On December 15, 2020, the U.S. Department of Labor (the “DOL”) issued its highly anticipated final prohibited transaction class exemption for fiduciary investment advice (the “Final Exemption”). The Final Exemption, which will be officially designated “Prohibited
Transaction Exemption 2020-02,” serves two broad functions. First, in the preamble, the DOL provides its “Final Interpretation” of the five-part test under its 1975 regulation defining who is an investment advice fiduciary under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”) and Section 4975 of the Internal Revenue Code (the “Code”). Second, in its operative text, the Final Exemption makes available prohibited transaction exemptive relief for such
fiduciaries, subject to certain conditions. The Final Exemption is the latest development in the DOL’s longstanding efforts to regulate the provision of investment advice to ERISA plans and their participants and IRAs. However, while the exemption is described as “final,” it is likely not the DOL’s final pronouncement in this area. Because there will be a change of administration prior to the Final Exemption’s effective date, it is very likely that new leadership at the DOL
will reassess the Final Exemption, which could result, at the very least, in a delay of the effective date. In this alert, we provide an overview of the Final Exemption. We begin with the DOL’s interpretation of the five-part test, including its application to rollover advice. We then summarize the actual exemption and describe its coverage and conditions. The DOL’s interpretation of the five-part test—which is arguably of
greater significance than the exemption itself—does not appear in the Final Exemption’s text; it is addressed in the preamble alone. Although refined to some degree in response to comments on the DOL’s proposed exemption that preceded the Final Exemption, the DOL retains an expansive interpretation of certain prongs of the five-part test, which could result in a broadening of the universe of those considered to be investment advice fiduciaries. This broadening could, in turn,
increase the need for prohibited transaction relief under ERISA and the Code. By way of background, the DOL established the definition of “investment advice” by regulation in 1975. The regulation states that a person provides “investment advice” if he or she: (1) renders advice to a plan as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing, or selling securities or other property;
(2) on a regular basis; (3) pursuant to a mutual understanding; (4) that such advice will be a primary basis for investment decisions; and that (5) the advice will be individualized to the plan. This is known as the “five-part test.” In order for a person to be a fiduciary for purposes of ERISA and the Code by reason of providing “investment advice,” each of the five parts or “prongs” of the test must be met. Historically, the DOL has issued very little guidance on how to
interpret each of the prongs. Financial services firms have often been able to interpret the five-part test in a manner that allows the firms and their employees, representatives and agents to not be fiduciaries. Additionally, DOL guidance issued in 2005 (discussed below) established that recommendations to take a distribution from a plan and rollover to an IRA was not investment advice for purposes of ERISA and the Code. The DOL says the
“regular basis” prong “broadly describes a relationship where advice is recurring, non-sporadic, and expected to continue.” The DOL notes that objective evidence, “such as the parties agreeing to check-in periodically on the performance of the customer’s post-rollover financial products” or a service provider holding itself “out to the customer as providing such ongoing services” could satisfy the regular basis requirement. The DOL confirms that not all investment advice
relationships satisfy the regular basis requirement. Specifically, the DOL “intends to preserve the ability of financial services professionals to engage in one-time sales transactions without becoming fiduciaries . . . including by assisting with a rollover.” In this regard, parties intending such one-time, non-fiduciary relationships “can make clear in their communications that they do not intend to enter into an ongoing relationship to provide investment advice and act in
conformity with that communication.” Notably, the DOL emphasizes that actual conduct is determinative, and thus even after making such clarifications, fiduciary status could arise from an investment advice provider’s actual conduct. The DOL similarly confirms that certain “sporadic” interactions would not satisfy the regular basis prong. For example, the regular basis prong would not be satisfied in situations where a plan participant initially receives rollover assistance but
“expresses the intent to direct his or her own investments,” and then at some point in the future receives advice from the same adviser. The DOL notes that if a mutual agreement or arrangement is not clearly demonstrated, it will consider the “reasonable understanding” of the parties to determine whether the “mutual agreement” requirement is satisfied. As with the other prongs of the five-part test, the DOL emphasizes that determining whether a
mutual agreement exists depends on the facts and circumstances. In this regard, the DOL notes that it “intends to consider marketing materials in which Financial Institutions and Investment Professionals hold themselves out as trusted advisers” in determining whether the requirement is satisfied. Notably, the DOL reaffirms that contractual terms or written statements “disclaiming a mutual understanding or forbidding reliance on the advice as a primary basis for investment decisions”
are not determinative with respect to whether a mutual agreement exists. In particular, the DOL cautions that “[a] financial services provider should not, for example, expect to avoid fiduciary status through a boilerplate disclaimer buried in the fine print, while in all other communications holding itself out as rendering best interest advice that can be relied upon by the customer in making investment decisions.” D. “Primary Basis” ProngWith respect to the “primary basis” prong, the DOL interprets the five-part test to require that advice be “a” rather than “the” primary basis of investment decisions, as reflected in the actual regulatory text. In this regard, the DOL notes that the primary basis prong does not require “proof that the advice was the single most important determinative factor” in an investment decision. Rather, it takes the view that the primary basis prong is met as long as it is reasonably understood that “the advice is important to the Retirement Investor and could determine the outcome of the investor’s decision.” Additionally, the DOL expressed its view that the “primary basis” prong could be met even if an investor consults with multiple financial professionals. Indeed, any one of those professionals may meet this prong of the test “…[i]f, in each instance, the parties reasonably understand that the advice is important to the Retirement Investor and could determine the outcome of the investor’s decision…” E. Rollover Advice1. Status of Deseret Advisory OpinionA key aspect of the DOL’s interpretation of the five-part test is its confirmation that Advisory Opinion No. 2005-23A (the “Deseret Opinion”) no longer reflects its views regarding fiduciary status in the context of rollover recommendations. Specifically, the DOL now clarifies that its statement in the Deseret Opinion that advice to take a distribution of assets from an ERISA plan is not advice to sell, withdraw, or transfer investment assets is incorrect. According to the DOL, the “better view” is that a recommendation to roll assets out of an ERISA plan is advice with respect to moneys or other property of a plan, which must be further evaluated in the context of the full five-part test. Since each prong of the five-part test would need to be satisfied, the DOL acknowledges “that not all rollover recommendations can be considered fiduciary investment advice.” In this regard, the DOL “acknowledges that a single instance of advice to take a distribution from a Title I Plan and roll over the assets would fail to meet the regular basis prong.” In response to concerns about potential liability for past reliance on the Deseret Opinion for rollover transactions, the DOL confirms that it “will not pursue claims for breach of fiduciary duty or prohibited transactions against any party, or treat any party as violating the applicable prohibited transaction rules” for conduct between 2005 and February 16, 2021 (the effective date of the Final Exemption). 2. Extent of Fiduciary RelationshipThe DOL says that rollover advice can mark “the beginning of an ongoing relationship,” and that, in those circumstances, the entire advisory relationship, “including the first instance of advice,” will be considered fiduciary in nature. This position, when published in the proposed exemption, generated some concern within the regulated community regarding the extent to which a relationship would be considered “fiduciary” if the relationship touched multiple retirement accounts (i.e., a Title I plan and an IRA). Specifically, several commenters argued that advisory relationships should be viewed as specific to each retirement account, and that by ignoring the precise timing for the start and end of such relationships, the DOL’s interpretation could result in “retroactive” fiduciary status. In response to such comments, the DOL notes that its view “merely recognizes that the rollover recommendation can be the beginning of an ongoing advice relationship,” and that in such situations, fiduciary status should extend “to the entire advisory relationship, including the first—and often most important—advice on rolling the investor’s retirement savings out of the Title I Plan in the first place.” The DOL further notes that its position does not result in “retroactive” fiduciary status because fiduciary status is ultimately “determined by the facts as they exist at the time of the recommendation, including whether the parties, at that time, mutually intend an ongoing advisory relationship.” In addressing advice provided to multiple retirement accounts, the DOL notes that it disagrees that the regular basis prong of the five-part test “must first be met with respect to the Title I Plan, and then again with respect to the IRA.” Instead, the DOL takes the view that “it is appropriate to conclude that an ongoing advisory relationship spanning both the Title I Plan and the IRA satisfies the regular basis prong.” In justifying this position, the DOL argues that “[i]t is enough . . . that the same financial services provider is giving advice to the same person with respect to the same assets (or proceeds of those assets), pursuant to identical five-part tests.” II. Final ExemptionBroadly speaking, the Final Exemption allows financial institutions to give fiduciary investment advice to ERISA plans, ERISA plan participants, and IRAs and to receive otherwise prohibited compensation resulting from that advice if certain conditions are satisfied. Further, the exemption permits a fiduciary to engage in riskless principal transactions and certain other principal transactions as described below. Unlike other existing statutory and administrative exemptions that only apply to particular transactions or investment products, the Final Exemption might be viewed as a “one stop shop” for providers of many types of fiduciary investment advice. The Final Exemption also reflects the DOL’s desire to harmonize its approach with that of the Securities and Exchange Commission (the “SEC”) in Regulation Best Interest (“Reg BI”) and the National Association of Insurance Commissioners (the “NAIC”) Suitability in Annuity Transactions Model Regulation (the “NAIC Model Regulation”). A. Rationale for ExemptionThe Final Exemption is intended to provide prohibited transaction relief to financial institutions that have fiduciary investment advice programs. Many institutions created or expanded their advice programs as a consequence of the DOL’s 2016 investment advice regulation, and they relied on the Best Interest Contract Exemption to receive compensation. After the Fifth Circuit Court of Appeals vacated the 2016 regulation and the Best Interest Contract Exemption in 2018, the DOL issued a temporary non-enforcement policy to allow the advice programs to continue. The Final Exemption provides permanent relief, provided it takes effect. The Final Exemption is particularly important given the DOL’s new, more expansive interpretation of the five-part test. B. Summary of Significant Changes to the Proposed ExemptionThe Final Exemption generally retains the structure of the DOL’s proposed exemption, which was issued in June 2020. Overall, while some changes were made to the conditions for relief, there are no changes to the DOL’s proposal with respect to the broad exemptive coverage available under the Final Exemption. Notable changes to the conditions for relief include:
C. Covered Transactions and Relief ProvidedThe Final Exemption provides relief from the restrictions of ERISA sections 406(a)(1)(A),(D), and 406(b) and Code sections 4975(c)(1)(A),(D), (E), and (F) for the receipt of prohibited compensation in connection with the provision of non-discretionary investment advice. The Final Exemption exempts prohibited transactions that arise from the payment of otherwise prohibited compensation in connection with the recommendation of any security or investment product, and fiduciary rollover recommendations, as well as recommendations of investment managers and investment advice providers. Moreover, the Final Exemption covers recommendations of a financial institution’s proprietary investment products or investment products that generate payments from third parties. Finally, in addition to recommendations to engage in agency transactions, the Final Exemption covers recommendations to engage in riskless principal transactions and principal transactions involving certain types of covered securities, described below. D. Covered Recipients of AdviceThe Final Exemption applies to investment advice given to “Retirement Investors,” which include (i) a participant or beneficiary of a plan subject to Title I of ERISA, or a plan described in section 4975(e)(1)(A) of the Code but not subject to Title I of ERISA[1] (in either case, a “Plan”) with authority to direct the investment of assets in his or her Plan account or to take a distribution, (ii) the beneficial owner of an IRA acting on behalf of the IRA,[2] and (iii) a fiduciary with respect to a Plan or IRA (no matter the size of the Plan). Despite the use of the term “Retirement Investor,” the DOL confirms in the Final Exemption’s preamble that advice to fiduciaries, participants, and beneficiaries with respect to ERISA welfare plans with an investment component is covered. E. Covered Providers of AdviceInvestment advice fiduciaries – both individual “Investment Professionals” and the “Financial Institutions” that employ or otherwise contract with them – and their Affiliates[3] and Related Entities[4] are eligible for relief under the Final Exemption.
F. ExclusionsThe Final Exemption is not available where:
Investment Professionals and Financial Institutions are ineligible to rely on the Final Exemption in certain circumstances, in each case for a period of ten years:
G. Final Exemption ConditionsInvestment Professionals and Financial Institutions must comply with all of the following conditions to obtain relief under the Final Exemption: 1. Impartial Conduct StandardsThe Investment Professional and Financial Institution must satisfy certain Impartial Conduct Standards:
2. DisclosureA Financial Institution must provide the following written disclosures to the Retirement Investor prior to a covered investment recommendation:
The DOL confirmed that the above disclosure requirements may be satisfied if the relevant information is included in disclosures already mandated by the DOL or other regulators, including disclosures mandated by Reg BI and Form CRS and, in appropriate circumstances, disclosures under Section 408(b)(2) of ERISA. 3. Policies and ProceduresThe Final Exemption requires Financial Institutions to establish, maintain, and enforce policies and procedures that (1) are prudently designed to ensure compliance with the Impartial Conduct Standards and (2) mitigate the Investment Professional’s and Financial Institution’s conflicts of interests to such an extent that a reasonable person would not view the Financial Institution’s incentive practices to create an incentive for the Financial Institution and Investment Professional to place their interests ahead of those of Retirement Investors. Additionally, as noted above, Financial Institutions would need to document and disclose specific information in support of rollover recommendations. Financial Institutions would be required to periodically review and revise their policies and procedures as circumstances dictate. The preamble to the Final Exemption provides examples of policies and procedures the Financial Institution may adopt in response to certain conflicts of interest and other circumstances. a. Commission-based Compensation Arrangements If Investment Professionals are compensated through transaction-based payments and incentives, Financial Institutions’ policies and procedures must focus on financial incentives and oversight of investment advice. The DOL notes that conflict mitigation measures identified by the SEC may be adopted by Financial Institutions:
In a slight shift from the DOL’s proposed exemption, the DOL states that the policies and procedures condition is principles-based and therefore does not necessarily prohibit sales contests and similar incentives. The DOL notes, however, that the Financial Institution would be required to carefully consider all performance and personnel actions and practices. b. Insurance Companies The DOL states that insurance companies’ policies and procedures could incorporate review of products, riders, and annuity features that might incentivize Investment Professionals to provide investment advice that does not comply with the Impartial Conduct Standards as well as review of annuity sales. Additionally, the DOL observes that distribution of insurance products is often conducted by independent agents, and that insurance companies could contract with an insurance intermediary to enforce policies and procedures and oversee agents. Indeed, such contracts may be necessary if these insurance intermediaries are not Financial Institutions. The DOL also notes that insurance companies are not responsible for insurance agents’ sales of unaffiliated insurers’ products. c. Proprietary Products, Products that Generate Third Party Payments, and Limited Menus of Investment Products The DOL confirms that Investment Professionals and Financial Institutions can satisfy the Best Interest standard when they provide investment advice on proprietary products or on a limited menu of investment options, including limitations to proprietary products and products that generate third party payments (e.g., shareholder servicing and distribution fees). However, Investment Professionals and Financial Institutions should provide complete and accurate disclosure of their material conflicts of interest associated with such products. Additionally, the DOL states that Financial Institutions that offer proprietary products or a limited menu of products should consider whether their offerings allow an Investment Professional to provide advice that meets the Impartial Conduct Standards and whether the offerings create incentives to place the interests of Investment Professionals and Financial Institutions above those of Retirement Investors. For this purpose, the DOL explains that Financial Institutions are not required to compare their offerings to every other available investment in the marketplace. Financial Institutions are not required to document these determinations, but they should be prepared to explain their process. The DOL also suggests that practices that “selectively promote” certain products may violate the policies and procedures conditions even if the practices do not directly involve the provision of investment advice. For example, Financial Institutions should not make it much more burdensome for the Retirement Investor to rollover assets to one investment rather than another. 4. Annual Retrospective Compliance ReviewThe Final Exemption requires Financial Institutions to conduct an annual retrospective review reasonably designed to assist in detecting and preventing violations of the Impartial Conduct Standards and the Financial Institution’s policies and procedures. The methodology and results of the review must be set forth in a written report submitted to the Senior Executive Officer of the Financial Institution (the CEO, Chief Compliance Officer, Chief Financial Officer, President, or one of the three most senior officers of the Financial Institution), who must certify, within six months of the end of the annual review period that:
The Financial Institution must retain the report, certification, and supporting data for a period of six years. These materials must be made available to the DOL within 10 business days of DOL’s request for them. The DOL envisions the annual review process involving a sample of recommended transactions. A Financial Institution’s Senior Executive Officer could consult with compliance professionals in making the required certifications. This condition is based upon FINRA rules requiring broker-dealers to engage in annual compliance reviews. However, the DOL declined to provide a safe harbor based on compliance with FINRA rules. 5. Self-CorrectionGenerally, if an Investment Professional or Financial Institution provides fiduciary investment advice and receives compensation resulting from that advice but fails to fully comply with any of the conditions of the Final Exemption, a non-exempt prohibited transaction will occur. However, in a departure from the DOL’s proposed exemption, the Final Exemption permits Financial Institutions to self-correct violations of the Final Exemption. If a Financial Institution follows the self-correction procedure, a non-exempt prohibited transaction will not occur. In order to self-correct a violation of the Final Exemption, a Financial Institution must:
6. Principal TransactionsThe Final Exemption is available to exempt prohibited transactions that arise by reason of an Investment Professional or Financial Institution recommending that a Retirement Investor engage in the following principal transactions: (i) a riskless principal transaction; (ii) a principal transaction involving the purchase of a security from a Retirement Investor by the Financial Institution; and, (iii) a principal transaction involving the sale of only certain, specified securities by a Financial Institution to a Retirement Investor (“Covered Principal Transactions”). In the case of Covered Principal Transactions, the security involved in the transaction must be:
In addition, for recommendations of sales of debt securities, Financial Institutions are required to adopt policies and procedures reasonably designed to ensure that the security, at the time of the recommendation, has no greater than moderate credit risk and sufficient liquidity that it could be sold at or near carrying value within a reasonably short period of time. In the case of municipal bond investment recommendations to Retirement Investors, the DOL urges Financial Institutions to exercise caution and to consider documenting the reasons for such recommendations. 7. RecordkeepingFinancial Institutions that rely on the Final Exemption must maintain compliance records for a period of six years. Under the proposed exemption, the records would have been made available to certain employers, plan fiduciaries, participants and beneficiaries, and IRA owners upon their request. However, under the Final Exemption, only the DOL and Treasury Department may request these records. The DOL added this limitation on who may request such records in order to restrict Retirement Investors and their attorneys from requesting these records as a mechanism to bring breach of fiduciary duty and other lawsuits against Financial Institutions and Investment Professionals. In other words, the DOL believes that enforcement of compliance with the Final Exemption should primarily lie with the DOL and the Treasury Department rather than the plaintiffs’ bar. III. Temporary Non-Enforcement PolicyOn May 7, 2018, the DOL issued transition relief pursuant to Field Assistance Bulletin 2018-02 (“FAB 2018-02”) following the vacatur by the Fifth Circuit Court of Appeals of the DOL’s 2016 fiduciary investment advice rulemaking. In FAB 2018-02, the DOL assured that it “will not pursue prohibited transaction claims against investment advice fiduciaries who are working diligently and in good faith to comply with the impartial conduct standards for transactions that would have been exempted in the 2016 Best Interest Contract Exemption and Principal Transactions Exemption, or treat such fiduciaries as violating the applicable prohibited transaction rules.” In the preamble to the Final Exemption, the DOL states that FAB 2018-02 will continue to be available for one year following the publication of the Final Exemption (the Final Exemption was published on December 18, 2020). [1] Plans described in section 4975(e)(1)(A) of the Code but not subject to ERISA may include plans for self-employed individuals and their spouses, such as Keogh plans or solo 401(k) plans. See 29 C.F.R. § 2510.3-3.[2] IRAs are defined to include Health Savings Accounts, Archer Medical Savings Accounts, and Coverdell Education Savings Accounts.[3] The term “Affiliate” refers to (1) any person directly or indirectly through one or more intermediaries, controlling, controlled by, or under common control with the Investment Professional or Financial Institution, (2) any officer, director, partner, employee, or relative (as defined in ERISA section 3(15)), of the Investment Professional or Financial Institution, and (3) any corporation or partnership of which the Investment Professional or Financial Institution is an officer, director, or partner.[4] The term “Related Entity” refers to entities that are not affiliates, but in which the Investment Professional or Financial Institution has an interest that may affect the exercise of its best judgment as a fiduciary.[5] The term “Controlled Group” is defined by reference to the terms “controlled group of corporations” or “under common control” under Code section 414(b) and (c), and their accompanying regulations.[6] Section 411 of ERISA restricts individuals convicted of certain crimes from serving in certain positions with respect to an ERISA plan, including as a fiduciary.
What is considered a prohibited transaction?A prohibited transaction is a transaction between a plan and a disqualified person that is prohibited by law.
What is the most common prohibited party in interest transaction?Note: One of the most common prohibited transactions involving the plan fiduciary is the failure to timely remit participant deferral contributions and loan repayments to the plan in accordance with DOL regulations.
Which of the following are examples of prohibited transactions with a traditional IRA?Prohibited transactions in an IRA. Borrowing money from it.. Selling property to it.. Using it as security for a loan.. Buying property for personal use (present or future) with IRA funds.. What type of investments are not allowed in an IRA?Key Takeaways
Any type of derivative trade that has unlimited or undefined risk, such as naked call writing or ratio spreads, is prohibited by the IRS. Collectibles such as artworks, rugs, antiques, metals, gems, stamps, coins, and alcoholic beverages cannot be held in these accounts.
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