Implementing the DOL Fiduciary Rule

by Morrison & Foerster LLP - Broker-Dealer Compliance + Regulation


On June 9, 2017, key provisions of the fiduciary rule adopted by the Department of Labor (DOL) will become applicable for most broker-dealers, as well as many bankers, insurance agents, and others who make investment recommendations to retail retirement investors (the “Fiduciary Rule”).  As discussed below, only a portion of the Fiduciary Rule and related exemptions become applicable on June 9.  The DOL is conducting a re-evaluation of the Fiduciary Rule and related exemptions, as directed by President Trump.  Many expect substantial changes to result from this re-evaluation, although it is impossible to predict the ultimate outcome.  In the meantime, during the transition period starting on June 9, 2017 and expected to continue until at least January 1, 2018 (the “Transition Period”), broker-dealers and others must comply with those provisions that become operative on June 9.

What happens on June 9?

Starting on June 9, you will be deemed a “fiduciary” if, for compensation, you provide advice or recommendations to a retail retirement investor[1] about investments, investment strategies, or investment counsellors.[2]  This will be true even if you don’t have discretionary authority over the account and even if the advice is episodic and not part of an ongoing relationship.

What are the responsibilities of a fiduciary?

Generally speaking, fiduciaries are required to act in the best interest of the persons to whom they owe a fiduciary duty.  They owe a duty of undivided loyalty to those persons and they must exercise the care and skill which a prudent person would use in like circumstances.  Absent an available exemption, ERISA generally prohibits fiduciaries from acting as principals[3] and from receiving commissions or other forms of variable compensation when dealing with retail retirement accounts to whom they owe a fiduciary duty.

Are there available exemptions that would permit me as a fiduciary to receive commissions or act as a principal?

Also becoming applicable on June 9, 2017 are two new prohibited transaction exemptions adopted by the DOL: the Best Interest Contract Exemption (“BIC Exemption”) and the Principal Transactions Exemption (“Principal Transactions Exemption”).  Both the BIC Exemption and the Principal Transactions Exemption contain extensive requirements for compliance.  However, most of the conditions set forth in these new exemptions will not become applicable on June 9.  Rather, during the Transition Period, fiduciaries need only comply with the impartial conduct standards described in the exemptions (the “Impartial Conduct Standards”).  By complying with the Impartial Conduct Standards, fiduciaries may use the BIC Exemption during the Transition Period to receive commissions or other forms of variable compensation for transactions effected on an agency or riskless principal basis.[4]  By complying with the Impartial Conduct Standards, fiduciaries may use the Principal Transactions Exemption during the Transition Period to sell investment products to retail retirement accounts on a principal basis, provided that the transaction involves financial instruments that are within the limited scope of the Principal Transactions Exemption.[5]

What are the Impartial Conduct Standards?

The Impartial Conduct Standards require fiduciaries to:

  • Act in the “best interest” of the client.
  • Charge only reasonable compensation.
  • Avoid any misleading disclosures regarding investment products and fees and any material conflicts of interest that might affect the fiduciary.

Does compliance with FINRA suitability requirements satisfy my obligation to act in the best interest of the client?

Not necessarily.  The best interest standard is a rigorous standard that requires the fiduciary to recommend investment products that are in the “best interest” of the client without regard to the financial interests of the fiduciary.  While a range of investment products may be “suitable” for an investor, only a subset of the suitable products may meet the best interest standard.  The guidance issued by FINRA in Regulatory Notice 12-25 narrows the gap between “suitability” and “best interest” by providing that recommendations must be “consistent” with a customer’s “best interests.”  However, in adopting the Fiduciary Rule, the DOL declined to rely on the FINRA suitability standard, observing that the DOL requires fiduciaries to make investment recommendations that are guided solely by what is best for the retirement investor.  To meet this standard, a fiduciary should conduct thorough diligence on all investment products, comparing product features and fees with comparable products in order to evaluate which products are in the best interest of the client.  The basis of this conclusion should be documented.

What else should I do to meet the Impartial Conduct Standards?

In addition to thorough product diligence, fiduciaries relying on the Impartial Conduct Standards should:

  • Train sales personnel and supervisors to understand the differences between a “suitability” standard and a “best interest” standard.
  • Meet with their retail retirement investors on a regular basis, seeking an adequate understanding of the client’s current circumstances and objectives.
  • Evaluate the reasonableness of all compensation received by the firm for each investment product.
  • Evaluate internal compensation arrangements and revise if necessary to ensure that they do not improperly incentivize sales personnel to recommend products that are not in the best interest of retail retirement investors.
  • Monitor account activity with a view to detecting potential deviations from the new best interest standard.
  • Be certain to provide full and timely disclosure of material conflicts of interest.

As our readers know, many market participants commenced these processes at the time the DOL first announced its final rules.

May I sell proprietary products during the Transition Period?

Yes, but you should proceed with caution.  The BIC Exemption and guidance from the DOL contemplate that proprietary products may be sold.  However, the inherent conflicts of interest associated with proprietary products pose a challenge under the best interest standard.  A broker-dealer seeking to sell proprietary products to a retail retirement account should be certain that (i) the product compares favorably in terms of benefits and costs with competing products and (ii) the financial benefits to the firm, its affiliates, and its representatives are not incentivizing the selection of proprietary products over other products that would be better for the client.

Documentation of this analysis is particularly important for proprietary products.  In addition, timely disclosure should be made of the potential conflicts of interest relating to the recommendation of a proprietary product.

What are my obligations if I only charge a fee based on the value of assets in the account?

Broker-dealers or others who charge a fee based on assets under management or a similar standard are deemed “level fee fiduciaries.”  Their fee arrangements are permissible under ERISA and they are generally not required to comply with an exemption.  However, they are fiduciaries and, while not technically subject to the Impartial Conduct Standards, they are expected to act in the best interest of their clients and to avoid any unreasonable compensation.

Level fee fiduciaries may not receive any kind of transaction-based compensation, nor may they effect transactions on a principal basis with accounts that they service on a level-fee basis.

In addition, level fee fiduciaries advising clients on rollovers or other changes in the status of accounts will need to comply with the BIC Exemption, given the possibility that such advice may result in higher fees for the fiduciary.  Therefore, level fee fiduciaries should carefully analyze a client’s options before making any recommendations on rollovers or similar actions, and be certain to document the rationale for their recommendations.

What happens if I make mistakes during the Transition Period?

The DOL and the IRS have both indicated that they intend to focus on compliance assistance, rather than enforcement actions, during the Transition Period.  In this regard, the DOL has noted the difficulty of adjusting long-standing business practices to the new requirements.  The DOL is also aware of the variety of interpretative questions that have arisen under the rules.

While this approach is welcome, there are two important caveats:  First, the DOL position is premised on the fiduciary making good faith efforts to comply with the Fiduciary Rule.  Firms that ignore the requirements or are cavalier about their compliance efforts may be subjected to enforcement actions.  Secondly, the DOL position is not binding on private parties.  As pointed out by many commentators, broker-dealers who become fiduciaries on June 9 will be potentially vulnerable to customer complaints alleging breach of their fiduciary responsibilities.

[1] “Institutional” retirement accounts managed by banks, investment managers, broker-dealers, insurance companies, and other fiduciaries with at least $50 million under management should generally be exempt from the requirements of the Fiduciary Rule.

[2] General educational materials would not be deemed the type of advice that would trigger the fiduciary duty.

[3] Under the Investment Advisers Act of 1940, investment advisers (who are subject to a fiduciary duty) may not enter into principal transactions with their clients absent full disclosure and client consent on a transaction by transaction basis, subject to an opt-out right.

[4] The BIC Exemption is not available for transactions in which the fiduciary is acting on a principal basis, including transactions effected for the account of an affiliate.

[5] The Principal Transactions Exemption only covers Government and agency securities, CDs, UITs, and certain debt securities issued by U.S. companies in registered offerings.  The exemption is not available to underwriters.

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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