The U.S. Department of Labor’s (the “DOL”) controversial final fiduciary rule is expected to have a significant impact on private funds. The final fiduciary rule substantially broadens the group of financial advisers that will be deemed to be fiduciaries with respect to plans subject to the U.S. Employee Retirement Income Security Act of 1974 (“ERISA”) and individual retirement arrangements (“IRAs”) and certain other arrangements subject to the U.S. Internal Revenue Code (the “Code”). Advisers who are subject to the fiduciary rules must act in their clients’ best interests when making investment recommendations, rather than making investment recommendations that are merely “suitable” for their clients.
The final fiduciary rule, which generally takes effect in April of next year, is considerably more favorable than the rule the DOL originally proposed in 2010 and subsequently withdrew in 2011 in response to widespread concern from the investment community. Last year, the DOL reproposed the fiduciary rule and proposed several new prohibited transaction exemptions, including the “best interest contracts” (or “BIC”) exemption and principal transactions exemption, which are intended to reduce the burden on investment advisers. The final fiduciary rule streamlines the requirements of the BIC exemption and certain other exemptions, and extends relief to non-traded REITs and certain annuities. However, not all of the exemptions are available to private funds, and certain of the exemptions that may be available to private funds may impose significant administrative burdens and increased costs.
New Fiduciary Rule
Under the final fiduciary rule, an adviser generally will be deemed to provide investment advice for purposes of ERISA and the Code if it makes an investment “recommendation” to a plan, plan fiduciary, plan participant or beneficiary, IRA or IRA owner for a fee or other direct or indirect compensation.
Advisers Subject to New Rule. The final fiduciary rule applies to recommendations provided directly or through an affiliate by an adviser who:
- represents or acknowledges that it is acting as a fiduciary within the meaning of ERISA and/or the Code;
- renders the advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is based on the particular investment needs of the advice recipient; or
- directs the advice to a specific advice recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA.
“Recommendation” Defined. The final fiduciary rule defines “recommendation” as “a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.” Whether a recommendation has been made is an objective, rather than subjective, test. The more individually tailored the communication is to a specific advice recipient or recipients about, for example, a security, investment property or investment strategy, the more likely the communication will be viewed as a recommendation.
Covered Recommendations. The final fiduciary rule covers “recommendations” as to the:
- advisability of acquiring, holding, disposing of or exchanging securities or other investment property, including how the proceeds from plan or IRA rollovers or distributions should be invested;
- management of securities or other investment property, including but not limited to recommendations on:
- investment policies or strategies;
- portfolio composition;
- selection of other persons to provide investment advice or investment management services;
- selection of investment account arrangements (e.g., brokerage versus advisory); and
- plan or IRA rollovers, transfers or distributions, including whether, in what amount, in what form and to what destination such a rollover, transfer or distribution should be made.
Excluded Recommendations. The final fiduciary rule does not cover the following, provided in each case that certain conditions are met:
- platforms provided to ERISA plans (this exclusion does not apply to IRAs or 401(k) brokerage windows);
- selection and monitoring activities (including in response to an RFP or RFI and certain mapping alternatives);
- general communications that a reasonable person would not view as investment advice (such as publicly broadcast talk shows, speeches given at widely attended conferences, newsletters and, importantly, general marketing data and prospectuses); and
- investment education, including, for example:
- plan information;
- general financial, investment or retirement information;
- asset allocation modeling; and
- interactive investment materials.
“Hire Me” Provisions. The final fiduciary rule makes clear that “hire me” provisions (recommendations to hire oneself or an affiliate to serve as the investment adviser) are exempt, but does not extend the exemption to invest in a particular fund. As a result, the relief provided to private funds by the “hire me” exemption may be somewhat limited.
Appraisals and Valuations. The DOL is expected to issue guidance on appraisals and valuations at a later date.
Investment Advice Exempt from Fiduciary Rule
The final fiduciary rule exempts from the definition of investment advice the following three types of advice, even if the advice includes recommendations. If the requirements of one of the three exemptions are satisfied and the adviser does not otherwise acknowledge fiduciary status, the adviser will not be considered a fiduciary for purposes of the final fiduciary rule.
Sophisticated Counterparties. The final fiduciary rule exempts counterparty transactions with an independent fiduciary of a plan or IRA in an arms length transaction, if the counterparty knows or reasonably believes that the independent fiduciary is a U.S. bank or insurance company, U.S. registered adviser or broker-dealer, or adviser that holds or has assets under management of at least US$50 million and if certain other conditions are met. The US$50 million threshold includes both plan and non-plan assets. This is an important exemption that allows financial institutions and broker-dealers to market products to non-retail investors. Note that, as currently drafted, the final fiduciary rule would not exempt IRA owners managing their own IRA accounts. Unless this is clarified in subsequent guidance, private fund sponsors that are not otherwise exempt from the final fiduciary rule should avoid making “recommendations” directly to IRA owners about investing or rolling over their IRAs.
Swaps and Securities-Based Swaps. The final fiduciary rule exempts certain swaps and securities-based swaps that are subject to Dodd-Frank’s Business Conduct Standards and are otherwise exempt under the U.S. Commodity Exchange Act or U.S. Securities Exchange Act of 1934. This exemption requires that the advice must be rendered to an independent plan fiduciary, that the investor acknowledges that he, she or it is not relying upon the advice, and that certain other conditions are met.
Plan Sponsor Employees. The final fiduciary rule retains the exemption for advice rendered by a plan sponsor’s employee, provided the employee does not receive a fee or other compensation for such advice over and above his or her normal compensation. This exemption covers advice by the plan sponsor’s employee to the plan sponsor or another employee or certain communications to plan participants regarding plan or distribution options.
Best Interest Contract Exemption
The BIC exemption, now officially designated as Prohibited Transaction Exemption 2016-01, permits qualified financial institutions, broker-dealers and advisers to provide investment recommendations to “retail” investors, provided that the adviser meets certain “impartial conduct standards” and other strict requirements. For purposes of the BIC exemption, “retail” investors generally include plan participants and beneficiaries, IRA owners and “retail” fiduciaries (non-institutional fiduciaries without financial expertise). Investment recommendations to “non-retail” investors would generally be covered under the sophisticated counterparties exemption described above.
No Asset Class List. Unlike the proposed fiduciary rule, the final fiduciary rule does not limit the types of asset classes that may be covered under this exemption. This is good news for non-publicly traded REITs and certain other asset classes that were not included in the asset class list set forth in the proposed fiduciary rule. However, the DOL makes clear in the preamble to the final fiduciary rule that:
“The fact that the exemption was broadened [to eliminate the approved asset list] does not mean the [DOL] is no longer concerned about some of the attributes of the investments that were not initially included in the proposed definition of Asset, such as unusual complexity, illiquidity, risk, lack of transparency, high fees or commissions, or tax benefits that are generally unnecessary in these tax preferred accounts. . . . Moreover, the [DOL] intends to pay special attention to recommendations involving such products after the applicability date to ensure adherence to the Impartial Conduct Standards and verify that the exemption is sufficiently protective.”
The DOL’s words of caution are particularly important to private funds, which by their nature may be more complex and illiquid than other investment alternatives.
Advisers Eligible for Exemption. The BIC exemption is available only to “financial institutions” and their employees, independent contractors, agents, representatives, affiliates and related entities. For this purpose, “financial institutions” includes only registered investment advisers, banks, insurance companies, broker/dealers and other entities. As a result, many private fund sponsors will not be able to rely upon the BIC exemption. The DOL will, however, offer non-institutional advisers the option to apply for an individual prohibited transaction exemption, provided certain (fairly onerous) requirements are met.
Conditions for Exemption. To qualify for the BIC exemption, the adviser must:
- acknowledge fiduciary status under ERISA and/or the Code;
- adhere to “impartial conduct standards”;
- adopt policies and procedures to ensure related advisers adhere to the “impartial conduct standards;
- clearly and prominently disclose any conflicts of interest, such as hidden fees, that might prevent the adviser from providing advice in the client’s best interest (commissions, 12b-1 fees, revenue sharing);
- comply with other disclosure (including maintaining website disclosure), record retention and DOL notification requirements; and
- enter into written contracts with IRAs or other non-ERISA plans (unlike under the proposed fiduciary rule, this requirement does not apply to ERISA plans, since ERISA plans have existing enforcement protections under ERISA).
Impartial Conduct Standards. The BIC exemption’s impartial conduct standards generally require that, when rendering investment advice to a non-retail investor, the adviser act in the best interest of the investor, charge no more than reasonable compensation and, subject to certain exceptions, refrain from charging bonuses, quotas and other differential compensation.
Streamlined Exemption Requirements. The final fiduciary rule includes streamlined exemption requirements for certain level fee and bank networking arrangements.
Special Rules for Proprietary Products. The BIC exemption includes special provisions for firms which limit their recommendations to proprietary products. Such firms are required to fully disclose that they are offering only a restricted menu of products and the associated conflicts of interest. Proprietary products firms must also adopt measures to protect investors from conflicts of interest and to insulate the adviser from conflicts of interest when making recommendations from the restricted menu. Advisers that recommend a limited set of products must consider what is in the retirement investor’s best interest and document the reasons for recommending the particular proprietary product. If the adviser determines that the investor’s best interest would be best served by another product that the adviser does not offer, the adviser cannot recommend a product from their limited menu. Given these limitations, and that the BIC exemption is only available to eligible financial institutions and their related advisers, many smaller private funds will not be able to rely on the BIC exemption.
Transitional Relief. The final fiduciary rule provides an additional grace period for advisers seeking to comply with the BIC exemption. Although the final fiduciary rule is generally effective in April of next year, advisers have until January 1, 2018 to enter into required agreements with IRAs and other non-ERISA plans and comply with most other requirements of the BIC exemption. The fiduciary acknowledgment and impartial conduct standards of the BIC exemption, however, become effective as of April 10, 2017.
Principal Transactions Exemption
The DOL also finalized the proposed “principal transactions” exemption, which provides relief from the prohibited transaction rules for buyers or sellers of certain assets in principal transactions and riskless principal transactions between a plan or IRA and certain financial institutions, as a result of the financial institution’s or related adviser’s advice. Under this exemption, the assets a plan or IRA may buy generally are limited to debt securities, unit investment trusts and certificates of deposit. However, under this exemption, a plan or IRA generally may sell any security or other investment property. The principal transactions exemption generally is not available to insurance companies or discretionary fiduciaries. Like the BIC exemption, the principal transactions exemption imposes certain “impartial conduct standards,” anti-conflict-of-interest policies and procedures, and certain disclosure requirements.
Other Prohibited Transaction Exemptions
The DOL also amended a number of other existing prohibited transaction class exemptions (“PTEs”), including:
- PTE 84-24, which currently provides prohibited transaction exemptive relief for the sale of insurance and annuity products to plans and IRAs;
- PTE 75-1 and PTE 86-128, which cover certain transactions involving employee benefit plans and broker-dealers and banks;
- PTE 77-4, which covers the investment of plans in open-end mutual funds;
- PTE 80-83, which covers securities transactions where the proceeds may be used to retire certain indebtedness; and
- PTE 83-1, which covers the acquisition of interests in certain mortgage pools by plans.
Relief under each of these amended PTEs is now conditioned upon compliance with the best interest standards set forth in the BIC exemption.
The final fiduciary rule will become effective on April 10, 2017. However, compliance with the BIC exemption and principal transactions exemption will be phased in from April 2017 to January 1, 2018 to give financial institutions and advisers more time to comply with the requirements for these exemptions.
Future of the Final Fiduciary Rule
The future of the DOL’s final fiduciary rule remains somewhat uncertain. Although the final fiduciary rule is less burdensome than its prior iterations, it continues to generate considerable concern within the investment community.
Both the Senate and the House of Representatives have approved resolutions of disapproval in an effort to block the final fiduciary rule. Congress is not, however, expected to garner enough approval to override a Presidential veto of these resolutions. Given the upcoming election in November, there is still the possibility that the final fiduciary rule will be suspended before it becomes effective next year.
In addition, on June 1, 2016, eight industry and trade groups filed a lawsuit in Texas federal court challenging the DOL’s final fiduciary rule. These industry groups include the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association, the Financial Services Institute and five other national and local business groups.
Next Steps for Private Funds
The final fiduciary rule substantially expands the group of advisers that are deemed to be fiduciaries for purpose of ERISA and the Code. As noted above, the availability of the BIC exemption is limited to financial institutions and their related advisers. Many private funds may find it difficult, if not impossible, to qualify for the BIC exemption (or even an individual prohibited transaction exemption similar to the BIC class exemption) or the special rules under the BIC exemption with respect to proprietary funds.
Fortunately, many private funds are structured to avoid the application of ERISA by limiting investment by benefit plan investors to less than 25% of any class of equity or by operating as a “venture capital operating fund” or under the “real estate operating company” exemption. In light of the additional complexities and restrictions that will be imposed under the final fiduciary rule, advisers to these private funds may wish to remain exempt from ERISA. Advisers to private funds that operate or are considering operating as an ERISA fund, should examine the ERISA issues carefully in light of the DOL’s final fiduciary rule.
Although the fate of the final fiduciary rule remains somewhat unclear, in light of the significant changes and the limited time to implement these changes, advisers to private funds are advised to begin reviewing their current structures and fund documents and consider whether any changes are necessary to comply with the final fiduciary rule.
Links to the final fiduciary rule, fact sheet, FAQs and comparison chart showing differences between the final rule and the 2015 proposed rule may be found here:
Final Fiduciary Rule