The DOL’s Best Interest Contract Requirement: Effect on Litigation Against Broker-Dealers

The playing field for the financial services industry in general, and broker-dealers and brokers in particular, has changed during this past year.  On June 9, 2017, the Department of Labor (“DOL”) fiduciary advice standard, which is applied to all financial professionals advising retirement (plan and IRA) accounts, became applicable.  As a result, the standard of care required of broker-dealers providing advice to IRA investors has changed, at least in many cases.  This Article describes the effect on litigation against broker-dealers providing advice to IRA investors that would result if firms are required to enter into “Best Interest Contracts” with IRA investors, as the DOL’s Best Interest Contract Exemption currently requires.

The New Fiduciary Duty Playing Field

On June 9, 2017, broker-dealers and their registered representatives became fiduciaries to IRA investors under a number of circumstances where no such status may have previously existed.  Under the Employee Retirement Income Security Act of 1974 (“ERISA”), as well as the Internal Revenue Code (“Code”), fiduciaries to plan and IRA clients are prohibited from making recommendations which influence the compensation the fiduciary receives.  They are also prohibited from receiving compensation from third parties in connection with recommended transactions.

In this new world, with some narrow exceptions, all investment advice offered for compensation other than a level fee or asset-based charge (where the charge is not dependent upon the advice given) triggers a “prohibited transaction.”  With its new Rule, the DOL has created legions of new fiduciaries, and significantly expanded the types of recommendations which are now treated as fiduciary advice.  Thus, the Rule has transformed many transactions historically performed in the normal course of broker/client relationships into prohibited ones.

Consequently, it was necessary for the DOL to issue a number of new and amended prohibited transaction exemptions to preserve access to advice in situations where advisors and firms have “conflicts” – because they are paid through commissions, 12b-1 fees or may recommend proprietary products and services – and so on.

The particular exemption that broker-dealers and their registered representatives will likely utilize most often is the “Best Interest Contract Exemption” or the “BIC” Exemption.

The DOL Fiduciary Duty Rule was penned during the Obama Administration, but was not scheduled to become effective until April 10, 2017, after President Obama’s term ended.  The Trump Administration postponed the applicability date of the Rule until June 9, 2017.  However, at that time the totality of the requirements imposed under certain exemptions did not begin to apply.  Rather, a “Transition Period” from June 9, 2017 through December 31, 2017 went into effect – during which some exemption requirements are not in force.  During this Transition Period, the only requirements directly imposed upon brokers and broker-dealers to satisfy the BIC Exemption is their adherence to the DOL’s “Impartial Conduct Standards,” which require that

  • advice be given in the customer’s “best interest;”
  • advice not cause the advisor, firm, their affiliates, etc. to receive compensation exceeding a reasonable level; and
  • no misleading statements be made to investors about investment transactions, compensation incentives, material conflicts of interest, and certain other matters.

It is likely that the Transition Period will be extended, and for reasons we will discuss later on, that the BIC Exemption will be amended further.  But as it currently exists, once the Transition Period ends, a slew of new requirements will be imposed on financial institutions under the BIC Exemption, including (but without limitation) multi-layered investor disclosures, the adoption of supervisory policies and procedures, and strict limitations on compensation incentives to individual advisors.  For most broker-dealers, the first day upon which “full BIC Exemption” begins to apply will arguably be more of a watershed than June 9, 2017 was.

Another requirement imposed under “full” BIC Exemption is that financial institutions must enter into enforceable written contracts with IRA investors, which require adherence to the Impartial Conduct Standards and also must include warranties about a number of additional matters.  The reason these “Best Interest Contracts” are required for IRA investors and not ERISA plan investors is that plans already have clear legal remedies under ERISA – both with respect to fiduciary breaches and prohibited transactions.  While the Code rules that apply to IRAs contain very similar prohibited transaction restrictions, they recognize no private right of action.  They also do not provide a private remedy for fiduciary breach claims.  In short, the Best Interest Contract is designed to ensure that IRA investors have legal remedies, in cases where they might not otherwise (or where the remedies available to them might not be as robust).

At this point in time, the existence of the Rule and the BIC Exemption is hardly “news” to the financial services industry, which has been scrambling to implement compliance systems since the Rule and exemptions were finalized in April 2016 (and in some cases, efforts have been underway much longer).  Early on in the rulemaking process though, many financial institutions responded with surprise to the notion that the DOL could regulate their activities as to IRAs – which they quite correctly noted are not subject to ERISA.  A bit of history may be helpful, as the jurisdictional issues at play are not intuitive.

Background and History

As alluded to previously, Section 406 of ERISA contains the prohibited transaction rules that apply to ERISA-covered plans.  Section 4975 of the Code contains largely “mirror” prohibited transaction rules that apply to plans and IRAs alike (imposing excise taxes for violations).  Originally, authority over prohibited transaction exemptions and certain interpretative matters was vested separately in the DOL (ERISA) and Treasury Department (Code).  But by 1978, it was deemed untenable to have two regulatory agencies providing potentially conflicting holdings on similar laws with a significant degree of subject matter overlap.  Thus, pursuant to a reorganization plan, authority to issue exemptions under both statutes was given to the DOL.  In turn, while both ERISA and the Code define the term “fiduciary,” the power to issue regulatory guidance on exactly what would constitute “fiduciary” investment advice likewise fell to the DOL going forward.

Previously, the definition of fiduciary investment advice was often referred to as a “five-part test” wherein (1) certain “covered” advice was provided, (2) on a regular basis, (3) pursuant to a mutual agreement or understanding, (4) that the advice would serve as a primary basis for investment decisions, and (5) that the advice was individualized based on particular needs.  This definition was issued in 1975, when defined benefit pension plans – and thus, experienced institutional investors – dominated the ERISA landscape.

As the retirement paradigm has shifted toward 401(k) and other participant-directed plans, as well as IRAs, the DOL became increasingly concerned that its prior definition had become obsolete.  The DOL believed it was too easy for brokers to hold themselves out to investors as “advisors” while escaping “fiduciary advisor” status, and thus the consequences of conflicted recommendations.  Its own enforcement activities as to ERISA plans were also frustrated.  As the DOL laments in the Rule’s preamble – with respect to the “regular basis” requirement alone:

Because advice on rollovers is usually one-time and not “on a regular basis,” it is often not covered by the 1975 standard, even though rollovers commonly involve the most important financial decisions that investors make in their lifetime.  An ERISA plan investor who rolls her retirement savings into an IRA could lose 6 to 12 and possibly as much as 23 percent of the value of her savings over 30 years of retirement by accepting advice from a conflicted financial adviser.  Timely regulatory action to redress advisers’ conflicts is warranted to avert such losses…

…One example of the five-part test’s shortcomings is the requirement that advice be furnished on a “regular basis.” As a result of the requirement, if a small plan hires an investment professional on a one-time basis for an investment recommendation on a large, complex investment, the adviser has no fiduciary obligation to the plan under ERISA. Even if the plan is considering investing all or substantially all of the plan’s assets, lacks the specialized expertise necessary to evaluate the complex transaction on its own, and the consultant fully understands the plan’s dependence on his professional judgment, the consultant is not a fiduciary because he does not advise the plan on a “regular basis.”  The plan could be investing hundreds of millions of dollars in plan assets, and it could be the most critical investment decision the plan ever makes, but the adviser would have no fiduciary responsibility under the 1975 regulation.

In the past, many broker-dealers have taken the position that they were not fiduciaries under such exacting standards, at least in most cases.  This notion finds conceptual support in the fact that broker-dealers have a “dual role” – they are not “exclusively” advisors, but also provide the service of bringing products to market in their capacity as distributors.  Many courts have agreed, finding that no fiduciary status would generally be triggered in the absence of “special circumstances,” such as situations where a dual-registrant provides services under a traditional fee-based advisory relationship (subject to the Investment Advisers Act of 1940), or where the account was managed on a discretionary basis.[ii]

The DOL’s concern was seemingly bolstered by the findings of other agencies and academics as well.  A 2013 report by the Government Accountability Office (“GAO”) was critical of the DOL’s and IRS’ alleged failure to protect retirement investors from unscrupulous IRA sales.[iii]  GAO agents called financial service providers posing as 401(k) participants who had recently left their jobs, and the GAO’s findings painted an ugly picture – citing among numerous other problems the use of scare tactics to convince investors to move their savings to IRAs, such as implying that their savings in the plan would be lost if the employer closed its doors.  Reports from FINRA warned that “hard sale” tactics were being used for variable annuity products that paid lucrative commissions, particularly on vulnerable senior citizens.[iv]  And so on.

But, why the DOL and not the SEC, or other regulators?  For years, the question of whether investment advisors should be fiduciaries to retail investors has languished with no uniform standard adopted.  Pursuant to the Dodd-Frank Act, the SEC was even charged with determining whether public confusion existed regarding the duties and responsibilities of investment professionals, and if so, to come up with a solution.  The SEC published its findings (confirming that confusion in fact existed) in 2011, and concluded that a uniform standard of care was called for.[v]

By 2016, the SEC still publicly maintained its intent to develop such a uniform standard, but it was unable to reach an accord on the particulars.  As a result, the conduct standards applicable to different types of advisors (i.e., broker-dealers vs. RIAs, etc.) continued to vary, despite the public’s apparent lack of understanding that different types of advisors even existed in the first place.  The applicable standards – as established through statute, case law, rules of self-regulatory organizations (“SROs”), etc. – likewise continued to vary based on geographic location, account type, and myriad other factors.

With billions of dollars of baby boomer retirement assets at stake, the Obama Administration decided it could no longer wait, and the Rule was born.  Among other things, the Rule abolishes the “regular basis,” “primary basis,” and “individualized advice” prongs of the previous five-part test, and adds to the list of fiduciary advice activities recommendations as to plan distributions, rollovers, and account types (brokerage vs. advisory).  There is simply no way for advisors to escape fiduciary status for advice to IRA owners.

Full circle then, the DOL does not have jurisdiction over IRAs as a general matter.  It cannot investigate a firm or advisor in connection with its IRA services, as it could for services to plans.  But what the DOL can do is impose a fiduciary standard (the “best interest” standard) and other requirements on IRA brokers indirectly by embedding them into the exemptions that brokers must rely on.  We should point out that, in a strange twist, this means that level fee-only advisors (including those that “self-levelize” their compensation by offsetting (reducing) their advisory fees dollar-for-dollar by any 12b-1s and other compensation they receive[vi]) are not subject to the DOL’s best interest requirement, since they do not need to rely on a prohibited transaction exemption.  But in many cases, this is not an option, and compliance with the BIC Exemption may be unavoidable.

To be clear, the BIC Exemption is not the only exemption for “conflicted” compensation.  But it is the only one that provides relief for broad types of recommendations, financial incentives, and different products. And, along with the DOL’s “Principal Transactions Exemption,”[vii] they are the only ones that impose upon broker-dealers a requirement to enter into a Best Interest Contract with IRA investors.

The Trump Administration has instructed the DOL to re-review the Rule and exemptions in light of concerns over industry disruption, a possible chilling effect on the availability of advice and certain products, and increased litigation costs which would be passed through to investors in the form of higher fees.  As part of this re-review, the DOL recently (as of the date of this Article) issued a Request For Information (“RFI”) for public comments on extending the Transition Period and ideas for how to improve the exemptions.[viii]

Industry concern about the effects of the Best Interest Contract requirement are quite substantial, and two of the eighteen questions in the DOL’s RFI specifically address the possibility of repealing or changing it:

  1. What is the likely impact on Advisers’ and firms’ compliance incentives if the Department eliminated or substantially altered the contract requirement for IRAs? What should be changed? Does compliance with the Impartial Conduct Standards need to be otherwise incentivized in the absence of the contract requirement and, if so, how?
  2. What is the likely impact on Advisers’ and firms’ compliance incentives if the Department eliminated or substantially altered the warranty requirements? What should be changed? Does compliance with the Impartial Conduct Standards need to be otherwise incentivized in the absence of the warranty requirement and, if so, how?

As of the date of this Article, it is too early to predict intelligently what changes could be made to the Best Interest Contract requirement.  But the above passages also illustrate the problem the DOL perceives in potentially repealing or changing the requirement – it is not clear what other mechanism or remedy an aggrieved IRA investor would have if he or she receives advice that is not in the investor’s best interest.

The remainder of this Article will address this very issue.  That is, how would the Best Interest Contract increase or otherwise affect litigation against broker-dealers?  We will address this question from two fronts:  First, is the “best interest” standard a higher standard than otherwise exists, thus making viable substantive theories of liability in some circumstances that would otherwise not be viable?  Second, how would the requirement affect such lawsuits in terms of damages, venue, and so on?

The Best Interest Contract Requirement

Financial institutions are required to enter into “Best Interest Contracts” with IRA investors under both the BIC Exemption and the Principal Transactions Exemption.  There are a handful of differences, but we will focus on the BIC Exemption version, which will be the most heavily relied upon exemption.  The three main components of the Best Interest Contract are as follows:

  1. Acknowledgment of the firm’s and advisor’s fiduciary status;
  2. An affirmative statement that the Impartial Conduct Standards (best interest, only reasonable compensation, no misleading statements) will be adhered to; and
  3. Warranties relating to the adoption of supervisory policies and procedures, including that the financial institution does not employ compensation incentives that would reasonably be expected to result in advisors giving advice that is not in the investor’s best interest.

While the warranties do not prohibit compensation differentials to individual advisors, they do require that

the Financial Institution’s policies and procedures and incentive practices, when viewed as a whole, are reasonably and prudently designed to avoid a misalignment of the interests of Advisers with the interests of the Retirement Investors they serve as fiduciaries (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, as opposed to the differences in the amounts of Third Party Payments the Financial Institution receives in connection with particular investment recommendations…(Emphasis added)

The highlighted reference in the above passage refers to the BIC Exemption’s prescribed system of ferreting out conflicts of interest created by advisor compensation incentives.  To summarize them briefly, advisors must receive the same compensation for selling products within each “reasonably designed” category, and variances between the categories must be based on “neutral factors” such as time and effort involved.  These are the only advisor compensation variances – as to recommendations of different investments – that appear to be clearly permitted under the BIC Exemption.

Further, the BIC Exemption places strict limitations on exculpatory terms.  Specifically, no terms disclaiming or limiting liability for breaching the contract’s terms can be included, except that otherwise-permissible waivers of punitive damages and rescission can be included.

As to individual claims, the BIC Exemption does not prohibit a requirement to arbitrate or mediate disputes so long as the venue is not distant, and the requirement does not “otherwise unreasonably limit the ability of the Retirement Investors to assert the claims safeguarded by (BIC [Exemption]).”

But, a contractual provision that the BIC Exemption does prohibit is one under which the IRA investor

waives or qualifies its right to bring or participate in a class action or other representative action in court in a dispute with the Adviser or Financial Institution, or in an individual or class claim agrees to an amount representing liquidated damages for breach of the contract.  (Emphasis added).

Current Theories of Liability Against Broker-Dealers

State and federal securities statutes, as well as state common law, generally govern civil liability in connection with losses arising from the purchase and sale of securities.

Common theories of liability involving alleged broker misconduct include misrepresentations and omissions, churning, and “unsuitable” investment recommendations.  As to a failure to satisfy FINRA’s “suitability” standard, some of the most common specific claims relate to investments that are inappropriate for the investor’s risk profile, as well as failures to diversify account assets or deploy appropriate hedging strategies, excessive use of margin, etc.

It should be noted that violations of SRO rules (such as FINRA rules) generally do not give rise to a private right of action under federal securities statutes.[ix]  Nonetheless, at a minimum, such rules denote professional standards of conduct, and may be used to support claims based on agency or tort duties.[x]  Moreover, an intentional violation of the rules may be deemed a violation of Rule 10b-5[xi] relating to the use of manipulative and deceptive devices.[xii]  Of course, state law fraud claims can also be brought, although the focus of this Article will not be on acts of willful misconduct, which should be presumed to give rise to liability regardless of the particulars of any “fiduciary” or “best interest” duty.

A broker’s violation of regulatory duties, while generally recognized to not give rise to a private right of action, may provide evidence in assessing whether the broker properly exercised the required degree of care in his dealings with a customer.  Thus, of particular note, a violation of FINRA’s suitability standard (Rule 2111) could be relevant in innumerable contexts.

Even where the broker is not acting as a fiduciary, state common law claims may include negligence (including negligent misrepresentation) or breach of contract claims.  In fact, many courts have held that a violation of regulatory rules may be the basis of a negligence claim.  Examples could include violations of FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade), as well as Rule 2111 (Suitability).  Likewise, most customer agreements and trade confirmations incorporate SRO rules and regulations into the contract with the customer, meaning that a violation may give rise to a breach of contract claim if damage results. Additionally, there is implied in all contracts the duty of good faith and fair dealing.

Securities statutes and conduct rules also require broker-dealer firms to reasonably supervise their individual brokers with a view to thwarting violations of the securities laws.  Under Section 20(a) of the Securities and Exchange Act, 15 U.S.C. § 78t(a), any person who directly or indirectly controls any person who is liable for selling securities in violation of the act is liable to the same extent as the seller, unless he acted in good faith and did not directly or indirectly induce the act at issue. The broker-dealer, as well as supervisors of the broker, may be liable as “controlling persons” for the acts of the broker if the broker-dealer has some indirect means of discipline or influence over them.

Claims against firms for failure to monitor are not uncommon and, when combined with general agency principles, can form a basis for a common law negligence claim against a firm.  Customer claims may also be based on individual broker misconduct that violates a broker-dealer’s internal compliance manual. Once the individual broker’s misconduct is established, agency principles again may make the firm liable as well.

Substantive Differences – the Best Interest Standard vs. Existing Standards.

In terms of the theories (and amounts) of additional liability exposure that the Best Interest Contract could create, we will explore its standards versus those currently prevailing – i.e., the “gap” should logically denote the additional exposure.  We discuss certain procedural aspects of potential claims in the next section.  Here, we will focus on the substantive differences.

Presumably, any breach of the Best Interest Contract (that is, any provision(s) of it) could lead to liability.  We believe it is likely that FINRA arbitrators (and courts) will indeed recognize the existence of “special circumstances” and thus fiduciary status where broker-dealers and their representatives are advising IRAs in reliance on the BIC Exemption.  For example, while the “best interest” standard is different (and higher) than FINRA’s suitability standard, FINRA arbitrators could still treat a breach of the contract’s terms as violating Rule 2010 (Standards of Commercial Honor and Principles of Trade), which is often regarded as a “catch-all” type provision.

In any case, FINRA already recognizes a number of rules pertaining to the distribution of particular securities, as well as others focusing on the avoidance of inappropriate conflicts.  But, the single most important and relevant rule is Rule 2111 (Suitability) – requiring a “reasonable basis” to conclude that a particular investment would be “suitable” for the investor’s profile, and generally taking into account the investor’s “age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs and risk tolerance.”

On its face, much of the DOL’s “best interest” standard reads similarly…but it goes further:

Investment advice is in the “Best Interest” of the Retirement Investor when the Adviser and Financial Institution providing the advice act 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, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.  (Emphasis added)

In short, the primary differences are that the “best interest” standard specifically requires that the investor’s interests never be subordinated to those of the advisor or firm, and that more than just a “reasonable basis” that the investment would be merely “suitable” must be established.  In the preamble to the BIC Exemption, the DOL rejected calls to apply the suitability standard in place of its best interest requirement, arguing that

(t)he text of (the Suitability Rule) does not…prohibit the selection of the least suitable (but more remunerative) of available investments, or require them to take the kind of measures to avoid or mitigate conflicts of interests required…(Emphasis added)

The differences between these standards are easier to describe conceptually than they may be to observe in practice.  Many FINRA claims are arbitrated, creating a dearth of reliable precedent, and there is no enforcement history for the BIC Exemption that can be pulled from.

There are other provisions in the Best Interest Contract that presumably could lead to liability.  Perhaps the most obvious example is the separate “reasonable compensation” restriction.  Because it is set forth as a distinct contractual term, it would appear that contract breach claims could be brought alleging only excessive fees or commissions, even in the absence of imprudent advice or investment losses (other than the “unreasonable” compensation).

So, sources of additional liability under the Best Interest Contract (that might not otherwise exist) could include, for example:

  • advice to an IRA owner to purchase a proprietary annuity generally suitable for the customer, but which is more expensive than most similar annuities on the market;
  • advice to an IRA owner to invest in generally suitable mutual funds with whom the broker-dealer has distribution relationships, but for which the performance (or expense ratios) are not competitive with many others in their peer groups;
  • accepting a large, ongoing advisory fee for allocating IRA assets across a suite of proprietary strategies that pay the institution additional management fees; and
  • receiving commissions or 12b-1 fees that exceed a reasonable level of compensation in light of the services rendered.

Procedural and Other Differences.

Clearly, and particularly in light of its prohibition against exculpatory clauses, the Best Interest Contract would provide a clearer and less ambiguous basis upon which to bring breach of contract claims. There would be no need to consider any nuances relating to quasi-contractual theories or the implied covenant of good faith and fair dealing where a fiduciary requirement is set forth in writing.  In addition, because the Best Interest Contract must be enforceable against the financial institution and acknowledge its fiduciary status (and must also contain specific warranties about supervisory policies and procedures), it may likewise make for clearer breach cases against firms – that is, it would likely make it more difficult for a firm to defend itself by arguing an absence of negligence in failing to oversee individual advisors, etc.  An absence of negligence would not mean that no fiduciary breach occurred (which contemplates a higher standard than just the avoidance of negligence), or that the contract was not breached.

In our discussion of the Best Interest Contract requirements, we noted the dichotomy between individual claims and class claims.  In the first case, arbitration can be mandated – and undoubtedly – broker-dealer firms will continue to incorporate clauses requiring the same, as they do now.

As to class claims, the Best Interest Contract does not permit investors’ rights to participate in such claims in court to be waived or otherwise qualified.  In other words, arbitration or mediation of class claims cannot be mandated under the BIC Exemption.[xiii]  FINRA Rule 12204 likewise provides that claims based upon the same facts and law, and involving the same defendants – as in a court-certified or putative class action – cannot be not be arbitrated in a FINRA forum unless the claimant “opts out” of the class claim.  FINRA also takes the position that arbitration provisions cannot contain class action waivers.[xiv]

Thus, on its face, the Best Interest Contract does not create material differences as to the types of lawsuits and other claims that can be brought against broker-dealers, at least in a procedural sense – individual claims can still be subject to arbitration, but class claims cannot (unless the plaintiffs agree to arbitration voluntarily).

As to class claims, the BIC Exemption does not draw any distinction as to venue – presumably, claims for breaching the Best Interest Contract would generally be state law claims, but could possibly be litigated in federal court where diversity jurisdiction exists.

The only specific “venue” restrictions in the BIC Exemption are the requirements that arbitration or mediation not be required (for individual claims) to occur in an inconvenient forum, and that such requirements do not “otherwise unreasonably limit the ability of the Retirement Investors to assert the claims safeguarded by this exemption.”  As noted previously, a common-sense reading of this passage would indicate that arbitration could not be required if the arbitrator would not apply the best interest standard (and other contractual provisions) in resolving the dispute.  This bolsters our belief that FINRA would be likely to recognize the fiduciary status created under the Rule and otherwise apply the BIC Exemption principles where an IRA investor brings an individual claim against a broker.

As to damages, where a breach of contract or a fiduciary duty occurs, the damaged party is generally entitled to be “made whole” for losses – i.e., investment losses.  Again, the BIC Exemption does not permit liquidated damages clauses, but it does permit waiver of punitive damages and rescission as remedies where otherwise permitted by law.  Current theories of liability, including negligence, breach of contract, and quasi-contractual theories, would likewise generally support (at least, and often no more than) an “actual damages” standard.  In many jurisdictions, and as a very general matter, punitive damages are rarely awarded under such theories, unless a further tort claim can be alleged or the defendant was particularly reckless or malicious.  In any case, the BIC Exemption would certainly not make punitive or similar damages more likely.

However, this does not mean that no additional economic consequences could result – quite the opposite.  Because satisfaction of the Best Interest Contract’s terms is a requirement of the BIC Exemption, a failure to satisfy them triggers an automatic (non-exempt) prohibited transaction.  The consequences have some independent litigation significance, but will also provide potential claimants more leverage to negotiate “amicable” resolution of disputes.

Under Section 4975 of the Code, a 15% excise tax is imposed on the “amount involved” in any non-exempt prohibited transaction involving an IRA.  For transactions not undone within certain time frames, a second-tier 100% tax attaches – a cudgel to prevent parties from accepting the 15% tax as a cost of doing business.  In our context, the “amount involved” would include – at least – the compensation paid to the advisor and firm in connection with the sale.

Faced with a potential claim, if the dispute can be resolved amicably, a financial institution may be able to conclude that no violation of the contract occurred – hence, no demonstrated prohibited transaction or excise tax.  But if a court or arbitrator rules that such a violation did occur, the consequences may include not only the 15% tax, but also the full “undoing” of the transaction.  Anything less and the 100% tax may attach, an even worse result – the money that might have been returned to the investor would then go to the IRS.

Historically, the IRS’ enforcement role as to prohibited transactions and excise taxes has focused more on dealings between the IRA and its owner, which can result in IRA disqualification.  Whether the IRS will take a more active role as to prohibited transactions by IRA advisors remains to be seen, but in any case, possible exposure to excise taxes for firms may constitute another potential arrow in the quill of claimants.


On June 1, 2017, the SEC announced that it intended to engage constructively with the DOL on the revision and implementation of the Fiduciary Duty Rule. [xv]  The Trump Administration has mandated a second look at the Rule and its negative effects on the investing public.  Therefore, the BIC Exemption may be changed before it is ultimately fully effective.  However, it is unlikely that there will NO fiduciary duty rule.  While we cannot presently predict the exact wording of any new rule, its scope or its exemptions, it is very likely that the new duties and liabilities of broker-dealers and brokers will include some level of fiduciary responsibility with respect to some, and possibly all, of their clients.

[i] Joshua Waldbeser and Jamie Helman are associates at Drinker Biddle & Reath LLP.  Mr. Waldbeser’s practice focuses on the representation of both plan sponsors and financial services providers with respect to ERISA, tax, securities and other compliance matters, including investment and fiduciary issues, as well as prohibited transactions and exemptions.  Ms. Helman’s practice focuses on the representation of banks and broker-dealers in litigation, arbitration and mediation.  Both Mr. Waldbeser and Ms. Helman are part of a cross-disciplinary team at Drinker which advises financial services clients as to their duties and best practices under the new DOL Fiduciary Duty Rule.

[ii] See, e.g., De Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293, 1302 (2d. Cir. 2002).


[iii] 401(K) Plans: Labor and IRS Could Improve the Rollover Process for Participants (2013), available at


[iv] See Variable Annuities: Beyond the Hard Sell (2009), available at


[v] Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, available at


[vi] See generally DOL Adv. Op. 2005-10A (May 11, 2005).


[vii] The Principal Transactions Exemption is structurally similar to the BIC Exemption, but permits inventory sales of CDs, certain debt securities, and UIT interests from broker-dealers to plan and IRA investors, and purchases from such accounts of all securities and investment property (to deal with cases where the broker-dealer is the only “buyer” offering reasonable terms).  A copy of the exemption is available at   The BIC Exemption itself does not provide relief for principal transactions other than “riskless” principal transactions – i.e., where the broker-dealer buys or sells a security to offset the contemporaneous transaction with the investor only after receiving an order – and which are deemed to be the functional equivalent of agency transactions.


[viii] The RFI is available at

[ix] See Touche Ross & Co. v. Redington, 442 U.S. 560 (1975); Jablon v. Dean Witter & Co., 614 F.2d 677 (9th Cir. 1980).

[x] See Piper, Jaffray & Hopwood, Inc. v. Ladin, 399 F. Supp. 292, 298–99 (S.D. Iowa 1975); Mercury Inv. Co. v. A.G. Edwards & Sons, 295 F. Supp. 1160, 1163 (S.D. Tex. 1969).

[xi] 17 C.F.R. 240.10b-5.


[xii] Clark v. John Lamula Investors, Inc., 583 F.2d 594 (2d Cir. 1978).

[xiii] The preamble to the BIC Exemption confirms that a class could voluntarily agree to arbitrate though.


[xiv] See Dep’t of Enforcement v. Charles Schwab & Co., No. 2011029760201, 2014 FINRA Discip. LEXIS 5 (FINRA Bd. of Governors Apr. 24, 2014).

[xv] Public Statement, Chairman Jay Clayton, Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers (June 1, 2017),

The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.

About the Author: Joshua Waldbeser

Joshua J. Waldbeser counsels plan sponsors and committees with respect to their fiduciary responsibilities under ERISA, as well as design and operational considerations for 401(k) plans, ESOPs and other defined contribution plans, cash balance and traditional defined benefit plans, and deferred compensation arrangements of all types. Josh also works extensively with insurance companies, investment advisors and funds, banks and trust companies, broker-dealers, record keepers, TPAs and other service providers with respect to ERISA, tax, securities and other compliance matters, including investment and fiduciary issues, as well as prohibited transactions and exemptions.

About the Author: Jamie L. Helman

Jamie L. Helman concentrates her practice on securities, broker-dealer arbitration, litigation, mediation, employment matters, and regulatory defense. She has experience first-chairing FINRA arbitrations, defended on-the-record testimony of broker-dealer employees before FINRA, and is presently involved in the representation of broker-dealers in several pending FINRA cases as well as regulatory matters.

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