Extracted from Law360
Recently, the U.S. Department of Labor proposed a new regulation to define when financial advisers are considered “fiduciaries” under the Employee Retirement Income Security Act and the Internal Revenue Code. The proposed regulation also includes new prohibited transaction exemptions (PTEs), as well as revisions to, and elimination of, certain existing PTEs. The primary PTE available to most financial advisers, should the DOL’s proposals become effective, is the proposed best interest contract prohibited transaction exemption (the “best interest contract PTE”). This PTE provides a broad prohibited transaction exemption (but not an exemption from the fiduciary rules) for financial advisers who agree to contracts that provide certain consumer protections for their customers. Those contracts would be enforceable in court by the customers. This article examines the likely litigation implications of lawsuits to enforce the “best interest” contracts.
Overview of the DOL’s Proposed Regulation
Generally speaking, a person can become an ERISA fiduciary by: (1) being designated as a fiduciary in the plan documents; (2) acting as a functional fiduciary by exercising discretionary control over certain aspects of the plan or having control over plan assets; and (3) giving investment advice to the plan. The DOL’s proposed regulation provides guidance to address what constitutes giving investment advice.
Under the proposed rule, a person renders investment advice by providing investment or investment management recommendations or appraisals to a plan and either acknowledging the fiduciary nature of the advice or acting pursuant to an understanding with the recipient that the advice is individualized to, or specifically directed to, the recipient for the recipient’s consideration in making investment or management decisions regarding plan assets. If this advice is provided for a fee or other compensation, the person rendering the advice would be considered an ERISA fiduciary under the proposed rule.
In addition to expanding the field of individuals considered to be ERISA fiduciaries, the DOL has also proposed new PTEs, as well as proposed amendments to certain existing exemptions. These proposed exemptions would allow certain advisers and firms to continue to receive compensation for what would otherwise be a prohibited transaction in light of their new fiduciary status under the proposed expansion to the definition of “fiduciary.”
Elements of the Best Interest Contract PTE
The DOL’s proposed best interest contract PTE is a broad, “principles-based” exemption (as opposed to exemptions that apply only to particular transactions) that would apply only to compensation received in connection with investments in certain types of assets. There are some fairly burdensome requirements that a financial adviser or institution would have to meet to qualify for the proposed PTE. The PTE would be available to financial advisers who receive compensation for investment advice given to retail investors regarding certain products, such as individual plan participants, individual retirement account (IRA) owners and small plans with fewer than 100 participants.
To qualify for the proposed best interest contract PTE, the financial adviser or institution would have to enter into a written contract with the investors that provides the following: (1) a contractual acknowledgment of fiduciary status; (2) a commitment to basic standards of impartial conduct; (3) a warranty of compliance with applicable laws; (4) a warranty of adoption of policies and procedures reasonably designed to mitigate any harmful impact of conflicts of interest and ensure compliance with the standards of impartial conduct; and (5) a disclosure of basic information on conflicts of interest and fees.
The best interest contract cannot include disclaimers or other limitations on liability for violations of the contract provisions or a waiver of the investor’s right to participate in class action litigation. However, an agreement to engage in binding arbitration with respect to the individual’s claims would be permissible. A financial institution that wishes to rely on this proposed PTE would also be subject to additional notice and data collection requirements.
Enforcing the Best Interest Contract — Unanswered Questions
The DOL contends that the proposed best interest contract PTE would allow consumers to hold fiduciary advisers accountable through a private right of action for breach of contract. If violated, the contractual obligations of the best interest contract could potentially expose financial advisers and institutions to liability for a nonexempt prohibited transaction, which could include: (1) civil penalties under ERISA Section 502(i) of up to 5 percent of the amount involved for each year (or part of a year) that the prohibited transaction continues; (2) criminal penalties; and (3) excise taxes under the Internal Revenue Code (including a tax of 100 percent of the amount involved if the breach is not timely corrected).
Notably, the best interest contract PTE is not a general exemption from the DOL’s proposed expanded version of the definition of a “fiduciary” under ERISA. Entering into a best interest contract could shield a financial adviser or institution from liability for a prohibited transaction, but doing so would not relieve the newly christened fiduciary from satisfying the general fiduciary duties under ERISA. Accordingly, the financial adviser or institution could still face potential civil liability for breach of the contract.
The litigation issues presented in suits to enforce best interest contracts are likely to vary widely depending on whether the adviser’s customer invested through a plan governed by ERISA (such as a 401(k) plan) or through a retirement plan governed only by the Internal Revenue Code (such as an IRA). However, there are some basic questions that are likely to come up in either type of litigation. Specifically, the DOL has not provided much detail on what best interest contracts need to specifically say or what supporting “policies and procedures” are required.
For example, a best interest contract must include “a commitment to basic standards of impartial conduct,” but the DOL has provided little guidance on what this actually means. The preamble seems to imply that in addition to having the right contractual language, proper execution is also required for the exemption to apply. However, the description of the standards of impartial conduct simply sounds like a discussion of existing duties under ERISA and/or trust law. Does a best interest contract impose duties beyond those imposed by existing law? If not, what is the point of re-imposing existing obligations in a contract? If so, what are the additional requirements?
Similarly, a best interest contract must include a warranty that the adviser has adopted policies and procedures reasonably designed to “mitigate any harmful impact of conflicts of interest” and disclose “basic information” on conflicts of interest. The preamble makes clear that ongoing compliance with the warranty is not required for the exemption to apply, but failure to comply on an ongoing basis could result in unspecified contractual liability. The preamble also acknowledges that the proposal does not mandate the specific content of the required policies and procedures in order to maintain flexibility. However, the lack of specification also creates uncertainty regarding what is required to avoid contractual liability. Some examples of approaches that could help satisfy the requirements are provided, but what would preclude a lawsuit is undefined.
Also undefined are the remedies, if any, for failing to comply with the best interest contract PTE requirements and/or the related warranties. If the contract does not say what it is supposed to, the exemption is not applicable and the fees the adviser charges, and potentially other transactions, could become prohibited transactions. However, what, if any, remedies are available for not having sufficient policies and procedures, or any at all? If a customer sues to enforce the warranty, does he or she need to show any actual damages? In other words, if the adviser’s policies and procedures are found deficient, are any damages available absent a monetary loss? Would injunctive relief be available? Are the courts going to be the ones to specify the requirements? What standards would a court apply in defining the required policies and procedures?
If there is a monetary loss, does the plaintiff have to show a causal nexus between the loss and the failure to adopt and/or implement adequate policies and procedures? In other words, what if there is a failure to adopt or enforce sufficient policies and procedures, and there is a financial loss, but the plaintiff cannot prove that the failure to follow adequate policies and procedures caused the loss? What if a conflict was not sufficiently disclosed, and it is just not clear whether the conflict played any role in the recommendation?
If the adviser’s customer is, or is investing through, an ERISA plan, a whole host of additional issues arise. ERISA preempts state law claims that relate to ERISA plans, and ERISA’s civil remedies provision contains a list of exclusive remedies. Will courts view a suit for breach of a best interest contract to be an additional civil remedy not included in the exclusive statutory list? Is it possible to make a claim for breach of a best interest contract under the existing statutory structure?
ERISA’s civil remedies provisions generally permit suits to recover benefits due for breach of fiduciary duty and for other appropriate equitable relief to enforce the terms of the plan and/or ERISA. Could a suit to enforce the terms of a best interest contract be viewed as suit to enforce the terms of the plan? That seems unlikely as the contract would simply be a contract with a service provider wholly unrelated to the terms of the plan itself.
Could a suit for breach of a best interest contract constitute a claim for breach of fiduciary duty? If not, there does not seem to be a way to fit this type of suit within ERISA statutory structure. If so, this simply raises the question of whether the standards of impartial conduct or any other aspect of the PTE imposes requirements beyond ERISA’s fiduciary requirements. If not, what is the point of a contractual requirement? If so, where is the statutory authorization if imposing additional duties?
Internal Revenue Code Concerns
Other complex issues arise in the context of plans governed only by the Internal Revenue Code (such as IRAs). Could a claim for breach of a best interest contract be based on state law? The question of what constitutes sufficient contractual terms or the requisite policies and procedures for purposes of the PTE would seem to be a matter of federal law. If state law claims are permitted to proceed, there seems to be substantial room for conflicts among state courts and between state and federal courts as to what the best interest contract PTE requires, what remedies are available and what supporting policies and procedures are required.
Typically, disputes between IRA account holders and investment advisers are subject to the securities laws and Financial Industry Regulatory Authority arbitration. Would the best interest contract PTE provide an end run around FINRA arbitration? Would two different sets of fiduciary requirements apply to advisers under the securities laws and the Internal Revenue Code?
It is not clear how the courts will resolve these issues, or what other issues may arise in litigation. This bodes well for attorneys who litigate disputes in this area. It is not such a positive development for those who make a living by providing investment advice to plans governed by ERISA and/or the Internal Revenue Code.
What’s Next for the Proposed PTE?
The DOL set a July 6, 2015, deadline for the submission of written comments concerning the proposed best interest contract PTE. However, the DOL has issued a statement indicating that the comment period regarding the fiduciary redraft (the Conflict of Interest Notice of Proposed Rulemaking) will be extended by 15 days. It is possible that, given the volume of objections and concerns raised during the comment period, the DOL could make significant changes to the proposed regulation, as well as the proposed best interest contract PTE.