Proposed Best Interest Contract Prohibited Transaction Exemption

Practical Law Legal Update 4-608-9145 (Approx. 15 pages)

Proposed Best Interest Contract Prohibited Transaction Exemption

by Practical Law Employee Benefits & Executive Compensation

Background

ERISA Sections 406(a)(1)(D) (29 U.S.C. § 1106(a)(1)(D)) and 406(b) (29 U.S.C. § 1106(b)) and Sections 4975(c)(1)(D), (E) and (F) of the Internal Revenue Code (Code) prohibit a fiduciary from engaging in transactions where there is a risk that the fiduciary's exercise of its judgment may be either:

Affected by its own interests.
Potentially adverse to the interests of the plan or plan participants and beneficiaries.

(See Practice Note, Prohibited Transactions and Exemptions under ERISA and the IRC: ERISA Section 406(b): Self-dealing Prohibited Transactions.)

Without an exemption, compensation received by a fiduciary investment adviser from an investment product provider for transactions involving employee benefit plan assets or IRA assets would be prohibited since the fiduciary investment adviser's advice could be influenced by the compensation they receive, creating a conflict of interest.

Reproposal of Fiduciary Rule for ERISA Plans and IRAs

Under the proposed rule that replaces the existing regulatory interpretation of fiduciary investment advice under ERISA Section 3(21), the type of advice that constitutes fiduciary investment advice is broadened, subject to specific carve-outs for particular types of communications that are non-fiduciary in nature (see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs).

The proposed PTE was issued in connection with the proposed rule to permit investment advice fiduciaries to receive reasonable compensation when plan participants and beneficiaries, IRA owners and certain small plans purchase, hold or sell certain investment products in accordance with the fiduciaries' advice. The DOL also proposed another PTE directed at principal transactions (see Legal Update, Proposed Principal Transactions Prohibited Transaction Exemption) along with amendments to several existing PTEs (see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs: Prohibited Transaction Exemptions).

Proposed Best Interest Contract Exemption

The proposed PTE allows certain investment advice fiduciaries (including broker-dealers and insurance agents) to receive various forms of compensation to facilitate the continued provision of advice to retail investors. In the past, the regulatory approach has been to create transaction specific PTEs, but the proposed PTE was drafted to accommodate a wide range of business practices as long as certain standards are met.

The proposed PTE:

Permits the receipt of compensation (that is otherwise prohibited) by advisers (see Advisers), financial institutions (see Financial Institutions) and their associated financial institutions, affiliates and other related entities (see Advisers, Financial Institutions and Their Affiliates and Related Entities) who provide investment advice to retirement investors (see Retirement Investors), in connection with the retirement investor's purchase, sale or holding of an asset (see Assets).
Excludes the receipt of compensation for certain transactions (see Transactions Not Covered by the PTE).
Requires the adviser and financial institution to comply with certain conditions, including:
- entering into a contract that acknowledges fiduciary status; and
- adhering to certain impartial conduct standards.
(See Contractual Obligations Applicable to the PTE.)
Applies to the following types of compensation:
- commissions paid directly by the plan or IRA;
- commissions, trailing commissions, sales loads, 12b-1 fees, and revenue sharing payments paid by the investment providers or other third parties to advisers and financial institutions; and
- other payments, such as investment management fees or administrative service fees from an investment vehicle in which the retirement investor invests.
Requires certain disclosures be made (see Disclosure Requirements).
Requires a financial institution to offer a broad range of investment options and imposes certain requirements if this range is limited (see Range of Investment Options).
Requires additional disclosures be made to the DOL's Employee Benefits Security Administration (EBSA) and certain recordkeeping requirements be met (see EBSA Disclosure and Recordkeeping).
Contains certain exemptions from the proposed PTE (see Supplemental Exemptions)

Advisers, Financial Institutions and Their Affiliates and Related Entities

The proposed PTE permits advisers (see Advisers), financial institutions (see Financial Institutions) and their affiliates and related entities (see Affiliates and Related Entities) to receive compensation from advising plans and IRAs (see Retirement Investors) to purchase, hold or sell investment products in reliance on that advice.

Advisers

The adviser:

Is an investment advice fiduciary of a plan or IRA who is an:
- employee;
- independent contractor;
- agent; or
- registered representative of a financial institution.
Must satisfy the applicable federal and state regulatory and licensing requirements of insurance, banking and securities laws for the receipt of the compensation.

For guidance on who is considered an investment advice fiduciary, see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs. Advisers are not limited to registered investment advisers under the Investment Advisers Act of 1940.

Financial Institutions

A financial institution:

Is an entity that employs an adviser or otherwise retains the adviser as an independent contractor, agent or registered representative.
Must be a registered investment adviser, bank, insurance company or registered broker-dealer.

Affiliates and Related Entities

An affiliate is any:

Person directly or indirectly through one or more intermediaries, controlling, controlled by, or under common control with the adviser or financial institution (see Practice Note, Controlled Group and Affiliated Service Group Rules).
Officer, director, employee, agent, registered representative, relative, member of family, or partner in the adviser or financial institution.
Corporation or partnership of which the adviser or financial institution is an officer, director or employee or in which the adviser or financial institution is a partner.

A related entity is any entity other than an affiliate in which an adviser or financial institution has an interest that may affect the exercise of its best judgment as a fiduciary.

Retirement Investors

Retirement investors are persons who can be investment advice recipients under the proposed PTE, including a:

Participant or beneficiary of an ERISA-governed participant-directed retirement plan with authority to direct the investment of assets in his plan account or to take a distribution.
Beneficial owner of an IRA.
Plan sponsor of a non-participant directed ERISA plan that has fewer than 100 participants.

Large ERISA plans, defined as those with more than 100 participants, are not eligible for relief as a retirement investor under this proposed PTE. However, the DOL has separately carved-out a seller's exception in the proposed rule for plans that have more than 100 participants (see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs: The Seller's Exception).

Transactions Not Covered by the PTE

The PTE does not apply to the receipt of compensation from a transaction involving an:

ERISA plan if the adviser, financial institution or affiliate is the employer of employees covered by the ERISA plan. This restriction does not include transactions with IRAs.
Adviser or financial institution that is a named fiduciary or plan administrator for an ERISA plan, or an affiliate of an ERISA plan, that was selected to provide advice to the plan by a fiduciary who is not independent of them.
Adviser that engages in a "principal transaction" with the plan, participant or beneficiary account, or IRA. There is a separate proposed PTE for principal transactions (see Legal Update, DOL Reproposes Fiduciary Rule for ERISA Plans and IRAs: Prohibited Transaction Exemptions).
Adviser or financial institution as a result of investment advice that is generated solely by an interactive website in which computer software-based models or applications provide investment advice to retirement investors based on personal information each investor supplies through the website without any personal interaction or advice from an individual adviser (also known as robo-advice).
Advisers who have:
- full investment discretion for an ERISA plan or IRA assets; or
- discretionary authority over the administration of the plan or IRA.

Assets

Compensation that falls outside the definition of assets are not covered by the PTE. The proposed PTE defines assets as:

Bank deposits.
CDs.
Shares or interests in registered investment companies.
Bank collective funds.
Insurance company separate accounts.
Exchange-traded real estate investment trusts (REITs).
Exchange-traded funds.
Corporate bonds offered under a registration statement under the Securities Act of 1933.
Agency debt securities as defined in FINRA Rule 6710(p) or its successor.
US Treasury securities as defined in FINRA Rule 6710(p) or its successor.
Insurance and annuity contracts.
Guaranteed investment contracts.
Equity securities within the meaning of 17 C.F.R. Section 230.405 that are exchange-traded funds within the meaning of 17 C.F.R. Section 242.600, but not:
- security futures;
- puts;
- calls;
- straddles; or
- any other option or privilege of buying an equity security from or selling an equity security to another without being bound to do so.
Other types of investments that are not covered by the PTE but that can be obtained through other means such as through pooled investment funds.

Contractual Obligations Applicable to the PTE

Under the proposed PTE, the adviser and financial institution must enter into a written contract with the retirement investor before recommending that the ERISA plan, participant or beneficiary account, or IRA, purchase, sell or hold an asset, in which the adviser and financial institution:

Acknowledge their fiduciary status.
Commit to adhere to basic standards of impartial conduct (see Standards of Impartial Conduct).
Warrant that they have adopted policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest (see Contractual Warranty Regarding Policies and Procedures).
Disclose basic information on their conflicts of interest and on the cost of their advice (see Contractual Obligations).

The adviser and the financial institution must commit to fundamental obligations of fair dealing and fiduciary conduct and must:

Give advice that is in the customer's best interest.
Avoid misleading statements.
Receive no more than reasonable compensation.
Comply with applicable federal and state laws governing advice.

The proposed PTE also prohibits certain provisions from inclusion in the contract (see Prohibited Provisions).

Standards of Impartial Conduct

Relief under the proposed PTE is only available if the adviser or financial institution adheres to standards of impartial conduct. This means that the adviser or financial institution must:

Provide advice regarding assets that is in the best interest of the retirement investor based on the standard in ERISA Section 404 (29 U.S.C. § 1104(c) and see Practice Note, ERISA Fiduciary Duties: Overview). This means that the adviser and financial institution, in providing advice to the retirement investor, must act with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent person would exercise based on:
- investment objectives;
- risk tolerance;
- financial circumstances; and
- needs of the retirement investor.
Agree that they will not recommend an asset if the total amount of compensation anticipated to be received exceeds reasonable compensation in relation to the total services provided to the applicable retirement investor based under the standard in ERISA Section 408(b)(2) and applicable regulations (29 U.S.C. § 1108(b)(2) and see Practice Note, Service Provider Disclosure Requirements for Pension Plans).

Contractual Warranty Regarding Policies and Procedures

The adviser and financial institution must contractually warrant that they have adopted written policies and procedures (see Policies and Procedures) reasonably designed to mitigate the impact of material conflicts of interest that exist for the provision of investment advice to retirement investors and ensure that individual advisers adhere to the impartial conduct standards (see Standards of Impartial Conduct).

A material conflict of interest exists when an adviser or financial institution has a financial interest that could affect the exercise of its best judgment as a fiduciary in rendering advice to a retirement investor regarding an asset.

Policies and Procedures

In formulating its policies and procedures, the financial institution must state that it:

Specifically identified material conflicts of interest.
Adopted measures to prevent the material conflicts of interest from causing violations of the impartial conduct standards (see Standards of Impartial Conduct). The PTE also states that financial institutions may consider designating someone (including an internal compliance officer or committee) to be responsible for addressing material conflicts of interest.
Will not use quotas, appraisals, performance or personnel actions, bonuses, contests, special awards, differentiated compensation or other actions or incentives to the extent they would tend to encourage individual advisers to make recommendations that are not in the best interest of retirement investors.

The financial institution's policies and procedures must not authorize compensation or incentive systems that would encourage individual advisers to make recommendations that are not in the best interest of retirement investors. One way to comply with this requirement is to adopt a level-fee structure.

In a level-fee structure compensation for advisers does not vary based on the particular investment product recommended. The proposed PTE includes examples of other approaches to compensation structures that could help satisfy the contractual warranty regarding policies and procedures.

The PTE also includes a list of items that a financial institution may consider in adopting effective policies and procedures relating to an adviser's compensation, including:

Avoiding creating compensation thresholds that enable an adviser to increase his compensation disproportionately through an incremental increase in sales.
Monitoring activity of advisers approaching compensation thresholds. For example:
- higher payout percentages;
- back-end bonuses; or
- participation in a recognition club (for example, a president's club).
Maintaining neutral compensation grids that pay the adviser a flat payout percentage regardless of the product type sold.
Refraining from providing higher compensation or other rewards for the sale of proprietary products or products for which the firm has entered into revenue sharing agreements.
Stringently monitoring recommendations around key liquidity events in the investor's lifecycle where the recommendation is particularly significant (for example, when an investor rolls over his pension or 401(k) account).
Developing metrics for good and bad behavior and using clawbacks of deferred compensation for employees who do not properly manage conflicts of interest.

Contractual Obligations

Relief under the proposed PTE is not available unless certain disclosures are made by the financial institution and adviser in the contract. The written contract should:

Identify any material conflicts of interest. This can be a general description of the types of material conflicts that are applicable, so long as the disclosure informs the retirement investor that a more specific description is available on the financial institution's website and by mail on request.
Inform the retirement investor of the right to complete information. This information must include all of the fees associated with the assets in which it is invested, including the fees payable to the adviser, financial institution, and any affiliates and related entities in connection with these investments. The fee information must:
- be complete; and
- include both the direct and the indirect fees paid by the plan or IRA.
Disclose proprietary products. Disclose to the retirement investor whether the financial institution offers proprietary products or receives third-party payments for the purchase, sale or holding of any asset.
Provide a webpage for more information. Provide the address of a webpage that discloses the compensation arrangements entered into by the adviser and the financial institution.

Prohibited Provisions

The proposed PTE prohibits certain provisions from inclusion in the contract. If any of these provisions appear in a contract with a retirement investor, the PTE is not satisfied for the transactions involving the retirement investor. The contract may not contain:

Indemnifications. The contract may not contain exculpatory provisions that disclaim or limit liability for an adviser's or financial institution's violation of the contract terms.
Waiver of class actions. The contract may not require the retirement investor to agree to waive or qualify its right to bring or participate in a class action or other representative action in court in a contract dispute with the adviser or financial institution.

Disclosure Requirements

Before retirement investors may purchase an asset based on advice from the adviser, the proposed PTE requires both public disclosure and disclosure to retirement investors of certain information, including:

A webpage (see Webpage).
Individual transactional disclosures (see Individual Transactional Disclosure).
Individual annual disclosures (see Individual Annual Disclosure).

Webpage

The financial institution must maintain a public webpage that shows the direct and indirect material compensation payable to the adviser, financial institution and any affiliate for services provided in connection with each asset that a plan, participant or beneficiary account, or an IRA:

Is able to purchase, hold or sell through the adviser or financial institution.
Has purchased, held or sold within the last 365 days.

The webpage must also:

Include the source of the compensation.
Include how the compensation varies within and among asset classes.
Be updated at reasonable intervals not less than quarterly.
Be easily accessible to a retirement investor and the public.
Be formatted in a machine-readable manner.

The compensation can be expressed as a monetary amount, formula or percentage of assets involved in the purchase, sale or holding. The proposed PTE contains an Appendix that is an example of a possible web disclosure.

Individual Transactional Disclosure

Certain disclosures must be made to the retirement investor before the investment transaction in the form of a chart. The chart is designed to:

Make clear the total cost (see Total Cost) that the plan, participant or beneficiary account, or IRA will incur when following the adviser's recommendation.
Show the projection of the costs over various holding periods to inform the retirement investor of the cumulative impact of the costs over time and of the potential costs when the investment is sold.

The chart must:

Contain the all-in cost and anticipated future cost of recommended assets.
Direct the investor's attention to important data points regarding fees in a time frame that enables the investor to discuss other alternatives with the adviser before executing the transaction. This chart is not required to be provided again for subsequent recommendations for the same investment product as long as it was provided within the past 12 months and the total cost (see Total Cost) has not materially changed. The chart must also disclose:
- for each recommended asset, the total cost (see Total Cost) to the retirement investor expressed as a dollar amount; and
- reasonable assumptions about investment performance.

In creating this chart, advisers and financial institutions may generally rely in good faith on information provided by other parties if the adviser and financial institution:

Do not know that the materials are incomplete or inaccurate.
Meet specific criteria so that they are not "related" to the entity providing the information. This means that the good faith reliance applies unless the entity providing the information to the adviser and financial institution is:
- a person directly or indirectly through one or more intermediaries, controlling, controlled by, or under common control with the adviser or financial institution; or
- any officer, director, employee, agent, registered representative, relative of, or partner in, the adviser or financial institution.

This chart is not required for insurance and annuity contracts that are securities under federal securities law (for example, variable annuities) and insurance and annuity contracts that are not securities (for example, fixed annuities).

Total Cost

The chart must disclose for each asset, the total cost to the plan, participant or beneficiary account, or IRA of the investment for one, five and 10-year periods expressed as a dollar amount, assuming an investment of the dollar amount recommended by the adviser and reasonable assumptions about investment performance which must be disclosed.

The total cost of investing in an asset means the sum of the following:

Acquisition costs.
Ongoing costs.
Disposition costs.
Any other costs that:
- reduce the asset's rate of return;
- are paid by direct charge to the plan, participant or beneficiary account, or IRA; or
- reduce the amounts received by the plan participant or beneficiary account, or IRA.

Individual Annual Disclosure

Certain information must be provided to the retirement investor in the form of annual disclosure that is intended to show the retirement investor the impact of the cost of the adviser's advice on the investments by the plan, participant or beneficiary account, or IRA. This disclosure must:

Be provided to each retirement investor within 45 days of the end of the applicable year.
Include the following:
- a list identifying each asset purchased or sold during the applicable period and the price at which the asset was purchased or sold;
- a statement of the total dollar amount of all fees and expenses paid by the plan, participant or beneficiary account, or IRA, both directly and indirectly, for each asset purchased, held or sold during the applicable period; and
- a statement of the total dollar amount of all compensation received by the adviser and financial institution, directly or indirectly, from any party, as a result of each asset sold, purchased or held by the plan, participant or beneficiary account, or IRA, during the applicable period.

This annual disclosure is not required for insurance and annuity contracts that are securities under federal securities law (for example, variable annuities) and insurance and annuity contracts that are not securities (for example, fixed annuities).

Range of Investment Options

The proposed PTE requires a financial institution to offer, and the adviser to make available to the retirement investor, a broad range of investment options for the transaction. If this range is limited, a financial institution may still rely on the PTE, provided:

Before limiting the investment products the financial institution must make a specific written finding that the limitations do not:
- prevent the adviser from providing advice that is in the best interest of the retirement investors (this means that the advice reflects the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the objectives, risk tolerance, financial circumstances, and needs of the retirement investor, without regard to the financial or other interests of the adviser, financial institution or any affiliate, related entity or other party or from otherwise adhering to the impartial conduct standards); or
- from otherwise adhering to the impartial conduct standards (see Standards of Impartial Conduct).
The payments received in connection with the limited investment menus are reasonable in relation to the value of the specific services provided to retirement investors in exchange for the payments and not in excess of the services' fair market value.
A clear written notice is given to the retirement investor of any limitations placed by the financial institution on the investment products offered by the adviser before giving any recommendations. It is insufficient for the notice to state that the financial institution may limit investment recommendations, without specifically disclosing the extent to which the financial institution in fact does so.
The financial institution or adviser must notify the retirement investor if the adviser does not recommend a sufficiently broad range of investment options to meet the retirement investor's needs. For example, a notice might be required if advice is provided for a limited class of investment products that do not meet a particular investor's needs.

These requirements do not apply if the adviser and financial institution did not provide advice to the responsible plan fiduciary regarding the menu of designated investment options.

EBSA Disclosure and Recordkeeping

As part of the proposed PTE, the DOL requires:

Disclosure be made to EBSA of the intention to rely on the PTE by e-mail or regular mail. The notice does not need to identify any specific plan or IRA and remains in effect until revoked in writing.
Certain records be maintained for six years from the date of the applicable transaction. This includes information regarding purchases, sales and holdings by retirement investors made in connection with advice provided by advisers and financial institutions relying on the proposed PTE.
Financial institutions to keep records necessary for the DOL and certain other entities to determine whether the conditions of the PTE are satisfied.

Enforcement of the Contractual Obligations

The DOL recognizes in the proposed PTE that the obligations in the PTE create different rights for:

IRA owners (see IRA Owners).
Plans, participants and beneficiaries (see Plan, Plan Participants and Beneficiaries).
The DOL (see DOL).

If violated, the contractual obligations can give rise to non-exempt prohibited transactions by the investment advice fiduciary (or other contractual claims by retirement investors).

Advisers and financial institutions that engage in prohibited transactions may be subject to:

Civil penalties under ERISA Section 502(i) (29 U.S.C. § 1132(i)) of up to 5% of the amount involved for each year (or part of a year) that the prohibited transaction continues.
Criminal penalties.
Excise taxes under the Code.

For more information, see Practice Note, Prohibited Transactions and Exemptions under ERISA and the IRC: ERISA Section 406(b): Self-dealing Prohibited Transactions.

IRA Owners

The proposed PTE creates new, actionable contractual obligations for IRA owners, including the:

Impartial conduct standards (see Standards of Impartial Conduct).
Contractual warranties regarding policies and procedures (see Contractual Warranty Regarding Policies and Procedures).

For example, the IRA owner would have a contract claim if the adviser recommends an investment product not in the best interest of the IRA owner.

Plan, Plan Participants and Beneficiaries

The protections in the proposed PTE and contractual requirements are enforceable by plans, plan participants and beneficiaries. For example, if an adviser or financial institutional receives compensation in a prohibited transaction but fails to satisfy any of the impartial conduct standards (see Standards of Impartial Conduct) or any other condition of the PTE, the adviser and financial institution would not be able to qualify for relief under the PTE and could be liable under ERISA.

The adviser's failure to comply with the impartial conduct standards (see Standards of Impartial Conduct) results in a non-exempt prohibited transaction constituting a fiduciary breach in which a plan, plan participant or beneficiary would be able to sue under ERISA. Plans, participants and beneficiaries would also be permitted to sue based on breach of the agreement.

DOL

If any of the conditions of the proposed PTE are not met, there would be a non-exempt prohibited transaction in which the DOL would be entitled to seek relief under ERISA.

Supplemental Exemptions

The PTE provides for two proposed supplemental exemptions:

Insurance and annuity exemption (see Insurance and Annuity Exemption).
Exemption for pre-existing transactions (see Exemption for Pre-Existing Transactions).

Insurance and Annuity Exemption

A plan's or IRA's purchase of an insurance or annuity product would be a prohibited transaction if the insurance company has a pre-existing relationship with the plan or IRA as a service provider or is otherwise a party in interest or a disqualified person. However, the DOL has provided an exemption for these transactions as long as:

The transaction is in the insurance company's ordinary course of business.
The combined total of all fees and compensation received by the insurance company is not in excess of reasonable compensation under the circumstances.
The purchase if for cash only.
The terms of the purchase are at least as favorable to the plan as the terms generally available in an arm's length transaction with an unrelated party.

Exemption for Pre-Existing Transactions

The proposed PTE contains a proposed exemption for advisers, financial institutions and their affiliates and related entities in connection with transactions that occurred prior to the applicability date of the proposed regulation, if adopted. This exemption provides relief from ERISA Section 406(a)(1)(D) and 406(d) for the receipt of prohibited compensation, after the applicability date of the regulation, by an adviser, financial institution and any affiliate or related entity for services provided in connection with the purchase, sale or holding of an asset before the applicability date.

There is another proposed exemption for advisers and financial institutions that:

Were considered fiduciaries before the applicability date.
Entered into transactions involving plans and IRAs before the applicability date in accordance with the terms of a prohibited transaction exemption that has since been amended.

This would permit advisers, financial institutions, and their affiliates and related entities, to receive compensation after the applicability date, that is attributable to a purchase, sale or holding of an asset by a plan participant or beneficiary account, or an IRA, that occurred prior to the applicability date.

Practical Implications

Under the proposed PTE, broker-dealers and insurance agents will be permitted to receive compensation in connection with investment advice to retirement investors if they satisfy certain requirements, including:

Acknowledging fiduciary status.
Contracting with their retirement investors that they will act in the best interest of retirement investors and can be held liable for breaching that contract.
Developing policies and procedures reasonably designed to mitigate conflicts of interest.
Complying with various new disclosure requirements to explain fees clearly.

These proposed requirements are significant and create a substantial burden on many investment advisers including an increase in compliance costs. Many of the requirements in the proposed PTE may be subject to significant revisions after the comment period and public hearings. The proposed regulations may lead to fee arrangements that are fixed and not contingent on the type of investments recommended.

The new standards for IRA fiduciaries provides IRA owners with new protections but it is unclear how these provisions will be enforced since the DOL does not have enforcement authority over IRAs. It is possible that many IRA fiduciaries may stop providing investment advice when the final regulations are issued.

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