The Ins and Outs of the DOL’s Best Interest Contract Exemption

W. Scott Simon is a principal at Prudent Investor Advisors, a registered investment advisory firm. He also provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. Simon is the recipient of the 2012 Tamar Frankel Fiduciary of the Year Award.

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By the time you read this month's column, we may (or may not) know the ultimate fate of the Conflict of Interest Rule (Rule) which was issued by the U.S. Department of Labor (DOL) on April 8, 2016. With an "applicability date" of April 10, 2017, the best guess as of this writing is that the Rule will remain in limbo for another six months or so, after which time it will be left as is, modified in some way, or outright extinguished.

In the meantime, I'll continue my analysis of the Rule as it was written for applicability on April 10.

The Best Interest Contract Exemption Under the Employee Retirement Income Security Act of 1974 (ERISA), fiduciaries cannot (1) breach the fiduciary duties they owe to plans and plan participants (and their beneficiaries), or (2) engage in prohibited transactions involving self-dealing or receive compensation from third parties for transactions involving a plan or IRA assets.

The Best Interest Contract Exemption (BICE) allows fiduciaries to receive variable compensation which ordinarily violates the prohibited transaction rules, since any investment advice rendered could be affected adversely by receipt of this kind of compensation. Such compensation includes: (1) commissions paid by a plan, a plan participant (or its beneficiaries), or an IRA, and (2) sales loads, 12b-1 fees, revenue-sharing or other payments, and commissions from third parties providing investment products.

The BICE, which is a key feature of the Rule, allows advisors a broad mandate in how they want to be compensated. Everything is hunky-dory in this respect as long as an advisor promises to act in a client’s best interest, is prudent and loyal (two critical fiduciary duties), and doesn’t charge unreasonable compensation.

Remember, though, that the BICE is not available to fiduciaries that receive variable compensation in exchange for rendering discretionary investment advice pursuant to ERISA section 3(21)(A)(i). For example, assume that an ERISA section 3(38) investment manager (a "kind" of ERISA section 3(21)(A)(i) plan fiduciary) has the power to invest IRA assets without approval from the IRA owner. If the manager earns any compensation, it would violate the prohibited transaction rules. And the manager couldn't obtain protection from the BICE because it’s providing discretionary--rather than non-discretionary--advice.

The Rule, then, is not concerned with discretionary fiduciaries but with non-discretionary ones pursuant to ERISA section 3(21)(A)(ii). All three elements described in that section--a fiduciary (element 1) that renders (non-discretionary) investment advice (element 2) for compensation (element 3)--must be present in order for the Rule to apply to an advisor communicating with a plan participant or an IRA owner.

Only Financial Institutions May Utilize the BICE Only eligible Financial Institutions may utilize the BICE in rendering investment advice to retail retirement investors. The Rule defines "Financial Institutions" as (1) registered investment advisors (the commonly used term rather than the legal term of "adviser"), broker/dealers, banks and insurance companies; and (2) their respective employees, contractors, agents, representatives, affiliates and related entities. "Retail retirement investors" are defined as (1) ERISA plans (holding less than $50 million in assets; i.e., unsophisticated investors), (2) plan fiduciaries and plan participants (and their beneficiaries), (3) non-ERISA plans such as Keogh plans, IRAs, IRA fiduciaries, HSAs, Archer medical savings accounts and Coverdell education savings accounts.

The Rule does not pertain to investment advice that's rendered to 529 plans, non-ERISA 403(b) plans, 457 plans or non-qualified, non-ERISA plans. The BICE is irrelevant in such cases.

Requirements of Financial Institutions Utilizing the BICE A Financial Institution generally must file a one-time notice with the DOL that it's utilizing the BICE. There's no need, however, to specifically identify any plan or IRA, nor is DOL approval required. Financial Institutions seeking to rely on the protections of the BICE are required to:

• Adopt "Impartial Conduct Standards," which must:
• Adhere to a Best Interest Standard similar to ERISA's fiduciary duties, including: prudent advice which is based on the investment objectives, risk tolerance, financial circumstances and needs of a retail retirement investor;
• Such advice must be rendered without regard to financial or other interests of the advisor, Financial Institution, or their affiliates, related entitles or other parties;
• Bar recommendations of transactions that will result in the receipt of unreasonable compensation; and
• Prohibit materially misleading statements.

Adopt "Anti-Conflict Policies and Procedures," which cannot allow:

1. Material conflicts of interest that cause advisors to violate the Impartial Conduct Standards; or

2. The use of compensation, personnel or other actions that incentivizes advisors to make recommendations not in the best interest of retail retirement investors.

In addition:

• Anti-conflict policies and procedures must be in writing and readily available free of charge to retail retirement investors on the Financial Institution's website;
• Any material conflicts of interest in a transaction must be described;
• Recommendations of proprietary products and those that generate third party payments must be disclosed; and
• A retail retirement investor must be informed that it may obtain disclosure of detailed costs, fees or any other compensation in a transaction--but only if such investor requests it.

The Best Interest Contract There are certain situations in which a simplified or streamlined version of the BICE--a "best interest contract" (BIC)--applies when investment advice is rendered.

There are four versions of a BIC: (1) a full-blown BIC, (2) a disclosure BIC, (3) BIC Lite, and (4) a transition BIC. Only a Full-Blown BIC requires a formal written contract while the other BIC versions require only assorted disclosures, representations and the like--although these are important and can be extensive.

A Full-Blown BIC Pertains to IRAs and Applicable Non-ERISA Plans

What's commonly referred to as a "Full-Blown" BIC pertains to situations where an advisor gives advice to IRAs and applicable non-ERISA plans which do not have the protections of ERISA.

• The terms that a Financial Institution must include in a Full-Blown BIC include:
• A statement of the fiduciary Best Interest Standard of care;
• An acknowledgement of fiduciary status in writing;
• General disclosures on compensation and potential conflicts of interest;
• Compliance policies that mitigate conflicts of interest;
• Detailed compensation figures--but only if requested by a retail retirement investor;
• Mandatory transaction disclosures for each investment made that focus on fiduciary standards and conflicts;
• Mandatory arbitration with reasonable venue (e.g., not in Fairbanks, AK, unless a resident of AK); and
• No language limiting a retail retirement investor's class action rights.

A Financial Institution must also make available on its website descriptions of any conflicts of interest and the advisor’s business model.

A Disclosure BIC Pertains to ERISA Plans What's commonly referred to as a "Disclosure" BIC pertains to situations where an advisor gives advice to ERISA plans. In such cases, an advisor isn't required to sign a written contract since an enforcement mechanism to police any such advice that may be imprudent is already found in ERISA section 502(a)(2) and (3), which contains a direct right of action against a plan fiduciary for a prohibited transaction or breach of fiduciary duty. What is required is a written statement of the plan fiduciary's compensation and fiduciary status. An advisor is also required to provide the same general disclosures on compensation and potential conflicts of interest as under the Full-Blown BIC.

A BIC Lite for Level Fee Fiduciaries The DOL defines a ''level fee'' as a "fee or compensation that is provided on the basis of a fixed percentage of the value of the assets or a set fee that does not vary with the particular investment recommended, rather than a commission or other transaction-based fee."

What's commonly referred to as a "BIC Lite" pertains to situations where the only fee received by a Financial Institution, an advisor, or any affiliate in connection with advisory or investment management services to a retirement plan or IRA assets is a level fee. Fee levelization eliminates the prohibited transaction (i.e., no variable compensation is present) to begin with, so there’s no conflict of interest which removes the need for a Full-Blown BIC.

And yet, even a fee-only advisor is prone to a conflict in an IRA rollover situation where it suggests to an investor that the investor roll over assets into an account that will pay the advisor higher fees as a result. In this kind of situation, a BIC Lite may be utilized.

A BIC Lite can apply in cases where a level-fee advisor has an existing relationship with a retirement plan or even where the advisor solicits participants not connected with the plan for IRA rollover services.

An advisor relying on a BIC Lite is required to provide a written statement of fiduciary status and a written rationale for why its recommendation is in the best interest of the retail retirement investor. But no written contract is necessary nor are other disclosures, nor is there the need for, say, compliance policies.

Financial Institutions are still required to acknowledge fiduciary status in writing and adhere to standards of fiduciary conduct such as the Impartial Conduct Standards and Anti-Conflict Policies and Procedures.

A Transition BIC

A transition BIC is available to advisors that wish to utilize a Full-Blown BIC but will not be able to comply with its requirements by April 10. In general, numerous requirements applicable to other BIC versions are waived until January 1, 2018. But first, we have to get through 2017 to see what the ultimate fate of the Rule will be.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.