Final rule includes many changes and clarifications intended to address concerns raised about the proposal, but issues remain.
The US Department of Labor (DOL) has released its final regulation “Definition of the Term ‘Fiduciary’; Conflict of Interest Rule—Investment Advice.” Though the final rule maintains the same basic structure as the proposed rule, it includes a number of changes and clarifications that the White House Office of the Press Secretary indicated are intended to “reduce the compliance burden and ensure continued access to advice, while maintaining an enforceable best interest standard that protects consumers.”
This LawFlash provides a brief summary of certain key changes between the proposed rule and the final rule. We will follow with more detailed and comprehensive analysis in the days to come.
The rule becomes effective 60 days after it is published in the Federal Register, but the revised definition of fiduciary investment advice and the new and amended exemptions do not become “applicable” until April 10, 2017. Until then, the current definition of fiduciary investment advice will remain in effect. Moreover, the new Best Interest Contract Exemption and exemption for principal transactions include a transition period under which more limited conditions will apply until January 1, 2018. This is a change from the proposed rule, which provided for an applicability date of eight months following publication in the Federal Register for both the new definition and the exemptions.
Definition of Fiduciary Investment Advice
Similar to the proposed rule, the final rule would substantially broaden the types of investment services and activities that could result in fiduciary status. Changes and clarifications to the definition include the following:
Appraisals out. The final rule does not include valuations and appraisals as fiduciary activities, but reserves these for a later regulatory initiative.
Education carve-out. Asset allocation models and interactive investment materials may identify specific designated investment alternatives for plans (subject to certain conditions) without being considered fiduciary advice—but not for Individual Retirement Accounts (IRAs).
“Recommendation”. Further guidance is provided on the types of communications with plans, plan participants, and IRA beneficiaries that constitute “recommendations” that could trigger fiduciary status, including that the DOL intends this to be an objective standard.
“Seller’s exception”. The final rule revises the seller’s exception to apply to advice provided to state and federally supervised banks, insurance carriers qualified under the laws of more than one state, state and federally registered investment advisers, federally registered broker-dealers, and any plan fiduciary independent of the seller with at least $50 million in total assets under management (as opposed to the more limited $100 million in employee benefit plan assets required under the proposed rule). The final rule no longer automatically makes the seller’s carve-out available to plans with 100 or more participants.
“Hire me”. The final rule clarifies that an adviser can recommend that a customer hire him or her to provide advisory or asset management services without becoming a fiduciary. However, the final rule also indicates that a recommendation to invest in a particular advisory program may be fiduciary investment advice. In such case, the final rule clarifies that financial institutions can rely on the Best Interest Contract Exemption for recommendations of services, including services for which a “level fee” is received (more on this below).
Best Interest Contract Exemption
As under the proposal, this exemption provides relief where the investment advice fiduciary adheres to a “best interest” standard and other conditions are satisfied. Some changes from the proposed exemption to final exemption include the following:
Contract requirements. The DOL made a number of changes to the contract requirement. In particular, the contract requirement is limited to IRAs and other non-ERISA plans. Moreover, rather than requiring a tri-party agreement among the customer, financial institution, and adviser, only the financial institution and customer need to sign the contract. The contract may be incorporated into other account opening documents and can be entered into before or at the same time the recommended transaction is executed, rather than prior to the time any advice is provided. Firms may use “negative consent” procedures to enter into the contract with existing customers, but any additional conditions or obligations imposed on existing customers are subject to affirmative consent. Further, written or electronic signatures must be obtained from any new customers after the contract condition becomes applicable.
Covered assets. The proposed exemption would have covered only recommendations to buy, sell, or hold specified types of assets. The DOL eliminated the specified list of assets so that the final exemption may be available for any asset type, so long as the adviser meets the impartial conduct standards and other conditions of the exemption. But the DOL indicates in the preamble that financial institutions must exercise “particular care and vigilance” in overseeing recommendations of products with “unusual complexity, illiquidity, risk, lack of transparency, high fees or commissions, or tax benefits that are generally unnecessary.” Additionally, the DOL states that the bases for recommendations, and the conclusion that the recommendation satisfies the impartial conduct standards, must be documented.
Further, though the preamble makes clear that the exemption does not mandate that financial institutions and advisers provide ongoing advice and monitoring services, the preamble also indicates that financial institutions should consider whether certain investments can be prudently recommended where ongoing monitoring is not available. Where ongoing monitoring is needed to prudently recommend an investment, the preamble states that the added cost of such monitoring must be considered in evaluating whether the recommendation is in the best interest of the customer.
Disclosures and data retention. The point of sale disclosure requirements have been streamlined and no longer require projected costs at 1-, 5-, and 10-year periods, the annual disclosure requirement has been eliminated entirely, and the website disclosure requirements have been changed. However, other disclosure requirements appear to have been expanded and enhanced. The detailed data retention requirement has also been eliminated, and the DOL clarified the exemption to require firms only to retain the records that show they complied with the exemption (consistent with the approach under current exemptions).
Policies and procedures. The policies and procedures now require that financial institutions designate specific persons who are responsible for addressing conflicts of interest and monitoring advisers’ compliance with the impartial conduct standards.
Level fee fiduciaries. A special exemption for level fee fiduciaries has been added. This exemption covers a recommendation to roll over assets from a plan into a fee-based account, or transfer assets from a commission-based account to an account that charges a fixed percentage of assets under management, if the financial institution and adviser are “level fee fiduciaries” and other conditions are satisfied.
The DOL indicates in the preamble that the ongoing receipt of a “level fee” typically would not raise prohibited transaction concerns because the compensation is not tied to investment recommendations, but that there is a “clear and substantial” conflict of interest when advisers recommend investments in a level fee account if the adviser would not otherwise receive fees absent the investment. The DOL also emphasizes that it would be a non-exempt prohibited transaction to move a customer into a fee-based model that is not in the customer’s best interest.
Exemption for Principal Transactions
In addition to a number of changes that are generally consistent with certain changes to the Best Interest Contract Exemption, the DOL has broadened the types of assets that may be traded on a principal basis under the principal transactions exemption to include (1) purchases by a plan of Certificates of Deposit (CDs), interests in Unit Investment Trusts (UITs), and “debt securities” (which generally include corporate debt securities offered pursuant to a registration statement, treasury securities, agency securities, and asset-backed securities that are guaranteed by an agency or government sponsored enterprises), and (2) sales by a plan of “securities or other property,” which the DOL indicates corresponds to “the broad range of assets that can be recommended” by fiduciary advisers. The DOL did not expand the exemption to cover purchases of other types of investments, including municipal securities, currency, asset-backed securities, equities, derivatives, and bank note offerings.
Further, among other changes, the DOL did not adopt the requirement under the proposed rule that the pricing of the principal transaction be at least as favorable as the price offered by two unaffiliated counterparties. Instead, the final exemption requires advisers and financial institutions to seek to obtain the best execution reasonably available under the circumstances.
Prohibited Transaction Exemption 84-24. The final PTE 84-24 has been further limited to apply only to “fixed rate annuity contracts” and “insurance contracts,” specifically excluding purchases by a plan or IRA of variable annuity contracts, indexed annuity contracts, or similar contracts. The proposed rule would have excluded only IRA purchases of variable annuities and other annuities classified as securities. The DOL’s intention with this change is that purchases of variable and indexed annuity contracts by both plans and IRAs will be covered under the Best Interest Contract Exemption or the Seller’s Exception.
Upcoming Morgan Lewis Analyses
Due to the breadth and complexity of these changes and the numerous ways in which they may affect how services are provided to ERISA plans and IRAs, we are planning to issue a series of analyses on the regulation and exemptions that will provide more detailed information on the rule and potential impacts. View the DOL’s rule and related documents.
Past Morgan Lewis publications covering the DOL’s fiduciary definition rulemaking are available at the links below:
 The White House, Office of the Press Secretary, “Fact Sheet: Middle Class Economics: Strengthening Retirement Security by Cracking Down on Conflicts of Interest in Retirement Savings” (Apr. 6, 2016).