In a previous post, we discussed why broker-dealers and their representatives will likely still be fiduciaries to ERISA plans and IRA investors in many cases despite the DOL Fiduciary Rule’s impending death (we say “impending” because, while the Fifth Circuit’s ruling in mid-March vacates the Fiduciary Rule in its entirety, the court’s official order implementing this decision has yet to be issued). To review, this is because broker-dealers and their representatives often satisfy all the prongs of the soon-to-be reinstated 1975 fiduciary regulation’s “Five-Part Test” defining when investment recommendations rise to the level of “fiduciary” advice. Previous industry assumptions that brokers and other “sellers” of investments generally were not fiduciaries under the 1975 regulation should no longer be relied upon. In this post, we’ll examine how the Fiduciary Rule’s impending demise will affect prohibited transaction and compensation issues for broker-dealers in light of their likely continuing status as fiduciaries.
Fiduciary status matters to broker-dealers for two primary reasons. First, fiduciary advisors to plans and participants must satisfy the duties of prudence and loyalty imposed under ERISA. Second, fiduciary advisors to plans and IRA investors are subject to the self-dealing and other prohibited transaction rules under ERISA and the Tax Code. These rules are very broad—an advisor cannot through its fiduciary advice influence its own or its affiliates’ compensation, and cannot receive third-party compensation in connection with its advice. In other words, the general rule is that the advisor and the broker-dealer must receive compensation that does not vary depending on the investments selected by the advice recipient, and generally cannot receive commissions or other third-party compensation like 12b-1 fees. While there are some exceptions to these broad general rules called “prohibited transaction exemptions,” they apply only to certain specified transactions, and they have their own conditions that must be satisfied. So what does this mean as a practical matter in a post-DOL Fiduciary Rule world?
The Fifth Circuit’s ruling will vacate the Rule in toto, which means that all of the new prohibited transaction exemptions disappear as well, including the Best Interest Contract Exemption (BIC Exemption) and the Principal Transactions Exemption. This presents a legal quandary for some broker-dealers. Many of them will still be fiduciaries under the 1975 Rule, but the variable or third-party compensation they received while relying on the BIC Exemption will no longer be permitted. Even though they were fully complying with the DOL Fiduciary Rule and the BIC Exemption, there may not be another exemption they can use once the 5th Circuit decision goes into effect.
Here are several specific examples of broker-dealer compensation that was exempted under the BIC Exemption but which likely will be a prohibited transaction once the Fiduciary Rule is vacated:
• Where the broker-dealer receives different amounts of compensation from mutual fund A than from mutual fund B (even if the registered representative is paid a level fee).
• Where the representative receives different commission amounts from different share classes of investments that he or she recommends to an IRA owner.
• Where the representative recommends a principal transaction with the broker-dealer.
• Where the representative receives a different fee or commission from different products (annuity vs. mutual fund, etc.).
Rollover transactions present a special case. As explained in our prior post, previous DOL guidance on rollovers will again be applicable. Advisory Opinion 2005-23A explains that a person who is not already a plan fiduciary can recommend a rollover without becoming a fiduciary (likely because rollover advice is a one-time transaction and thus the advice is not provided “regularly”). But the same guidance also provides that a fiduciary advisor to a plan is a fiduciary when recommending a rollover to a participant in that plan. And, other than the BIC Exemption, there is no existing exemption that clearly provides relief where a fiduciary advisor recommends a rollover to an IRA account that will pay the advisor more compensation than the advisor received from the plan.
Fortunately, on May 7, 2018, the DOL issued Field Assistance Bulletin (FAB) 2018-02, which provides some relief in the form of a temporary enforcement policy for advice fiduciaries. The FAB, which is binding on both the DOL and IRS, provides that prohibited transaction claims will not be brought against advice fiduciaries who “are working diligently and in good faith” to satisfy the impartial conduct standards set forth in the BIC Exemption and the Principal Transactions Exemption. It also goes on to state that advice fiduciaries may rely on other still-available exemptions (for example, PTE 86-128 as to brokerage commissions, or PTE 77-4 as to affiliated mutual funds), but that the DOL will not treat an adviser’s failure to rely upon such other exemptions as resulting in a violation of the prohibited transaction rules if the adviser meets the terms of this enforcement policy.
The FAB applies from June 9, 2017, (the Fiduciary Rule’s “go-live” date) until further guidance is issued. And while there are aspects of the FAB that are a bit unclear, it appears that fiduciary advisors will be protected from DOL enforcement action and IRS excise taxes with respect to “conflicted” recommendations as long as advice satisfies the impartial conduct standards:
1. The advice is in the “best interest” of the plan or IRA investor.
2. Compensation to the firm, advisor and their affiliates does not exceed a reasonable level (for principal transactions, a “best execution” standard applies instead).
3. No misleading statements are made to the plan or IRA investor.
Firms and advisors are cautioned that the FAB does not preclude the possibility of private lawsuits by ERISA investors, claims from IRA investors (i.e., FINRA arbitrations), or actions by the states.
In any case though, the “best interest” standard is not fundamentally different from the conduct standard imposed under ERISA for fiduciary advice to plans and participants, and it is generally at least as robust as FINRA’s suitability standard. Thus, whether the investor is a plan sponsor or other fiduciary, plan participant or IRA owner, brokers who believe that their recommendations will rise to a “fiduciary” level under the Five-Part Test can significantly reduce their risks by ensuring that (and documenting why) those recommendations satisfy the “best interest” standard, and the other impartial conduct standards.
As a final note, fiduciaries to ERISA plans (other than SEPs and SIMPLEs) are required to provide a 408(b)(2) disclosure to the responsible plan fiduciary acknowledging their status as a fiduciary (among other things). Firms are encouraged to consider whether new disclosures, or updates to existing disclosures, may be advisable. This may include situations where fiduciary advice is provided and no previous disclosure was furnished, or even cases where a previous fiduciary acknowledgment was provided in anticipation of the Fiduciary Rule, but no fiduciary status is anticipated under the Five-Part Test.