associated with the recommendation. The brochure must be delivered to the prospective client at or before entering into an advisory agreement. The purpose of the brochure is to enable the client to use the information to decide whether or not to enter into the advisory relationship.
D. Changes in disclosure. The Proposed PTE does not require disclosure of any changes.

Note, however, that for ERISA Fiduciaries, changes in the 408(b)(2) disclosure need to be provided to the responsible plan fiduciary not later than 60 days from the date the ERISA Fiduciary is informed of the change.

Change disclosures are generally not required since the disclosure obligation tends to be a point-in-time requirement.

Note that for both broker-dealers and investment advisers, if any information in the Form CRS becomes materially inaccurate, then the Form CRS must be updated and filed with the SEC within 30 days and retail investors must be notified within 60 days after the updates are required to be made.

Each year that there are material changes to the brochure, an investment adviser must deliver within 120 days of the end of its fiscal year to each client either (1) an updated brochure that includes or is accompanied by a summary of material changes or (2) a summary of material changes that includes an offer to provide a copy of the updated brochure and information on how to obtain it.
E. Dual registrant requirements. The registration of the representative is not relevant to the application of the Proposed PTE. Dually registered associated persons and associated persons who are not dually registered but only offer broker-dealer services through a firm that is dually registered as an investment adviser must disclose whether they are acting (or, only acting) as an associated person of a broker-dealer. Also, an associated person of a dual-registrant who does not offer investment advisory services must disclose that fact as a material limitation. For firms that are dually registered as investment advisers and broker-dealers and who serve the same client, the disclosure must describe the circumstances in which they intend to act in their brokerage capacity and their advisory capacity and any circumstances under which advice will be limited to certain product offerings through the affiliated broker-dealer or affiliated investment adviser.
Annual review. To satisfy the Proposed PTE, a Financial Institution would be required to conduct a retrospective review at least annually to achieve compliance with the Impartial Conduct Standards and detect and prevent violations. The review must be reduced to a written report and certified by the CEO (or equivalent officer). Not required. Not required.
Consequences for failure to comply. A Financial Institution that relies on the Proposed PTE to avoid a prohibited transaction and fails to comply with all of its requirements would need to pay back the prohibited compensation plus lost earnings. It also would need to file a Form 5330 with the IRS along with payment of an excise tax.

Also, if the Financial Institution is an ERISA Fiduciary and fails to satisfy the ERISA standard of care, then it is in breach of its fiduciary duty, which can result in civil and/or criminal liability, as well as possible assessment of a 20 percent DOL penalty.

These rules will be enforced against the broker-dealer and/or registered representatives of the broker-dealer by the SEC. Reg BI does not create any new private right of action or right of rescission. These rules will be enforced against the RIA and supervised persons of the RIA by the SEC. The RIA Interpretation does not create any new private right of action.

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Takeaway

As the chart indicates, the standards that apply to broker-dealers, RIAs and Code/ERISA Fiduciaries are harmonized under these rules. Yet, there are distinctions as to the scope of the standard, to whom it applies and the implications of noncompliance. Financial Institutions that have relied in the past on other prohibited transaction exemptions – such as PTE 84-24 (for annuity, insurance and certain mutual fund transactions), PTE 77-4 (for open-end affiliated mutual funds), PTE 86-128 (for brokerage commissions) – will need to evaluate whether the Proposed PTE, if finalized in its current form, is a more appealing option. These other prohibited transaction exemptions will continue to be available and will not be replaced by the Proposed PTE. Once the Proposed PTE is finalized, Financial Institutions will need to update policies and procedures to address these distinctions and develop training programs to promote compliance.

DISCLAIMER: 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.

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