DOL’s Proposed Prohibited Transaction Exemption: Best Interest Contracts

Background

The Proposed Rule would treat certain persons who provide investment advice for a fee or other compensation to an employer-sponsored retirement plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner as fiduciaries (investment advice fiduciaries) under the Employee Retirement Income Security Act of 1974 (ERISA), as amended or the Internal Revenue Code of 1986, as amended. (Please see our Client Advisory, “Take Two: DOL Reproposes Changes to Definition of Fiduciary for ERISA Plans and IRAs,” published concurrently with this one, for more information on persons who would qualify as investment advice fiduciaries and the categories of advice covered by the Proposed Rule.)

Investment advice fiduciaries are generally prohibited from receiving payments from third parties or from receiving compensation that varies depending on the particular investments made or recommended by the fiduciary. Unless a prohibited transaction exemption applies, investment advice fiduciaries are prohibited from receiving brokerage and insurance commissions, 12b-1 fees, revenue sharing payments and certain other types of compensation resulting from their investment advice to plan sponsors, plan participants and beneficiaries, and IRA owners.

Proposed Best Interest Contract Exemption

The new proposed prohibited transaction exemption published with the Proposed Rule—the “best interest contract” exemption—would allow “advisors,” “financial institutions,” and their “affiliates and related entities” to receive compensation for investment advice provided to “retirement investors” that would otherwise be prohibited as a conflict of interest. The exemption seeks to promote investment advice that is in the best interests of retirement investors by requiring the advisor and financial institution to enter into contracts in which they “acknowledge fiduciary status, commit to adhere to basic standards of impartial conduct, warrant that they have adopted policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest, and disclose basic information on their conflicts of interest and on the cost of their advice.”

The U.S. Department of Labor (DOL) has proposed a standards-based approach that is intended to preserve existing beneficial business models and broadly permit investment advice fiduciaries to continue to rely on common fee practices. This represents a departure from the DOL’s typical regulatory approach of creating highly prescriptive transaction-specific exemptions.

The proposed exemption would be limited to investment advice provided to individual participants who can direct their own investments in 401(k) and 403(b) plans and other plans governed by ERISA, to IRA owners, and to plan sponsors of plans covering fewer than 100 participants that do not allow participant-directed investments. Investment advice provided to plan sponsors who are picking a menu of investment funds for a participant-directed plan, or to sponsors of large pension plans that do not permit participant-directed investments, is not covered by the exemption. Investment advice for such plans may, however, be covered by other DOL exemptions, a number of which are being revised in conjunction with the Proposed Rule.

A summary of the material aspects of the proposed “best interest contract” exemption follows below.

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