DOL Final “Investment Advice” Regulation

On April 6, 2016, the Department of Labor (the “DOL”) promulgated final regulations (the “Final Regulations”) defining the circumstances in which a person will be treated as a fiduciary under both the Employee Retirement Income Security Act of 1974 (“ERISA”) and Section 4975 of the Internal Revenue Code (the “Code”) by reason of providing investment advice to retirement plans and individual retirement accounts (“IRAs”). As part of the regulatory package, the DOL also released final versions of prohibited transaction class exemptions (“PTEs”) intended to minimize the industry disruptions that might otherwise result from the Final Regulations, most notably, the so-called “Best Interest Contract Exemption” (the “BIC Exemption”) and the “Principal Transaction Exemption.”

While the Final Regulations address many of the troublesome aspects of the proposed regulations and PTEs that were issued on April 14, 2015 (collectively, the “Proposed Regulations”), the primary effect of the Proposed Regulations—more broadly subjecting financial service providers to the fiduciary rules under ERISA and the Code—remains unchanged. As a consequence, the Final Regulations can be expected to have a significant impact.

The Final Regulations will not be effective until April 10, 2017. Further, as described below, the requirements of the BIC Exemption and the Principal Transaction Exemption will be modified during a transition period from April 10, 2017 to January 1, 2018.

As discussed in more detail below, under current law (in effect until April 10, 2017), investment advisers to IRAs or plans generally are not treated as fiduciaries for purposes of ERISA and the Code unless the advice is provided pursuant to a mutual agreement that the plan or IRA would primarily rely on the advice in making investment decisions. Since many common client relationships do not meet these standards (such as typical retail brokerage arrangements), many financial services providers are not classified as fiduciaries under current law and therefore (1) may receive commission income, revenue-sharing payments or other similar forms of compensation that would otherwise be prohibited by ERISA and the Code, and (2) are not subject to fiduciary claims under ERISA. Under the Final Regulations, it is significantly more likely that an investment adviser to a plan or IRA will be treated as a fiduciary of the plan or IRA and, accordingly, will not be permitted under ERISA and the Code to receive such income or payments unless the financial services provider satisfies the BIC Exemption or Principal Transaction Exemption. Furthermore, these exemptions, when applicable, will enable an IRA to bring a fiduciary claim against an investment adviser. In addition, in the case of plans that are subject to ERISA, the general ERISA rules will entitle the DOL and plan to bring a fiduciary claim against an investment adviser that is a fiduciary of the plan.

Broadly speaking, under the Final Regulations:

• Many common types of investment “recommendations” made to plans and IRAs that are not currently subject to the rules governing fiduciaries under ERISA or the Code will constitute fiduciary investment advice. As a consequence, many financial service providers who provide such recommendations that formerly were not ERISA fiduciaries will become fiduciaries and will be subject to ERISA fiduciary standards of care and/or the prohibited transaction rules.
• Widely used compensation arrangements in the retail financial services industry—such as sales commissions, revenue-sharing arrangements and other types of indirect compensation—will be prohibited to these fiduciaries under ERISA and the Code unless the fiduciaries satisfy the requirements of the BIC Exemption, the Principal Transaction Exemption, or qualify for certain other exceptions.
• The BIC Exemption applies only with respect to participant-directed plan participants, IRA owners and plans with small, non-institutional fiduciaries—no relief is provided for plans with institutional fiduciaries.
• Some of the more troublesome aspects of the Proposed Regulations have been addressed by the Final Regulations and PTEs, including the following:
  • Appraisals are no longer treated as investment advice (but may be included in future rulemaking);
  • The exception for investment education has been broadened and clarified;
  • The BIC Exemption now applies to all assets and not a narrow list of highly liquid assets;
  • The BIC Exemption now expressly covers the recommendation of proprietary products and the receipt of compensation from third parties;
  • An enforceable legal contract is required under the exemption only for IRAs and non-ERISA plans; negative consents can be used to amend existing contracts; and the contract can be executed after the fact, so long as the contract covers all advice given; and
  • Required disclosures have been streamlined.

Nevertheless, the core substantive requirements of the BIC Exemption and the Principal Transaction Exemption remain unchanged, namely, that a financial institution and its investment advisers must generally act in the best interest of their retirement investor clients, without regard to the interests of the institution or adviser, and that the financial institution must generally adopt and enforce policies and procedures designed to ensure compliance with this standard.

Background

ERISA Generally. ERISA imposes stringent duties on persons treated as fiduciaries of an employee benefit plan, including a duty of undivided loyalty, a duty to act for the exclusive purpose of providing plan benefits (and defraying costs) and a stringent duty of care. In addition, ERISA and Section 4975 of the Code prohibit a plan fiduciary from causing a plan to engage in certain “prohibited transactions,” such as receiving commissions for advice provided to a plan and engaging in transactions involving a conflict of interest between the fiduciary and the plan.

Unless otherwise covered by a DOL exemption, a breach of ERISA’s fiduciary duties or the prohibited transaction rules with respect to an employee benefit plan can result in liability under ERISA to make the plan whole for any losses, disgorge profits, pay civil penalties to the DOL and, under the comparable provisions of Section 4975, pay penalty taxes ranging from 15% to 100% of the face amount of the relevant transaction. [1]

ERISA and Section 4975 of the Code generally use the same defined terms and regulations promulgated by the DOL. However, it is important to note that, unlike ERISA plan participants, IRA owners—who are only covered by Section 4975 of the Code—do not have a statutory right to bring a suit against fiduciaries for violation of the prohibited transaction rules, and fiduciaries are not personally liable to IRA owners for violating the requirements of Section 4975 of the Code.

“Investment Advice” Under Current Law. Under ERISA and Section 4975, a person who directly or indirectly renders investment advice for a fee or other compensation with respect to the assets of a plan or IRA is treated as a fiduciary. A DOL regulation issued in 1975 that will continue to apply until the effective date of the Final Regulations provides that a person who does not have discretionary authority or control with respect to the assets of a plan will not be treated as a fiduciary by reason of providing investment advice unless: (1) such person renders advice with respect to the value of securities or other property or makes recommendations as to the advisability of investing in particular securities or property, (2) on a regular basis, (3) the advice is provided pursuant to a mutual agreement, arrangement or understanding with the plan that (4) the advice will serve as a primary basis for investment decisions with respect to plan assets, and (5) the advice is individualized to the plan based on the needs of the plan (the “five-factor test”). [2]

In the preamble to the Final Regulation (the “Preamble”), the DOL expressed its view that the five-factor test is too narrow to appropriately protect employee benefit plans and, in particular, IRA investors, in light of current market practices that could give rise to conflicts of interests for consultants and investment advisers who influence retirement investment decisions but may not be treated as fiduciaries under the five-factor test.

Final Regulations

The Final Regulations replace the five-factor test with a new rule that expands the types of investment advice that will cause a person to be classified as a fiduciary for purposes of ERISA. The Final Regulations also apply for purposes of Section 4975 of the Code, meaning that the new definition of “fiduciary” will apply when investment advice is provided to IRAs and other tax-favored accounts not protected by ERISA.

Investment Advice—General Rule

Under the Final Regulations, a person that receives a fee for providing investment advice to a plan or IRA will be treated as a fiduciary if (1) the person provides the advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular investment needs of the advice recipient; (2) the person directs the advice to a specific recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA; or (3) the person represents or acknowledges that it is acting as a fiduciary within the meaning of ERISA or the Code.

For this purpose, “investment advice” broadly includes most types of investment recommendations to a retirement investor—e.g., recommendations as to the advisability of acquiring, holding, disposing of or exchanging, securities or other investment property (including after a rollover from a plan to an IRA); recommendations regarding investment policies or strategies; and recommendations regarding rollovers, transfers or distributions from a plan or IRA.

The Proposed Regulations would have also included certain appraisal or fairness opinions as investment advice. The Final Regulations do not include such opinions within its scope but the DOL has indicated that such opinions may be part of a future rulemaking project.

The new definition of investment advice substantially expands the circumstances in which an investment investment adviser can be treated as a fiduciary under ERISA and the Code. Under the five-factor test in effect until April 10, 2017, ERISA fiduciary status attaches only with respect to investment advice provided on a regular basis, pursuant to a mutual understanding that the advice will serve as a primary basis for the investment decision. By contrast, the DOL stated in the Preamble that this new rule is intended to impose fiduciary duties upon investment advisers even when they include a disclaimer in an advertisement or client documentation that the recommendations are not fiduciary investment advice, or when investment advisers give advice on a one-off or irregular basis.

Investment Advice—Exceptions

Transactions with Independent Fiduciaries with Financial Expertise. The Final Regulations include an exception for advice given in connection with an arm’s-length transaction with a plan or IRA represented by an independent institutional fiduciary (a regulated bank, registered investment adviser, registered broker-dealer, or regulated insurance company) or an independent fiduciary with more than $50 million in assets under management or control, so long as the investment adviser (1) reasonably believes that the independent fiduciary is a fiduciary under ERISA or the Code, (2) the investment adviser informs the independent fiduciary that the investment adviser is not acting as a fiduciary and discloses the investment adviser’s interests in the transaction, and (3) the investment adviser does not receive a fee or other compensation from the plan or IRA for giving advice in connection with the transaction. This exemption is intended to apply in cases in which an investment adviser is acting as a counterparty under a transaction with an IRA or plan and is not otherwise receiving fees or compensation for advice that the investment adviser renders in respect of the transaction.

Swap Transactions. A similar exemption covers advice provided by certain counterparties to swap transactions. Counterparties to IRAs are not eligible for the swap exception, but the exception applies to all ERISA plans, irrespective of who serves as fiduciary for the plan.

Employees of the Plan Sponsor. The Final Regulations also exclude advice rendered by employees of the plan sponsor or fiduciary, provided the employee does not receive fees or compensation for the advice (beyond normal compensation for work performed) and certain other conditions are satisfied.

Other Exclusions. The Final Regulations further identify several activities that will not be treated as investment advice for these purposes, including:

• Platform Providers to ERISA plans. Marketing or making available through a platform or similar mechanism (without regard to the individual needs of the plan, its participants or beneficiaries) securities or other property which may be selected by the plan fiduciary as investment alternatives under the plan, but only if (1) the platform is provided to an ERISA-covered plan, (2) the plan fiduciary is independent of the person who markets or makes available the platform (the “Platform Provider”), and (3) the Platform Provider discloses in writing to the plan fiduciary that the Platform Provider is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity;
• Objective Data for ERISA plans. Providing or making available objective data to assist in selecting and monitoring investment alternatives, but only where such assistance is provided to an ERISA-covered plan;
• General Communications. Providing or making available general communications to a plan or IRA that a reasonable person would not view as an investment recommendation (e.g., general circulation newsletters and public commentary); and
• Investment Education. Providing or making available most types of investment ‘education,’ as defined in the Final Regulations.

Pre-Existing Transactions. Compensation received as a result of the provision of investment advice in connection with a transaction effected before (or entered pursuant to a systematic program established before) April 10, 2017 is generally exempt from the Final Regulations, so long as (1) no additional advice is provided after April 10, 2017, (2) the investment adviser’s compensation does not exceed reasonable compensation, and (3) the compensation is not received in respect of amounts invested after April 10, 2017.

New Exemptions

ERISA and the Code provide statutory exemptions to the prohibited transaction rules discussed above. In addition, the Secretary of Labor has the authority to grant administrative PTEs. The complete ‘fiduciary’ regulatory package includes new PTEs and amendments to several existing PTEs. [3] These new PTEs are intended to reduce the industry disruption that would have otherwise resulted from the breadth of the new fiduciary investment advice rule.

The Best Interest Contract Exemption

The Department of Labor intends the BIC Exemption to be the primary vehicle through which investment advisers to small plans and IRAs can receive compensation for investment advice that would otherwise be prohibited by ERISA or the Code (such as sales commissions and revenue-sharing payments). As discussed below, however, compliance with the BIC Exemption will expose investment advisers to significantly increased compliance costs and obligations and increased litigation risk.

Overview of the BIC Exemption

The BIC Exemption permits financial institutions (a category that includes registered investment advisers, registered broker-dealers, insurance companies meeting specific requirements, and regulated banks) and their associated investment advisers to receive all types of compensation for providing investment advice to a “Retirement Investor,” so long as the financial institution and investment advisers comply with the conditions of the exemption. A “Retirement Investor” is (1) a participant or beneficiary of a participant-directed plan (e.g., a 401(k)), (2) the owner or beneficiary of an IRA, or (3) a “retail” fiduciary of a plan or IRA (generally persons who hold or manage less than $50 million in assets, and are not banks, insurance carriers, registered investment advisers or broker-dealers).

By thus limiting its scope to individuals and to small, non-institutional fiduciaries, the BIC Exemption will be primarily relevant to investment advisers that provide advice to retail investors.

As discussed below, the BIC Exemption requires a fiduciary to acknowledge fiduciary status, to conduct itself in accordance with certain impartial conduct standards, and to comply with certain warrantied policies and procedures. As discussed in more detail below, in the case of IRAs and plans that are not subject to ERISA, such requirements must be documented in a binding contract (the “BIC Contract”) with the particular investor so that such investor has a private right of action against fiduciaries that do not comply with the terms of the BIC Exemption. In other words, investment advisers that rely on the BIC Exemption to provide investment advice to IRAs and non-ERISA plans will, in effect, be subject to fiduciary standards similar to those imposed by ERISA. The BIC Contract, however, is not necessary for ERISA plan investors because the rules under ERISA already provide such investors with a right of action against fiduciaries that violate their ERISA obligations, including, if applicable, their requirements under the BIC Exemption.

Importantly, the final BIC Exemption now applies to all types of assets, and is not limited to narrow classes of highly liquid assets specifically enumerated in the Proposed Regulations. The DOL, however, stated in the Preamble its belief that some assets, such as complex financial instruments, “require particular care” and that the DOL will “pay special attention to recommendations involving such products.” As a result, extra caution should be given before recommending more complex financial products under the BIC Exemption.

Exclusions from the BIC Exemption

There are several types of transactions that are excluded from the BIC Exemption, in which case financial institutions and investment advisers must rely on another exemption or otherwise avoid a prohibited transaction. For example, so-called “Principal Transactions” are not eligible for the BIC Exemption, but are instead eligible for the Principal Transaction Exemption (discussed below). A “Principal Transaction” generally involves the purchase or sale of an investment product if an investment adviser or financial institution is purchasing from or selling to a plan or IRA on behalf of the financial institution’s own account (or the account of a related person). However, Riskless Principal Transactions are eligible for either the Principal Transaction Exemption or the BIC Exemption. In general, a “Riskless Principal Transaction” is one in which a financial institution, after having received an order from an investor to buy or sell a principal traded asset, purchases or sells the asset for the financial institution’s own account to offset the contemporaneous transaction with such investor.

The BIC Exemption also does not apply to transactions in which (1) the investment adviser has any discretionary authority or control over the plan or IRA assets or (2) the investment adviser, financial institution or any of their affiliates is the sponsor, named fiduciary or plan administrator of the plan or IRA. Finally, the BIC Exemption does not apply to online wealth management services that provide automated, algorithm-based portfolio management advice without the use of human financial planners (“robo-advice”), unless such robo-advice is provided by a “Level Fee Fiduciary” that complies with the conditions described below.

Requirements under the Best Interest Contract Exemption

As discussed in greater detail below, in order to qualify for the BIC Exemption, a financial institution must: (1) acknowledge fiduciary status in writing; (2) acknowledge in writing that the financial institution and its investment advisers will adhere to the “Impartial Conduct Standards” (defined below); (3) warrant that the financial institution and its investment advisers will comply with policies and procedures designed to prevent a violation of such impartial conduct standards; and (4) make certain required disclosures to the investor.

Contract Required only for IRAs and non-ERISA Plans. Under the final BIC Exemption, a financial institution will be required to enter into a BIC Contract only with IRA and non-ERISA plan investors. The BIC Contract must be in writing, must be enforceable against the financial institution, and must be entered into prior to the date that the investor enters into a transaction with respect to which advice was rendered. The contract may be a standalone document, or be incorporated in other account documents. In contrast with the Proposed Regulations, the contract need not be in place at the time advice is first provided to the client, but its terms must cover any advice provided prior to execution of the contract. Contracts with existing clients can be amended to comply with the exemption through a negative consent procedure described in the exemption.

Even though the final BIC Exemption does not require a formal written contract with ERISA plans, a financial institution and its investment advisers must nevertheless comply with the conditions listed below, which will require the financial institution to provide significant written materials to be provided to Retirement Investors. Further, the financial institution and its investment advisers may not (1) disclaim any responsibility, obligation or duty under ERISA to the extent doing so would be prohibited by ERISA, (2) waive or disclaim the Retirement Investor’s right to bring or participate in a class action, (3) require arbitration or mediation in distant locations, or (4) otherwise unreasonably limit the ability of the Retirement Investor to assert claims safeguarded by the exemption.

Written Acknowledgement of Fiduciary Status. The financial institution must affirmatively state in writing that it and its investment advisers are acting as fiduciaries under ERISA and/or the Code with respect to the advice that is the subject of the BIC Exemption. This affirmation must be included in the Best Interest Contract for IRAs and non-ERISA plans.

Impartial Conduct Standards. In the case of IRAs and non-ERISA plans, the financial institution must affirmatively state in the Best Interest Contract that the financial institution and its investment advisers will adhere to the “Impartial Conduct Standards” described below, and the financial institution and its investment advisers must comply with such standards. In the case of ERISA plans, the financial institution and the investment adviser must comply with the Impartial Conduct Standards. The “Impartial Conduct Standards” require that:

• The investment adviser must act in the “Best Interest” of the Retirement Investor, defined as:
  • acting with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor; and [4]
  • without regard to the financial or other interests of the investment adviser, financial institution or any affiliate, related entity, or other party.
• The compensation received by the investment adviser or the financial institution (or its affiliates or related entities) with respect to the recommended transaction will not exceed reasonable compensation; [5] and
• The financial institution and its investment advisers may not make any materially misleading statements to the Retirement Investor about the recommended transaction, fees and compensation, conflicts of interest, and any other matters relevant to the Retirement Investor’s investment decisions.

The requirement that investment recommendations be given “without regard” to the interests of the investment adviser and the financial institution has been retained from the 2015 Proposed Regulations. Many commentators raised the concern that the “without regard” standard would effectively prohibit financial institutions from offering proprietary investments or being paid on a commission basis, arguing that investment advisers could not reasonably be expected to ignore such factors.

The DOL stated in the Preamble, however, that the DOL does not intend to:

“wring out every potential conflict, no matter how slight, but rather to ensure that financial institutions and investment advisers put Retirement Investors’ interest first, take care to minimize incentives to act contrary to investors’ interests, and carefully police those conflicts that remain. Within this best interest framework, the exemption is designed to preserve commissions and other transaction-based compensation structures.”

Stated differently, the BIC Exemption requires that the interests of Retirement Investors be placed first, and that the competing interests of the investment adviser and financial institution are not ignored but instead minimized and managed. In light of the ambiguity and uncertainty of this standard, the DOL has stated that it will be “available” to provide guidance in implementing this aspect of the BIC Exemption.

Required Warranties, Policies and Procedures. The financial institution must adopt policies and procedures reasonably designed to prevent material conflicts of interest from causing a violation of the Impartial Conduct Standards, and the financial institution must warrant that it and its investment advisers will comply with such policies and procedures.

The DOL has stated that such policies and procedures are not intended to prevent the financial institution from providing investment advisers with commissions and other types of differential compensation based upon investment decisions by IRAs and plans, so long as the policies and procedures, viewed as a whole, are reasonably and prudently designed to avoid a misalignment of the interests of investment advisers with the interests of the Retirement Investors. The exemption states that such compensation practices can include differential compensation based on neutral factors tied to the differences in the services delivered to the Retirement Investor with respect to the different types of investments (e.g., more complex investments may justify higher compensation for the investment adviser). The Preamble further outlines several other methods of compensating investment advisers that the DOL views as sufficient but emphasizes that other alternatives could satisfy this requirement.

Disclosures. The financial institution must make detailed disclosures to a Retirement Investor, including a recitation of the Best Interest standard of care, description of fees (both direct compensation and indirect compensation from third parties), description of compensation practices, descriptions of material conflicts of interest, access to the firm’s policies and procedures under the BIC Exemption, access to web-based disclosures, in each case, such that an investor or potential investor can reasonably assess the costs and risks of any conflict of interest. The disclosure requirement under the BIC Exemption eliminates the provisions under the Proposed Regulations that would have required fiduciaries to make an annual disclosure and to disclose projections of the total cost of an investment over 1-, 5-, and 10-year periods.

Disclosure to the DOL and Recordkeeping. Before making use of the BIC Exemption, the financial institution must notify the DOL of the financial institution’s intention to do so. The financial institution must maintain for six years the records necessary to enable the DOL, the IRS and plan fiduciaries, sponsors and participants to determine whether the conditions of the exemption have been satisfied.

Special Rules under the Best Interest Contract Exemption

Special Rules for Proprietary Products and Third-Party Payments. In a significant revision of the Proposed Regulations, the final BIC Exemption expressly permits the recommendation of “proprietary products” and investments that generate “third-party payments,” so long as all of the conditions of the exemption described above are satisfied. A proprietary product is any product that is managed, issued or sponsored by the financial institution or any of its affiliates. A third-party payment includes commissions and fees (such as revenue-sharing payments, referral fees, and volume-based fees) that a fiduciary receives from parties that are unrelated to the IRA or plan. By specifically addressing proprietary products and third-party payments within the exemption itself, the DOL responded to industry concerns that the substantive standards of the exemption would, in practice, prohibit these types of transactions.

In addition, if the financial institution limits its offerings in whole or in part to investments that are proprietary products or that generate third-party payments, the following additional conditions must be satisfied (in addition to the general requirements of the BIC Exemption), at or prior to the investment, in order to satisfy the BIC Exemption:

• The Retirement Investor must be clearly and prominently informed in writing (1) that the financial institution offers proprietary products or receives third-party payments and (2) of the limitations placed on the universe of investments that may be recommended.
• The financial institution must document in writing the limitations on the universe of investments; any material conflicts of interest, and any services or consideration that the financial institution will provide to any other party (such as the payor of the third-party payments).
• The financial institution must reasonably determine (and document in writing) that such limitations and material conflicts of interest will not cause the financial institution or investment adviser to receive compensation in excess of reasonable compensation, and that as a result of the policies and procedures adopted pursuant to the exemption, these limitations and conflicts will not cause the financial institution or its investment advisers to recommend imprudent investments.

Special Rules for Level Fee Fiduciaries. In an expansion over the Proposed Regulations, the BIC Exemption provides a simplified set of conditions for financial institutions and investment advisers if the only fee received is based on a fixed percentage of the value of assets or is a set fee that does not vary with the particular investment that is recommended (“Level Fee Fiduciaries”). Level Fee Fiduciaries will comply with the BIC Exemption as long as the Level Fee Fiduciaries:

• Acknowledge fiduciary status in writing as described above;
• Comply with the Impartial Conduct Standards; and
• In the case of a rollover from a plan to an IRA, or from one IRA to another, or a change from a commission based fee arrangement to a level fee arrangement, document the reasons why such a transaction is in the Best Interest of the Retirement Investor.

Special Rules for Bank Networking Arrangements. In an expansion over the Proposed Regulations, a bank or similar financial institution that receives compensation pursuant to a “bank networking arrangement” will satisfy the BIC Exemption as long as the investment adviser satisfies the Impartial Conduct Standards. A “bank networking arrangement” is an arrangement for the referral of retail nondeposit investment products that satisfies applicable federal banking, securities and insurance regulations, under which employees of a bank refer bank customers to an unaffiliated registered investment adviser, qualified insurance company, or registered broker or dealer. The DOL relaxed the BIC Exemption in this case because bank employees are already prohibited under federal banking laws from providing investment advice in connection with such transactions, and, therefore, the Impartial Conduct Standards should be sufficient to protect the interests of plans and IRAs that engage in such transactions.

Effective Date and Transition Period. The new definition of investment advice will be effective starting April 10, 2017. During a transition period from April 10, 2017 to January 1, 2018, the BIC Exemption will generally be available as long as the fiduciary (1) renders advice that is in the best interest of the plan or IRA, (2) does not make any misleading statements to the plan or IRA, (3) does not receive compensation in excess of reasonable compensation, and (4) makes certain disclosures to the plan or IRA regarding the policies and procedures with respect to the applicable transaction. Commencing on January 1, 2018, the full disclosure and contract requirements of the BIC Exemption must be met in order to qualify for prohibited transaction relief.

The Principal Transaction Exemption

As discussed above, a Principal Transaction between an investment adviser or financial institution and a plan or IRA is excluded from the BIC Exemption, but will not constitute a prohibited transaction so long as the financial institution and its investment advisers satisfy the conditions of the Principal Transaction Exemption.

Scope. The Principal Transaction exemption permits a plan or IRA to sell any asset to an investment adviser or financial institution. In the reverse case, however, an investment adviser or financial institution may only sell CDs, interests in unit investment trusts and U.S. dollar-denominated and agency debt securities to plans and IRAs. (The DOL may later add other investments to this list.)

Further, debt securities may not be sold to a plan or IRA under the exemption if (1) the debt security is issued by the financial institution or any affiliate; or (2) the plan or IRA purchased such debt security as part of an underwriting syndicate in which the financial institution or an affiliate is an underwriter or member. In addition, the investment adviser must, at the time of the transaction, determine that the debt security possesses no greater than a moderate credit risk and is sufficiently liquid that the debt security could be sold at or near its carrying value within a reasonably short period of time. [6]

Other Conditions. The terms and conditions of the Principal Transaction Exemption are similar to the BIC Exemption, in that an enforceable written contract is required for IRA and non-ERISA clients, the Impartial Conduct Standards must be satisfied, the financial institution must adopt policies and procedures to ensure compliance with the exemption, and the financial institution must provide disclosures to investors. Key differences between the two exemptions include:

• Under the Principal Transaction Exemption, the plan or IRA must affirmatively consent to engage in principal transactions covered by the exemption (such consent to be revocable at will).
• Under the Principal Transaction Exemption, the Impartial Conduct Standards also require that, with respect to the transaction, the investment adviser seek to obtain the best execution reasonably available under the circumstances.
• Under the Principal Transaction Exemption, if the financial institution is a FINRA member, the financial institution is required to comply with FINRA rules governing fair pricing, commissions and deal execution. This grants plans and IRAs with a right of action against an advising financial institution that has violated FINRA rules in carrying out the Principal Transaction.
• Under the Principal Transaction Exemption, the financial institution’s policies and procedures must address credit risk determinations with respect to debt securities sold to plans and IRAs.

Riskless Principal Transactions. All of the foregoing also apply to Riskless Principal Transactions. As discussed above, a Riskless Principal Transaction may be covered by either the BIC Exemption or the Principal Transaction Exemption. In practice, however, it may not be certain at the outset whether a transaction will be executed as a Principal Transaction or a Riskless Principal Transaction. By organizing its practices to comply with the narrower Principal Transaction Exemption, a financial institution can engage in a transaction without concern for whether it ultimately proves to be a Principal Transaction or a Riskless Principal Transaction.

Effective Date and Transition Period. The new definition of investment advice will be effective starting April 10, 2017. During a transition period from April 10, 2017 to January 1, 2018, the Principal Transaction Exemption will generally be available as long as the fiduciary (1) renders advice that is in the best interest of the plan or IRA, (2) does not make any misleading statements to the plan or IRA, (3) does not receive compensation in excess of reasonable compensation, and (4) makes certain disclosures to the plan or IRA regarding the policies and procedures with respect to the applicable transaction. Commencing on January 1, 2018, the full disclosure and contract requirements of the Principal Transaction Exemption must be met in order to qualify for prohibited transaction relief.

Amendments to Existing PTE 84-24

The final regulatory package includes amendments to existing PTE 84-24, which covers transactions involving mutual fund shares or insurance or annuity contracts sold to plans or IRA investors by pension consultants, insurance agents or brokers, insurance companies and mutual fund principal underwriters. Under the current PTE 84-24 (in effect until April 10, 2017), pension consultants, insurance agents or brokers, and mutual fund principal underwriters are permitted to receive, directly or indirectly, a commission for selling insurance or annuity contracts, or mutual fund shares, to plans and IRAs. The exemption also permits the purchase by plans and IRAs of insurance and annuity contracts from insurance companies that are service providers to a plan or IRA, or are otherwise parties in interest or disqualified persons. Under the current exemption, “insurance or annuity contract” includes variable annuities, indexed annuities and similar annuities.

As amended, PTE 84-24 is revoked in part with respect to annuities by limiting the exemption to “Fixed Rate Annuity Contracts” (as defined below) and by revoking the exemption as it applies to IRA purchases of mutual fund shares. Accordingly, the exemption as amended will continue to permit investment advisers and other service providers to receive commissions in connection with the purchase of insurance contracts and Fixed Rate Annuity Contracts by plans and IRAs, as well as the purchase of mutual fund shares by plans. In order to receive compensation for variable annuities, indexed annuities or similar annuities sold to plans or IRAs, or for mutual fund shares purchased by IRAs, investment advisers will be forced to rely on the Best Interest Contract Exemption or another available exemption. PTE 84-24 is further amended to require adherence to the Impartial Conduct Standards with respect to any transaction covered by the exemption (such as Fixed Rate Annuity Contract transactions). Moreover, in response to insurance industry comments, the exemption has been extended to include the “receipt of compensation or other consideration” by an insurance company in connection with the sale of insurance contracts and Fixed Rate Annuity Contracts, in addition to the receipt of commissions already included under the current exemption. However, regardless of whether a transaction is subject to PTE 84-24 or the BIC Exemption, compensation received for the sale of any insurance contracts or annuities is required to adhere to the “reasonable compensation” standard set forth in the Impartial Conduct Standards.

A “Fixed Rate Annuity Contract” is defined to mean “an immediate annuity contract or a deferred annuity contract that (i) satisfies applicable state standard nonforfeiture laws at the time of issue, or (ii) in the case of a group fixed annuity, guarantees return of principal net of reasonable compensation and provides a guaranteed declared minimum interest rate in accordance with the rates specified in the standard nonforfeiture laws in that state that are applicable to individual annuities; in either case, the benefits of which do not vary, in part or in whole, based on the investment experience of a separate account or accounts maintained by the insurer or the investment experience of an index or investment model.” The definition further explicitly excludes any variable or indexed annuity or “similar annuity.” The final amendment departs from the Proposed Regulations, which did not explicitly eliminate indexed annuities from PTE 84-24, but instead proposed revoking relief for transactions involving variable annuities and other annuity contracts that are securities under federal securities laws. The Final Regulations can be expected to significantly impact the provision and sale of annuities by insurance companies and brokers and agents.

Amendments to Other Existing PTEs

In addition to amending PTE 84-24, the final regulatory package addressing fiduciary standards under ERISA and the Code includes amendments to several other existing PTEs. Each of the amendments generally requires fiduciaries relying on such exemptions to adhere to the same impartial conduct standards required in the BIC Exemption. [7] These changes will require financial institutions that have relied on such PTEs in the past to revise their policies and procedures in order to ensure that such financial institutions continue to satisfy the requirements of the revised PTEs.