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Jul 14, 2020

DOL: Rollover Recommendations May Constitute Advice; Proposes Prohibited Transaction Exemption

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In a proposed class prohibited transaction exemption published on June 29, 2020 (the “proposed exemption”), the Department of Labor (DOL) stated that advising employee benefit plan (“plan”) participants to roll over plan assets to an IRA may constitute the type of investment advice that could render the adviser a fiduciary under ERISA and the Internal Revenue Code (Code).[1] On that same date, the DOL issued a final rule reinstating ERISA’s five-part fiduciary investment advice test (the “five-part test”) to determine who is an investment advice fiduciary under ERISA and the Code.[2] The preamble to the proposed exemption sets forth the DOL’s views as to when an adviser is acting on a “regular-basis” under the five-part test when the adviser makes a rollover recommendation to a retirement investor.

The proposed exemption permits covered “financial institutions” and their “investment professionals” who may be acting as fiduciaries in making a rollover recommendation to receive reasonable fees, provided the conditions of the proposed exemption are met. Separately, the proposed exemption provides relief for covered investment advice fiduciaries engaging in certain principal transactions.

The proposed exemption was published in the federal register on July 7, 2020, and the comment period will remain open for thirty days. The exemption will be available sixty days after publication of the final exemption.

The following summarizes the key points and may be helpful to decision-makers at investment advisers, broker-dealers and other financial institutions planning to comment on the rule or chart the path forward.

Rollover Recommendations and the Five-Part Test

An investment adviser providing advice to retirement investors will be acting in a fiduciary capacity if the adviser satisfies the DOL’s five-part test. The five-part test requires that the adviser: (1) render advice as to the value of securities or other property or make recommendations as to the advisability of investing in, purchasing or selling securities or other property (“financial advice”), (2) on a regular basis, (3) pursuant to a mutual agreement, arrangement or understanding with the plan, plan fiduciary or IRA owner that (4) the advice will serve as a primary basis for investment decisions and that (5) the advice will be individualized based on the particular needs of the plan or IRA. In the event all five prongs are met, compensation received in connection with investment advice, including a rollover recommendation, may, absent an exemption, constitute a prohibited transaction under ERISA and the Code.

The DOL appears to have abandoned its efforts over the last decade to reframe the test for determining who is an investment advice fiduciary and has instead reaffirmed the five-part test. The DOL continues to believe that rollover recommendations constitute financial advice and therefore satisfy the first prong of the five-part test. As a result, advisers who provide such recommendations will be deemed “investment advice fiduciaries” under ERISA and the Code if they satisfy the other four prongs of the five-part test. Whether these prongs are met is based on the particular facts and circumstances, but the DOL notes that a roll-over recommendation that initiates a relationship where the advice provider will be regularly giving financial advice may satisfy the “regular basis” requirement.

Unresolved by the guidance are the types of relationships involving an adviser providing “financial advice” on a regular basis. Although the DOL notes that broker-dealers and their affiliates may have certain incentives to encourage plan participants to roll assets into an IRA they sponsor, broker-dealers typically do not provide financial advice. Further, investment advice is often only provided on a “regular basis” when the assets are invested in securities. Advice with respect to commodities and real estate is generally provided in connection with the purchase and, therefore, fiduciary status would not be imposed on the adviser.

Importantly, advice with respect to securities is already subject to regulatory protections similar to the proposed exemption’s Impartial Conduct Standard (described below), so it remains unclear whether the new rule will provide retirement investors with any additional protections, as it does not appear to expand the range of remedies available to plan participants for a fiduciary breach.

The Proposed Exemption

The proposed exemption provides relief from certain of the prohibited transaction rules of ERISA and the Code[3] for reasonable compensation received as a result of investment advice and for receipt of a mark-up, mark-down or other payments as a result of purchases or sales in certain principal transactions. The proposed exemption is available to investment advice fiduciaries that qualify as “financial institutions”[4] and their employees, agents and representatives, or “investment professionals,” who provide advice to employee benefit plan participants, beneficiaries and fiduciaries and IRA owners and fiduciaries, which are collectively referred to as “retirement investors.”

Receipt of Reasonable Compensation for Investment Advice

Subject to compliance with the conditions of the proposed exemption described below, financial institutions and investment professionals will be permitted to receive reasonable compensation in connection with their provision of investment advice to retirement investors. Notably, the proposed exemption includes reasonable compensation received as a result of a recommendation to roll over plan assets from an ERISA covered plan to an IRA (or vice versa).

In providing broad, principles-based relief for financial advisers’ compensation arrangements, the proposed exemption differs from the DOL’s historic approach to granting prohibited transaction exemptions, which generally provided relief for discrete, identified transactions. Further, unlike the Best Interest Contract exemption promulgated along with the now vacated 2016 fiduciary rule, the proposed exemption does not expand retirement investors’ ability to enforce their rights in court beyond those expressly authorized by ERISA.

This approach is not unexpected, as the current Secretary of Labor had a leading role in successfully arguing at the Fifth Circuit that the 2016 fiduciary rule was enforceable because the DOL had exceeded its authority.

Principal Transactions

The proposed exemption provides limited relief for the receipt of a mark-up, mark-down or other payment in connection with the purchase or sale of an asset in certain principal transactions. Generally, principal transactions are those on behalf of the financial institution’s own account or the account of a person directly or indirectly controlling, controlled by or under common control with the financial institution. The following transactions are covered by the exemption:

  • Riskless principal transactions. A transaction in which a financial institution, after receiving an order from a retirement investor to buy or sell an investment product, purchases or sells the same investment product in a contemporaneous transaction for the financial institution’s own account to offset the transaction with the retirement investor.
  • Sales to a Plan or an IRA: The exemption is limited to the sale of certain enumerated debt securities, a certificate of deposit or an interest in a Unit Investment Trust. In addition, if an investment is permitted independently pursuant to an individual exemption, such investment will be permitted by the class exemption. To the extent the sale involves a debt security, the security must be recommended pursuant to written procedures adopted by the financial institution that are reasonably designed to ensure that the security has no greater than moderate credit risk and sufficient liquidity that it could be sold at or near carrying value within a reasonable, short period of time.
  • Purchases from a Plan or IRA: The purchase by the financial institution or investment professional of any security or investment property from the plan or IRA.

Exemption Conditions

Financial institutions and investment professionals relying on the exemption must satisfy the conditions noted below. These conditions will be familiar to the financial services industry, as they were largely developed over the last decade as part of the DOL’s now vacated fiduciary rule and have been a core part of the DOL’s transition relief.

  • Impartial Conduct Standards. The Impartial Conduct Standard requires fiduciaries provide investment advice that is in the “best interest” of the retirement investor, charge only reasonable compensation and obtain best execution and make no materially misleading statement about the transaction or other relevant matter. The best interest standard is intended to be consistent with the fiduciary standards set forth in ERISA section 404, as well as the SEC’s Regulation Best Interest. To that end, financial institutions and their investment professionals have a duty not to place their interests ahead of the interests of the retirement investor.
  • Written Disclosure. Financial institutions must, prior to engaging in a transaction, provide a written disclosure to the retirement investor acknowledging that the financial institution and its investment professionals are fiduciaries under ERISA and the tax code, as applicable. The disclosure would have to describe all services to be provided, as well as material conflicts of interest.[5]
  • Written Policies and Procedures. The financial institution would have to establish, maintain and enforce written policies and procedures designed to ensure that the financial institution and its investment professionals comply with the Impartial Conduct Standards. Further, the policies and procedures must be designed to minimize conflicts of interest. With respect to commission-based compensation arrangements, the DOL highlights in the preamble to the proposed regulation the challenge of meeting the proposed exemption’s conflict mitigation standard and offers some best practices for consideration. In addition, following a recommendation to take a distribution of or roll-over ERISA plan or IRA assets, additional documentation is required describing why the advice was in the best interest of the retirement investor.
  • Annual Retrospective Review. Financial institutions must conduct an annual retrospective review to ensure compliance with the Impartial Conduct Standards. The review would be a written report delivered to the CEO (or equivalent officer) of the financial institution who would have to certify that the financial institution’s policies and procedures are designed to achieve compliance with the exemption and can be modified, if necessary.
  • Recordkeeping. Financial institutions must maintain records demonstrating compliance with the exemption for six years. Records would include the policies and procedures discussed above, as well as the documentation with respect to rollover recommendations.

Footnotes

[1]  In connection with the release of the proposed exemption, the DOL has withdrawn Advisory Opinion 2005-23A. In Advisory Opinion 2005-23A, the DOL stated that merely advising a plan participant to take an otherwise permissible plan distribution, even when that advice is combined with a recommendation as to how the distribution should be invested, does not constitute investment advice within the meaning of ERISA. Further, the Advisory Opinion stated that investment recommendations regarding the proceeds of a distribution would be advice with respect to funds that are no longer assets of the plan.

[2]  In addition, the final rule revokes certain prohibited transaction exemptions granted in connection with the 2016 fiduciary rule and reinstates IB 96-1, which describes certain categories of plan information that, when provided to plan participants, do not constitute “investment advice.” The revoked prohibited transaction exemptions are the Best Interests Contract Exemption and the Class Exemption for Principal Transactions in Certain Assets between Investment Advice Fiduciaries and Employee Benefit Plans and IRAs. In addition, the final rule repeals the amendments to the previously granted exemptions, PTEs 75–1, 77–4, 80–83, 83–1, 84–24 and 86–128.2 that were issued in connection with the 2016 fiduciary rule.

[3]  The proposed exemption would provide relief from the prohibitions in ERISA sections 406(a)(1)(A), (D) and 406(b) and the sanctions imposed by Code sections 4975(a) and (b), by reason of Code sections 4975(c)(1)(A), (D), (E) and (F).

[4]  To qualify as a “financial institution,” the entity must be either an SEC or state registered investment adviser, an SEC registered broker or dealer, a bank or savings association or an insurance company.[3] In addition, to the extent the DOL grants individual exemptions to other types of entities, those individual exemptions will serve to expand the definition of “financial institution” in the class exemption. The proposed exemption would not be available, however, if the financial institution or investment professional (or an affiliate) is either the employer of employees covered by the plan or a named fiduciary or plan administrator who was selected to provide advice to the plan by a fiduciary who is not independent of the financial institution or investment professional.

[5]  The proposed exemption defines conflicts of interest as “an interest that might incline a financial institution or investment professional – consciously or unconsciously – to make a recommendation that is not in the Best Interest of the Retirement Investor.”

Authors and Contributors

John J. Cannon III

Partner

Compensation, Governance & ERISA

+1 212 848 8159

+1 212 848 8159

New York

Kenneth J. Laverriere

Of Counsel

Compensation, Governance & ERISA

+1 212 848 8172

+1 212 848 8172

New York

Doreen E. Lilienfeld

Partner

Compensation, Governance & ERISA

+1 212 848 7171

+1 212 848 7171

+1 650 838 3804

+1 650 838 3804

New York

Gillian Emmett Moldowan

Partner

Compensation, Governance & ERISA

+1 212 848 5356

+1 212 848 5356

New York

Matthew Behrens

Associate

Compensation, Governance & ERISA

+1 212 848 7045

+1 212 848 7045

New York