On April 14th, the US Department of Labor (“DOL”) issued a release requesting comment on a proposed rule designed to mitigate the effects of conflicts of interest by advisers to IRA and 401(k) accounts — the principal types of US self-directed retirement plans.
The comment period for the proposal ends on July 6, 2015, and a hearing is contemplated within 30 days after the close of the comment period.
If implemented, many retirement advisers, including registered broker-dealers and banks, providing such advice would become subject to a fiduciary standard to act in the best interests of their clients and to strictly manage conflicts of interest.
In order to permit the continuation of common fee and compensation practices, the DOL also proposed the adoption of a principles-based Best Interest Contract Exemption from its prohibited transaction rules:
“In order to protect the interest of plans, participants and beneficiaries, and IRA owners, the exemption requires the firm and the adviser to contractually acknowledge fiduciary status, commit to adhere to basic standards of impartial conduct, adopt policies and procedures reasonably designed to minimize the harmful impact of conflicts of interest, and disclose basic information on their conflicts of interest and on the costs of their advice.”
This exemption also bars the inclusion of certain disclaimers and exculpatory provisions in the contract governing the relationship, although it permits mandatory arbitration of disputes, similar in effect to FINRA requirements.
The result of the interaction of these requirements will have the effect of requiring many broker-dealers and banks to adopt a fiduciary standard with respect to these retirement accounts, causing major changes in the offering of affiliated products and services, compensation arrangements and compliance procedures. The Securities and Exchange Commission is also expected to consider later this year whether it will adopt a uniform fiduciary standard for investment advisers and broker-dealers making investment recommendations to their customers.
Subject to enumerated carve-outs, investment advice that will trigger fiduciary obligations is defined as the following activities conducted for any direct or indirect compensation, including compensation received by an affiliate:
“(1) providing investment or investment management recommendations or appraisals to an employee benefit plan, a plan fiduciary, participant or beneficiary, or an [IRA] owner or fiduciary, and (2) either (a) acknowledging the fiduciary nature of the advice or (b) acting pursuant to an agreement, arrangement, or understanding with the advice recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.”
The DOL suggested that the concept of a “recommendation” should be interpreted in a manner similar to recommendations under FINRA’s suitability requirements. Fiduciary investment advice would include advice regarding the investment of assets to be rolled over from other plans to IRAs and 401(k) plans in order to capture potential abuses in which advisers encourage the rollover from employer plans to new plans with greater costs or less attractive overall returns.
Covered advice would also be deemed to include individualized advice or recommendations as to proxy voting or other decisions related to ownership rights for securities, such as tender or exchange rights.
Recommendations on the selection of investment managers or advisers is also covered by the proposal.
The concept of indirect compensation includes compensation to an affiliate, so that, for example, if an adviser recommends a mutual fund advised by an affiliated adviser, the advisory fee earned by that adviser in respect of the referred client is consider indirect compensation to the adviser making the initial recommendation. Similarly, a broker receiving revenue sharing, mutual fund distribution fees or other compensation from the parties whose products they recommend would be considered to receive compensation in respect of their advice. These compensation arrangements could potentially be continued, but under stringent conditions afforded by the proposed Best Interest Contract Exemption. The DOL also stated that it is considering a more streamlined exemption for compensation received in connection with certain high-quality, low-fee investments.
Conditional carve-outs have been proposed for a number of arrangements where fiduciary responsibilities are not expected, including for general investment or retirement education, certain arm’s length transaction counterparties, employees of plan sponsors, platform providers, and persons who offer or enter into swaps with plans. The carve-out for arm’s length transaction counterparties is not available in respect of retail investors, such as IRA account-holders, since these investors are not considered to be adequately protected from the impact of conflict of interests and are often unable to assess the quality of advice that is received. This is also viewed as being true of small plan sponsors.
A prohibited transaction exemption with similar conditions to the Best Interest Contract Exemption has also been proposed by the DOL to permit the sale of fixed income securities to these retirement accounts from inventory, in permissible principal transactions, subject to additional assurance that the client is receiving the best price that would have been available from an unaffiliated counterparty and with full disclosure of the compensation received in respect of each transaction.
Certain existing prohibited transaction exemptions are also being modified to apply their conditions affirmatively to IRAs. For example, the exemption that allows an adviser to use an affiliated broker to receive commissions for executing a transaction has a condition that transactions not occur in excessive amount or frequency. This exemption also, subject to a number of substantive and disclosure requirements, permits certain agency cross transactions. These conditions are proposed to be extended to transactions involving IRAs. The Best Interest Contract Exemption would exclusively govern compensation to investment advice fiduciaries to IRA owners.
Certain other prohibited transaction exemptions to facilitate sales of other investment products, including mutual fund shares and annuities, from affiliated entities are proposed to be amended along similar lines.