Investment Advice Revisited
Art by Tim Bower
On June 29, the Department of Labor (DOL) issued a notice of proposed class exemption titled “Improving Investment Advice for Workers and Retirees.” At that point, the ink was still drying on advisers’ Form CRSs and Regulation Best Interest (Reg BI) disclosures. Now, the department has introduced a new exemption for advisers who act as fiduciaries to Employee Retirement Income Security Act (ERISA)-covered plans, individual retirement accounts (IRAs) and other tax preferred accounts.
More importantly, in the preamble, the DOL provides a potentially significant expansion of the definition of “investment advice.” This expansion applies not only to broker/dealers (B/Ds), but also to other financial institutions such as registered investment advisers (RIAs), banks, insurance companies, recordkeepers and all of their respective employees, representatives and agents.
The agency proposed the exemption in order to allow financial institutions and their representatives to give investment advice, as defined under ERISA Section 3(21) and Internal Revenue Code (IRC) Section 4975(e)(3), notwithstanding the existence of certain conflicts of interest. Thus, the adviser could receive transaction-based and other conflicted compensation and would be able to engage in principal transactions under certain circumstances.
Advisers would need to comply with the DOL’s impartial conduct standards. These require that the adviser: 1) make recommendations in accordance with a best interest standard, which is articulated the same way as the standard of conduct under Reg BI; 2) receive reasonable compensation; and 3) not make any materially misleading statements. The adviser must also provide written disclosures acknowledging fiduciary status and describing the services to be provided and material conflicts of interest.
Further, the firm must also establish policies and procedures prudently designed to ensure compliance with the impartial conduct standards and to mitigate conflicts of interest. Here, the firm must document the rationale for any rollover and account transfer recommendations.
While some of the conditions resemble prior DOL guidance, others will be unfamiliar. For one, the adviser would need to conduct an annual retrospective review to help him detect and prevent violations of the impartial conduct standards or his policies and procedures. The firm’s CEO must certify that he has reviewed a report summarizing the compliance review and that the firm has adopted policies and procedures that comply with the exemption.
While the proposed exemption is significant, arguably the most important developments appear in its preamble. There, the DOL changes its view on how to determine when an adviser provides investment advice, particularly when recommending a participant take a distribution and roll the money into an IRA.
In the preamble, the DOL states it will nullify Advisory Opinion 2005-23A, often referred to as the Deseret letter. In that, the agency wrote that someone not already a fiduciary to a benefit plan was not acting as a fiduciary when he recommended taking a distribution and rolling it into an IRA, even if he would give investment advice once the assets were moved. It now says advisers should apply the 1975 five-part test found in 29 CFR [Code of Federal Regulations] 2510.3-21(c)(1) in determining whether a rollover or any other recommendation as to the advisability of investing in, purchasing or selling securities or other property is investment advice.
The DOL went on to explain its interpretation of each prong of the five-part test. The result completely reverses the DOL’s position in the Deseret letter. The agency also expresses its views on the “mutual agreement, arrangement or understanding” and “primary basis” prongs of the test. In so doing, it broadens the circumstances as to when adviser/customer interactions rise to a fiduciary advice relationship.
The proposed exemption, particularly the language in the preamble, is a significant development. Some advisers will find it helpful, at least in principle, others may find its conditions unworkable in the current form.
Whether the DOL will issue a final exemption remains to be seen. Yet, the preamble and application of the five-part test suggests a shift in thinking as to when an adviser provides investment advice and indicates this thinking will continue to apply, final exemption or not.
David Kaleda is a principal in the fiduciary responsibility practice group at Groom Law Group, Chartered, in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers.