On May 22, 2017, the Department of Labor (DOL) announced that the DOL’s new fiduciary investment advice rule would go into effect on June 9, 2017 (as opposed to April 10, the originally scheduled implementation date). This paper focuses on what the new applicability date means for our clients—separate account managers and private fund managers. Specifically, it addresses what they should start doing now and what they must do before the end of the transition period on December 31, 2017.
In plain English, a fiduciary’s receipt of any type of compensation that varies based on the particular investment has always been unlawful under ERISA. It creates an incentive to steer the plan client to the better paying investment alternative and therefore presents a conflict of interest for the adviser. Under current law, a fiduciary adviser could only earn variable compensation if the adviser qualifies for an available exemption from the prohibited transaction rules. The new DOL Fiduciary Rule creates such an exemption and thereby creates a class of advisers who can continue to earn “conflicted” compensation if they apply with the terms of an applicable exemption, in particular, the new “Best Interest Contract Exemption” (BICE). The paper will focus on the ramifications of the new rules for advisers and fund managers who opt to comply with the BICE.
To get right to the point, advisers accepting new retirement plan assets (i.e., IRAs and small plans subject to ERISA and small plan participants) are now faced with three choices:
- Stop accepting new IRA, small plan or self-directed plan clients, as well as new money from existing IRA, small plan or self-directed plan clients;
- Alter contracts and client communications to fit within the new rule or accept the risk that those communications may be interpreted as fiduciary acts; or
- Rely on the “Best Interest Contract Exemption” (“BICE) and adopt and implement the policies and procedures required to meet all of the exemption’s conditions that are applicable to your situation (more on this below).
The Best Interest Contract Exemption (BICE)
Compliance with the Best Interest Contract Exemption permits “advice fiduciaries” to receive compensation for the giving “conflicted” investment advice, which would otherwise be prohibited, as long as certain conditions are met. The conditions fall into two separate compliance “regimes,” each of which imposes its own set of varying conditions depending on how the adviser is compensated by the IRA or plan client. For purposes of this paper, we refer to these regimes as the “full BICE regime” and the “streamlined BICE regime.”
It should be noted at the outset that the BICE will exempt the receipt of compensation received prior to April 17, 2017 in respect of communications made to IRAs, small plans (subject to ERISA) and small plan participants. However, the grandfathered relief will not apply to communications made after this date.
The “Streamlined BICE Regime” – Level-Fee Fiduciaries
In actual practice, most investment advisers will qualify as “level-fee fiduciaries.” This is an important concept because while so-called “level-fee” advisers will still need relief under the BICE when advising IRAs and small plan clients, they will be entitled to rely on a streamlined version of the exemption—sometimes referred to as “BICE-lite.” For this reason, their world will not change much post-June 9.
In brief, there are two requirements to the determination. The first requirement is the fee or compensation in question must be level. A “level fee” is a fee (or compensation) that is provided on the basis of a fixed percentage of the value of the client’s assets—it does not vary with the particular investment recommended. The second requirement relates to third-party compensation—receipt of any compensation by the adviser beyond the level fee will compromise the adviser’s status as a level-fee fiduciary (and require full compliance with the BICE). So, for example, the receipt of soft dollars would not be permitted.
Reliance on the streamlined BICE regime is subject to only the following conditions:
- Fiduciary Acknowledgement. The adviser must acknowledge in writing that it is acting as an advice fiduciary.
- Impartial Conduct Standard. The adviser must affirmatively state, in writing, that it will:
- provide investment advice that is in the “best interest” of the IRA or plan investor;
- not recommend transactions that cause compensation to be paid that exceeds the “reasonable compensation” standard under ERISA Sec. 408(b) (which section requires specific disclosure of all fees and other compensation received by the fund manager); and
- refrain from making materially misleading statements regarding the investor’s investment decisions.
The “Full BICE Regime”
If the Adviser does not qualify as a level-fee fiduciary (i.e., it accepts investments from IRAs and small plans or small plan participants, and it offers multiple fee or compensation arrangements or if the adviser accepts any third-party payments (e.g., soft dollars)), it can rely on the BICE only if it meets all of the conditions set forth above relating to level-fee fiduciaries and all of the following additional requirements:
- Required Warranties. The advisory agreement must affirmative warrant to the following:
- the adviser has adopted, and will comply with, written procedures designed to prevent conflicts of interest from causing violations of the impartial conduct standard;
- the adviser has taken specified steps designed to manage material conflicts of interest; and
- the adviser’s compensation structure would not be reasonably expected to cause the adviser to make a recommendation not in the best interest of the investor.
- Required Disclosures. In a written disclosure (e.g., advisory agreement), the following must be disclosed:
- a description of the standard of care owed to the plan or plan participant, the services provided, all fees charged, how the retirement investor will pay the fees, and all material conflicts of interest;
- a statement that the plan or plan participant has the right to obtain copies of the adviser’s policies and procedures regarding the impartial conduct standard;
- contact information including a telephone number for a representative of the adviser to whom concerns about the advice or services received should be addressed; and
- a statement as to whether the advice relationship is ongoing.
- Prohibited Contract Provisions. The following cannot be included in any contract (e.g. advisory agreement):
- a disclaimer of responsibility or liability to the extent prohibited by Section 410 of ERISA;
- any waiver or qualification of the right to bring a class action lawsuit;
- agreements to arbitrate or mediate claims in venues that are distant or otherwise unreasonable (but reasonable arbitration clauses are allowed).
- Disclosure to the DOL. Before receiving compensation in reliance on the BICE, the adviser must notify the DOL in writing of its intention to rely on the BICE.
- Recordkeeping. The adviser is required to keep records sufficient to allow for a determination of whether the conditions of the exemption have been met for a six-year period.
Additional Conditions Applicable to IRAs
An adviser who is not a level-fee fiduciary will only be able to offer investments to IRAs in reliance on the BICE if it complies with the full BICE requirements and the following additional contract requirement:
- a contract must be entered into prior to or at the execution of the recommended transaction that provides the IRA and the IRA owner with an enforceable contractual remedy if the fund manager fails to act in the “best interests” of the IRA when recommending that the IRA invest in the private fund.
Beyond the Basics—What advisers have to do now to be compliant
SEPARATE ACCOUNT MANAGERS
As a practical matter, an adviser’s receipt of compensation based on the particular investment recommended to a plan client has always been unlawful because it creates an incentive to steer the plan client to the better paying investment alternative thereby creating a conflict of interest for the adviser. An adviser is only permitted to earn variable compensation if it complies with the terms of an applicable exemption from the current prohibited transaction rules. Think of the BICE as just that—a new exemption from the prohibited transaction rules.
All advisers should make sure they know what it takes for compensation to qualify as a “level fee” for this purpose. Assuming the level-fee condition is satisfied, the requirements of the streamlined BICE will apply, and compliance will be relatively simple. To review—the retirement account investor must be given a written statement of the fiduciary status of the adviser and the investment adviser representative; they must both comply with the new impartial conduct standard which simply means acting in the best interest of the plan client; they can accept only reasonable compensation; and, they must avoid misleading statements. However, no contract, warranties, compliance policies or disclosures are needed.
Compliance with the “streamlined BICE”
If, after reviewing its investor base, compensation structure and third-party payment arrangements, an adviser determines that it wishes to rely on the streamlined BICE, the adviser should:
- Make sure its compensation structure is “level” and it is not receiving any other payments in connection with advice to IRA, small plan and plan participant clients.
- Determine whether its fees are “reasonable” based on the market.
- Adopt impartial conduct standards.
- Develop processes for documenting that IRA rollover transactions are in the best interest of the client (whether or not you are going to rely on the BICE).
Compliance with the “full BICE”
If, after reviewing its investor base, an adviser determines that it wishes to continue receiving “conflicted” compensation in reliance on the full BICE, the adviser should:
- Adopt the required policies and procedures.
- Review and amend the relevant documents to provide the required warranties, disclosures and contract provisions.
- Notify the DOL of its reliance on the BICE.
- Develop procedures to meet the impartial conduct standard.
- Develop procedures for documenting and retaining records of compliance with the BICE.
PRIVATE FUND MANAGERS
In practice, if the private fund manager does not adopt one of the three choices set forth at the beginning of this paper, it risks becoming an “advice fiduciary.” If this happens:
- An IRA cannot purchase an interest in any private fund where the fund manager holds 50% or more of the value of the fund (or the vote); and
- In the case of small plans subject to ERISA, the recommendation to invest in the private fund must be given with the “best interest” of the plan or plan participant in mind considering the expenses associated with the investment.
In sum, a fund manager that decides to continue offering its private fund to IRAs and small plans subject to ERISA will have to restructure its operations to avoid becoming an “advice fiduciary.” The best and most effective way of accomplishing this under the new rules is to rely on the Best Interest Contract Exemption.
The “Streamlined BICE Regime” – Level-Fee Fiduciaries
In actual practice, most fund managers offering interests in their own private funds to IRAs and small plans (subject to ERISA) are compensated through a combination of a single management fee and/or a single performance fee. Assuming this is the case, and also assuming the fund manager receives no third-party payments (e.g., soft dollars), the fund manager will qualify as a “level-fee fiduciary.”
The “Full BICE Regime”
If the fund manager accepts investments from IRAs and small plans (or small plan participants), and it has multiple management fee and/or performance fee options (e.g., a potential investor can select a straight management fee or a reduced management fee plus a performance fee) or if the fund manager accepts any third-party payments (e.g., soft dollars), it can rely on the BICE only if it meets all of its conditions; i.e., the full BICE.
Compliance with the BICE
As a practical matter, most fund managers will qualify as level-fee fiduciaries. For them, life does not change to a large extent. However, all fund managers will likely need to update their subscription documents and may need to obtain additional representations from IRA and ERISA investors for any new investment made after June 9, 2017.
With this said, all fund managers that will continue to accept IRAs, small plans or plan participant investors in reliance on the BICE should carefully consider the following advice:
- Determine which of the BICE regimes are applicable to its activities.
- Review and amend the relevant subscription documents to provide the required disclosures, warranties and contract provisions.
- Notify the DOL of the fund manager’s reliance on the BICE (if required).
- Develop procedures and policies to meet the impartial conduct standard.
- Develop procedures to develop and retain records of compliance with the BICE.
Clients reviewing their contracts and agreements will need to take care to ensure the documents not only satisfy the DOL fiduciary rule’s requirements, but also conform to the firm’s related customer agreements and disclosures and also employ conventional terms that are designed to provide protections to the firm, where appropriate. The Securities Law Group is fully prepared to help our clients with their compliance efforts with the rule when it becomes applicable on June 9.
This newsletter is published as a source of information only for clients and friends of The Securities Law Group and should not be construed as legal advice or opinion on any specific facts or circumstances. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship.
The Securities Law Group
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm. This article is for general information purposes and is not intended to be and should not be taken as legal advice.