Federal Register, Volume 81 Issue 68 (Friday, April 8, 2016)
[Federal Register Volume 81, Number 68 (Friday, April 8, 2016)]
[Rules and Regulations]
[Pages 21089-21139]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2016-07926]
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DEPARTMENT OF LABOR
Employee Benefits Security Administration
29 CFR Part 2550
[Application Number D-11713]
ZRIN 1210-ZA25
Class Exemption for Principal Transactions in Certain Assets
Between Investment Advice Fiduciaries and Employee Benefit Plans and
IRAs
AGENCY: Employee Benefits Security Administration (EBSA), U.S.
Department of Labor.
ACTION: Adoption of Class Exemption.
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SUMMARY: This document contains an exemption from certain prohibited
transactions provisions of the Employee Retirement Income Security Act
of 1974 (ERISA) and the Internal Revenue Code (the Code). The
provisions at issue generally prohibit fiduciaries with respect to
employee benefit plans and individual retirement accounts (IRAs) from
purchasing and selling investments when the fiduciaries are acting on
behalf of their own accounts (principal transactions). The exemption
permits principal transactions and riskless principal transactions in
certain investments between a plan, plan participant or beneficiary
account, or an IRA, and a fiduciary that provides investment advice to
the plan or IRA, under conditions to safeguard the interests of these
investors. The exemption affects participants and beneficiaries of
plans, IRA owners, and fiduciaries with respect to such plans and IRAs.
DATES:
Issuance date: This exemption is issued June 7, 2016.
Applicability date: This exemption is applicable to transactions
occurring on or after April 10, 2017. See Section F of this preamble,
Applicability Date and Transition Rules in this preamble, for further
information.
FOR FURTHER INFORMATION CONTACT: Brian Shiker, Office of Exemption
Determinations, Employee Benefits Security Administration, U.S.
Department of Labor (202) 693-8824 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Executive Summary
Purpose of Regulatory Action
The Department grants this exemption in connection with its
publication today, elsewhere in this issue of the Federal Register, of
a final regulation defining who is a ``fiduciary'' of an employee
benefit plan under ERISA as a result of giving investment advice to a
plan or its participants or beneficiaries (Regulation). The Regulation
also applies to the definition of a ``fiduciary'' of a plan (including
an IRA) under the Code. The Regulation amends a prior regulation,
dating to 1975, specifying when a person is a ``fiduciary'' under ERISA
and the Code by reason of the provision of investment advice for a fee
or other compensation regarding assets of a plan or IRA. The Regulation
takes into account the advent of 401(k) plans and IRAs, the dramatic
increase in rollovers, and other developments that have transformed the
retirement plan landscape and the associated investment market over the
four decades since the existing regulation was issued. In light of the
extensive changes in retirement investment practices and relationships,
the Regulation updates existing rules to distinguish more appropriately
between the sorts of advice relationships that should be treated as
fiduciary in nature and those that should not.
This exemption allows investment advice fiduciaries to engage in
purchases and sales of certain investments out of their inventory
(i.e., engage in principal transactions) with plans, participant or
beneficiary accounts, and IRAs, under conditions designed to safeguard
the interests of these investors. In the absence of an exemption, these
transactions would be prohibited under ERISA and the Code. In this
regard, ERISA and the Code generally prohibit fiduciaries with respect
to plans and IRAs from purchasing or selling any property to plans,
participant or beneficiary accounts, or IRAs. Fiduciaries also may not
engage in self-dealing or, under ERISA, act in any transaction
involving the plan on behalf of a party whose interests are adverse to
the interests of the plan or the interests of its participants and
beneficiaries. When a fiduciary purchases or sells an investment in a
principal transaction or riskless principal transaction, it violates
these prohibitions.
ERISA section 408(a) specifically authorizes the Secretary of Labor
to grant administrative exemptions from ERISA's prohibited transaction
provisions.\1\ Regulations at 29 CFR 2570.30 to 2570.52 describe the
procedures for applying for an administrative exemption. In granting
this exemption, the Department has determined that the exemption is
administratively feasible, in the interests of plans and their
participants and beneficiaries and IRA owners, and protective of the
rights of participants and beneficiaries of plans and IRA owners.
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\1\ Code section 4975(c)(2) authorizes the Secretary of the
Treasury to grant exemptions from the parallel prohibited
transaction provisions of the Code. Reorganization Plan No. 4 of
1978 (5 U.S.C. app. at 214 (2000)) (Reorganization Plan) generally
transferred the authority of the Secretary of the Treasury to grant
administrative exemptions under Code section 4975 to the Secretary
of Labor. To rationalize the administration and interpretation of
dual provisions under ERISA and the Code, the Reorganization Plan
divided the interpretive and rulemaking authority for these
provisions between the Secretaries of Labor and of the Treasury, so
that, in general, the agency with responsibility for a given
provision of Title I of ERISA would also have responsibility for the
corresponding provision in the Code. Among the sections transferred
to the Department were the prohibited transaction provisions and the
definition of a fiduciary in both Title I of ERISA and in the Code.
ERISA's prohibited transaction rules, 29 U.S.C. 1106-1108, apply to
ERISA-covered plans, and the Code's corresponding prohibited
transaction rules, 26 U.S.C. 4975(c), apply both to ERISA-covered
pension plans that are tax-qualified pension plans, as well as other
tax-advantaged arrangements, such as IRAs, that are not subject to
the fiduciary responsibility and prohibited transaction rules in
ERISA. Specifically, section 102(a) of the Reorganization Plan
provides the Department of Labor with ``all authority'' for
''regulations, rulings, opinions, and exemptions under section 4975
[of the Code]'' subject to certain exceptions not relevant here.
Reorganization Plan section 102. In President Carter's message to
Congress regarding the Reorganization Plan, he made explicitly clear
that as a result of the plan, ``Labor will have statutory authority
for fiduciary obligations. . . . Labor will be responsible for
overseeing fiduciary conduct under these provisions.''
Reorganization Plan, Message of the President. This exemption
provides relief from the indicated prohibited transaction provisions
of both ERISA and the Code.
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Summary of the Major Provisions
The exemption allows an individual investment advice fiduciary (an
Adviser) \2\ and the firm that employs or otherwise contracts with the
Adviser (a Financial Institution) to engage in principal transactions
and riskless principal transactions involving certain investments, with
plans, participant and beneficiary accounts, and IRAs. The exemption
limits the type of investments that may be purchased or sold and
contains conditions which the
[[Page 21090]]
Adviser and Financial Institution must satisfy in order to rely on the
exemption. To safeguard the interests of plans, participants and
beneficiaries, and IRA owners, the exemption requires Financial
Institutions to give the appropriate fiduciary of the plan or IRA owner
a written statement in which the Financial Institution acknowledges its
fiduciary status and that of its Advisers. The Financial Institution
and Adviser must adhere to enforceable standards of fiduciary conduct
and fair dealing when providing investment advice regarding the
transaction to Retirement Investors. In the case of IRAs and non-ERISA
plans, the exemption requires that these standards be set forth in an
enforceable contract with the Retirement Investor. Under the
exemption's terms, Financial Institutions are not required to enter
into a contract with ERISA plan investors, but they are obligated to
acknowledge fiduciary status in writing, and adhere to these same
standards of fiduciary conduct, which the investors can effectively
enforce pursuant to section 502(a)(2) and (3) of ERISA. Under this
standards-based approach, the Adviser and Financial Institution must
give prudent advice that is in the customer's Best Interest, avoid
misleading statements, and seek to obtain the best execution reasonably
available under the circumstances with respect to the transaction.
Additionally, Financial Institutions must adopt policies and procedures
reasonably designed to mitigate any harmful impact of conflicts of
interest, and must disclose their conflicts of interest to Retirement
Investors.
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\2\ By using the term ``Adviser,'' the Department does not
intend to limit the exemption to investment advisers registered
under the Investment Advisers Act of 1940 or under state law. As
explained herein, an Adviser must be an investment advice fiduciary
of a plan or IRA who is an employee, independent contractor, agent,
or registered representative of a registered investment adviser,
bank, or registered broker-dealer.
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The exemption is calibrated to align the Adviser's interests with
those of the plan or IRA customer, while leaving the Adviser and the
Financial Institution the flexibility and discretion necessary to
determine how best to satisfy the exemption's standards in light of the
unique attributes of their business. Financial Institutions relying on
the exemption must obtain the Retirement Investor's consent to
participate in principal transactions and riskless principal
transactions, and the Financial Institutions are subject to
recordkeeping requirements.
Executive Order 12866 and 13563 Statement
Under Executive Orders 12866 and 13563, the Department must
determine whether a regulatory action is ``significant'' and therefore
subject to the requirements of the Executive Order and subject to
review by the Office of Management and Budget (OMB). Executive Orders
12866 and 13563 direct agencies to assess all costs and benefits of
available regulatory alternatives and, if regulation is necessary, to
select regulatory approaches that maximize net benefits (including
potential economic, environmental, public health and safety effects,
distributive impacts, and equity). Executive Order 13563 emphasizes the
importance of quantifying both costs and benefits, of reducing costs,
of harmonizing and streamlining rules, and of promoting flexibility. It
also requires federal agencies to develop a plan under which the
agencies will periodically review their existing significant
regulations to make the agencies' regulatory programs more effective or
less burdensome in achieving their regulatory objectives.
Under Executive Order 12866, ``significant'' regulatory actions are
subject to the requirements of the Executive Order and review by the
OMB. Section 3(f) of Executive Order 12866, defines a ``significant
regulatory action'' as an action that is likely to result in a rule (1)
having an annual effect on the economy of $100 million or more, or
adversely and materially affecting a sector of the economy,
productivity, competition, jobs, the environment, public health or
safety, or State, local or tribal governments or communities (also
referred to as ``economically significant'' regulatory actions); (2)
creating serious inconsistency or otherwise interfering with an action
taken or planned by another agency; (3) materially altering the
budgetary impacts of entitlement grants, user fees, or loan programs or
the rights and obligations of recipients thereof; or (4) raising novel
legal or policy issues arising out of legal mandates, the President's
priorities, or the principles set forth in the Executive Order.
Pursuant to the terms of the Executive Order, OMB has determined that
this action is ``significant'' within the meaning of Section 3(f)(1) of
the Executive Order. Accordingly, the Department has undertaken an
assessment of the costs and benefits of the proposal, and OMB has
reviewed this regulatory action. The Department's complete Regulatory
Impact Analysis is available at www.dol.gov/ebsa.
I. Background
The Department proposed this class exemption on its own motion,
pursuant to ERISA section 408(a) and Code section 4975(c)(2), and in
accordance with the procedures set forth in 29 CFR part 2570, subpart B
(76 FR 66637 (October 27, 2011)).
A. Regulation Defining a Fiduciary
As explained more fully in the preamble to the Regulation, ERISA is
a comprehensive statute designed to protect the interests of plan
participants and beneficiaries, the integrity of employee benefit
plans, and the security of retirement, health, and other critical
benefits. The broad public interest in ERISA-covered plans is reflected
in its imposition of stringent fiduciary responsibilities on parties
engaging in important plan activities, as well as in the tax-favored
status of plan assets and investments. One of the chief ways in which
ERISA protects employee benefit plans is by requiring that plan
fiduciaries comply with fundamental obligations rooted in the law of
trusts. In particular, plan fiduciaries must manage plan assets
prudently and with undivided loyalty to the plans and their
participants and beneficiaries.\3\ In addition, they must refrain from
engaging in ``prohibited transactions,'' which ERISA does not permit
because of the dangers posed by the fiduciaries' conflicts of interest
with respect to the transactions.\4\ When fiduciaries violate ERISA's
fiduciary duties or the prohibited transaction rules, they may be held
personally liable for the breach.\5\ In addition, violations of the
prohibited transaction rules are subject to excise taxes under the
Code.
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\3\ ERISA section 404(a).
\4\ ERISA section 406. ERISA also prohibits certain transactions
between a plan and a party in interest.
\5\ ERISA section 409; see also ERISA section 405.
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The Code also has rules regarding fiduciary conduct with respect to
tax-favored accounts that are not generally covered by ERISA, such as
IRAs. In particular, fiduciaries of these arrangements, including IRAs,
are subject to the prohibited transaction rules and, when they violate
the rules, to the imposition of an excise tax enforced by the Internal
Revenue Service. Unlike participants in plans covered by Title I of
ERISA, IRA owners do not have a statutory right to bring suit against
fiduciaries for violations of the prohibited transaction rules.
Under this statutory framework, the determination of who is a
``fiduciary'' is of central importance. Many of ERISA's and the Code's
protections, duties, and liabilities hinge on fiduciary status. In
relevant part, ERISA section 3(21)(A) and Code section 4975(e)(3)
provide that a person is a fiduciary with respect to a plan or IRA to
the extent he or she (i) exercises any discretionary authority or
discretionary control with respect to management of such plan or IRA,
or exercises any authority or control with respect to management or
disposition of
[[Page 21091]]
its assets; (ii) renders investment advice for a fee or other
compensation, direct or indirect, with respect to any moneys or other
property of such plan or IRA, or has any authority or responsibility to
do so; or, (iii) has any discretionary authority or discretionary
responsibility in the administration of such plan or IRA.
The statutory definition deliberately casts a wide net in assigning
fiduciary responsibility with respect to plan and IRA assets. Thus,
``any authority or control'' over plan or IRA assets is sufficient to
confer fiduciary status, and any persons who render ``investment advice
for a fee or other compensation, direct or indirect'' are fiduciaries,
regardless of whether they have direct control over the plan's or IRA's
assets and regardless of their status as an investment adviser or
broker under the federal securities laws. The statutory definition and
associated responsibilities were enacted to ensure that plans, plan
participants and IRA owners can depend on persons who provide
investment advice for a fee to provide recommendations that are
untainted by conflicts of interest. In the absence of fiduciary status,
the providers of investment advice are neither subject to ERISA's
fundamental fiduciary standards, nor accountable under ERISA or the
Code for imprudent, disloyal, or biased advice.
In 1975, the Department issued a regulation, at 29 CFR 2510.3-
21(c)(1975) defining the circumstances under which a person is treated
as providing ``investment advice'' to an employee benefit plan within
the meaning of section 3(21)(A)(ii) of ERISA (the 1975 regulation).\6\
The 1975 regulation narrowed the scope of the statutory definition of
fiduciary investment advice by creating a five-part test for fiduciary
advice. Under the 1975 regulation, for advice to constitute
``investment advice,'' an adviser must--(1) render advice as to the
value of securities or other property, or make 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
agreement, arrangement or understanding, with the plan or a plan
fiduciary that (4) the advice will serve as a primary basis for
investment decisions with respect to plan assets, and that (5) the
advice will be individualized based on the particular needs of the
plan. The 1975 regulation provided that an adviser is a fiduciary with
respect to any particular instance of advice only if he or she meets
each and every element of the five-part test with respect to the
particular advice recipient or plan at issue.
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\6\ The Department of Treasury issued a virtually identical
regulation, at 26 CFR 54.4975-9(c), which interprets Code section
4975(e)(3).
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The market for retirement advice has changed dramatically since the
Department first promulgated the 1975 regulation. Individuals, rather
than large employers and professional money managers, have become
increasingly responsible for managing retirement assets as IRAs and
participant-directed plans, such as 401(k) plans, have supplanted
defined benefit pensions. At the same time, the variety and complexity
of financial products have increased, widening the information gap
between advisers and their clients. Plan fiduciaries, plan participants
and IRA investors must often rely on experts for advice, but are unable
to assess the quality of the expert's advice or effectively guard
against the adviser's conflicts of interest. This challenge is
especially true of retail investors, who typically do not have
financial expertise and can ill-afford lower returns to their
retirement savings caused by conflicts. The IRA accounts of these
investors often account for all or the lion's share of their assets,
and can represent all of savings earned for a lifetime of work. Losses
and reduced returns can be devastating to the investors who depend upon
such savings for support in their old age. As baby boomers retire, they
are increasingly moving money from ERISA-covered plans, where their
employer has both the incentive and the fiduciary duty to facilitate
sound investment choices, to IRAs where both good and bad investment
choices are myriad and advice that is conflicted is commonplace. These
rollovers are expected to approach $2.4 trillion cumulatively from 2016
through 2020.\7\ These trends were not apparent when the Department
promulgated the 1975 regulation. At that time, 401(k) plans did not yet
exist and IRAs had only just been authorized.
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\7\ Cerulli Associates, ``Retirement Markets 2015.''
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As the marketplace for financial services has developed in the
years since 1975, the five-part test has now come to undermine, rather
than promote, the statutes' text and purposes. The narrowness of the
1975 regulation has allowed advisers, brokers, consultants and
valuation firms to play a central role in shaping plan and IRA
investments, without ensuring the accountability that Congress intended
for persons having such influence and responsibility. Even when plan
sponsors, participants, beneficiaries, and IRA owners clearly relied on
paid advisers for impartial guidance, the 1975 regulation has allowed
many advisers to avoid fiduciary status and disregard basic fiduciary
obligations of care and prohibitions on disloyal and conflicted
transactions. As a consequence, these advisers have been able to steer
customers to investments based on their own self-interest (e.g.,
products that generate higher fees for the adviser even if there are
identical lower-fee products available), give imprudent advice, and
engage in transactions that would otherwise be prohibited by ERISA and
the Code without fear of accountability under either ERISA or the Code.
In the Department's amendments to the 1975 regulation defining
fiduciary advice within the meaning of ERISA section 3(21)(A)(ii) and
Code section 4975(e)(3)(B) (the Regulation), which are also published
in this issue of the Federal Register, the Department is replacing the
existing regulation with one that more appropriately distinguishes
between the sorts of advice relationships that should be treated as
fiduciary in nature and those that should not, in light of the legal
framework and financial marketplace in which IRAs and plans currently
operate.\8\
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\8\ The Department initially proposed an amendment to its
regulation defining a fiduciary within the meaning of ERISA section
3(21)(A)(ii) and Code section 4975(e)(3)(B) on October 22, 2010, at
75 FR 65263. It subsequently announced its intention to withdraw the
proposal and propose a new rule, consistent with the President's
Executive Orders 12866 and 13563, in order to give the public a full
opportunity to evaluate and comment on the new proposal and updated
economic analysis. The first proposed amendment to the rule was
withdrawn on April 20, 2015, see 80 FR 21927.
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The Regulation describes the types of advice that constitute
``investment advice'' with respect to plan or IRA assets for purposes
of the definition of a fiduciary at ERISA section 3(21)(A)(ii) and Code
section 4975(e)(3)(B). The Regulation covers ERISA-covered plans, IRAs,
and other plans not covered by Title I, such as Keogh plans, and health
savings accounts described in Code section 223(d).
As amended, the Regulation provides that a person renders
investment advice with respect to assets of a plan or IRA if, among
other things, the person provides, directly to a plan, a plan
fiduciary, plan participant or beneficiary, IRA or IRA owner, the
following types of advice, for a fee or other compensation, whether
direct or indirect:
(i) A recommendation as to the advisability of acquiring, holding,
disposing of, or exchanging, securities or other investment property,
or a
[[Page 21092]]
recommendation as to how securities or other investment property should
be invested after the securities or other investment property are
rolled over, transferred or distributed from the plan or IRA; and
(ii) A recommendation as to the management of securities or other
investment property, including, among other things, recommendations on
investment policies or strategies, portfolio composition, selection of
other persons to provide investment advice or investment management
services, types of investment account arrangements (brokerage versus
advisory), or recommendations with respect to rollovers, transfers or
distributions from a plan or IRA, including whether, in what amount, in
what form, and to what destination such a rollover, transfer or
distribution should be made.
In addition, in order to be treated as a fiduciary, such person,
either directly or indirectly (e.g., through or together with any
Affiliate), must: Represent or acknowledge that it is acting as a
fiduciary within the meaning of ERISA or the Code with respect to the
advice described; represent or acknowledge that it is acting as a
fiduciary within the meaning of ERISA or the Code; render 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 direct 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.
The Regulation also provides that as a threshold matter in order to
be fiduciary advice, the communication must be a ``recommendation'' as
defined therein. The Regulation, as a matter of clarification, provides
that a variety of other communications do not constitute
``recommendations,'' including non-fiduciary investment education;
general communications; and specified communications by platform
providers. These communications which do not rise to the level of
``recommendations'' under the Regulation are discussed more fully in
the preamble to the final Regulation.
The Regulation also specifies certain circumstances where the
Department has determined that a person will not be treated as an
investment advice fiduciary even though the person's activities
technically may satisfy the definition of investment advice. For
example, the Regulation contains a provision excluding recommendations
to independent fiduciaries with financial expertise that are acting on
behalf of plans or IRAs in arm's length transactions, if certain
conditions are met. The independent fiduciary must be a bank, insurance
carrier qualified to do business in more than one state, investment
adviser registered under the Investment Advisers Act of 1940 or by a
state, broker-dealer registered under the Securities Exchange Act of
1934 (Exchange Act), or any other independent fiduciary that holds, or
has under management or control, assets of at least $50 million, and:
(1) The person making the recommendation must know or reasonably
believe that the independent fiduciary of the plan or IRA is capable of
evaluating investment risks independently, both in general and with
regard to particular transactions and investment strategies (the person
may rely on written representations from the plan or independent
fiduciary to satisfy this condition); (2) the person must fairly inform
the independent fiduciary that the person is not undertaking to provide
impartial investment advice, or to give advice in a fiduciary capacity,
in connection with the transaction and must fairly inform the
independent fiduciary of the existence and nature of the person's
financial interests in the transaction; (3) the person must know or
reasonably believe that the independent fiduciary of the plan or IRA is
a fiduciary under ERISA or the Code, or both, with respect to the
transaction and is responsible for exercising independent judgment in
evaluating the transaction (the person may rely on written
representations from the plan or independent fiduciary to satisfy this
condition); and (4) the person cannot receive a fee or other
compensation directly from the plan, plan fiduciary, plan participant
or beneficiary, IRA, or IRA owner for the provision of investment
advice (as opposed to other services) in connection with the
transaction.
Similarly, the Regulation provides that the provision of any advice
to an employee benefit plan (as described in ERISA section 3(3)) by a
person who is a swap dealer, security-based swap dealer, major swap
participant, major security-based swap participant, or a swap clearing
firm in connection with a swap or security-based swap, as defined in
section 1a of the Commodity Exchange Act (7 U.S.C. 1a) and section 3(a)
of the Exchange Act (15 U.S.C. 78c(a)) is not investment advice if
certain conditions are met. Finally, the Regulation describes certain
communications by employees of a plan sponsor, plan, or plan fiduciary
that would not cause the employee to be an investment advice fiduciary
if certain conditions are met.
B. Prohibited Transactions
The Department anticipates that the Regulation will cover many
investment professionals who did not previously consider themselves to
be fiduciaries under ERISA or the Code. Under the Regulation, these
entities will be subject to the prohibited transaction restrictions in
ERISA and the Code that apply specifically to fiduciaries. ERISA
section 406(b)(1) and Code section 4975(c)(1)(E) prohibit a fiduciary
from dealing with the income or assets of a plan or IRA in his own
interest or his own account. ERISA section 406(b)(2), which does not
apply to IRAs, provides that a fiduciary shall not ``in his individual
or in any other capacity act in any transaction involving the plan on
behalf of a party (or represent a party) whose interests are adverse to
the interests of the plan or the interests of its participants or
beneficiaries.'' ERISA section 406(b)(3) and Code section 4975(c)(1)(F)
prohibit a fiduciary from receiving any consideration for his own
personal account from any party dealing with the plan or IRA in
connection with a transaction involving assets of the plan or IRA.
Parallel regulations issued by the Departments of Labor and the
Treasury explain that these provisions impose on fiduciaries of plans
and IRAs a duty not to act on conflicts of interest that may affect the
fiduciary's best judgment on behalf of the plan or IRA.\9\ The
prohibitions extend to a fiduciary causing a plan or IRA to pay an
additional fee to such fiduciary, or to a person in which such
fiduciary has an interest that may affect the exercise of the
fiduciary's best judgment as a fiduciary. Likewise, a fiduciary is
prohibited from receiving compensation from third parties in connection
with a transaction involving the plan or IRA.\10\
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\9\ Subsequent to the issuance of these regulations,
Reorganization Plan No. 4 of 1978, 5 U.S.C. App. (2010), divided
rulemaking and interpretive authority between the Secretaries of
Labor and the Treasury. The Secretary of Labor was given
interpretive and rulemaking authority regarding the definition of
fiduciary under both Title I of ERISA and the Internal Revenue Code.
Id. section 102(a) (``all authority of the Secretary of the Treasury
to issue [regulations, rulings opinions, and exemptions under
section 4975 of the Code] is hereby transferred to the Secretary of
Labor'').
\10\ 29 CFR 2550.408b-2(e); 26 CFR 54.4975-6(a)(5).
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The purchase or sale of an investment in a principal transaction or
riskless principal transaction between a plan or IRA and a fiduciary,
resulting from the fiduciary's provision of investment advice,
implicates the prohibited
[[Page 21093]]
transaction rules set forth in ERISA section 406(b) and Code section
4975(c)(1)(E).\11\ Nevertheless, the Department recognizes that certain
investment advice fiduciaries view the ability to execute principal
transactions or riskless principal transaction as integral to the
economically efficient distribution of fixed income securities.
Therefore, in connection with the Regulation, the Department reviewed
the existing legal framework to determine whether additional exemptions
were needed for investment advice fiduciaries to engage in these
transactions. In this regard, as further discussed below, fiduciaries
who engage in such transactions under certain circumstances can avoid
the ERISA and Code restrictions. Moreover, there are existing statutory
and administrative exemptions, also discussed below, that already
provide prohibited transaction relief for fiduciaries engaging in
principal transactions and riskless principal transactions with plans
and IRAs. Nevertheless, the Department determined that additional
relief in this area is necessary and therefore, after reviewing the
comments on the proposal, determined to grant this exemption for
investment advice fiduciaries to engage in certain principal
transactions and riskless principal transactions with plans and IRAs.
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\11\ The purchase or sale of an investment in a principal
transaction or a riskless principal transaction between a plan or
IRA and a fiduciary also is prohibited by ERISA section 406(a)(1)(A)
and (D) and Code section 4975(c)(1)(A) and (D).
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1. Blind Transactions
Certain principal transactions and riskless principal transactions
between a plan or IRA and an investment advice fiduciary may not need
exemptive relief because they are blind transactions executed on an
exchange. The ERISA Conference Report states that a transaction will,
generally, not be a prohibited transaction if the transaction is an
ordinary ``blind'' purchase or sale of securities through an exchange
where neither the buyer nor the seller (nor the agent of either) knows
the identity of the other party involved.\12\
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\12\ See H.R. Rep. 93-1280, 93rd Cong., 2d Sess. 307 (1974); see
also ERISA Advisory Opinion 2004-05A (May 24, 2004).
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2. Principal Transactions Permitted Under an Exemption
As the prohibited transaction provisions demonstrate, ERISA and the
Code strongly disfavor conflicts of interest. In appropriate cases,
however, the statutes provide exemptions from their broad prohibitions
on conflicts of interest. In addition, the Secretary of Labor has
discretionary authority to grant administrative exemptions under ERISA
and the Code on an individual or class basis, but only if the Secretary
first finds that the exemptions are (1) administratively feasible, (2)
in the interests of plans and their participants and beneficiaries and
IRA owners, and (3) protective of the rights of the participants and
beneficiaries of such plans and IRA owners. Accordingly, fiduciary
advisers may always give advice without need of an exemption if they
avoid the sorts of conflicts of interest that result in prohibited
transactions. However, when they choose to give advice in which they
have a conflict of interest, they must rely upon an exemption.
a. Statutory Exemptions
ERISA section 408(b)(14) provides a statutory exemption for
transactions entered into in connection with the provision of fiduciary
investment advice to a participant or beneficiary of an individual
account plan or an IRA owner. The exemption provides relief for, among
other things, the acquisition, holding, or sale of a security or other
property as an investment under the plan pursuant to the investment
advice. As set forth in ERISA section 408(g), the exemption is
available if the advice is provided under an ``eligible investment
advice arrangement'' which either (1) ``provides that any fees
(including any commission or other compensation) received by the
fiduciary adviser for investment advice or with respect to the sale,
holding or acquisition of any security or other property for purposes
of investment of plan assets do not vary depending on the basis of any
investment option selected'' or (2) ``uses a computer model under an
investment advice program meeting the requirements of [ERISA section
408(g)(3)].'' The ERISA section 408(g) exemptions include special
conditions calibrated to insulate the fiduciary adviser from conflicts
of interest. Code section 4975(d)(17) provides the same relief from the
taxes imposed by Code section 4975(a) and (b).
ERISA section 408(b)(16) provides relief for transactions involving
the purchase or sale of securities between a plan and a party in
interest, including an investment advice fiduciary, if the transactions
are executed through an electronic communication network, alternative
trading system, or similar execution system or trading venue. Among
other conditions, subparagraph (B) of the statutory exemption requires
that either: (i) ``the transaction is effected pursuant to rules
designed to match purchases and sales at the best price available
through the execution system in accordance with applicable rules of the
Securities and Exchange Commission or other relevant governmental
authority,'' or (ii) ``neither the execution system nor the parties to
the transaction take into account the identity of the parties in the
execution of trades[.]'' The transactions covered by ERISA section
408(b)(16) include principal transactions between a plan and an
investment advice fiduciary. Code section 4975(d)(19) provides the same
relief from the taxes imposed by Code section 4975(a) and (b).
b. Administrative Exemptions
An administrative exemption for certain principal transactions will
continue to be available through PTE 75-1.\13\ Specifically, PTE 75-1,
Part IV, provides an exemption that is available to investment advice
fiduciaries who are ``market-makers.'' Relief is available from ERISA
section 406 for the purchase or sale of securities by a plan or IRA,
from or to a market-maker with respect to such securities who is also
an investment advice fiduciary with respect to the plan or IRA, or an
affiliate of such fiduciary. However, PTE 75-1, Part IV, is amended
today in a Notice, published elsewhere in this issue of the Federal
Register, to require fiduciaries relying on the exemption to comply
with the Impartial Conduct Standards that are also incorporated in this
exemption.
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\13\ 40 FR 50845 (Oct. 31, 1975), as amended, 71 FR 5883 (Feb.
3, 2006).
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Further, Part II(1) of PTE 75-1 provides relief from ERISA section
406(a) and Code section 4975(c)(1)(A) through (D) for the purchase or
sale of a security in a principal transaction between a plan or IRA and
a broker-dealer registered under the Exchange Act or a bank supervised
by the United States or a state. However, the exemption permits plans
and IRAs to engage in principal transactions with broker-dealers and
banks only if the broker-dealers and banks do not have or exercise any
discretionary authority or control (except as a directed trustee) with
respect to the investment of plan or IRA assets involved in the
transaction, and do not render investment advice (within the meaning of
29 CFR 2510.3-21(c)) with respect to the investment of those assets.
PTE 75-1, Part II(1) will continue to be available to parties in
interest that are not fiduciaries and that satisfy its conditions. In
this regard, the Regulation provides that parties will not be
investment advice fiduciaries if they engage in arm's length
transactions with
[[Page 21094]]
certain independent fiduciaries of a plan or IRA with financial
expertise, including banks, insurance carriers, registered investment
advisers, broker-dealers and persons holding, or possessing under
management or control, total assets of at least $50 million, and who
are capable of evaluating investment risks independently, both in
general and with regard to particular transactions and investment
strategies, and certain other conditions are satisfied. These non-
fiduciary counterparties can continue to rely on PTE 75-1, Part II, for
relief regarding principal transactions.
In connection with the proposed Regulation, the Department
recognized the need for additional relief. Accordingly, the Department
proposed this exemption for principal transactions in certain debt
securities between a plan, participant or beneficiary account, or IRA,
and an investment advice fiduciary. The proposed exemption was intended
to facilitate continued access by plan and IRA investors to certain
types of investments commonly sold in principal transactions.
The Department also proposed the Best Interest Contract Exemption,
which is adopted elsewhere in this issue of the Federal Register. The
Best Interest Contract Exemption provides broad relief for investment
advice fiduciaries and their Affiliates and related entities to receive
compensation as a result of investment advice to retail Retirement
Investors (plan participants and beneficiaries, IRA owners, and certain
plan fiduciaries, including small plan sponsors) under conditions
specifically designed to address the conflicts of interest associated
with the wide variety of payments advisers receive in connection with
retail transactions involving plans and IRAs.
At the same time that the Department has granted these new
exemptions, it has also amended existing exemptions to ensure uniform
application of the Impartial Conduct Standards, which are fundamental
obligations of fair dealing and fiduciary conduct, and include
obligations to act in the customer's Best Interest, avoid misleading
statements, and receive no more than reasonable compensation.\14\ Taken
together, the new exemptions and amendments to existing exemptions
ensure that Retirement Investors are consistently protected by
Impartial Conduct Standards, regardless of the particular exemption
upon which the adviser relies.
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\14\ The amended exemptions, published elsewhere in this Federal
Register, include Prohibited Transaction Exemption (PTE) 75-1; PTE
77-4; PTE 80-83; PTE 83-1: PTE 84-24; and PTE 86-128.
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The amendments also revoke certain existing exemptions, which
provided little or no protections to IRA and non-ERISA plan
participants, in favor of a more uniform application of the Best
Interest Contract Exemption in the market for retail investments. With
limited exceptions, it is the Department's intent that investment
advice fiduciaries in the retail investment market rely on statutory
exemptions, the Best Interest Contract Exemption, or this exemption to
the extent that they receive conflicted forms of compensation that
would otherwise be prohibited. The new and amended exemptions reflect
the Department's view that Retirement Investors should be protected by
a more consistent application of fundamental fiduciary standards across
a wide range of investment products and advice relationships, and that
retail investors, in particular, should be protected by the stringent
protections set forth in the Best Interest Contract Exemption and this
exemption. When fiduciaries have conflicts of interest, they will
uniformly be expected to adhere to fiduciary norms and to make
recommendations that are in their customer's Best Interest.
These new and amended exemptions follow a lengthy public notice and
comment process, which gave interested persons an extensive opportunity
to comment on this proposed exemption, proposed Regulation and other
related exemption proposals. The proposals initially provided for 75-
day comment periods, ending on July 6, 2015, but the Department
extended the comment periods to July 21, 2015. The Department then held
four days of public hearings on the new regulatory package, including
the proposed exemptions, in Washington, DC from August 10 to 13, 2015,
at which over 75 speakers testified. The transcript of the hearing was
made available on September 8, 2015, and the Department provided
additional opportunity for interested persons to comment on the
proposals or hearing transcript until September 24, 2015. A total of
over 3000 comment letters were received on the new proposals. There
were also over 300,000 submissions made as part of 30 separate
petitions submitted on the proposal. These comments and petitions came
from consumer groups, plan sponsors, financial services companies,
academics, elected government officials, trade and industry
associations, and others, both in support and in opposition to the
rule.\15\ The Department has reviewed all comments, and after careful
consideration of the comments, has decided to grant this exemption.
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\15\ As used throughout this preamble, the term ``comment''
refers to information provided through these various sources,
including written comments, petitions and witnesses at the public
hearing.
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II. Exemption for Principal Transactions in Certain Assets
As finalized, this exemption for certain principal transactions and
riskless principal transactions retains the core protections of the
proposed exemption, but with revisions designed to facilitate
implementation and compliance with the exemption's terms. In broadest
outline, the exemption permits Advisers and the Financial Institutions
that employ or otherwise retain them to enter into principal
transactions and riskless principal transactions with plans and IRAs
regarding certain investments, provided that they give advice regarding
the transactions that is in their customers' Best Interest and the
Financial Institution implements basic protections against the dangers
posed by conflicts of interest. In particular, to rely on the
exemption, Financial Institutions must:
Acknowledge fiduciary status with respect to any
investment advice regarding principal transactions or riskless
principal transactions;
Adhere to Impartial Conduct Standards requiring them to
[cir] Give advice that is in the Retirement Investor's Best
Interest (i.e., prudent advice that is based on the investment
objectives, risk tolerance, financial circumstances, and needs of the
Retirement Investor, without regard to financial or other interests of
the Adviser, Financial Institution or any Affiliates or other parties);
[cir] Seek to obtain the best execution reasonably available under
the circumstances with respect to the transaction; and
[cir] Make no misleading statements about investment transactions,
compensation, and conflicts of interest;
Implement policies and procedures reasonably and prudently
designed to prevent violations of the Impartial Conduct Standards;
Refrain from giving or using incentives for Advisers to
act contrary to the customer's Best Interest; and
Make additional disclosures.
Advisers relying on the exemption must comply with the Impartial
Conduct Standards when making investment recommendations regarding
principal transactions and riskless principal transactions.
[[Page 21095]]
The exemption takes a principles-based approach that permits
Financial Institutions and Advisers to enter into transactions that
would otherwise be prohibited. The exemption holds Financial
Institutions and their Advisers responsible for adhering to fundamental
standards of fiduciary conduct and fair dealing, while leaving them the
flexibility and discretion necessary to determine how best to satisfy
these basic standards in light of the unique attributes of their
particular businesses. The exemption's principles-based conditions,
which are rooted in the law of trust and agency, have the breadth and
flexibility necessary to apply to a large range of investment and
compensation practices, while ensuring that Advisers put the interests
of Retirement Investors first. When Advisers choose to give advice
regarding principal transactions and riskless principal transactions to
Retirement Investors, they must protect their customers from the
dangers posed by conflicts of interest.
In order to ensure compliance with the exemption's broad protective
standards and purposes, the exemption gives special attention to the
enforceability of the exemption's terms by Retirement Investors. When
Financial Institutions and Advisers breach their obligations under the
exemption and cause losses to Retirement Investors, it is generally
critical that the investors have a remedy to redress the injury. The
existence of enforceable rights and remedies gives Financial
Institutions and Advisers a powerful incentive to comply with the
exemption's standards, implement policies and procedures that are more
than window-dressing, and carefully police conflicts of interest to
ensure that the conflicts of interest do not taint the advice.
Thus, in the case of IRAs and non-ERISA plans, the exemption
requires the Financial Institution to commit to the Impartial Conduct
Standards in an enforceable contract with Retirement Investor
customers. The exemption does not similarly require the Financial
Institution to execute a separate contract with ERISA investors (plan
participants, beneficiaries, and fiduciaries), but the Financial
Institution must acknowledge its fiduciary status and that of its
Advisers, and ERISA investors can directly enforce their rights to
proper fiduciary conduct under ERISA section 502(a)(2) and (3). In
addition, the exemption safeguards Retirement Investors' enforcement
rights by providing that Financial Institutions and Advisers may not
rely on the exemption if they include contractual provisions
disclaiming liability for compensatory remedies or waiving or
qualifying Retirement Investors' right to pursue a class action or
other representative action in court. However, the exemption does
permit Financial Institutions to include provisions waiving the right
to punitive damages or rescission as contract remedies to the extent
permitted by other applicable laws. In the Department's view, the
availability of make-whole relief for such claims is sufficient to
protect Retirement Investors and incentivize compliance with the
exemption's conditions.
While the final exemption retains the proposed exemption's core
protections, the Department has revised the exemption to ease
implementation in response to commenters' concerns about the
exemption's workability. Thus, for example, the final exemption
eliminates the contract requirement altogether in the ERISA context and
simplifies the mechanics of contract-formation for IRAs and plans not
covered by Title I of ERISA. For new customers, the final exemption
provides that the required contract terms may simply be incorporated in
the Financial Institution's account opening documents and similar
commonly-used agreements. The exemption additionally permits reliance
on a negative consent process for existing contract holders. The
Department recognizes that Retirement Investors may talk to numerous
Advisors in numerous settings over the course of their relationship
with a Financial Institution. Accordingly, the exemption also
simplifies execution of the contract by simply requiring the Financial
Institution to execute the contract, rather than each of the individual
Advisers from whom the Retirement Investor receives advice. For similar
reasons, the exemption does not require execution of the contract at
the start of Retirement Investors' conversations with Advisers, as long
as it is entered into prior to or at the same time as the recommended
transaction.
As a means of facilitating use of the exemption, the Department
also reduced compliance burdens by eliminating some of the conditions
that were not critical to the exemption's protective purposes, and
expanding the scope of the exemption's coverage (e.g., by covering
interests in unit investment trusts (UITs) and certificates of deposit
(CDs)). The Department eliminated the requirement of adherence to other
state and federal laws relating to advice as unduly expansive and
duplicative of other laws; dropped a two-quote requirement; and
eliminated a mark-up and mark-down disclosure requirement. In addition,
the Department streamlined the disclosure conditions by simplifying the
obligations. The Department also provided a mechanism for correcting
good faith violations of the disclosure conditions, so that Financial
Institutions would not lose the benefit of the exemption as a result of
such good faith errors and would have an incentive to promptly correct
them.
While making these changes to facilitate the implementation of the
exemption, the Department emphasizes that the exemption is limited
because of the severity of the conflicts of interest associated with
principal transactions. When acting as a principal in a transaction
involving a plan, participant or beneficiary account, or IRA, a
fiduciary can have difficulty reconciling its duty to avoid conflicts
of interest with its concern for its own financial interests as the
Retirement Investor's counterparty. Of primary concern are issues
involving liquidity, pricing, transparency, and the fiduciary's
possible incentive to ``dump'' unwanted assets. The scope of this
exemption balances the Department's significant concerns regarding
principal transactions with the need to preserve market choice for
plans, participants and beneficiary accounts, and IRAs.
The comments on this exemption, the Best Interest Contract
Exemption, the Regulation, and related exemptions have helped the
Department improve this exemption, while preserving and enhancing its
protections. As described above, the Department has revised the
exemption to facilitate implementation and compliance with the
exemption, without diluting its core protections, which are critical to
reducing the harm caused by conflicts of interest in the marketplace
for advice. The tax-preferred investments covered by the exemption are
critical to the financial security and physical health of investors.
After consideration of the comments, the Department remains convinced
of the importance of the exemption's core protections.
ERISA and the Code are rightly skeptical of the dangers posed by
conflicts of interest, and generally prohibit conflicted advice. Before
granting exemptive relief, the Department has a statutory obligation to
ensure that the exemption is in the interests of plan and IRA investors
and protective of their rights. Adherence to the fundamental fiduciary
norms and basic protective conditions of this exemption helps ensure
that investment recommendations are not driven by Adviser conflicts,
but by the Best Interest of the Retirement Investor. The
[[Page 21096]]
conditions of this exemption are carefully calibrated to permit
principal transaction and riskless principal transactions in certain
investments, while protecting Retirement Investors' interest in
receiving sound advice on vitally important investments. Based upon
these protective conditions, the Department finds that the exemption is
administratively feasible, in the interests of plans and their
participants and beneficiaries and IRA owners, and protective of the
rights of participants and beneficiaries of plans and IRA owners.
The preamble sections that follow provide a much more detailed
discussion of the exemption's terms, comments on the exemption, and the
Department's responses to those comments. After a discussion of the
exemption's scope and limitations, the preamble discusses the
conditions of the exemptions.
A. Scope of Relief in the Exemption
The exemption provides relief for ``Advisers'' and ``Financial
Institutions'' to enter into ``principal transactions'' and ``riskless
principal transactions'' in ``principal traded assets'' with plans and
IRAs. For purposes of the exemption, a principal transaction is a
transaction in which an Adviser or Financial Institution is purchasing
from or selling to the plan, participant or beneficiary account, or IRA
on behalf of the account of the Financial Institution or the account of
any person directly or indirectly, through one or more intermediaries,
controlling, controlled by, or under common control with the Financial
Institution. The term principal transaction does not include a riskless
principal transaction as defined in the exemption. A riskless principal
transaction is defined as a transaction in which a Financial
Institution, after having received an order from a Retirement Investor
to buy or sell a principal traded asset, purchases or sells the asset
for the Financial Institution's own account to offset the
contemporaneous transaction with the Retirement Investor.
The exemption uses the term ``Retirement Investor'' to describe the
types of persons who can be investment advice recipients under the
exemption, and the term ``Affiliate'' to describe people and entities
with a connection to the Adviser or Financial Institution. These terms
are defined in Section VI of this exemption. The following sections
discuss the scope and conditions of the exemption as well as key
definitional terms.
1. Principal Traded Assets
The exemption provides relief for principal transactions and
riskless principal transactions involving certain investments, referred
to as ``principal traded assets,'' between a plan, participant or
beneficiary account, or IRA, and an Adviser, Financial Institution or
an entity in a control relationship with the Financial Institution,
when the transaction is a result of an Adviser's or Financial
Institution's provision of investment advice. Relief is provided from
ERISA sections 406(a)(1)(A) and (D), and 406(b)(1) and (2), and the
taxes imposed by Code section 4975(a) and (b), by reason of Code
section 4975(c)(1)(A), (D) and (E). Relief has not been provided in
this exemption from ERISA section 406(b)(3) and Code section
4975(c)(1)(F), which prohibit a fiduciary from receiving any
consideration for its own personal account from any party dealing with
the plan or IRA in connection with a transaction involving the assets
of the plan or IRA.
The principal traded assets that are permitted to be purchased by
plans, participant and beneficiary accounts, and IRAs, under the
exemption include CDs, interests in UITs, and securities within the
exemption's definition of ``debt security.'' Debt securities are
generally defined as corporate debt securities offered pursuant to a
registration statement under the Securities Act of 1933; treasury
securities; agency securities; and asset-backed securities that are
guaranteed by an agency or government sponsored enterprise (GSE).
In addition, the final exemption includes a feature under which the
definition of principal traded asset can be expanded without amending
the class exemption. Under the definition of principal traded asset,
investments can be added to the class exemption in the future based on
an individual exemption granted by the Department. Accordingly, a
principal traded asset for purposes of the class exemption also
includes an investment that is permitted to be purchased under an
individual exemption granted by the Department after the issuance date
of this exemption, that provides relief for investment advice
fiduciaries to engage in the purchase of the investment in a principal
transaction or riskless principal transaction with a plan or IRA under
the same conditions as this exemption. To the extent parties wish to
expand the definition of principal traded asset in the future, they can
submit a request for an individual exemption to the Department setting
forth the specific attributes of the principal traded asset, the sales
and compensation practices, and how conflicts of interest will be
mitigated with respect to principal transactions and riskless principal
transactions in that principal traded asset. If the exemption is
granted, the class exemption will expand to include that investment
within the definition of principal traded asset.
The exemption's definition of principal traded assets is more
expansive with respect to the sale of principal traded assets by plans
and IRAs. The definition extends to ``securities or other investment
property,'' which corresponds to the broad range of assets that can be
recommended by fiduciary advisers under the Regulation. This permits
trades that may be necessary, according to commenters, when a
Retirement Investor seeks to sell an investment and cannot obtain a
reasonable price from a third party. In addition, in response to
commenters, the Department expanded the scope of the Best Interest
Contract Exemption to cover riskless principal transactions involving
all investment products.
As proposed, the exemption limited the types of assets that could
be traded (both bought and sold) on a principal basis to corporate debt
securities offered pursuant to a registration statement under the
Securities Act of 1933, treasury securities, and agency securities. The
Department received many comments regarding this limitation and the
general intent of the exemption. Supporting comments emphasized that
the exemption's limited scope and conditions were appropriate for the
mitigation of conflicts of interest and the protection of plans and
IRAs. One commenter particularly supported the exemption's approach of
granting relief only to those securities least likely to be subject to
principal trading abuses. The commenter supported, in particular, the
exclusion of municipal securities.
Others urged the Department to broaden the scope of the exemption.
Many of these commenters argued that principal transactions are
necessary for the maintenance of inventory, liquidity, access to
investments, and best execution. They contended that the failure to
provide broader relief would drive up the cost to investors, and hinder
normal transactions that are generally classified as facilitation
trades or riskless principal transactions. Commenters took the position
that the Department should not substitute its judgment for the judgment
of investors and advisers. In particular, commenters
[[Page 21097]]
urged the Department to: (a) Provide relief for riskless principal
transactions, (b) add specific additional securities to the scope of
the exemption, and (c) provide broad principal transaction relief for
all securities and other property.
a. Riskless Principal Transactions
A number of comments noted that the proposal did not specifically
address riskless principal transactions. In a riskless principal
transaction, according to a commenter, a Financial Institution, after
receiving an order to purchase or sell a security from a customer,
purchases or sells the investment for its own account to offset the
contemporaneous transaction with the customer. Commenters argued that
riskless principal transactions are the functional equivalent of agency
transactions. A commenter asserted that for this reason, riskless
principal transactions would not involve the incentive to dump unwanted
investments on Retirement Investors, which was one of the Department's
concerns. Another commenter indicated that without wider availability
of riskless principal transactions, many investments would not be
available at all to plans and IRAs because it is typical for broker-
dealers to engage in transactions with third parties on a riskless
principal basis rather than a pure agency basis. One commenter stated
that this is because counterparties may not want to assume settlement
risk with an investor.
After consideration of these comments, the Department concurs with
commenters that broader relief in this area is appropriate. The
Department intended that the proposal cover riskless principal
transactions within the general meaning of principal transactions, but
the transactions would have been limited to the debt securities covered
under the proposed exemption. The Department agrees with commenters
that, to the extent a Financial Institution engages in a transaction
based on an existing customer order, the riskless principal transaction
can be viewed as functionally similar to an agency transaction, and the
Department accepts the position of commenters that some investments may
not be functionally available without this relief. For this reason, the
Department expanded the scope of the companion Best Interest Contract
Exemption to permit riskless principal transactions in all investments,
and provide relief for compensation received in connection with such
transactions, subject to the conditions of that exemption.
The Department also clarified that this exemption is available for
riskless principal transactions involving principal traded assets. The
definition of a principal transaction now explicitly excludes riskless
principal transactions, and the exemption's scope specifically
encompasses both principal transactions and separately-defined riskless
principal transactions. In this manner, the exemption now clearly draws
a distinction between principal transactions and riskless principal
transactions and provides relief for both with respect to principal
traded assets.
This approach results in some overlap between coverage of riskless
principal transactions in the Best Interest Contract Exemption and this
exemption. With respect to a recommended purchase of an investment that
occurs in a riskless principal transaction, this exemption is available
for principal traded assets. The Best Interest Contract Exemption,
however, provides broader relief for all recommended purchases. In
addition, sales from a plan or IRA in riskless principal transactions
can occur under either exemption.
This approach is intended to provide flexibility to Financial
Institutions relying on the exemptions. The Department believes that
some Financial Institutions have business models that involve only
riskless principal transactions. These Financial Institutions may not,
as a general matter, hold investments in inventory to sell in principal
transactions, but they may execute certain transactions as riskless
principal transactions. Financial Institutions that do not engage in
principal transactions, as defined in the exemptions, do not have to
rely on this exemption at all, and can organize their practices to
comply with the Best Interest Contract Exemption alone.
On the other hand, Financial Institutions that engage in both
principal transactions and riskless principal transactions may want to
organize their practices to comply with this exemption. They may not be
certain at the outset whether a particular purchase by a plan or IRA
will be executed as a principal transaction or a riskless principal
transaction. Those Financial Institutions can rely on this exemption
for principal traded assets that may be sold to plans and IRAs without
concern for whether the transaction is, in fact a riskless principal
transaction or principal transaction.
b. Adding to the Definition of Principal Traded Assets
Some commenters requested that this exemption extend to principal
transactions in specific additional types of securities or investments,
including municipal securities, currency, agency debt securities, CDs
(including brokered CDs), asset backed securities, unit investment
trusts (UITs), equities (including new issue and initial public
offerings), new issue of debt securities, preferred securities, foreign
corporate securities, foreign sovereign debt, debt of a charitable
organization, derivatives, bank note offerings and wrap or other
contracts that are not insurance products.
In response, the Department added to this final exemption CDs,
UITs, and asset backed securities guaranteed by an agency or GSE. Both
CDs and UITs were included as investments permitted to be sold under
the proposed Best Interest Contract Exemption, and commenters informed
us that these investments are typically sold in principal transactions.
Without relief for CDs and UITs in this exemption, commenters asserted
that Retirement Investors might lose access to such investments.
Commenters indicated that these investments were common investments in
ERISA plans, IRAs and non-ERISA plans. The Department therefore
included them in this final exemption. As with the exemptive relief
originally proposed regarding principal transactions in debt
securities, the Department believes that the conflicts of interest
created by principal transactions in CDs and UITs are effectively
addressed by the conditions of this exemption so as to protect the
interests of Retirement Investors while maintaining Retirement
Investors' access to these investments.
Agency and GSE guaranteed asset backed securities were always
intended to be included in the definition of debt security. The
proposal provided that agency debt securities were defined by reference
to the Financial Industry Regulatory Authority (FINRA) rule
6710(l).\16\ Commenters informed us that the Department's definition
omitted agency and GSE mortgage backed securities. Based on the
Department's original intent to provide relief for these investments,
and the view that the conditions are protective in these contexts, the
Department included them in the final exemption.
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\16\ FINRA is registered with the Securities and Exchange
Commission (SEC) as a national securities association and is a self-
regulatory organization, as those terms are defined in the Exchange
Act, which operates under SEC oversight.
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Reflecting this expansion of relief to CDs, UITs and agency and GSE
guaranteed asset backed securities, the final exemption uses the term
``principal traded asset,'' rather than ``debt security'' to describe
the
[[Page 21098]]
investments that can be purchased or sold.
As explained in greater detail below, the Department did not expand
the purchase provisions of the exemption, as some commenters suggested,
to include other investments such as municipal securities, currency,
asset backed securities, equities (including new issue and initial
public offerings), new issue of debt securities, preferred securities,
foreign corporate securities, foreign sovereign debt, debt of a
charitable organization, derivatives, bank note offerings and wrap or
other contracts that are not insurance products. The Department
determined that the conditions of this exemption may not be
appropriately tailored to these types of investments. The Department
invites interested parties to request an individual exemption for other
investments that they would like to see included in this class
exemption. This will provide the Department with the opportunity to
gain additional information about those investments, their sales
practices and associated conflicts of interest.
c. Principal Transaction Relief for All Securities and Other Property
Other commenters sought to more generally expand the scope of the
exemption. Some commenters felt that unrestricted relief should be
provided with respect to all principal transactions with few, if any,
conditions. Some of these commenters took issue with the Department's
decision to place any limitations at all on investments that can be
purchased or sold in a principal transaction. The commenters expressed
the view that the Department was substituting its judgment for those of
individual investors and their advisers.
In support of their approach, a few commenters urged the Department
to more closely hew to the approach taken under the securities laws,
citing Temporary Rule 206(3)-3T issued by the Securities and Exchange
Commission (SEC) under the Investment Advisers Act of 1940.\17\
According to the commenters, Temporary Rule 206(3)-3T applies to
institutions that are dually registered as investment advisers and
broker-dealers and to transactions in non-discretionary accounts at
such institutions, and it permits principal transactions involving all
securities unless the investment adviser or Affiliate is the issuer of,
or, at the time of the sale, an underwriter of, a security that is not
an investment grade debt security. The rule generally requires written
prospective consent by the customer to principal transactions; oral or
written pre-transaction disclosure and customer consent; written
confirmation to the customer; and written annual disclosure to the
customer of transactions entered into in reliance on the rule.
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\17\ 17 CFR 275.206(3)-3T.
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Commenters also focused on principal transactions involving sales
by plans and IRAs. Commenters indicated that broader relief was
necessary to provide liquidity for Retirement Investors. They said that
Financial Institutions serve an essential function in purchasing
securities from their clients who need such liquidity.
The Department did not accept the commenters' call for relief for
all principal transactions. The Department's approach in the proposal
of this exemption was intentionally narrow, based on the potentially
acute conflicts of interest associated with principal transactions that
are recommended by fiduciaries. The Department believes that broad
relief for all principal transactions, without tailored conditions, is
inconsistent with longstanding principles that fiduciaries must act
with loyalty to Retirement Investors. Because the fiduciary is on both
sides of a principal transaction, the fiduciary duty of loyalty is
sorely tested. In addition, the securities typically traded in
principal transactions often lack objective market prices and
Retirement Investors may have difficulty evaluating the fairness of a
particular transaction. Principal traded investments also can be
associated with low liquidity, low transparency and the possible
incentive to dump unwanted investments.
Therefore, although the Department's approach harmonizes in many
ways, as discussed below, with the disclosures required by the SEC's
Temporary Rule 206(3)-3T, the Department did not adopt an exemption
that is as broad in scope. The Department also notes in this respect
that the SEC has not yet finalized its approach to rule 206(3)-3T, and
the SEC has indicated the delay is related to the SEC's consideration
of regulatory standards of care for broker-dealers and investment
advisers under section 913 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (Dodd-Frank Act). In the most recent release
proposing to extend the Temporary Rule, the SEC stated:
As part of our broader consideration of the regulatory
requirements applicable to broker-dealers and investment advisers,
we intend to carefully consider principal trading by advisers,
including whether rule 206(3)-3T should be substantively modified,
supplanted, or permitted to sunset.\18\
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\18\ See SEC's Release No. IA-3893, August 12, 2014.
Given the SEC's ongoing consideration of these issues, the Department
does not believe there is a significant advantage to mirroring the
scope of the Temporary Rule.
Although the Department retained the limited definition of
principal traded asset, as discussed above, for recommendations that a
plan or IRA purchase an investment, the Department did provide broader
relief for recommended sales from a plan or IRA to a Financial
Institution. The Department is persuaded by commenters that a broader
exemption is necessary to provide liquidity to plans and IRAs.
The Department also notes that the final Regulation provides
additional ways in which parties can engage in principal transactions
and riskless principal transactions and avoid prohibited transactions.
The Regulation provides that a person is not a fiduciary when the
person engages in an arm's length transaction with an independent plan
fiduciary with financial expertise, as defined in the Regulation.
Financial professionals that engage in such transactions are not
considered fiduciaries, and may rely on other exemptions such as PTE
75-1, Part II, or ERISA section 408(b)(17) and Code section
4975(d)(20), for a broader range of principal transactions and riskless
principal transactions. Therefore, the concerns of commenters such as
the Stable Value Investment Association, about principal transactions
involving a stable value fund managed by a professional investment
manager, should be addressed in that fashion.
Finally, this exemption does not affect the ability of a self-
directed investor to obtain the services of a financial professional to
effect or execute a transaction involving any type of investment, in
the absence of investment advice. In that sense, the Department is not
limiting investment opportunities for individual investors or
substituting the Department's judgment for theirs. Instead, the
exemption is aimed squarely at conflicted investment advice by
fiduciaries and is intended to minimize the harms of such conflicts of
interest.
In this regard, one commenter requested a clarification as to
whether an exemption is necessary for the provision of principal
transaction services where the services do not involve the provision of
individual recommendations to a plan or IRA. In
[[Page 21099]]
response, the Department notes that relief from ERISA section 406(b)
would only be necessary to the extent the service provider was acting
as a fiduciary. To the extent the service provider does not make
recommendations, it does not act as a fiduciary investment adviser. If
the service provider is not a fiduciary, ERISA section 406(b) relief is
not necessary, and the other exemptions referenced above, apply.
2. Exclusions
The exclusions set forth in Section I(c) of the proposal remain a
part of the final exemption. First, under Section I(c)(1), Advisers who
have or exercise discretionary authority or discretionary control with
respect to management of the assets of a plan, participant or
beneficiary account, or IRA or who exercise any discretionary authority
or control respecting management or the disposition of the assets, or
have any discretionary authority or discretionary responsibility in the
administration of the plan, participant or beneficiary account, or IRA,
may not take advantage of relief under the exemption to engage in
principal transactions and riskless principal transactions with such
investors.
A comment related to this provision asked that the limitation on
investment managers be modified so that Financial Institutions that
sponsor separately managed accounts that use independent, individual
investment managers should be permitted to engage in principal
transactions on behalf of their managed plans and IRAs with the
sponsor. The Department did not adopt this suggestion. Instead, the
Department notes that the Regulation was revised to provide that a
person does not act as a fiduciary when engaged in an arm's length
transaction with a plan fiduciary with financial expertise under the
circumstances set forth in the Regulation. In such circumstances, the
financial professionals may, therefore, rely on existing exemptions for
non-fiduciary principal transactions and riskless principal
transactions.
Second, under Section I(c)(2), the exemption is not available for a
principal transaction involving a plan covered by Title I of ERISA if
the Adviser or Financial Institution, or any Affiliate is the employer
of employees covered by the plan. In accordance with this condition,
the exemption is not available for a principal transaction entered into
as part of a rollover from such a plan to an IRA, where the principal
transaction is being executed by the plan, not the IRA. This
restriction on employers does not apply in the case of an IRA or other
similar plan that is not covered by Title I of ERISA. Accordingly, an
Adviser or Financial Institution may provide advice to the beneficial
owner of an IRA who is employed by the Adviser, its Financial
Institution or an Affiliate, and receive compensation as a result,
provided the IRA is not covered by Title I of ERISA.
No comments were received specific to the principal transactions
exemption on proposed Section I(c)(2). Comments were received, however,
on the same language, proposed in Section I(c)(1), of the Best Interest
Contract Exemption. Specifically, industry commenters requested
elimination of this exclusion in the Best Interest Contract Exemption.
In particular, they said that Financial Institutions in the business of
providing investment advice should not be compelled to hire a
competitor to provide services to the Financial Institution's own plan.
They warned that the exclusion could effectively prevent these
Financial Institutions from providing any investment advice to their
employees. Some commenters additionally stated that for compliance
reasons, employees of a Financial Institution are often required to
maintain their financial assets with that Financial Institution. As a
result, they argued employees of Financial Institutions could be denied
access to investment advice on their retirement savings.
As with the Best Interest Contract Exemption, the Department has
not scaled back the exclusion. As noted above, the Department did not
receive comments requesting that Financial Institutions be able to
engage in principal transactions with their in-house plans. More
generally, however, the Department continues to be concerned that the
danger of abuse is compounded when the advice recipient receives
recommendations from the employer, upon whom he or she depends for a
job, to make investments in which the employer has a financial
interest. To protect employees from abuse, employers generally should
not be in a position to use their employees' retirement benefits as
potential revenue or profit sources, without stringent safeguards. See,
e.g., ERISA section 403(c)(1) (generally providing that ``the assets of
a plan shall never inure to the benefit of any employer'').
Additionally, the exclusion of employers in Section I(c) does not apply
in the case of an IRA or other similar plan that is not covered by
Title I of ERISA. The decision to open an IRA account or obtain IRA
services from the employer is much more likely to be entirely voluntary
on the employees' part than would be true of their interactions with
the retirement plan sponsored and designed by their employer for its
employee benefit program. Accordingly, an Adviser or Financial
Institution may provide advice to the beneficial owner of an IRA who is
employed by the Adviser, its Financial Institution or an Affiliate
regarding a principal transaction or riskless principal transaction,
and engage in a principal transaction or riskless principal transaction
as a result, provided the IRA is not covered by Title I of ERISA, and
the conditions of this exemption are satisfied.
Section I(c)(2) further provides that the exemption is unavailable
if the Adviser or Financial Institution is a named fiduciary or plan
administrator, as defined in ERISA section 3(16)(A) with respect to an
ERISA plan, or an Affiliate thereof, that was selected to provide
advice to the plan by a fiduciary who is not independent of them. This
provision is intended to disallow the selection of Advisers and
Financial Institutions by named fiduciaries or plan administrators that
have a significant financial stake in the selection and was adopted in
the final exemption unchanged from the proposal.\19\
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\19\ The definition of ``independent'' was adjusted in response
to comments, as discussed below, to permit circumstances in which
the person selecting the Adviser and Financial Institution could
receive no more than 2% of its compensation from the Financial
Institution.
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B. Conditions of the Exemption
Section I, discussed above, establishes the scope of relief
provided by this Principal Transactions Exemption. Sections II-V set
forth the conditions of the exemption. All applicable conditions must
be satisfied in order to avoid application of the specified prohibited
transaction provisions of ERISA and the Code. The Department finds
that, subject to these conditions, the exemption is administratively
feasible, in the interests of plans and of their participants and
beneficiaries, and IRA owners and protective of the rights of the
participants and beneficiaries of such plans and IRA owners. Under
ERISA section 408(a), and Code section 4975(c)(2), the Secretary may
not grant an exemption without making such findings. The conditions of
the exemption, comments on those conditions, and the Department's
responses, are described below.
1. Enforceable Right to Best Interest Advice (Section II)
Section II of the exemption sets forth the requirements that
establish the Retirement Investor's enforceable right
[[Page 21100]]
to adherence to the Impartial Conduct Standards and related conditions.
For advice to certain Retirement Investors--specifically, advice
regarding transactions with IRAs, and plans that are not covered by
Title I of ERISA (non-ERISA plans), such as Keogh plans--Section II(a)
requires the Financial Institution and Retirement Investor to enter
into a written contract that includes the provisions described in
Section II(b)-(d) of the exemption and that also does not include any
of the ineligible provisions described in Section II(f) of the
exemption, and provide the disclosures set forth in Section II(e). As
discussed further below, pursuant to Section II(g) of the exemption,
advice to Retirement Investors regarding ERISA plans does not have to
be subject to a written contract but Advisers and Financial
Institutions must comply with the substantive standards established in
Section II(b)-(e) to avoid liability for a non-exempt prohibited
transaction.
The contract with Retirement Investors regarding IRAs and non-ERISA
plans must include the Financial Institution's acknowledgment of its
fiduciary status and that of its Advisers, as required by Section
II(b); the Financial Institution's agreement that it and its Advisers
will adhere to the Impartial Conduct Standards, including a Best
Interest standard, as required by Section II(c); the Financial
Institution's warranty that it has adopted and will comply with certain
policies and procedures, including anti-conflict policies and
procedures reasonably and prudently designed to ensure that Advisers
adhere to the Impartial Conduct Standards, as required by Section
II(d). The Financial Institution's disclosure of information about
Material Conflicts of Interest associated with principal transactions
and riskless principal transactions, as required by Section II(e), may
be provided in the contract or in a separate single written disclosure.
Section II(f) generally provides that the exemption is unavailable if
the contract includes exculpatory provisions or provisions waiving the
rights and remedies of the plan, IRA or Retirement Investor, including
their right to participate in a class action in court. The contract
may, however, provide for binding arbitration of individual claims, and
may waive contractual rights to punitive damages or rescission.
The contract between the IRA or non-ERISA plan, and the Financial
Institution, forms the basis of the IRA's or non-ERISA plan's
enforcement rights. The Department intends that all the contractual
obligations imposed on the Financial Institution (the Impartial Conduct
Standards and warranties) will be actionable by the IRAs and non-ERISA
plans. Because these standards are contractually imposed, an IRA or
non-ERISA plan has a contract claim if, for example, its Adviser
recommends an investment product that is not in the Best Interest of
the IRA or other non-ERISA plan.
In the Department's view, these contractual rights serve a critical
function for IRA owners and participants and beneficiaries of non-ERISA
plans. Unlike participants and beneficiaries in plans covered by Title
I of ERISA, IRA owners and participants and beneficiaries in non-ERISA
plans do not have an independent statutory right to bring suit against
fiduciaries for violation of the prohibited transaction rules. Nor can
the Secretary of Labor bring suit to enforce the prohibited
transactions rules on their behalf.\20\ Thus, for investors in IRAs and
non-ERISA plans, the contractual requirement creates a mechanism for
investors to enforce their rights and ensures that they will have a
remedy for misconduct. In this way, the exemption creates a powerful
incentive for Financial Institutions and Advisers alike to oversee and
adhere to basic fiduciary standards when engaging in principal
transactions and riskless principal transactions, without requiring the
imposition of unduly rigid and prescriptive rules and conditions.
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\20\ An excise tax does apply in the case of a violation of the
prohibited transaction provisions of the Code, generally equal to
15% of the amount involved. The excise tax is generally self-
enforced; requiring parties not only to realize that they've engaged
in a prohibited transaction but also to report it and pay the tax.
Parties who have participated in a prohibited transaction for which
an exemption is not available must pay the excise tax and file Form
5330 with the Internal Revenue Service.
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Under Section II(g), however, the written contract requirement does
not apply to advice to Retirement Investors regarding transactions with
plans that are covered by Title I of ERISA (ERISA plans) in light of
the existing statutory framework which provides a pre-existing
enforcement mechanism for these investors and the Department. Instead,
Advisers and Financial Institutions must satisfy the provisions in
Section II(b)-(e) as conditions of the exemption when transacting with
such Retirement Investors. Under the terms of the exemptions, the
Financial Institution must provide a written acknowledgment of its and
its Advisers' fiduciary status prior to or at the same time as the
execution of the transaction, although it does not have to be part of a
contract, as required by Section II(b); the Financial Institution and
its Advisers must comply with the Impartial Conduct Standards, as
required by Section II(c); the Financial Institutions must establish
and comply with certain policies and procedures, as required by Section
II(d); and they must provide the disclosures required by Section II(e).
If these conditions are not satisfied with respect to an ERISA plan
engaging in a principal transaction or a riskless principal
transaction, the Adviser and Financial Institution would be unable to
rely on the exemption for relief from ERISA's prohibited transactions
restrictions. An Adviser's failure to comply with the exemption would
result in a non-exempt prohibited transaction under ERISA section 406
and would likely constitute a fiduciary breach under ERISA section 404.
As a result, a plan, plan participant or beneficiary would be able to
sue under ERISA section 502(a)(2) or (3) to recover any loss in value
to the plan (including the loss in value to an individual account), or
to obtain disgorgement of any wrongful profits or unjust enrichment. In
addition, the Secretary of Labor can enforce ERISA's prohibited
transaction and fiduciary duty provisions with respect to these ERISA
plans, and an excise tax under the Code, as described above, applies.
In this regard, under Section II(g)(5) of the exemption, the
Financial Institution and Adviser may not rely on the exemption if, in
any contract, instrument, or communication they disclaim any
responsibility or liability for any responsibility, obligation, or duty
under Title I of ERISA to the extent the disclaimer would be prohibited
by ERISA section 410, waive or qualify the right of the Retirement
Investor to bring or participate in a class action or other
representative action in court in a dispute with the Adviser or
Financial Institution, or require arbitration or mediation of
individual claims in locations that are distant or that otherwise
unreasonably limit the ability of the Retirement Investors to assert
the claims safeguarded by this exemption. The exemption's
enforceability, and the potential for liability, is critical to
ensuring adherence to the exemption's stringent standards and
protections, notwithstanding the competing pull of the conflicts of
interest associated with principal transactions and riskless principal
transactions.
The Department expects claims of Retirement Investors regarding
investments in ERISA plans to be brought under ERISA's enforcement
provisions, discussed above. In general, ERISA section 410 invalidates
[[Page 21101]]
instruments purporting to relieve a fiduciary from responsibility or
liability for any responsibility, obligation, or duty under ERISA.
Accordingly, provisions purporting to waive fiduciary obligations under
ERISA serve only to mislead Retirement Investors about the scope of
their rights. Additionally, the legislative intent of ERISA was, in
part, to provide for ``ready access to federal courts.'' Accordingly,
any recommended transaction covered by a contract or other instrument
that waives or qualifies the right of the Retirement Investor to bring
or participate in a class action or other representative action in
court, will not be eligible for relief under this exemption.
A number of comments were received on the contract requirement as
it was proposed. The comments, and the Department's responses, are
discussed below. The Department notes that some of the commenters
simply cross-referenced their comments, in the entirety, with respect
to the same provisions in the proposed Best Interest Contract
Exemption. Additionally, some commenters focused their comments solely
on the Best Interest Contract Exemption. The Department determined it
was important that the contract provisions in the Best Interest
Contract Exemption be compatible with the contract provisions in this
exemption, so that the two exemptions can easily be used together. For
this reason, the Department considered all comments made on either
exemption on a consolidated basis, and made corresponding changes in
the two exemptions. For ease of use, the Department has included in
this preamble the same general discussion of comments as in the Best
Interest Contract Exemption, despite the fact that some comments
discussed below were not made directly with respect to this exemption.
In this regard, one commenter inquired as to whether the contract
required in this exemption could be combined with the contract required
by the Best Interest Contract Exemption, or whether two contracts would
be needed. It was the Department's intent in crafting this exemption
that it could be used in connection with the Best Interest Contract
Exemption, and it is the Department's view that there need only be one
contract. If parties wish to give themselves flexibility to engage in
principal transactions and riskless principal transactions with
Retirement Investors, they can include the contract provisions that are
specific to principal transactions and riskless principal transactions
and obtain the Retirement Investor's consent to participate in such
transactions.
a. Contract Requirement Applicable to IRAs and Non-ERISA Plans
A number of commenters took the position that the consumer
protections afforded by the contract requirement are an essential
feature of the exemption, particularly in the IRA market. Commenters
indicated that enforceability is critical in the IRA market because of
IRA owners' lack of a statutory right to enforce prohibited
transactions provisions. Commenters said that, in order to achieve the
goal of providing meaningful new protections to Retirement Investors,
the exemption must provide a mechanism by which Advisers and Financial
Institutions can be held legally accountable for the retirement
recommendations they make.
Many other commenters, however, raised significant objections to
the contract requirement. Commenters pointed to certain conditions of
the exemption that they found ambiguous or subjective and indicated
that these conditions could form the basis of class action lawsuits by
disappointed investors. Some commenters said the contract requirement
and associated litigation exposure will cause investment advice
providers to cease serving Retirement Investors or provide only fee-
based accounts that do not vary on the basis of the advice provided,
resulting in the loss of services to retirement investors with smaller
account balances. These commenters stated that investment advice
fiduciaries would not risk the anticipated legal liability for
Retirement Investors, or at least with respect to small accounts.
Commenters also indicated that the SEC's Temporary Rule 206(3)-3T
already addresses the issues regarding principal transactions that the
Department is attempting to address.
In the final exemption, the Department retained the contract
requirement with respect to IRAs and non-ERISA plans. The contractual
commitment provides an administrable means of ensuring fiduciary
conduct, eliminating ambiguity about the fiduciary nature of the
relationship, and enforcing the exemption's conditions, thereby
assuring compliance. The existence of enforceable rights and remedies
gives Financial Institutions and Advisers a powerful incentive to
comply with the exemption's standards, implement effective anti-
conflict policies and procedures, and carefully police conflicts of
interest. The enforceable contract gives clarity to the fiduciary
nature of the undertaking, and ensures that Advisers and Financial
Institutions do not subordinate the interests of the Retirement
Investor to their own competing financial interests. The contract
effectively aligns the interests of Retirement Investor, Advisers, and
the Financial Institution, and gives the Retirement Investor the means
to redress injury when violations occur.
Without a contract, the possible imposition of an excise tax
provides an additional, but inadequate incentive to ensure compliance
with the exemption's standards-based approach. This is particularly
true because imposition of the excise tax critically depends on
fiduciaries' self-reporting of violations, rather than independent
investigations and litigation by the IRS. In contrast, contract
enforcement does not rely on conflicted fiduciaries' assessment of
their own adherence to fiduciary norms or require the creation and
expansion of a government enforcement apparatus. The contract provides
an administrable way of ensuring adherence to fiduciary standards,
broadly applicable to an enormous range of investments and advice
relationships.
The enforceability of the exemption's provisions enables the
Department to grant exemptive relief based upon broad protective
standards rather than rely exclusively upon highly proscriptive
conditions. In the context of this exemption, the risk of litigation
and enforcement serves many of the same functions that it has for
hundreds of years under the law of trust and agency. It gives
fiduciaries a powerful incentive to adhere to broad, flexible, and
protective standards applicable to principal transactions and riskless
principal transactions by imposing liability and providing a remedy
when fiduciaries fail to comply with those standards.
In addition, a number of features of this final exemption,
discussed more fully below, should temper commenters' concerns about
the risk of excessive litigation. In particular, the exemption permits
Advisers and Financial Institutions to require mandatory arbitration of
individual claims, so that claims that do not involve systemic abuse or
entire classes of participants can be resolved outside of court.
Similarly, the exemption permits waivers of the right to obtain
punitive damages or rescission based on violation of the contract. In
the Department's view, make-whole compensatory relief is sufficient to
incentivize compliance and redress injury caused by fiduciary
misconduct. The Department has also clarified a number of the
exemption's conditions and simplified the disclosure and
[[Page 21102]]
compliance obligations to facilitate adherence to the exemption's
terms.
The core principles of the exemption are well-established under
trust law, ERISA and the Code, and have a long history of
interpretations in court. Moreover, the Impartial Conduct Standards are
measured based on the circumstances existing at the time of the
recommendation, not based on the ultimate performance of the investment
with the benefit of hindsight. It is well settled as a legal matter
that fiduciary advisers are not guarantors of the success of
investments under ERISA or the Code, and this exemption does nothing to
change that fact. Finally, the Department added provisions enabling
Advisers and Financial Institutions to correct good faith errors in
disclosure, without facing loss of the exemption.
The Department did not rely solely on the approach in the SEC's
Temporary Rule 206(3)-3T, or another primarily disclosure-based
approach, as suggested by some commenters. In the Department's view,
disclosure of conflicts is a necessary, but not sufficient, basis for
relief in the context of fiduciary self-dealing involving tax-favored
accounts.
One commenter asked the Department to address the interaction of
the contract cause of action and state securities laws. In this
connection, the Department confirms that it is not the Department's
intent to preempt or supersede state securities law and enforcement,
and the state securities laws remain subject to the ERISA section
514(b)(2)(A) savings clause.
b. No Contract Requirement Applicable to ERISA Plans
Under Section II(g) of the exemption, there is no contract
requirement for transactions involving ERISA plans, but Financial
Institutions and their Advisers must satisfy the conditions of Section
II(b)-(e), including the conditions requiring written fiduciary
acknowledgment, adherence to Impartial Conduct Standards, policies and
procedures, and disclosures.
The Department eliminated the proposed contract requirement with
respect to ERISA plans in this final exemption in response to public
comment on this issue. A number of commenters indicated that the
contract requirement was unnecessary for ERISA plans due to the
statutory framework that already provides enforcement rights to such
plans, their participants and beneficiaries, and the Secretary of
Labor. Some commenters additionally questioned the extent to which the
contract provided additional rights or remedies, and whether state-law
contract claims would be pre-empted under ERISA's pre-emption
provisions.
In the Department's view, the requirement that a Financial
Institution provide written acknowledgement of fiduciary status for
itself and its Advisers provides protections in the ERISA plan context
that are comparable to the contract requirement for IRAs and non-ERISA
plans. As a result of the written acknowledgment of fiduciary status,
the fiduciary nature of the relationship will be clear to the parties
both at the time of the investment transaction, and in the event of
subsequent disputes over the conduct of the Advisers or Financial
Institutions. There will be far less cause for the parties to litigate
disputes over fiduciary status, as opposed to the substance of the
fiduciaries' recommendations and conduct.
2. Contract Operational Issues--Section II(a)
Section II(a) specifies the mechanics of entering into the contract
and provides that the contract must be enforceable against the
Financial Institution. In addition, the section indicates that the
contract may be a master contract covering multiple recommendations,
and that it may cover advice that was rendered prior to the execution
of the contract as long as the contract is entered into prior to or at
the same time as the execution of the recommended transaction.
Section II(a)(1) further describes the methods for obtaining
customer assent to the contract. For ``new contracts,'' the Retirement
Investor's assent must be demonstrated through a written or electronic
signature. The exemption provides flexibility by permitting the
contract terms to be set forth in a standalone document or in an
investment advisory agreement, investment program agreement, account
opening agreement, insurance or annuity contract or application, or
similar document, or amendment thereto.
For Retirement Investors with ``existing contracts,'' the exemption
permits assent to be evidenced either by affirmative consent, as
described above, or by a negative consent procedure. Under the negative
consent procedure, the Financial Institution delivers a proposed
contract amendment along with the disclosure required in Section II(e)
to the Retirement Investor prior to January 1, 2018, and if the
Retirement Investor does not terminate the amended contract within 30
days, the amended contract is effective. If the Retirement Investor
does terminate the contract within that 30-day period, this exemption
will provide relief for 14 days after the date on which the termination
is received by the Financial Institution.\21\ An existing contract is
defined in the exemption as ``an investment advisory agreement,
investment program agreement, account opening agreement, insurance
contract, annuity contract, or similar agreement or contract that was
executed before January 1, 2018 and remains in effect.'' If the
Financial Institution elects to use the negative consent procedure, it
may deliver the proposed amendment by mail or electronically, but it
may not impose any new contractual obligations, restrictions, or
liabilities on the Retirement Investor by negative consent.
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\21\ Alternatively, for purposes of this exemption, Advisers and
Financial Institutions can provide the contractual terms required by
the exemption and permit the Retirement Investor to specifically
decline to authorize principal transactions and riskless principal
transactions within 30 days but continue the existing contract. Of
course, to the extent prohibited transaction relief is needed for
transactions under the existing contract, the Adviser and Financial
Institution would need to comply with another exemption.
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Finally, Section II(a)(2) of the exemption requires the Financial
Institution to maintain an electronic copy of the Retirement Investor's
contract on its Web site that is accessible by the Retirement Investor.
This condition ensures that the Retirement Investor has ready access to
the terms of the contract, and reinforces the exemption's goals of
clearly establishing the fiduciary status of the Adviser and Financial
Institution and ensuring their adherence to the exemption's conditions.
Comments on specific contract operational issues are discussed
below.
a. Contract Timing
As proposed, Section II(a) required that, ``[p]rior to recommending
that the plan, participant or beneficiary account, or IRA purchase,
sell or hold the Asset, the Adviser and Financial Institution enter
into a written contract with the Retirement Investor that incorporates
the terms required by Section II(b)-(e).'' A large number of commenters
responded to various aspects of this proposed requirement.
Many commenters objected to the timing of the contract requirement.
They said that requiring execution of a contract ``prior to'' any
recommendations would be contrary to existing industry practices. The
commenters indicated that preliminary discussions may evolve into
recommendations before a Retirement Investor has decided to work with a
particular Adviser and Financial Institution. Requiring a contract
upfront
[[Page 21103]]
could chill such preliminary discussions, unduly complicate the
relationship between the Adviser and the Retirement Investor, and
interfere with an investor's ability to shop around. Many commenters
suggested that it would be better to time the requirement so that the
contract would have to be entered into prior to the execution of the
actual principal transaction, or even later, rather than before any
advice was rendered. While some other commenters supported the proposed
timing, noting the benefit of allowing Retirement Investors the chance
to carefully review the contract prior to engaging in transactions,
several commenters that strongly supported the contract requirement
agreed that the timing could be adjusted without loss of protection to
the Retirement Investor.
In the Department's view, the precise timing of the contract is not
critical to the exemption, provided that the parties enter into a
contract covering the advice. The Department did not intend to chill
developing advice relationships or limit investors' ability to shop
around. Therefore, the Department adjusted the exemption on this point
by deleting the proposed requirement that the contract be entered into
prior to the advice recommendation. Instead, the exemption generally
provides that the advice must be subject to an enforceable written
contract entered into prior to or at the same time as the execution of
the recommended transaction. However, in order for the exemption to be
available to recommendations made prior to the contract's formation,
the contract's terms must cover the prior recommendations.
A few commenters suggested that the Department require the contract
to be a separate document, not combined with any other document.
However, other commenters requested that the Department allow Financial
Institutions to incorporate the contract terms into other account
documents. While the Department believes the contract is critical to
IRA and non-ERISA plan investors, the Department recognizes the need
for flexibility in its implementation. Therefore, the exemption
contemplates that the contract may be incorporated into other documents
to the extent desired by the Financial Institution. Additionally, as
requested by commenters, the Department confirms that the contract
requirement may be satisfied through a master contract covering
multiple recommendations and does not require execution prior to each
additional recommendation.
b. Contract Parties
A number of commenters questioned the necessity of the proposed
requirement that Advisers be parties to the contract. These commenters
indicated that the proposed requirement posed significant logistical
challenges. For example, commenters stated that Advisers often work in
teams and it would be difficult to obtain signatures from all such
Advisers. Similarly, if call center representatives made
recommendations that include principal transactions and riskless
principal transactions, it could be hard to cover them under a
contract. Over the course of a Retirement Investor's relationship with
a Financial Institution, he or she could receive advice from a number
of persons. Requiring that each such person execute a contract could
prove difficult and unwieldy.
Based upon these objections, the Department deleted the requirement
that individual Advisers be parties to the contract. The Financial
Institution must be a party to the contract and take responsibility for
satisfying the exemption's conditions, including the obligation to have
policies and procedures reasonably and prudently designed to ensure
that individual Advisers adhere to the Impartial Conduct Standards, and
the obligation to insulate the Adviser from incentives to violate the
Best Interest standard. Such Advisers include call center
representatives who provide investment advice within the meaning of the
Regulation.
Some commenters suggested that the Department provide additional
flexibility and allow the individual Adviser to be obligated under the
contract instead of the Financial Institution. The Department has not
adopted that suggestion. To ensure operation of the exemption as
intended, the Financial Institution should be a party to the contract.
The supervisory responsibility and liability of the Financial
Institution is important to the exemption's protections. In particular,
the exemption contemplates that the Financial Institution will adopt
and monitor stringent anti-conflict policies and procedures; avoid
financial incentives that undermine the Impartial Conduct standards;
and take appropriate measures to ensure that it and its representatives
adhere to the exemption's conditions. The contract provides both a
mechanism for imposing these obligations on the Financial Institution
and creates a powerful incentive for the Financial Institution to take
the obligations seriously in the management and supervision of
investment recommendations.
c. Contract Signatures
Section II(a) of the exemption provides that the contract must be
enforceable against the Financial Institution. As long as that is the
case, the Financial Institution is not required to sign the contract.
Section II(a) of the exemption further describes the methods through
which customer assent may be achieved, and reflects commenters'
requests for greater specificity on this point.
With respect to new contracts, a few commenters asked the
Department to confirm that electronic execution by the Retirement
Investor is sufficient. Another commenter asked about telephone assent.
In the final exemption, the Department specifically permits electronic
execution as a form of customer assent. The Department has not
permitted telephone assent, however, because of the potential issues of
proof regarding the existence and terms of a contract executed in that
manner. It is the Department's goal that Retirement Investors obtain
clear evidence of the contract terms and their applicability to the
Retirement Investor's own account or contract. The exemption will best
serve its purpose if the contractual commitments are clear to all the
parties, and if ancillary disputes about the fiduciary nature of the
advice relationship are avoided. For this same reason, the exemption
requires that a copy of the applicable contract be maintained on a Web
site accessible to the Retirement Investor.
Commenters also asked for the ability to use a negative consent
procedure with respect to existing customers to avoid the expense and
difficulty associated with obtaining a large number of client
signatures. The Department adjusted the exemption on this point to
permit amendment of existing contracts by negative consent, as
discussed above. As this approach will still result in the Retirement
Investor receiving clear evidence of the contract terms and their
applicability to the Retirement Investor's own account or contract, the
Department concurred with commenters on its use.
Treating the Retirement Investor's silence as consent after 30 days
provides the Retirement Investor a reasonable opportunity to review the
new terms and to reject them. The Financial Institution may not use the
negative consent procedure, however, to impose new obligations,
restrictions or liabilities on the Retirement Investor in connection
with this exemption. Any attempt by the Financial Institution to
[[Page 21104]]
impose additional obligations, restrictions or liabilities on the
Retirement Investor must receive affirmative consent from the
Retirement Investor, and cannot violate Section II(f).
A number of commenters also asked that the exemption authorize
Financial Institutions to satisfy the contract requirement for all
Retirement Investors--including new customers after the January 1,
2018--through unilateral contracts or implied or negative consent. Some
commenters suggested that the Department should not require a contract
at all, but only a ``customer bill of rights'' or similar disclosure,
without any additional signature requirement. Some commenters suggested
that the requirement of obtaining signatures could delay execution of
time sensitive investment strategies.
Although the final exemption accommodates a wide variety of
concerns regarding contract operational issues, the Department did not
adopt the alternative approaches suggested by some commenters, such as
merely requiring delivery of a customer bill of rights, broader
reliance on a unilateral contract approach, or increased reliance on
negative consent. The Department intends that Retirement Investors that
are new customers of the Financial Institution should enter into an
enforceable contract under Section II(a)(1)(i). Consistent with the
Department's goal that Retirement Investors obtain clear evidence of
the contract terms and their applicability to the Retirement Investor's
own account or contract, the exemption limits the negative consent
option to existing customers as a form of transitional relief, so that
Financial Institutions can avoid the burdens associated with obtaining
signatures from a large number of already-existing customers.
Apart from this transitional relief, the Department does not
believe it is appropriate to dispense with the clarity, enforceability
and legal protections associated with an affirmative contract.
Contracts are commonplace in a wide range of commercial transactions
occurring in person, on the web, and elsewhere. The Department has
facilitated the process by providing that Financial Institutions can
incorporate the contract terms into commonplace account opening or
similar documents that they already use; by permitting electronic
signatures; and by revising the timing rules, so that the contract's
execution can follow the provision of advice, as long as it precedes or
occurs at the same time as the execution of the recommended
transaction.
3. Fiduciary Acknowledgment--Section II(b)
Section II(b) of the exemption requires the Financial Institution
to affirmatively state in writing that the Financial Institution and
the Adviser(s) act as fiduciaries under ERISA or the Code, or both,
with respect to any investment advice regarding principal transactions
and riskless principal transactions provided by the Financial
Institution or the Adviser subject to the contract or, in the case of
an ERISA plan, with respect to any investment advice regarding the
principal transactions and riskless principal transactions between the
Financial Institution and the Plan or participant or beneficiary
account.
With respect to IRAs and non-ERISA plans, if this acknowledgment of
fiduciary status does not appear in a contract with a Retirement
Investor, the exemption is not satisfied with respect to transactions
involving that Retirement Investor. With respect to ERISA plans, this
acknowledgment must be provided to the Retirement Investor prior to or
at the same time as the execution of the recommended transaction, but
not as part of a contract. This fiduciary acknowledgment is critical to
ensuring clarity and certainty with respect to fiduciary status of both
the Adviser and Financial Institution under ERISA and the Code with
respect to that advice.
The fiduciary acknowledgment provision received significant support
from some commenters. Commenters described it as a necessary protection
and noted that it would clarify the obligations of the Adviser. One
commenter said that facilitating proof of fiduciary status should
enhance investors' ability to obtain a remedy for Adviser misconduct in
arbitration by eliminating ancillary litigation over fiduciary status.
Rather than litigate over fiduciary status, the fiduciary
acknowledgment would help ensure that the proceedings focused on the
Advisers' compliance with fundamental fiduciary norms.
Some commenters opposed the fiduciary acknowledgment requirement in
the proposal, as applicable to Financial Institutions, on the basis
that it could force Financial Institutions to take on fiduciary
responsibilities, even if they would not otherwise be functional
fiduciaries under ERISA or the Code. The commenters pointed out that
under the proposed Regulation, the acknowledgment of fiduciary status
would have been a factor in imposing fiduciary status on a party.
Therefore, Financial Institutions could become fiduciaries by virtue of
the fiduciary acknowledgment. To address these concerns, a few
commenters suggested language under which a Financial Institution would
only be considered a fiduciary to the extent that it is ``an affiliate
of the Adviser within the meaning of 29 CFR 2510.3-21(f)(7) that, with
the Adviser, functions as a fiduciary.''
The Department has not adjusted the exemption as these commenters
requested. The exemption requires as a condition of relief that a
sponsoring Financial Institution accept fiduciary responsibility for
the recommendations of its Adviser(s). The Financial Institution's role
in supervising individual Advisers and overseeing their adherence to
the Impartial Conduct Standards is a key safeguard of the exemption.
The exemption's success critically depends on the Financial
Institution's careful implementation of anti-conflict policies and
procedures, avoidance of Adviser incentives to violate the Impartial
Conduct Standards and broad oversight of Advisers. Accordingly,
Financial Institutions that wish to engage in principal transactions
and riskless principal transactions that would otherwise be prohibited
under ERISA and the Code must agree to take on these responsibilities
as a condition of relief under the exemption. To the extent Financial
Institutions do not wish to take on this role with their associated
responsibilities and liabilities, they may structure their operations
to avoid prohibited transactions and the resultant need of the
exemption.
Other commenters expressed the view that the fiduciary
acknowledgement would potentially require broker-dealers to satisfy the
requirements of the Investment Advisers Act of 1940. As described by
commenters, the Act does not require broker-dealers to register as
investment advisers if they provide advice that is solely incidental to
their brokerage services. Commenters expressed concern that
acknowledging fiduciary status and providing advice in satisfaction of
the Impartial Conduct Standards could call into question whether the
advice provided was solely incidental.
The Department does not, however, require the Adviser or Financial
Institution to acknowledge fiduciary status under the securities laws,
but rather under ERISA or the Code or both. Neither does the Department
require Advisers to agree to provide investment advice on an ongoing,
rather than transactional, basis. An Adviser's status as an ERISA
fiduciary is not dispositive of its obligations under the securities
laws, and compliance with the
[[Page 21105]]
exemption does not trigger an automatic loss of the broker-dealer
exception under the separate requirements of those laws. A broker-
dealer who provides investment advice under the Regulation is an ERISA
fiduciary; acknowledgment of ERISA fiduciary status would not, by
itself, cause the Adviser to lose the broker-dealer exception. Under
the Regulation and this exemption, the primary import of fiduciary
status is that the broker has to act in the customer's Best Interest
when making recommendations; seek to obtain the best execution
reasonably available under the circumstances with respect to the
transaction; and refrain from making misleading statements. Certainly,
nothing in the securities laws precludes brokers from adhering to these
basic standards, or forbids them from working for Financial
Institutions that implement appropriate policies and procedures to
ensure that these standards are met.
The Department changed the fiduciary acknowledgment provision in
response to several comments requesting revisions to clarify the
required extent of the fiduciary acknowledgment. Accordingly, the
Department has clarified that the acknowledgment can be limited to
investment recommendations subject to the contract or, in the case of
an ERISA plan, any investment recommendations regarding the plan or
beneficiary or participant account. As discussed in more detail below,
the exemption (including the required fiduciary acknowledgment) does
not in and of itself, impose an ongoing duty to monitor on the Adviser
and Financial Institution. However, there may be some investments which
cannot be prudently recommended for purchase to individual Retirement
Investors, in the first place, without a mechanism in place for the
ongoing monitoring of the investment.
4. Impartial Conduct Standards--Section II(c)
Section II(c) of the exemption requires that the Adviser and
Financial Institution comply with fundamental Impartial Conduct
Standards. Generally stated, the Impartial Conduct Standards require
that Advisers and Financial Institutions provide investment advice
regarding the principal transaction or riskless principal transaction
that is in the Retirement Investor's Best Interest, seek to obtain the
best execution reasonably available under the circumstances with
respect to the transaction, and not make misleading statements to the
Retirement Investor about the recommended transaction and Material
Conflicts of Interest. As defined in the exemption, a Financial
Institution and Adviser act in the Best Interest of a Retirement
Investor when they provide investment advice that reflects ``the care,
skill, prudence, and diligence under the circumstances then prevailing
that a prudent person acting in a like capacity and familiar with such
matters would use in the conduct of an enterprise of a like character
and with like aims, based on the investment objectives, risk tolerance,
financial circumstances, and needs of the Retirement Investor, without
regard to the financial or other interests of the Adviser, Financial
Institution, any Affiliate or other party.''
The Impartial Conduct Standards represent fundamental obligations
of fair dealing and fiduciary conduct. The concepts of prudence,
undivided loyalty and reasonable compensation are all deeply rooted in
ERISA and the common law of agency and trusts.\22\ These longstanding
concepts of law and equity were developed in significant part to deal
with the issues that arise when agents and persons in a position of
trust have conflicting loyalties, and accordingly, are well-suited to
the problems posed by conflicted investment advice. The phrase
``without regard to'' is a concise expression of ERISA's duty of
loyalty, as expressed in section 404(a)(1)(A) of ERISA and applied in
the context of advice. It is consistent with the formulation stated in
the common law, and it is consistent with the language used by Congress
in Section 913(g)(1) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (the Dodd-Frank Act),\23\ and cited in the Staff of the
U.S. Securities and Exchange Commission ``Study on Investment Advisers
and Broker-Dealers as Required by Section 913 of the Dodd-Frank Wall
Street Reform and Consumer Protection Act'' (Jan. 2011) (SEC staff
Dodd-Frank Study).\24\
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\22\ See generally ERISA sections 404(a), 408(b)(2); Restatement
(Third) of Trusts section 78 (2007), and Restatement (Third) of
Agency section 8.01.
\23\ Section 913(g) of the Dodd-Frank Act governs ``Standard of
Conduct'' and subsection (1) provides that ``The Commission may
promulgate rules to provide that the standard of conduct for all
brokers, dealers, and investment advisers, when providing
personalized investment advice about securities to retail customers
(and such other customers as the Commission may by rule provide),
shall be to act in the best interest of the customer without regard
to the financial or other interest of the broker, dealer, or
investment adviser providing the advice.''
\24\ SEC Staff Study on Investment Advisers and Broker-Dealers,
January 2011, available at https://www.sec.gov/news/studies/2011/913studyfinal.pdf, pp. 109-110.
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Under ERISA section 408(a) and Code section 4975(c)(2), the
Department cannot grant an exemption unless it first finds that the
exemption is administratively feasible, in the interests of plans and
their participants and beneficiaries and IRA owners, and protective of
the rights of participants and beneficiaries of plans and IRA owners.
An exemption permitting transactions that violate the Impartial Conduct
Standards would fail these standards.
The Impartial Conduct Standards are conditions of the exemption for
the provision of advice with respect to all Retirement Investors. For
advice to Retirement Investors in IRAs and non-ERISA plans, the
Impartial Conduct Standards must also be included as contractual
commitments on the part of the Financial Institution and its Advisers.
As noted above, there is no contract requirement for advice with
respect Retirement Investors in ERISA plans.
Comments on each of the Impartial Conduct Standards are discussed
below. Additionally, in response to commenters' assertion that the
exemption is not administratively feasible due to uncertainty regarding
some terms and requests for additional clarity, the Department has
clarified some key terms in the text and provides additional
interpretive guidance in the preamble discussion that follows. Finally,
the Department discusses comments on the treatment of the Impartial
Conduct Standards as both exemption conditions for all Retirement
Investors as well as contractual representations with respect to IRAs
and other non-ERISA Plans.
a. Best Interest Standard
Under Section II(c)(1), the Financial Institution must state that
it and its Advisers will comply with a Best Interest standard when
providing investment advice to the Retirement Investor with respect to
principal transactions and riskless principal transactions, and, in
fact, adhere to the standard. Advice in the Retirement Investor's Best
Interest means advice that, at the time of the recommendation:
reflects the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent person acting in a like
capacity and familiar with such matters would use in the conduct of
an enterprise of a like character and with like aims, based on the
investment objectives, risk tolerance, financial circumstances, and
needs of the Retirement Investor, without regard to the financial or
other interests of the Adviser, Financial Institution or any
Affiliate, or other party.
The Best Interest standard set forth in the exemption is based on
longstanding
[[Page 21106]]
concepts derived from ERISA and the law of trusts. It is meant to
express the concept, set forth in ERISA section 404, that a fiduciary
is required to act ``solely in the interest of the participants . . .
with the care, skill, prudence, and diligence under the circumstances
then prevailing that a prudent man acting in a like capacity and
familiar with such matters would use in the conduct of an enterprise of
a like character and with like aims.'' Similarly, both ERISA section
404(a)(1)(A) and the trust-law duty of loyalty require fiduciaries to
put the interests of trust beneficiaries first, without regard to the
fiduciaries' own self-interest. Under this standard, for example, an
Adviser, in choosing between two investments, could not select an
investment because it is better for the Adviser's or Financial
Institution's bottom line, even though it is a worse choice for the
Retirement Investor.
A wide range of commenters indicated support for a broad Best
Interest standard. Some comments indicated that the Best Interest
standard is consistent with the way Advisers provide investment advice
to clients today. However, a number of these commenters expressed
misgivings as to the definition used in the proposed exemption, in
particular, the ``without regard to'' formulation. The commenters
indicated uncertainty as to the meaning of the phrase, including
whether it effectively precluded an Adviser from receiving compensation
if a particular investment would generate higher Adviser compensation.
Other commenters asked the Department to use a different definition
of Best Interest, or simply use the exact language from ERISA's section
404 duty of loyalty. Others suggested definitional approaches that
would require that the Adviser and Financial Institution ``not
subordinate'' their customers' interests to their own interests, or
that the Adviser and Financial Institution ``put their customers'
interests ahead of their own interests,'' or similar constructs.
FINRA suggested that the federal securities laws should form the
foundation of the Best Interest standard. Specifically, FINRA urged
that the Best Interest definition in the exemption incorporate the
suitability standard applicable to investment advisers and broker
dealers under federal securities laws. According to FINRA, this would
facilitate customer enforcement of the Best Interest standard by
providing adjudicators with a well-established basis on which to find a
violation.
Other commenters found the Best Interest standard to be an
appropriate statement of the obligations of a fiduciary investment
advice provider and believed it would provide concrete protections
against conflicted recommendations. These commenters asked the
Department to maintain the Best Interest definition as proposed. One
commenter wrote that the term ``best interest'' is commonly used in
connection with a fiduciary's duty of loyalty and cautioned the
Department against creating an exemption that failed to include the
duty of loyalty. Others urged the Department to avoid definitional
changes that would reduce current protections to Retirement Investors.
Some commenters also noted that the ``without regard to'' language is
consistent with the recommended standard in the SEC staff Dodd-Frank
Study, and suggested that it has added benefit of potentially
harmonizing with a future securities law standard for broker-dealers.
In the context of principal transactions, one commenter suggested
that the Department make clear that both the advice and the execution
of the transaction must be in the Retirement Investor's Best Interest.
The Department agrees that the execution of the transaction is an
important concern, and has incorporated in Section II(c)(2) of the
exemption, a provision requiring Financial Institutions that are FINRA
members to agree that they and their Advisers and Financial Institution
will comply with the terms of FINRA rule 5310 (Best Execution and
Interpositioning).
The final exemption retains the Best Interest definition as
proposed, with minor adjustments. The first prong of the standard was
revised to more closely track the statutory language of ERISA section
404(a), and, is consistent with the Department's intent to hold
investment advice fiduciaries to a prudent investment professional
standard. Accordingly, the definition of Best Interest now requires
advice that ``reflects the care, skill, prudence, and diligence under
the circumstances then prevailing that a prudent person acting in a
like capacity and familiar with such matters would use in the conduct
of an enterprise of a like character and with like aims, based on the
investment objectives, risk tolerance, financial circumstances, and
needs of the Retirement Investor . . .'' The exemption adopts the
second prong of the proposed definition, ``without regard to the
financial or other interests of the Adviser, Financial Institution or
any Affiliate or other party,'' without change. The Department
continues to believe that the ``without regard to'' language sets forth
the appropriate, protective standard under which a fiduciary investment
adviser should act. The standard ensures that the advice will not be
tainted by self-interest. Under this language, an Adviser and Financial
Institution must make a recommendation with respect to the principal
transaction or riskless principal transaction without considering their
own financial or other interests, or those of their Affiliates, or
others. They may not recommend such a transaction on the basis that it
pays them more, or otherwise benefits them more than a transaction
conducted on an agency basis. Many of the alternative approaches
suggested by commenters pose their own ambiguities and interpretive
challenges, and lower standards run the risk of undermining this
regulatory initiative's goal of reducing the impact of conflicts of
interest on Retirement Investors.
The Department has not specifically incorporated the suitability
obligation as an element of the Best Interest standard, as suggested by
FINRA but many aspects of suitability are also elements of the Best
Interest standard. An investment recommendation that is not suitable
under the securities laws would not meet the Best Interest standard.
Under FINRA's rule 2111(a) on suitability, broker-dealers ``must have a
reasonable basis to believe that a recommended transaction or
investment strategy involving a security or securities is suitable for
the customer.'' The text of rule 2111(a), however, does not do any of
the following: Reference a best interest standard, clearly require
brokers to put their client's interests ahead of their own, expressly
prohibit the selection of the least suitable (but more remunerative) of
available investments, or require them to take the kind of measures to
avoid or mitigate conflicts of interests that are required as
conditions of this exemption.
The Department recognizes that FINRA issued guidance on rule 2111
in which it explains that ``in interpreting the suitability rule,
numerous cases explicitly state that a broker's recommendations must be
consistent with his customers' best interests,'' and provided examples
of conduct that would be prohibited under this standard, including
conduct that this exemption would not allow.\25\ The guidance goes on
to state that ``[t]he suitability requirement that a broker make only
those recommendations that are consistent with the customer's best
interests prohibits a broker from placing his or her interests ahead of
the customer's interests.'' The Department, however is reluctant to
adopt as an
[[Page 21107]]
express standard such guidance, which has not been formalized as a
clear rule and that, in any case, may be subject to change.
Additionally, FINRA's suitability rule may be subject to
interpretations which could conflict with interpretations by the
Department, and the cases cited in the FINRA guidance, as read by the
Department, involved egregious fact patterns that one would have
thought violated the suitability standard even without reference to the
customer's best interest.
---------------------------------------------------------------------------
\25\ FINRA Regulatory Notice 12-25, p. 3 (2012).
---------------------------------------------------------------------------
Moreover, suitability under SEC practice differs somewhat from the
FINRA approach. According to the SEC staff Dodd-Frank Study, the SEC
requirements are based on the anti-fraud provisions of the Securities
Act Section 17(a), the Exchange Act Section 10(b) and Rule 10b-5
thereunder.\26\ As a general matter, SEC Rule 10b-5 prohibits any
person, directly or indirectly, from: (a) Employing any device, scheme,
or artifice to defraud; (b) making untrue statements of material fact
or omitting to state a material fact necessary in order to make the
statements made, in the light of the circumstances, not misleading; or
(c) engaging in any act or practice or course of business which
operates or that would operate as a fraud or deceit upon any person in
connection with the purchase or sale of any security. FINRA does not
require scienter, but the weight of authority holds that violations of
the Self-Regulatory Organization rules, standing alone, do not give
right to a private cause of action. Courts, however, allow private
claims for violations of SEC Rule 10b-5 for fraud claims, including,
among others, unsuitable recommendations. The private plaintiff must
establish that the broker's unsuitable recommendation involved a
misrepresentation (or material omission) made with scienter.
Accordingly, after review of the issue, the Department has decided not
to accept the comment. The Department has concluded that its
articulation of a clear loyalty standard within the exemption, rather
than by reference to the FINRA guidance, will provide clarity and
certainty to investors, and better protect their interests.
---------------------------------------------------------------------------
\26\ SEC staff Dodd-Frank Study at 61.
---------------------------------------------------------------------------
The Best Interest standard, as set forth in the exemption, is
intended to effectively incorporate the objective standards of care and
undivided loyalty that have been applied under ERISA for more than
forty years. Under these objective standards, the Adviser must adhere
to a professional standard of care in making investment recommendations
regarding principal transactions and riskless principal transactions
that are in the Retirement Investor's Best Interest. The Adviser may
not base his or her recommendations on the Adviser's own financial
interest in the transaction. Nor may the Adviser recommend a principal
transaction or riskless principal transaction, unless it meets the
objective prudent person standard of care. Additionally, the duties of
loyalty and prudence embodied in ERISA are objective obligations that
do not require proof of fraud or misrepresentation, and full disclosure
is not a defense to making an imprudent recommendation or favoring
one's own interests at the Retirement Investor's expense.
A few commenters also questioned the requirement in the Best
Interest standard that recommendations be made without regard to the
interests of the Adviser, Financial Institution, any Affiliate, or
other party. The commenters indicated they did not know the purpose of
the reference to ``other party'' and asked that it be deleted. The
Department intends the reference to make clear that an Adviser and
Financial Institution operating within the Impartial Conduct Standards
should not take into account the interests of any party other than the
Retirement Investor--whether the other party is related to the Adviser
or Financial Institution or not--in making a recommendation regarding a
principal transaction or riskless principal transaction. For example,
an entity that may be unrelated to the Adviser or Financial Institution
but could still constitute an ``other party,'' for these purposes, is
the manufacturer of the investment product being recommended.
Other commenters asked for confirmation that the Best Interest
standard is applied based on the facts and circumstances as they
existed at the time of the recommendation, and not based on hindsight.
Consistent with the well-established legal principles that exist under
ERISA today, the Department confirms that the Best Interest standard is
not a hindsight standard, but rather is based on the facts as they
existed at the time of the recommendation. Thus, the courts have
evaluated the prudence of a fiduciary's actions under ERISA by focusing
on the process the fiduciary used to reach its determination or
recommendation--whether the fiduciary, ``at the time they engaged in
the challenged transactions, employed the proper procedures to
investigate the merits of the investment and to structure the
investment.'' \27\ The standard does not measure compliance by
reference to how investments subsequently performed or turn Advisers
and Financial Institutions into guarantors of investment performance,
even though they gave advice that was prudent and loyal at the time of
transaction.\28\
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\27\ Donovan v. Mazzola, 716 F.2d 1226, 1232 (9th Cir. 1983).
\28\ One commenter requested an adjustment to the ``prudence''
component of the Best Interest standard, under which the standard
would be that of a ``prudent person serving clients with similar
retirement needs and offering a similar array of products.'' In this
way, the commenter sought to accommodate varying perspectives and
opinions on particular investment products and business practices.
The Department disagrees with the comment, which could be read as
qualifying the stringency of the prudence obligation based on the
Financial Institution's or Adviser's independent decisions on which
products to offer, rather than on the needs of the particular
Retirement Investor. Therefore, the Department did not adopt this
suggestion.
---------------------------------------------------------------------------
This is not to suggest that the ERISA section 404 prudence
standard, or Best Interest standard, are solely procedural standards.
Thus, the prudence standard, as incorporated in the Best Interest
standard, is an objective standard of care that requires investment
advice fiduciaries to investigate and evaluate investments, make
recommendations, and exercise sound judgment in the same way that
knowledgeable and impartial professionals would. ``[T]his is not a
search for subjective good faith--a pure heart and an empty head are
not enough.'' \29\ Whether or not the fiduciary is actually familiar
with the sound investment principles necessary to make particular
recommendations, the fiduciary must adhere to an objective professional
standard. Additionally, fiduciaries are held to a particularly
stringent standard of prudence when they have a conflict of
interest.\30\ For this reason, the Department declines to provide a
safe harbor based on ``procedural prudence'' as requested by a
commenter.
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\29\ Donovan v. Cunningham, 716 F.2d 1455, 1467 (5th Cir. 1983),
cert. denied, 467 U.S. 1251 (1984); see also DiFelice v. U.S.
Airways, Inc., 497 F.3d 410, 418 (4th Cir. 2007) (``Good faith does
not provide a defense to a claim of a breach of these fiduciary
duties; `a pure heart and an empty head are not enough.''').
\30\ Donovan v. Bierwirth, 680 F.2d 263, 271 (2d Cir. 1982)
(``the[] decisions [of the fiduciary] must be made with an eye
single to the interests of the participants and beneficiaries'');
see also Bussian v. RJR Nabisco, Inc., 223 F.3d 286, 298 (5th Cir.
2000); Leigh v. Engle, 727 F.2d 113, 126 (7th Cir. 1984).
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The Department additionally confirms its intent that the phrase
``without regard to'' be given the same meaning as the language in
ERISA section 404 that requires a fiduciary to act ``solely in the
interest of'' participants and
[[Page 21108]]
beneficiaries, as such standard has been interpreted by the Department
and the courts. Therefore, the standard would not, as some commenters
suggested, foreclose the Adviser and Financial Institution from being
paid. The Department confirms that the standard does not preclude the
Financial Institution from receiving reasonable compensation or from
recouping the cost of obtaining and carrying the security, assuming the
investment remains prudent when all its costs are considered.
In response to commenter concerns, the Department also confirms
that the Best Interest standard does not impose an unattainable
obligation on Advisers and Financial Institutions to somehow identify
the single ``best'' investment for the Retirement Investor out of all
the investments in the national or international marketplace, assuming
such advice or management were even possible. Instead, as discussed
above, the Best Interest standard set out in the exemption,
incorporates two fundamental and well-established fiduciary
obligations: the duties of prudence and loyalty. Thus, the fiduciary's
obligation under the Best Interest standard is to give advice or
acquire or dispose of investments in a manner that adheres to
professional standards of prudence, and to put the Retirement
Investor's financial interests in the driver's seat, rather than the
competing interests of the Adviser or other parties.
Finally, in response to questions regarding the extent to which
this Best Interest standard or other provisions of the exemption impose
an ongoing monitoring obligation on Advisers or Financial Institutions,
the Department has added specific language in Section II(e) regarding
monitoring. The text does not impose a monitoring requirement, but
instead requires clarity. As suggested by FINRA, Section II(e) requires
Advisers and Financial Institutions to disclose whether or not they
will monitor the Retirement Investor's investments and alert the
Retirement Investor to any recommended changes to those investments
and, if so, the frequency with which the monitoring will occur and the
reasons for which the Retirement Investor will be alerted. This is
consistent with the Department's interpretation of an investment advice
fiduciary's monitoring responsibility as articulated in the preamble to
the Regulation.
The terms of the contract or disclosure along with other
representations, agreements, or understandings between the Adviser,
Financial Institution and Retirement Investor, will govern whether the
nature of the relationship between the parties is ongoing or not. The
preamble to the proposed Best Interest Contract Exemption stated that
adherence to a Best Interest standard did not mandate an ongoing or
long-term relationship, but instead left the determination of whether
to enter into such a relationship to the parties.\31\ This exemption
builds upon this and requires that the contract clearly state the
nature of the relationship and whether there is any duty to monitor on
the part of the Adviser or Financial Institution. Whether the Adviser
and Financial Institution, in fact, have an obligation to monitor the
investment and provide long-term advice depends on the parties'
reasonable understandings, arrangements, and agreements.
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\31\ 80 FR 21969 (Apr. 20, 2015).
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b. Best Execution
Section II(c)(2) of the exemption requires that the Adviser and
Financial Institution seek to obtain the best execution reasonably
available under the circumstances with respect to the principal
transaction or riskless principal transaction with the plan,
participant or beneficiary account or IRA.
Section II(c)(2)(i) further provides that Financial Institutions
that are FINRA members may satisfy Section II(c)(2) by complying with
the terms of FINRA rules 2121 (Fair Prices and Commissions) and 5310
(Best Execution and Interpositioning), or any successor rules in effect
at the time of the transaction,\32\ as interpreted by FINRA, with
respect to the principal transaction or riskless principal transaction.
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\32\ Accordingly, to the extent FINRA rules 2121 (Fair Prices
and Commissions) or 5310 (Best Execution and Interpositioning) are
amended, the Adviser and Financial Institution must comply with the
requirements that are in effect at the time the transaction occurs.
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This provision is revised from the proposal, which provided that
the purchase or sales price could not be unreasonable under the
circumstances. Commenters on the proposal indicated that they were
uncertain as to what an unreasonable price would be and requested
additional clarification of the rule.
Further, some commenters indicated that FINRA rule 2121 (Fair
Prices and Commissions) should be incorporated in the alternative.
According to FINRA, rule 2121 ``prohibits a broker-dealer from entering
into a transaction with a customer `at any price' that is not
reasonably related to the current market price of the security.'' FINRA
additionally recommended that the Department incorporate FINRA rule
5310 (Best Execution and Interpositioning) instead of its proposed two-
quote requirement (discussed below). According to FINRA:
[Rule 5310] uses a ``facts and circumstances'' analysis by
requiring that a firm dedicate reasonable diligence to ascertain the
best market for the security and to buy or sell in such market so
that the price to the customer is as favorable as possible under the
prevailing market conditions. A key determinant in assessing whether
a firm has met this reasonable diligence standard is the character
of the market for the security itself, which includes an analysis of
price, volatility and relative liquidity.
[The] Rule . . . also addresses instances in which there is
limited quotation or pricing information available. The rule
requires a broker-dealer to have written policies and procedures
that address how the firm will determine the best inter-dealer
market for such a security in the absence of pricing information or
multiple quotations and to document its compliance with those
policies and procedures.
After consideration of the comments received, the Department
revised the proposed condition to focus on best execution, rather than
an unreasonable price. The Department determined that a requirement
that Advisers and Financial Institutions seek to obtain the best
execution reasonably available under the circumstances with respect to
the transaction, particularly as articulated by FINRA in rule 5310,
would provide protections that are comparable to the Department's
proposed condition but that are more familiar to the parties relying on
the exemption.
The Department specifically incorporated FINRA rules 2121 and 5310
for FINRA members, as a method of satisfying this requirement, as
suggested by some commenters. For Advisers and Financial Institutions
that are not FINRA members, the best execution obligation under the
exemption is satisfied if the Adviser and Financial Institution
satisfies the best execution obligation as interpreted by their
functional regulator. However, to the extent non-FINRA members wish for
additional certainty as to their compliance obligations under this
exemption, they may comply with the provisions of FINRA rules 2121 and
5310 to satisfy Section II(c)(2).
Under Section II(c)(2)(ii), if the Department expands the scope of
this exemption to include additional principal traded assets by
individual exemption,\33\ the Department may
[[Page 21109]]
identify specific alternative best execution and fair pricing
requirements imposed by another regulator or self-regulatory
organization that must be complied with. This would potentially permit,
for example, Financial Institutions to cite specific requirements of
the Municipal Securities Rulemaking Board, if municipal securities
become covered under the exemption.
---------------------------------------------------------------------------
\33\ See Section VI(j)(1)(iv).
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c. Misleading Statements
The final Impartial Conduct Standard, set forth in Section
II(c)(3), requires that statements by the Financial Institution and its
Advisers to the Retirement Investor about the recommended transaction,
fees and compensation, Material Conflicts of Interest, and any other
matters relevant to a Retirement Investor's investment decision to
engage in a principal transaction or a riskless principal transaction,
may not be materially misleading at the time they are made. In response
to commenters, the Department adjusted the text to clarify that the
standard is measured at the time of the representations, i.e., the
statements must not be misleading ``at the time they are made.''
Similarly, the Department added a materiality standard in response to
comments.
The Department did not accept certain other comments, however. One
commenter requested that the Department add a qualifier providing that
the standard is violated only if the statement was ``reasonably
relied'' on by the Retirement Investor. The Department rejected the
comment. The Department's aim is to ensure that Financial Institutions
and Advisors uniformly adhere to the Impartial Conduct Standards,
including the obligation to avoid materially misleading statements,
when they give advice. Whether a Retirement Investor relied on a
particular statement may be relevant to the question of damages in
subsequent arbitration or court proceedings, but it is not and should
not be relevant to the question of whether the fiduciary violated the
exemption's standards in the first place. Moreover, inclusion of a
reasonable reliance standard runs the risk of inviting boilerplate
disclaimers of reliance in contracts and disclosure documents precisely
so the Adviser can assert that any reliance is unreasonable.
One commenter asked the Department to require only that the Adviser
``reasonably believe'' the statements are not misleading. The
Department is concerned that this standard too could undermine the
protections of this condition, by requiring Retirement Investors or the
Department to prove the Adviser's actual belief rather than focusing on
whether the statement is objectively misleading. However, to address
commenters' concerns about the risks of engaging in a prohibited
transaction, as noted above, the Department has clarified that the
standard is measured at the time of the representations and has added a
materiality standard.
The Department believes that Retirement Investors are best served
by statements and representations that are free from material
misstatements. Financial Institutions and Advisers best avoid
liability--and best promote the interests of Retirement Investors--by
ensuring that accurate communications are a consistent standard in all
their interactions with their customers.
A commenter suggested that the Department adopt FINRA's
``Frequently Asked Questions regarding Rule 2210'' in this
connection.\34\ FINRA's rule 2210, Communications with the Public, sets
forth a number of procedural rules and standards that are designed to,
among other things, prevent broker-dealer communications from being
misleading. The Department agrees that adherence to FINRA's standards
can promote materially accurate communications, and certainly believes
that Financial Institutions and Advisers should pay careful attention
to such guidance documents. After review of the rule and FAQs, however,
the Department declines to simply adopt FINRA's guidance, which
addresses written communications, since the condition of the exemption
is broader in this respect. In the Department's view, the meaning of
the standard is clear, and is already part of a plan fiduciary's
obligations under ERISA. If, however, issues arise in implementation of
the exemption, the Department will consider requests for additional
guidance.
---------------------------------------------------------------------------
\34\ Currently available at http://www.finra.org/industry/finra-rule-2210-questions-and-answers.
---------------------------------------------------------------------------
d. Contractual Representation Versus Exemption Condition
Commenters expressed a variety of views on whether violations of
the Impartial Conduct Standards with respect to advice regarding
principal transactions to Retirement Investors regarding IRAs and non-
ERISA plans should result in loss of the exemption, violation of the
contract, or both.\35\ Some commenters objected to the incorporation of
the Impartial Conduct Standards as contract terms, generally, on the
basis that the requirement would contribute to litigation risk. Some
commenters preferred that the Impartial Conduct Standards only be
required as a condition of the exemption, and not give rise to contract
claims.
---------------------------------------------------------------------------
\35\ Commenters also asserted that the Department did not have
the authority to condition the exemption on the Impartial Conduct
Standards. Comments on the Department's jurisdiction are discussed
in a separate Section D. of this preamble.
---------------------------------------------------------------------------
Other commenters advocated for the opposite result, asserting that
the Impartial Conduct Standards should be required for contractual
promises only, and not treated as exemption conditions. These
commenters asserted that the Impartial Conduct Standards are too vague
and would result in uncertainty as to whether an excise tax under the
Code, which is self-assessed, is owed. There were also suggestions to
limit the contractual representation to the Best Interest standard
alone. One commenter asserted that the favorable price requirement and
the obligation not to make misleading statements fall within a Best
Interest standard, and do not need to be stated separately. There were
also suggestions that the Impartial Conduct Standards not apply to
ERISA plans because fiduciaries to these plans already are required to
adhere to similar statutory fiduciary obligations. In these commenters'
views, requiring these standards in an exemption is redundant and
inappropriately increases the consequences of any fiduciary breach by
imposing an excise tax.
In response to comments, the Department has revised the language of
the Impartial Conduct Standards and provided interpretive guidance to
alleviate the commenters' concerns about uncertainty and litigation
risk. However, the Department has concluded that, failure to adhere to
the Impartial Conduct Standards should be both a violation of the
contract (where required) and the exemption. Accordingly, the
Department has not eliminated any of the conduct standards or, for IRAs
and non-ERISA plans, restricted them just to conditions of the
exemption for Retirement Investors investing in IRAs or non-ERISA
plans. In the Department's view, all the Impartial Conduct Standards
form the baseline standards that should be applicable to fiduciaries
relying on the exemption; therefore, the Department has not accepted
comments suggesting that the contract representation be limited to the
Best Interest standard. Making all the Impartial Conduct Standards
required contractual promises for dealings with IRAs and other non-
ERISA plans creates the potential for contractual liability,
incentivizes Financial Institutions to comply, and gives injured
Retirement Investors a remedy if those Financial Institutions do not
comply. This enforceability is critical to the safeguards afforded by
the exemption.
[[Page 21110]]
As previously discussed, the Impartial Conduct Standards will not
unduly increase litigation risk. The standards are not unduly vague or
unknown, but rather track longstanding concepts in law and equity.
Also, the Department has simplified execution of the contract,
streamlined disclosure, and made certain language changes to address
legitimate concerns.
Similarly, the Department has not accepted the comment that the
Impartial Conduct Standards should apply only to IRAs and non-ERISA
plans. One of the Department's goals is to ensure equal footing for all
Retirement Investors. The SEC staff Dodd-Frank Study found that
investors were frequently confused by the differing standards of care
applicable to broker-dealers and registered investment advisers. The
Department hopes to minimize such confusion in the market for
retirement advice by holding Advisers and Financial Institutions to
similar standards, regardless of whether they are giving the advice to
an ERISA plan, IRA, or a non-ERISA plan.
Moreover, inclusion of the standards in the exemption's conditions
adds an important additional safeguard for ERISA and IRA investors
alike because the party engaging in a prohibited transaction has the
burden of showing compliance with an applicable exemption, when
violations are alleged.\36\ In the Department's view, this burden-
shifting is appropriate because of the dangers posed by conflicts of
interest, as reflected in the Department's Regulatory Impact Analysis
and because of the difficulties Retirement Investors have in
effectively policing such violations.\37\ One important way for
Financial Institutions to ensure that they can meet this burden is by
implementing strong anti-conflict policies and procedures, and by
refraining from creating incentives to violate the Impartial Conduct
Standards. Thus, treating the Impartial Conduct Standards as exemption
conditions creates an important incentive for Financial Institutions to
carefully monitor and oversee their Advisers' conduct for adherence
with fiduciary norms.
---------------------------------------------------------------------------
\36\ See, e.g., Fish v. GreatBanc Trust Company, 749 F.3d 671
(7th Cir. 2014).
\37\ See Regulatory Impact Analysis.
---------------------------------------------------------------------------
Moreover, as noted repeatedly, the language for the Impartial
Conduct Standards borrows heavily from ERISA and the law of trusts,
providing sufficient clarity to alleviate the commenters' concerns.
Ensuring that fiduciary investment advisers adhere to the Impartial
Conduct Standards and that all Retirement Investors have an effective
legal mechanism to enforce the standards are central goals of this
regulatory project.
5. Sales Incentives and Anti-Conflict Policies and Procedures
Under Section II(d)(1)-(3) of the exemption, the Financial
Institution is required to adopt certain anti-conflict policies and
procedures and to insulate Advisers from incentives to violate the Best
Interest standard. In order for relief to be available under the
exemption, a Financial Institution that meets the definition set forth
in the exemption must provide oversight of Advisers' recommendations,
as described in this section. The Financial Institution must prepare a
written document describing the Financial Institution's policies and
procedures, and make copies of the document readily available to
Retirement Investors, free of charge, upon request as well as on the
Financial Institution's Web site.\38\ The written description must
accurately describe or summarize key components of the policies and
procedures relating to conflict-mitigation and incentive practices in a
manner that permits Retirement Investors to make an informed judgment
about the stringency of the Financial Institution's protections against
conflicts of interest. The Department opted against requiring
disclosure of the full policies and procedures to Retirement Investors
to avoid giving them a potentially overwhelming amount of information
that could run contrary to its purpose (e.g., by alerting Advisers to
the particular surveillance mechanisms employed by Financial
Institutions). However, the exemption requires that the full policies
and procedures must be made available to the Department upon request.
---------------------------------------------------------------------------
\38\ See Section IV(e).
---------------------------------------------------------------------------
These obligations have several important components. First, the
Financial Institution must adopt and comply with written policies and
procedures reasonably and prudently designed to ensure that its
individual Advisers adhere to the Impartial Conduct Standards set forth
in Section II(c). Second, the Financial Institution in formulating its
policies and procedures, must specifically identify and document its
Material Conflicts of Interest associated with principal transactions
and riskless principal transactions; adopt measures reasonably and
prudently designed to prevent Material Conflicts of Interest from
causing violations of the Impartial Conduct Standards set forth in
Section II(c); and designate a person or persons, identified by name,
title or function, responsible for addressing Material Conflicts of
Interest and monitoring Advisers' adherence to the Impartial Conduct
Standards. For purposes of the exemption, a Material Conflict of
Interest exists when an Adviser or Financial Institution has a
financial interest that a reasonable person would conclude could affect
the exercise of its best judgment as a fiduciary in rendering advice to
a Retirement Investor.
Finally, the Financial Institution's policies and procedures must
require that, neither the Financial Institution nor (to the best of its
knowledge) any Affiliate uses or relies on quotas, appraisals,
performance or personnel actions, bonuses, contests, special awards,
differential compensation or other actions or incentives that are
intended or would reasonably be expected to cause individual Advisers
to make recommendations regarding principal transactions and riskless
principal transactions that are not in the Best Interest of the
Retirement Investor.
In this respect, however, the exemption makes clear that that
requirement does not prevent the Financial Institution or its
Affiliates from providing Advisers with differential compensation
(whether in type or amount, and including, but not limited to,
commissions) based on investment decisions by Plans, participant or
beneficiary accounts, or IRAs, to the extent that the policies and
procedures and incentive practices, when viewed as a whole, are
reasonably and prudently designed to avoid a misalignment of the
interests of Advisers with the interests of the Retirement Investors
they serve as fiduciaries.
The anti-conflict policies and procedures will safeguard the
interests of Retirement Investors by causing Financial Institutions to
consider the conflicts of interest affecting their provision of advice
to Retirement Investors regarding principal transactions and riskless
principal transactions and to take action to mitigate the impact of
such conflicts. In particular, under the final exemption, Financial
Institutions must not use compensation and other employment incentives
to the extent they are intended to or would reasonably be expected to
cause Advisers to make recommendations that are not in the Best
Interest of the Retirement Investor. Financial Institutions must also
establish a supervisory structure reasonably and prudently designed to
ensure the Advisers will adhere to the
[[Page 21111]]
Impartial Conduct Standards. Mitigating conflicts of interest
associated with principal transactions and riskless principal
transactions by requiring greater alignment of the interests of the
Adviser and Financial Institution, and the Retirement Investor, is
necessary for the Department to make the findings under ERISA section
408(a) and Code section 4975(c)(2) that the exemption is in the
interests of, and protective of, Retirement Investors. This warranty
gives the Financial Institution a powerful incentive to ensure advice
is provided in accordance with fiduciary norms, rather than risk
litigation, including class litigation and liability.
Like the proposal, the exemption does not specify the precise
content of the anti-conflict policies and procedures. This flexibility
is intended to allow Financial Institutions to develop policies and
procedures that are effective for their particular business models,
while prudently ensuring compliance with their and their Advisers'
fiduciary obligations and the Impartial Conduct Standards. The policies
and procedures requirement, if taken seriously, can also reduce
Financial Institutions' litigation risk by minimizing incentives for
Advisers to provide advice that is not in Retirement Investors' Best
Interest.
As adopted in the final exemption, the policies and procedures
requirement is a condition of the exemption for all Retirement
Investors--in ERISA plans, IRAs and non-ERISA plans. Failure to comply
could result in liability under ERISA for engaging in a prohibited
transaction and the imposition of an excise tax under the Code, payable
to the Treasury. Additionally, with respect to Retirement Investors in
IRAs and non-ERISA plans, the requirements take the form of a
contractual warranty. The Financial Institution must warrant that it
has adopted and will comply with the anti-conflict policies and
procedures (including the obligation to avoid misaligned incentives).
Failure to comply with the warranty could result in contractual
liability.
Comments on the proposed policies and procedures requirement are
discussed below. As stated above, for ease of use, the Department has
included in this preamble the same general discussion of comments as in
the Best Interest Contract Exemption, to the extent applicable to
principal transactions and riskless principal transactions, despite the
fact that some comments discussed below were not made directly with
respect to this exemption.
a. Policies and Procedures Requirement Generally
Under the policies and procedures requirement, described in greater
detail above, Financial Institutions must adopt and comply with anti-
conflict policies and procedures. In addition, neither the Financial
Institution nor (to the best of its knowledge) any Affiliates may use
or rely on quotas, appraisals, performance or personnel actions,
bonuses, contests, special awards, differential compensation or other
actions or incentives that are intended or would reasonably be expected
to cause Advisers to make recommendations that are not in the Best
Interest of the Retirement Investor.
Some commenters were extremely supportive of the policies and
procedures requirement as proposed. They expressed the view that the
policies and procedures requirement, and in particular the restrictions
on compensation and other employment incentives, was one of the most
critical investor protections in the proposal because it would cause
Financial Institutions to make specific and necessary changes to their
compensation arrangements that would result in significant protections
to Retirement Investors.
Some commenters believed that the Department did not go far enough.
These commenters indicated that flat compensation arrangements should
be required, or at least that the rules applicable to differential
compensation should be more specific and stringent.
A few commenters also indicated that, in addition to focusing on
the Adviser, the Financial Institution's policies and procedures need
to consider the impact of compensation practices on branch managers. A
commenter indicated that branch managers have responsibilities under
FINRA's supervisory rules to ensure suitability and possibly approve
individual transactions. The commenter asserted that branch managers
financially benefit from Advisers' recommendations and have a variety
of methods of influencing Adviser behavior.
Many others objected to the policies and procedures warranty and
requested that it be eliminated in the final exemption. Some commenters
believed that compliance would require drastic changes to current
compensation arrangements or could possibly result in the complete
prohibition of commissions and other transaction-based compensation.
Other commenters suggested that the requirement should be eliminated as
it would be unnecessary in light of the exemption's Best Interest
standard, and because it would unnecessarily increase litigation risk
to Financial Institutions. Alternatively, there were requests to
clarify specific provisions and provide safe harbors in the policies
and procedures requirement.
In the final exemption, the Department has retained the general
approach of the proposal. The Department concurs with commenters who
view the policies and procedures requirement as an important safeguard
for Retirement Investors and as a necessary condition for the
Department to make the findings under ERISA section 408(a) and Code
section 4975(c)(2) that the exemption is in the interests of, and
protective of, Retirement Investors. This provision will require
Financial Institutions to take concrete and specific steps to ensure
that its individual Advisers adhere to the Impartial Conduct Standards,
and in particular, forego compensation practices and employment
incentives (quotas, appraisals, performance or personnel actions,
bonuses, contests, special awards, differential compensation or other
actions or incentives) that are intended or would reasonably be
expected to cause Advisers to make recommendations that are not in the
Best Interest of the Retirement Investor. Strong policies and
procedures reduce the temptation (conscious or unconscious) to violate
the Best Interest standard in the first place by ensuring that the
Advisers' incentives are appropriately aligned with the interests of
the customers they serve, and by ensuring appropriate monitoring and
supervision of individual Advisers' conduct. While the Department views
the Best Interest standard as critical to the protections of the
exemption, the policies and procedures requirement is equally critical
as a means of supporting Best Interest advice and protecting Retirement
Investors from having to enforce the Best Interest standard after the
advice has already been rendered and the damage done.
The Department has not made the requirements more stringent, as
suggested by some commenters, so as to require completely level
compensation. The Department designed the exemption to preserve mark-
ups and mark-downs and other payments as applicable to the transaction
in connection with principal transactions and riskless principal
transactions, thereby preserving existing business models.
The Department also adopted the suggestion of one commenter that
the exemption require the Financial
[[Page 21112]]
Institution to designate a specific person to address Material
Conflicts of Interest and monitor Advisers' adherence to the Impartial
Conduct Standards.\39\ In the proposal, the Department had already
suggested that Financial Institutions consider this approach; however,
the commenter suggested that it should be a specific requirement and
indicated that most Financial Institutions already have a designated
compliance officer. The Department concurs with the commenter and has
included that requirement in the final exemption, based on the view
that formalizing the process for identifying and monitoring these
issues will result in increased protections to Retirement Investors.
---------------------------------------------------------------------------
\39\ One important consideration in addressing conflicts of
interest is the Financial Institution's attentiveness to the
qualifications and disciplinary history of the persons it employs to
provide such advice. See Egan, Mark, Gregor Matvos and Amit Seru,
The Market for Financial Adviser Misconduct, at 3 (February 26,
2016) (``Past offenders are five times more likely to engage in
misconduct than the average adviser, even compared with other
advisers in the same firm at the same point in time. The large
presence of repeat offenders suggests that consumers could avoid a
substantial amount of misconduct by avoiding advisers with
misconduct records.'').
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b. Specific Language of Policies and Procedures Requirement
There were also questions and comments on certain language in the
proposed policies and procedures requirement. As proposed, the
components of the policies and procedures requirement in Section II(d)
read as follows:
The Financial Institution has adopted written policies
and procedures reasonably designed to mitigate the impact of
Material Conflicts of Interest and to ensure that its individual
Advisers adhere to the Impartial Conduct Standards set forth in
Section II(c);
In formulating its policies and procedures, the
Financial Institution has specifically identified Material Conflicts
of Interest and adopted measures to prevent the Material Conflicts
of Interest from causing violations of the Impartial Conduct
Standards set forth in Section II(c); and
Neither the Financial Institution nor (to the best of
its knowledge) any Affiliate uses quotas, appraisals, performance or
personnel actions, bonuses, contests, special awards, differential
compensation or other actions or incentives to the extent they would
tend to encourage individual Advisers to make recommendations
regarding principal transactions that are not in the Best Interest
of the Retirement Investor.
A few commenters asked the Department to explain the difference
between the first and second prongs of the policies and procedures
requirement, as proposed. In response, the first prong of the
requirement was intended to establish a general standard, while the
second (and third) prongs provided specific rules regarding the
policies and procedures requirement. This approach was also adopted in
the final exemption. In addition, the language of Section II(d)(3)
specifically provides that the third prong of the requirement,
requiring Financial Institutions to insulate Advisers from incentives
to violate the Best Interest standard, is part of the policies and
procedures requirement.
There were also comments on (i) the definition and use of the term
``Material Conflicts of Interest;'' (ii) the language requiring the
policies and procedures to be ``reasonably designed'' to mitigate the
impact of such conflicts of interest, and (iii) the meaning of
incentives that ``tend to encourage'' individual Advisers to make
recommendations that are not in the Best Interest of the Retirement
Investor. These comments are discussed below.
i. Materiality
A number of commenters focused on the definition of Material
Conflict of Interest used in the proposal. Under the definition as
proposed, a Material Conflict of Interest exists when an Adviser or
Financial Institution ``has a financial interest that could affect the
exercise of its best judgment as a fiduciary in rendering advice to a
Retirement Investor.'' Some commenters took the position that the
proposal did not adequately explain the term ``material'' or
incorporate a materiality standard into the definition. A commenter
wrote that the proposed definition was so broad that it would be
difficult for Financial Institutions to comply with the various aspects
of the exemption related to Material Conflicts of Interest, such as
provisions requiring disclosure of Material Conflicts of Interest.
Another commenter indicated that the Department should not use the
term ``material'' in defining conflicts of interest. The commenter
believed that it could result in a standard that was too subjective
from the perspective of the Adviser and Financial Institution, and
could undermine the protectiveness of the exemption.
After consideration of the comments, the Department adjusted the
definition of Material Conflict of Interest. In the final exemption, a
Material Conflict of Interest exists when an Adviser or Financial
Institution has a ``financial interest that that a reasonable person
would conclude could affect the exercise of its best judgment as a
fiduciary in rendering advice to a Retirement Investor.'' This language
responds to concerns about the breadth and potential subjectivity of
the standard. The Department did not, as some commenters suggested,
include the word ``material'' in the definition of Material Conflict of
Interest, to avoid the potential circularity of that approach.
ii. Reasonably Designed
One commenter asked that the Department more broadly use the
modifier ``reasonably designed'' in describing the standard the
policies and procedures must meet so as to avoid a construction that
required standards that ensured perfect compliance, a potentially
unattainable standard. The Department has accepted the comment and
adjusted the language in Sections II(d)(1) and (2) to generally use the
phrase ``reasonably and prudently designed.'' Other commenters asked
for guidance on the proposed phrasing ``reasonably designed to
mitigate'' the impact of Material Conflicts of Interest. The Department
provides additional guidance in this respect in the preamble of the
Best Interest Contract Exemption published elsewhere in this issue of
the Federal Register, which gives examples of some possible approaches
to policies and procedures.
iii. Tend To Encourage
A number of commenters asked for clarification or revision of the
proposed exemption's prohibition of incentives that ``tend to
encourage'' violation of the Best Interest standard, generally to
require a tight link between the incentives and the Advisers'
recommendations. Commenters argued that the ``tend to encourage''
language established a standard that could be impossible to meet in the
context of differential compensation. Accordingly, they requested that
the Department use language such as ``intended to encourage,'' ``does
encourage,'' ``causes,'' or similar formulation.
In response to these commenters the Department has adjusted the
condition's language as follows:
[N]either the Financial Institution nor (to the best of the
Financial Institution's knowledge) any Affiliate uses or relies on
quotas, appraisals, performance or personnel actions, bonuses,
contests, special awards, differential compensation or other actions
or incentives that are intended or would reasonably be expected to
cause individual Advisers to make recommendations regarding
Principal Transactions and Riskless Principal Transactions that are
not in the Best Interest of the Retirement Investor (emphasis
added).
This language more accurately captures the Department's intent,
which was to require that procedures reasonably address Advisers'
incentives,
[[Page 21113]]
not guarantee perfection. The Department disagrees, however, with the
suggestion that Financial Institutions should be permitted to tolerate
or create incentives that would ``reasonably be expected to cause such
violations'' unless the Retirement Investor can actually prove the
Financial Institution's intent to cause violations of the standard or
the Adviser's improper motivation in making the recommendation. The aim
of the policies and procedures requirement is to require the Financial
Institution to take prophylactic measures to ensure that Retirement
Advisers adhere to the Impartial Conduct Standards, a goal completely
at odds with the creation of incentives to violate the Best Interest
standard. In exchange for the receipt of compensation that would
otherwise be prohibited by ERISA and the Code, the Financial
Institution's responsibility under the exemption is to protect
Retirement Investors from conflicts of interest, not to promote or
continue to offer incentives to violate the Best Interest standard.
Moreover, absent extensive discovery or the ability to prove the
motivations of individual Advisers, Retirement Investors would
generally be in a poor position to prove such ill intent.
However, the final exemption provides that the policies and
procedures requirement does not:
[P]revent the Financial Institution or its Affiliates from
providing Advisers with differential compensation (whether in type
or amount, and including, but not limited to, commissions) based on
investment decisions by Plans, participant or beneficiary accounts,
or IRAs, to the extent that the policies and procedures and
incentive practices, when viewed as a whole, are reasonably and
prudently designed to avoid a misalignment of the interests of
Advisers with the interests of the Retirement Investors they serve
as fiduciaries (emphasis added).
This language is designed to make clear that differential
compensation is permitted, but only if the Financial Institution's
policies and procedures, as a whole, are reasonably designed to avoid a
misalignment of interests between Advisers and Retirement Investors.
For further guidance, the preamble to the Best Interest Contract
Exemption, published in this same issue of the Federal Register,
provides examples of the types of policies and procedures that may
satisfy the warranty.
c. Contractual Warranty Versus Exemption Condition
In the proposal, both the Adviser and Financial Institution had to
give a warranty to the Retirement Investor about the adoption and
implementation of anti-conflict policies and procedures. A few
commenters indicated that the Adviser should not be required to give
the warranty, and questioned whether the Adviser would always be in a
position to speak to the Financial Institution's incentive and
compensation arrangements. The Department agrees that the Financial
Institution has the primary responsibility for design and
implementation of the policies and procedures requirement and,
accordingly, has limited the warranty requirement to the Financial
Institution.
Some commenters believed that even if the Department included a
policies and procedure requirement in the exemption, it should not
require a warranty on implementation and compliance with the
requirement. According to some of these commenters the warranty was
unnecessary in light of the Best Interest standard, and would unduly
contribute to litigation risk. A few commenters also suggested that a
Financial Institution's failure to comply with the contractual warranty
could give rise to a cause of action to Retirement Investors who had
suffered no injuries from failure to implement or comply with
appropriate policies and procedures. A few other commenters expressed
concern that the provision of a warranty could result in tort
liability, rather than just contractual liability.
Other commenters argued that the Department should require
Financial Institutions not only to make an enforceable warranty as a
condition of the exemption, but also require actual compliance with the
warranty as a condition of the exemption. One such commenter argued
that it would be difficult for Retirement Investors to prove that
policies and procedures were not ``reasonably designed'' to achieve the
required purpose.
As noted above, the final exemption adopts the required policies
and procedures as a condition of the exemption. The policies and
procedures requirement is a critical part of the exemption's
protections. The risk of liability associated with a non-exempt
prohibited transaction gives Financial Institutions a strong incentive
to design protective policies and procedures in a way that is
consistent with the purposes and requirements of this exemption. Of
course, the Department does not expect that successful contract claims
will be brought by Retirement Investors without a showing of damages.
In addition, the final exemption requires the Financial Institution
to make a warranty regarding the policies and procedures in contracts
with Retirement Investors regarding IRAs and other non-ERISA plans. The
warranty, and potential liability associated with that warranty, gives
Financial Institutions both the obligation and the incentive to tamp
down harmful conflicts of interest and protect Retirement Investors
from misaligned incentives that encourage Advisers to violate the Best
Interest standard and other fiduciary obligations and ensures that
there is a means to redress the failure to do so. While the warranty
exposes Financial Institutions and Advisers to litigation risk, these
risks are circumscribed by the availability of binding arbitration for
individual claims and the legal restrictions that courts generally use
to police class actions.
The Department does not share a commenter's view that it would be
too difficult for Retirement Investors to prove that the policies and
procedures were not ``reasonably designed'' to achieve the required
purpose. The final exemption requires the Financial Institution to
disclose Material Conflicts of Interest associated with the principal
transactions and riskless principal transactions to Retirement
Investors and to describe its policies and procedures for safeguarding
against those conflicts of interest. These disclosures should assist
Retirement Investors in assessing the care with which Financial
Institutions have designed their procedures, even if they are
insufficient to fully convey how vigorously the Financial Institution
implements the protections. In some cases, a systemic violation, or the
possibility of such a violation, may be apparent on the face of the
policies. In other cases, normal discovery in litigation may provide
the information necessary. Certainly, if a Financial Institution were
to provide significant prizes or bonuses for Advisers to push principal
transactions and riskless principal transactions that were not in the
Best Interest of Retirement Investors, Retirement Investors would often
be in a position to pursue the claim. Most important, however, the
enforceable obligation to adopt and comply with the policies and
procedures as set forth herein, and to make relevant disclosures of the
policies and procedures and of Material Conflicts of Interest, should
create a powerful incentive for Financial Institutions to carefully
police conflicts of interest, reducing the need for litigation in the
first place.
In response to commenters that expressed concern about the specific
use of the term ``warranty,'' the Department intends the term to have
its standard meaning as a ``promise that something in furtherance of
the contract
[[Page 21114]]
is guaranteed by one of the contracting parties.'' \40\ The Department
merely requires that the contract with IRA and non-ERISA plan investors
include an express enforceable promise of compliance with the policies
and procedures condition. As previously discussed, the potential
liability for violation of the warranty is cabined by the availability
of non-binding arbitration in individual claims, and the ability to
waive claims for punitive damages and rescission to the extent
permitted by applicable law.
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\40\ Black's Law Dictionary 10th ed. (2014).
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Additionally, although the policies and procedure requirement
applies equally to ERISA plans, the final exemption does not require
Financial Institutions to make a warranty with respect to ERISA plans,
just as it does not require the execution of a contract with respect to
ERISA plans. For these plans, a separate warranty is unnecessary
because Title I of ERISA already provides an enforcement mechanism for
failure to comply with the policies and procedures requirement. Under
ERISA section 502(a), plan participants, fiduciaries, and the Secretary
of Labor have ready means to enforce any failure to meet the conditions
of the exemption, including a failure to comply with the policies and
procedure requirement. A Financial Institution's failure to comply with
the exemption's policies and procedure requirements would result in a
non-exempt prohibited transaction under ERISA section 406 and would
likely constitute a fiduciary breach under ERISA section 404. As a
result, a plan participant or beneficiary, plan fiduciary, and the
Secretary would be able to sue under ERISA section 502(a)(2), (3), or
(5) to recover any loss in value to the plan (including the loss in
value to an individual account), or to obtain disgorgement of any
wrongful profits or unjust enrichment. Accordingly, the warranty is
unnecessary in the context of ERISA plans.
d. Compliance With Laws Proposed Warranty
The proposed exemption also contained a requirement that the
Adviser and Financial Institution would have had to warrant that they
and their Affiliates would comply with all applicable federal and state
laws regarding the rendering of the investment advice, the purchase,
sale or holding of the Asset and the payment of compensation related to
the purchase, sale and holding. While the Department did receive some
support for this condition in comments, several commenters opposed this
warranty proposal as being overly broad, and urged that it be deleted.
The commenters argued that the warranty could create contract claims
based on a wide variety of state and federal laws, without regard to
the limitations imposed on individual actions under those laws. In
addition, commenters suggested that many of the violations associated
with these laws could be quite minor or unrelated to the Department's
concerns about conflicts of interest. In response to these comments,
the Department has eliminated this warranty from the final exemption.
6. Credit Standards and Liquidity
Section II(d)(4) provides that the Financial Institution's written
policies and procedures regarding principal transactions and riskless
principal transactions must address how the credit risk and liquidity
assessments required by Section III(a)(3) of the exemption will be
made. This requirement serves as an implementation tool for the
exemption condition that a debt security that is purchased by a plan,
participant or beneficiary account, or IRA, possess at the time of
purchase no greater than moderate credit risk and sufficiently
liquidity that it can be sold at or near its carrying value within a
reasonably short period of time.
As discussed later in this preamble, when addressing the credit and
liquidity conditions set forth in Section III(a) of the exemption, many
commenters identified perceived compliance difficulties. Of those
comments, one comment was applicable to Section II of the exemption.
The commenter suggested that the Financial Institution be required to
develop policies and procedures to assist Advisers by specifying how
these assessments are to be made. This suggestion addressed some
concerns expressed by commenters regarding the credit and liquidity
conditions, and the Department concurs with the comment. The Department
believes that Financial Institutions will be able to comply with the
requirement, in part, by developing, if they do not already exist,
policies and procedures to ensure that the credit worthiness and
liquidity of debt securities are properly evaluated.
7. Contractual Disclosures
Section II(e) of the exemption obligates the Financial Institution
to make specified contract disclosures to Retirement Investors in order
to ensure that they have basic information about the scope of Adviser
conflicts and that they appropriately authorize principal transactions
and riskless principal transactions. For advice to Retirement Investors
in IRAs and non-ERISA plans, the disclosures must be provided prior to
or at the same time as the recommended transaction either as part of
the contract or in a separate written disclosure provided to the
Retirement Investor. For advice to Retirement Investors regarding
investments in ERISA plans, the disclosures must be provided prior to
or at the same time as the execution of the recommended transaction.
The disclosure may be provided in person, electronically, or by mail.
In the disclosures, the Financial Institution must clearly and
prominently in a single written disclosure:
(1) Set forth in writing (i) the circumstances under which the
Adviser and Financial Institution may engage in Principal
Transactions and Riskless Principal Transactions with the Plan,
participant or beneficiary account, or IRA, (ii) a description of
the types of compensation that may be received by the Adviser and
Financial Institution in connection with Principal Transactions and
Riskless Principal Transactions, including any types of compensation
that may be received from third parties, and (iii) identify and
disclose the Material Conflicts of Interest associated with
Principal Transactions and Riskless Principal Transactions;
(2) Except for existing contracts, document the Retirement
Investor's affirmative written consent, on a prospective basis, to
Principal Transactions and Riskless Principal Transactions between
the Adviser or Financial Institution and the Plan, participant or
beneficiary account, or IRA;
(3) Inform the Retirement Investor (i) that the consent set
forth in Section II(e)(2) is terminable at will upon written notice
by the Retirement Investor at any time, without penalty to the Plan
or IRA, (ii) of the right to obtain, free of charge, copies of the
Financial Institution's written description of its policies and
procedures adopted in accordance with Section II(d), as well as
information about the Principal Traded Asset, including its purchase
or sales price, and other salient attributes, including, as
applicable: The credit quality of the issuer; the effective yield;
the call provisions; and the duration, provided that if the
Retirement Investor's request is made prior to the transaction, the
information must be provided prior to the transaction, and if the
request is made after the transaction, the information must be
provided within 30 business days after the request, (iii) that model
contract disclosures or other model notice of the contractual terms
which are reviewed for accuracy no less than quarterly and updated
within 30 days as necessary are maintained on the Financial
Institution's Web site, and (iv) that the Financial Institution's
written description of its policies and procedures adopted in
[[Page 21115]]
accordance with Section II(d) is available free of charge on the
Financial Institution's Web site; and
(4) Describe whether or not the Adviser and Financial
Institution will monitor the Retirement Investor's investments that
are acquired through a Principal Transaction or Riskless Principal
Transaction and alert the Retirement Investor to any recommended
change to those investments and, if so, the frequency with which the
monitoring will occur and the reasons for which the Retirement
Investor will be alerted.
By ``clearly and prominently in a single written disclosure,'' the
Department means that the Financial Institution may provide a document
prepared for this purpose containing only the required information, or
include the information in a specific section of the contract in which
the disclosure information is provided, rather than requiring the
Retirement Investor to locate the relevant information in several
places throughout a larger disclosure or series of disclosures.
In addition, Section II(e)(5) of the exemption provides a mechanism
for correcting disclosure errors, without losing the exemption. It
provides that the Financial Institution will not fail to satisfy
Section II(e), or violate a contractual provision based thereon, solely
because it, acting in good faith and with reasonable diligence, makes
an error or omission in disclosing the required information, or if the
Web site is temporarily inaccessible, provided that (i) in the case of
an error or omission on the web, the Financial Institution discloses
the correct information as soon as practicable, but not later than 7
days after the date on which it discovers or reasonably should have
discovered the error or omission, and (ii) in the case of other
disclosures, the Financial Institution discloses the correct
information as soon as practicable, but not later than 30 days after
the date on which it discovers or reasonably should have discovered the
error or omission. Section II(e)(5) further provides that to the extent
compliance with the contract disclosure requires Advisers and Financial
Institutions to obtain information from entities that are not closely
affiliated with them, they may rely in good faith on information and
assurances from the other entities, as long as they do not know that
the materials are incomplete or inaccurate. This good faith reliance
applies unless the entity providing the information to the Adviser and
Financial Institution is (1) a person directly or indirectly through
one or more intermediaries, controlling, controlled by, or under common
control with the Adviser or Financial Institution; or (2) any officer,
director, employee, agent, registered representative, relative (as
defined in ERISA section 3(15)), member of family (as defined in Code
section 4975(e)(6)) of, or partner in, the Adviser or Financial
Institution.
Several commenters supported the proposed disclosures. Commenters
recognized that well-designed disclosure can serve multiple purposes,
including facilitating informed investment decisions. However, even if
investors do not carefully review the disclosures they receive,
commenters perceived a benefit to investors from the greater
transparency of public disclosure. For example, Financial Institutions
may change practices that run contrary to Retirement Investors'
interests rather than disclose them publicly. One commenter suggested
the disclosures should be strengthened and required for all retirement
savings products, even beyond the scope of the Regulation and this
exemption.
As proposed, the provision required disclosure of complete
information about all the fees and other payments currently associated
with the Retirement Investor's investments. Commenters objected to this
as overly broad, given the exemption's limitation to principal
transactions. The Department accepted this comment, and limited the
disclosure to the information about the principal traded asset,
including its purchase or sales price and other salient attributes,
while still ensuring timely access by the Retirement Investor. By
salient attributes, the Department means the credit quality of the
issuer, the effective yield, the call provisions, and the duration,
among other similar attributes, and the Department recognizes that the
salient attributes will differ depending on the principal traded asset.
In accepting this comment, the Department did not elect to modify the
disclosure requirement further with qualifiers such as ``reasonably''
or ``in the Financial Institution's possession.'' The Department
believes that no additional limitation need be placed on the rights of
the Retirement Investor to request information because, if a Financial
Institution is advising a Retirement Investor to enter into a principal
transaction or a riskless principal transaction, it should have all of
the salient information available when providing that advice. The
Department also made a clarification, requested by a commenter, that
the Retirement Investor's consent must be withdrawn in writing. The
Department concurs that this will provide additional certainty to the
parties.
FINRA's suggestion that the parties agree on the extent of
monitoring of the Retirement Investor's investments was adopted, in
Section II(e)(4). In making this determination, Financial Institutions
should carefully consider whether certain investments can be prudently
recommended to the individual Retirement Investor, in the first place,
without a mechanism in place for the ongoing monitoring of the
investment. Finally, a number of commenters requested relief for good
faith, inadvertent failure to comply with the exemption. A specific
provision applicable to the Section II(e) disclosures is included in
Section II(e)(5).
8. Ineligible Provisions
Under Section II(f) of the final exemption, relief is not available
if a Financial Institution's contract with Retirement Investors
regarding investments in IRAs and non-ERISA plans contains the
following:
(1) Exculpatory provisions disclaiming or otherwise limiting
liability of the Adviser or Financial Institution for a violation of
the contract's terms;
(2) Except as provided in paragraph (f)(4), a provision under
which the Plan, IRA or Retirement Investor waives or qualifies its
right to bring or participate in a class action or other
representative action in court in a dispute with the Adviser or
Financial Institution, or in an individual or class claim agrees to
an amount representing liquidated damages for breach of the
contract; provided that the parties may knowingly agree to waive the
Retirement Investor's right to obtain punitive damages or rescission
of recommended transactions to the extent such a waiver is
permissible under applicable state or federal law; or
(3) Agreements to arbitrate or mediate individual claims in
venues that are distant or that otherwise unreasonably limit the
ability of the Retirement Investors to assert the claims safeguarded
by this exemption.
Section II(f)(4) provides that, in the event the provision on pre-
dispute arbitration agreements for class or representative claims in
paragraph (f)(2) is ruled invalid by a court of competent jurisdiction,
this provision shall not be a condition of the exemption with respect
to contracts subject to the court's jurisdiction unless and until the
court's decision is reversed, but all other terms of the exemption
shall remain in effect.
The purpose of Section II(f) is to ensure that Retirement Investors
receive the full benefit of the exemption's protections, by preventing
them from being contracted away. If an Adviser makes a recommendation
regarding a principal transaction or a riskless principal transaction,
for compensation, within the meaning of the Regulation, he or she may
not disclaim the duties or liabilities that flow from that
[[Page 21116]]
recommendation. For similar reasons, the exemption is not available if
the contract includes provisions that purport to waive a Retirement
Investor's right to bring or participate in class actions. However,
contract provisions in which Retirement Investors agree to arbitrate
any individual disputes are allowed to the extent permitted by
applicable state law. Moreover, Section II(f) does not prevent
Retirement Investors from voluntarily agreeing to arbitrate class or
representative claims after the dispute has arisen.
The Department's approach in this respect is consistent with
FINRA's rules permitting mandatory pre-dispute arbitration for
individual claims, but not for class action claims.\41\ This rule was
adopted in 1992, in response to a directive, articulated by former SEC
Chairman David Ruder, that investors have access to courts in
appropriate cases.\42\ Section 12000 of the FINRA manual establishes a
Code of Arbitration Procedure for Customer Disputes which sets forth
rules on, inter alia, filing claims, amending pleadings, prehearing
conferences, discovery, and sanctions for improper behavior.
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\41\ FINRA rule 12204(a) provides that class actions may not be
arbitrated under the FINRA Code of Arbitration Procedures. FINRA
rule 2268(d)(3) provides that no predispute arbitration agreement
may limit the ability of a party to file any claim in court
permitted to be filed in court under the rules of the forums in
which a claim may be filed under the agreement. The FINRA Board of
Governors has ruled that a broker's predispute arbitration agreement
with a customer may not include a waiver of the right to file or
participate in a class action in court. Department of Enforcement v.
Charles Schwab & Co. (Complaint 2011029760201) (Apr. 24, 2014).
\42\ NASD Notice 92-65 SEC Approval of Amendments Concerning the
Exclusion of Class-Action Matters from Arbitration Proceedings and
Requiring that Predispute Arbitration Agreements Include a Notice
That Class-Action Matters May Not Be Arbitrated, available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=1660.
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A number of commenters addressed the proposed approach to
arbitration and the other ineligible provisions of Section II(f). A
discussion of the comments and the Department's responses follow.
a. Exculpatory Provisions
The Department included Section II(f)(1) in the final exemption
without changes from the proposal. Commenters did, however, raise a few
questions on the provision. In particular, commenters asked whether the
contract could disclaim liability for acts or omissions of third
parties, and whether there could be venue selection clauses. In
addition, commenters asked whether the contract could require
exhaustion of arbitration or mediation before filing in court. Section
II(f)(1) does not prevent a Financial Institution's contract with IRA
and non-ERISA plan investors from disclaiming liability for acts or
omissions of third parties to the extent permissible under applicable
law. In addition, for individual claims, reasonable arbitration and
mediation requirements are not prohibited. In response to questions
about venue selection, the final exemption includes a new Section
II(f)(3), which provides that investors may not be required to
arbitrate or mediate their individual claims in venues that are distant
or that otherwise unreasonably limit their ability to assert the claims
safeguarded by this exemption.
The Department has not revised Section II(f) to address every
provision that may or may not be included in the contract. While some
commenters submitted specific requests regarding specific contract
language, and others suggested the Department provide model contracts
for Financial Institutions to use, the Department has declined to make
these changes in the exemption. The Department notes that Section
II(f)(1) prohibits all exculpatory provisions disclaiming or otherwise
limiting liability of the Adviser or Financial Institution for a
violation of the contract's terms, and Section II(g)(5) prohibits
Financial Institutions and Advisers from purporting to disclaim any
responsibility or liability for any responsibility, obligation, or duty
under Title I of ERISA to the extent the disclaimer would be prohibited
by Section 410 of ERISA. Therefore, in response to comments regarding
choice of law provisions, modifying ERISA's statute of limitations, and
imposing obligations on the Retirement Investor, the Financial
Institutions must determine whether their specific provisions are
exculpatory and would disclaim or limit their liability under ERISA, or
that of their Advisers. If so, they are not permitted. The Department
will provide additional guidance in response to questions and
enforcement proceedings
b. Arbitration
Section II(f)(2) of the final exemption adopts the approach, as
proposed, that individual claims may be the subject of contractual pre-
dispute binding arbitration. Class or other representative claims,
however, must be allowed to proceed in court. The final exemption also
provides that contract provisions may not limit recoveries to an amount
representing liquidated damages for breach of the contract. However,
the final exemption expressly permits Retirement Investors to knowingly
waive their rights to obtain punitive damages or rescission of
recommended transactions to the extent such waivers are permitted under
applicable law. Commenters were divided on the approach taken in the
proposal, as discussed below.
Some commenters objected to limiting Retirement Investors' right to
sue in court on individual claims and specifically focused on the FINRA
arbitration process. These commenters described FINRA's process as an
unequal playing field, with insufficient protections for individual
investors. They asserted that arbitrators are not required to follow
federal or state laws, and so would not be required to enforce the
terms of the contract. In addition, commenters complained that the
decision of an arbitrator generally is not subject to appeal and cannot
be overturned by any court. According to these commenters, even when
the arbitrators find in favor of the consumer, the consumers often
receive significantly smaller recoveries than they deserve. Moreover,
some asserted that binding pre-dispute arbitration may be contrary to
the legislative intent of ERISA, which provides for ``ready access to
federal courts.''
Some commenters opposed to arbitration indicated that preserving
the right to bring or participate in class actions in court would not
give Retirement Investors sufficient access to courts. According to
these commenters, allowing Financial Institutions to require resolution
of individual claims by arbitration would impose additional and
unnecessary hurdles on investors seeking to enforce the Best Interest
standard. One commenter warned that the Regulation would make it more
difficult for Retirement Investors to pursue class actions because the
individualized requirements for proving fiduciary status could
undermine any claims about commonality. Commenters said that class
action lawsuits tend to be expensive and protracted, and even where
successful, investors often recover only a small portion of their
losses.
Other commenters just as forcefully supported pre-dispute binding
arbitration agreements. Some asserted that arbitration is generally
quicker and less costly than judicial proceedings. They argued that
FINRA has well-developed protections in place to protect the interests
of aggrieved investors. One commenter pointed out that FINRA requires
that the arbitration provisions of a contract be highlighted and
disclosed to the customer, and that customers be allowed to choose an
``all-
[[Page 21117]]
public'' panel of arbitrators.\43\ FINRA rules also impose larger
filing fees on the industry party than on the investor. Commenters also
cited evidence that investors are as likely to prevail in arbitration
proceedings as they are in court, and even argued that permitting
mandatory arbitration for all disputes would be in investors' best
interest.
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\43\ The term ``Public Arbitrator'' is defined in FINRA rule
12100(u). According to FINRA, non-``Public Arbitrators'' are often
referred to as ``industry'' arbitrators. See Final Report and
Recommendations of the FINRA Dispute Resolution Task Force, released
December 16, 2015.
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A number of commenters argued that arbitration should be available
for all disputes that may arise under the exemption, including class or
representative claims. Some of these commenters favored arbitration of
class claims due to concerns about costs and potentially greater
liability associated with class actions brought in court. Some
commenters took the position that the ability of the Retirement
Investor to participate in class actions could deter Financial
Institutions from relying on the exemption at all.
After consideration of the comments on this subject, the Department
has decided to adopt the general approach taken in the proposal.
Accordingly, contracts with Retirement Investors may require pre-
dispute binding arbitration of individual disputes with the Adviser or
Financial Institution. The contract, however, must preserve the
Retirement Investor's right to bring or participate in a class action
or other representative action in court in such a dispute in order for
the exemption to apply.
The Department recognizes that, for many claims, arbitration can be
more cost-effective than litigation in court. Moreover, the exemption's
requirement that Financial Institutions acknowledge their own and their
Advisers' fiduciary status should eliminate an issue that frequently
arises in disputes over investment advice. In addition, permitting
individual matters to be resolved through arbitration tempers the
litigation risk and expense for Financial Institutions, without
sacrificing Retirement Investors' ability to secure judicial relief for
systemic violations that affect numerous investors through class
actions.
On the other hand, the option to pursue class actions in court is
an important enforcement mechanism for Retirement Investors. Class
actions address systemic violations affecting many different investors.
Often the monetary effect on a particular investor is too small to
justify the pursuit of an individual claim, even in arbitration.
Exposure to class claims creates a powerful incentive for Financial
Institutions to carefully supervise individual Advisers, and ensure
adherence to the Impartial Conduct Standards. This incentive is
enhanced by the transparent and public nature of class proceedings and
judicial opinions, as opposed to arbitration decisions, which are less
visible and pose less reputational risk to Financial Institutions or
Advisers found to have violated their obligations.
The ability to bar investors from bringing or participating in such
claims would undermine important investor rights and incentives for
Advisers to act in accordance with the Best Interest standard. As one
commenter asserted, courts impose significant hurdles for bringing
class actions, but where investors can surmount theses hurdles, class
actions are particularly well suited for addressing systemic breaches.
Although by definition communications to a specific investor generally
must have a degree of specificity in order to constitute fiduciary
advice, a class of investors should be able to satisfy the requirements
of commonality, typicality and numerosity where there is a systemic or
wide-spread problem, such as the adoption or implementation of non-
compliant policies and procedures applicable to numerous Retirement
Investors, the systematic use of prohibited or misaligned financial
incentives, or other violations affecting numerous Retirement Investors
in a similar way. Moreover, the judicial system ensures that disputes
involving numerous retirement investors and systemic issues will be
resolved through a well-established framework characterized by
impartiality, transparency, and adherence to precedent. The results and
reasoning of court decisions serve as a guide for the consistent
application of that law in future cases involving other Retirement
Investors and Financial Institutions.
This is consistent with the approach long adopted by FINRA and its
predecessor self-regulatory organizations. FINRA Arbitration rule 12204
specifically bars class actions from FINRA's arbitration process and
requires that pre-dispute arbitration agreements between brokers and
customers contain a notice that class action matters may not be
arbitrated. In addition, it provides that a broker may not enforce any
arbitration agreement against a member of certified or putative class
action, until the certification is denied, the class action is
decertified, the class member is excluded from, or elects not
participate in, the class. This rule was adopted by the National
Association of Securities Dealers and approved by the SEC in 1992.\44\
In the release announcing this decision, the SEC stated:
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\44\ SEC Release No. 34-31371 (Oct. 28, 1992), 1992 WL 324491.
[T]he NASD believes, and the Commission agrees, that the
judicial system has already developed the procedures to manage class
action claims. Entertaining such claims through arbitration at the
NASD would be difficult, duplicative and wasteful. . . . The
Commission agrees with the NASD's position that, in all cases, class
actions are better handled by the courts and that investors should
have access to the courts to resolve class actions efficiently.\45\
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\45\ Id.
In 2014, the FINRA Board of Governors upheld this rule in reviewing an
enforcement action.\46\
---------------------------------------------------------------------------
\46\ FINRA Decision, Department of Enforcement v. Charles Schwab
& Co. (Complaint 2011029760201), p.14 (Apr. 24, 2014).
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Additional Protections
One commenter suggested that if the Department preserved the
ability of a Financial Institution to require arbitration of claims, it
should consider requiring a series of additional safeguards for
arbitration proceedings permitted under the exemption. The commenter
suggested that the conditions could state that (i) the arbitrator must
be qualified and independent; (ii) the arbitration must be held in the
location of the person challenging the action; (iii) the cost of the
arbitration must be borne by the Financial Institution; (iv) the
Financial Institution's attorneys' fees may not be shifted to the
Retirement Investor, even if the challenge is unsuccessful; (v)
statutory remedies may not be limited or altered by the contract; (vi)
access to adequate discovery must be permitted; (vii) there must be a
written record and a written decision; (viii) confidentiality
requirements and protective orders which would prohibit the use of
evidence in subsequent cases must be prohibited. The commenter said
that some, but not all, of these procedures are currently required by
FINRA.
The Department declines to mandate additional procedural safeguards
for arbitration beyond those already mandated by other applicable
federal and state law or self-regulatory organizations. In the
Department's view, the FINRA arbitration rules, in particular, provide
significant safeguards for fair dispute resolution, notwithstanding the
concerns raised by some commenters. FINRA's Code of Arbitration
Procedures for Customer Disputes applies when required by written
agreement between the FINRA member and the customer, or if the
[[Page 21118]]
customer requests arbitration. The rules cover any dispute between the
member and the customer that arises from the member's business
activities, except for disputes involving insurance business activities
of a member that is an insurance company.\47\ FINRA's code of
procedures also provide detailed instructions for initiating and
pursuing an arbitration, including rules for selection of arbitrators
(FINRA rule 12400), for discovery of evidence (FINRA rule 12505), and
expungement of customer dispute information (FINRA rule 12805), which
are designed to allow access by investors and preserve fairness for the
parties. In addition, FINRA rule 12213 specifies that FINRA will
generally select the hearing location closest to the customer. To the
extent that the contracts provide for binding arbitration in individual
claims, the Department defers to the judgment of FINRA and other
regulatory bodies, such as state insurance regulators, responsible for
determining the safeguards applicable to arbitration proceedings.
---------------------------------------------------------------------------
\47\ FINRA rule 12200.
---------------------------------------------------------------------------
Federal Arbitration Act
Some commenters asserted that the Department does not have the
authority to include the exemption's provisions on class action waivers
under the Federal Arbitration Act (FAA), which they said protects
enforceable arbitration agreements and expresses a federal policy in
favor of arbitration over litigation. Without clear statutory authority
to restrict arbitration, these commenters said, the Department cannot
include the provisions on class action waivers.
These comments misconstrue the effect of the FAA on the
Department's authority to grant exemptions from prohibited
transactions. The FAA protects the validity and enforceability of
arbitration agreements. Section 2 of the FAA states: ``[a] written
provision in any . . . contract . . . to settle by arbitration a
controversy thereafter arising out of such contract . . . shall be
valid, irrevocable, and enforceable, save upon such grounds as exist at
law or in equity for the revocation of any contract.'' \48\ This Act
was intended to reverse judicial hostility to arbitration and to put
arbitration agreements on an equal footing with other contracts.\49\
---------------------------------------------------------------------------
\48\ 9 U.S.C. 2.
\49\ See AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 342
(2011).
---------------------------------------------------------------------------
Section II(f)(2) of the exemption is fully consistent with the FAA.
The exemption does not purport to render an arbitration provision in a
contract between a Financial Institution and a Retirement Investor
invalid, revocable, or unenforceable. Nor, contrary to the concerns of
one commenter, does Section II(f)(2) prohibit such waivers. Both
Institutions and Advisers remain free to invoke and enforce arbitration
provisions, including provisions that waive or qualify the right to
bring a class action or any representative action in court. Instead,
such a contract simply does not meet the conditions for relief from the
prohibited transaction provisions of ERISA and the Code. As a result,
the Financial Institution and Adviser would remain fully obligated
under both ERISA and the Code to refrain from engaging in prohibited
transactions. In short, Section II(f)(2) does not affect the validity,
revocability, or enforceability of a class-action waiver in favor of
individual arbitration. This regulatory scheme is thus a far cry from
the State judicially created rules that the Supreme Court has held
preempted by the FAA,\50\ and the National Labor Relations Board's
attempt to prohibit class-action waivers as an ``unfair labor
practice.'' \51\
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\50\ See American Express Co. v. Italian Colors Restaurant, 133
S. Ct. 2304 (2013); AT&T Mobility LLC v. Concepcion, 563 U.S. 333
(2011).
\51\ See D.R. Horton, Inc. v. NLRB, 737 F.3d 344 (5th Cir.
2013).
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The Department has broad discretion to craft exemptions subject to
the Department's overarching obligation to ensure that the exemptions
are administratively feasible, in the interests of plan participants,
beneficiaries, and IRA owners, and protective of their interests. In
this instance, the Department has concluded that the enforcement rights
and protections associated with class action litigation are important
to safeguarding the Impartial Conduct Standards and other anti-conflict
provisions of the exemption. If a Financial Institution enters into a
contract requiring binding arbitration of class claims, the Department
would not purport to invalidate the provision, but rather would insist
that the Financial Institution fully comply with statutory provisions
prohibiting conflicted fiduciary transactions in its dealings with its
Retirement Investment customers. The FAA is not to the contrary. It
neither limits the Department's express grant of discretionary
authority over exemptions, nor entitles parties that enter into
arbitration agreements to a pass from the prohibited transaction rules.
While the Department is confident that its approach in the
exemption does not violate the FAA, it has carefully considered the
position taken by several commenters that the Department exceeded the
Department's authority in including provisions in the exemption on
class and representative claims, and the possibility that a court might
rule that the condition regarding arbitration of class claims in
Section II(f)(2) of the exemption is invalid based on the FAA.
Accordingly, in an abundance of caution, the Department has
specifically provided that Section II(f)(2) can be severable if a court
finds it invalid based on the FAA. Specifically, Section II(f)(4)
provides that:
In the event that the provision on pre-dispute arbitration
agreements for class or representative claims in paragraph (f)(2) of
this Section is ruled invalid by a court of competent jurisdiction,
this provision shall not be a condition of this exemption with
respect to contracts subject to the court's jurisdiction unless and
until the court's decision is reversed, but all other terms of the
exemption shall remain in effect.
The Department is required to find that the provisions of an
exemption are administratively feasible, in the interests of plans and
their participants and beneficiaries and IRA owners, and protective of
participants and beneficiaries and IRA owners. The Department finds
that the exemption with paragraph (f)(2) satisfies these requirements.
The Department believes, consistent with the position of the SEC and
FINRA, that the courts are generally better equipped to handle class
claims than arbitration procedures and that the prohibition on
contractual provisions mandating arbitration of such claims helps the
Department make the requisite statutory findings for granting an
exemption.
Nevertheless, the Department has determined that, based on all the
exemption's other conditions, it can still make the necessary findings
to grant the exemption even without the condition prohibiting pre-
dispute agreements to arbitrate class claims. In particular, if a court
were to invalidate the condition, the Department would still find that
the exemption is administratively feasible, in the interests of plans
and their participants and beneficiaries, and protective of the rights
of the participants and beneficiaries. It would be less protective, but
still sufficient to grant the exemption.
The Department's adoption of the specific severability provision in
Section II(f)(4) of the exemption should not be viewed as evidence of
the Department's intent that no other conditions of this or the other
exemptions granted today are severable if a court were to invalidate
them.
[[Page 21119]]
Instead, the Department intends that invalidated provisions of the rule
and exemptions may be severed when the remainder of the rule and
exemptions can function sensibly without them.\52\
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\52\ See Davis County Solid Waste Management v. United States
Environmental Protection Agency, 108 F.3d 1454, 1459 (D.C. Cir.
1997) (finding that severability depends on an agency's intent and
whether the provisions can operate independently of one another).
---------------------------------------------------------------------------
c. Remedies
Some commenters asked whether the proposal's prohibition of
exculpatory clauses would affect the parties' ability to limit remedies
under the contract, particularly regarding liquidated damages, punitive
damages, consequential damages and rescission. In response, the
Department has added text to Section II(f)(2) in the final exemption
clarifying that the parties, in an individual or class claim, may not
agree to an amount representing liquidated damages for breach of the
contract. However, the exemption, as finalized, expressly permits the
parties to knowingly agree to waive the Retirement Investor's right to
obtain punitive damages or rescission of recommended transactions to
the extent such a waiver is permissible under applicable state or
federal law.
In the Department's view, it is sufficient to the exemptions'
protective purposes to permit recovery of actual losses. The
availability of such a remedy should ensure that plaintiffs can be made
whole for any losses caused by misconduct, and provide an important
deterrent for future misconduct. Accordingly, the exemption does not
permit the contract to include liquidated damages provisions, which
could limit Retirement Investors' ability to obtain make-whole relief.
On the other hand, the exemption permits waiver of punitive damages
to the extent permissible under governing law. Similarly, rescission
can result in a remedy that is disproportionate to the injury. In cases
where an advice fiduciary breached its obligations, but there was no
injury to the participant, a rescission remedy can effectively make the
fiduciary liable for losses caused by market changes, rather than its
misconduct. These new provisions in section II(f)(2) only apply to
waiver of the contract claims; they do not qualify or limit statutory
enforcement rights under ERISA. Those statutory remedies generally
provide for make-whole relief and to rescission in appropriate cases,
but they do not provide for punitive damages.
9. General Conditions Applicable to Each Transaction (Section III)
Section III of the exemption sets forth conditions that apply to
the terms of each principal transaction or a riskless principal
transaction entered into under the exemption. Section III(a) applies
only to purchases by a Plan, participant or beneficiary account, or
IRA, of principal traded assets that are debt securities, as defined in
the exemption. Section III(b) and (c) apply to both purchase and sale
transactions, involving all principal traded assets. Many comments were
received with respect to the proposed conditions, and the Department
has revised the proposed language to address these comments.
a. Issuer/Underwriter Restrictions
Section III(a)(1) and (2) of the exemption provides that the debt
security being bought by the Plan, participant or beneficiary account,
or IRA must not have been issued or, at the time of the transaction,
underwritten by the Financial Institution or any Affiliate. The
Department received comments generally objecting to these conditions as
unduly limiting investment opportunities to Retirement Investors.
Commenters argued that many debt securities will only be available for
purchase by a Retirement Investor on a principal basis as part of the
initial issuance or underwriting since the debt securities are not
frequently resold in small lots to retail investors on either a
principal or an agency basis.
The Department is sympathetic to the commenters' position, but has
determined to adopt the language without modification. This reflects
the Department's concerns that additional conflicts of interest are
inherent in transactions where the issuer or underwriter of a security
(whether debt or equity) is a fiduciary to a plan or IRA. In such
instances, the Financial Institution generally has either been retained
by a third party to sell securities as part of an underwriting and has
made guarantees as to such sales and will likely profit from such sales
more than in a traditional principal transaction or is issuing
securities on its own behalf for the specific purposes of benefiting
itself. Further, since generally the issued or underwritten securities
are being issued or underwritten by the Financial Institution for the
first time, heightened issues regarding pricing and liquidity result.
Since these unique conflicts exist with respect to both issuance and
underwriting transactions, they would require conditions unique to
issuance and underwriter principal transactions, respectively. This
exemption was not designed to address such conflicts. The Department
believes that permitting such transactions without applying additional
conditions would not be protective of participants and beneficiaries of
plans and IRA owners. Parties seeking relief for such transactions are
encouraged to seek an individual exemption from the Department.
b. Credit Standards and Liquidity
Section III(a)(3) of the exemption requires that, using information
reasonably available to the Adviser at the time of the transaction, the
Adviser must determine that the debt security being purchased by the
Plan, participant or beneficiary account, or IRA, possesses no greater
than a moderate credit risk and is sufficiently liquid that the debt
security could be sold at or near its carrying value within a
reasonably short period of time. Debt securities subject to a moderate
credit risk should possess at least average credit-worthiness relative
to other similar debt issues. Moderate credit risk would denote current
low expectations of default risk, with an adequate capacity for payment
of principal and interest.
This condition is intended to identify investment grade securities,
and avoid the circumstance in which an investment advice fiduciary can
recommend speculative debt securities and then sell them to the Plan,
participant or beneficiary account, or IRA, from its own inventory. The
SEC used similar provisions in setting credit standards in its
regulations, including its Rule 6a-5 issued under the Investment
Company Act.\53\
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\53\ 17 CFR 270.6a-5, 77 FR 70117 (November 23, 2012).
---------------------------------------------------------------------------
Some commenters on this aspect of the proposal generally objected
to the condition's lack of objectivity. Some requested that the
Department instead specifically condition the exemption on the
security's being ``investment grade,'' rather than the proposed credit
and liquidity standards. While the Department generally intends the
exemption to be limited to securities that a reasonable investor would
treat as investment grade securities, Section 939A of the Dodd-Frank
Act provides that the Department may not ``reference or rely on''
credit ratings--including ``investment grade''--in the exemption's
conditions. Accordingly, Advisers and Financial Institutions wishing to
rely on the exemption must make a reasonable determination of
creditworthiness,
[[Page 21120]]
without automatic adherence to specified credit ratings.
Another commenter suggested that the Department replace the
liquidity component of the standard with the provision of two quotes or
a requirement that the Financial Institution reasonably believe a
principal transaction provides a better price than would be available
in the absence of a principal transaction. The Department agrees that
it is important that the price of the principal transaction or a
riskless principal transaction is reasonable and has conditioned the
exemption on the Adviser and Financial Institution's commitment to seek
to obtain the best execution reasonably available under the
circumstances with respect to the transaction (and for FINRA members,
specifically on satisfaction of FINRA rules 2121 (Fair Prices and
Commissions) and 5310 (Best Execution and Interpositioning)). However,
the Department determined not to replace the liquidity component with
the two quote requirement in light of commenters' views that the
requirement was unlikely to be workable or effective in achieving the
Department's aims.
Other commenters focused on the timing associated with the
liquidity component of the condition. They expressed concern that the
condition may apply throughout the time period in which the security is
held by the Retirement Investor. The Department revised the operative
text to make clear that the standard must be satisfied based on the
information reasonably available to the Adviser at the time of the
transaction and not thereafter. Nevertheless, the Department notes that
the Adviser's consideration of whether the recommendation is in the
Retirement Investor's Best Interest may also need to include
consideration of information that is reasonably available regarding
restrictions or near term expected performance of the debt security, in
light of the Retirement Investor's needs and objectives. The Department
additionally eliminated the credit standards with respect to sales from
a plan, participant or beneficiary account, or IRA; accordingly, this
condition will not stand in the way of a plan or IRA selling a security
that no longer meets the credit standards to a Financial Institution in
a principal transaction. The purpose of the liquidity condition was to
protect Retirement Investors from the dangers associated with a
conflicted Adviser saddling them with low-quality securities, not to
prevent them from disposing of such securities.
Commenters also argued that although the Department cited the
similar credit standards set forth in the SEC's Rule 6a-5 issued under
the Investment Company Act, the Department's reliance on SEC language
as a template for the credit risk language is not necessarily
appropriate because the SEC uses the language for a different purpose
unrelated to retail accounts. While in a different context, the SEC's
adoption of similar language supports the Department's view that
Financial Institutions are capable of implementing the standard. For
that reason, the SEC language remains relevant. Further, the Department
itself has previously proposed the use of the same language in multiple
class exemptions without material objections by the financial services
industry to the workability of the language.\54\
---------------------------------------------------------------------------
\54\ See, 78 FR 37572 (June 21, 2013).
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Some commenters also indicated that the Department's use of the
term ``fair market value'' in the proposal, in place of the term
``carrying value,'' that is used in the SEC standard, was confusing. In
response, the Department revised the final exemption to use the term
``carrying value'' rather than ``fair market value.'' In addition, the
Department adopted the suggestion of a commenter that Financial
Institutions be required to establish policies and procedures to
determine how credit risk and liquidity assessments will be made and to
develop standards for such assessments. This requirement is in Section
II(d), discussed above, and is intended to provide a mechanism for
Financial Institutions to operationalize this requirement. As revised,
the Department believes that the credit standards condition can serve a
protective role without being too vague or operationally difficult.
In addition to operational concerns, commenters addressed whether
credit standards should be part of the exemption at all. Some
commenters opposed both the credit and liquidity conditions on the
grounds that the Department was substituting the Department's judgment
for the judgment of Retirement Investors. Other commenters, however,
supported the Department's approach as imposing appropriate safeguards
against the added risk associated with investment advice fiduciaries
recommending principal transactions and riskless principal transactions
involving securities that possess substantial credit risk or are thinly
traded.
The Department has decided to retain the credit standards. First,
the exemption addresses only those principal transactions and riskless
principal transactions that are the result of the provision of
fiduciary investment advice. To the extent that a Retirement Investor
is truly acting on his or her own without the advice of an investment
advice fiduciary, the necessary exemptive relief already exists. As
discussed above, Part II of PTE 75-1 currently provides relief from
ERISA section 406(a) for principal transactions so long as the broker-
dealer or bank does not render investment advice with respect to the
assets involved in the principal transaction. Second, the most commonly
held categories of debt securities will continue to be available to
plans and IRAs.
Most importantly, with respect to investment advice that is being
provided by an investment advice fiduciary, the Department believes
that inherent conflicts of interest justify the credit and liquidity
conditions. As discussed elsewhere in this preamble, principal
transactions in particular raise significant conflicts of interest, and
are often associated with substantial pricing, transparency and
liquidity issues. These concerns are magnified when a debt security is
of lesser quality. Further, beyond the Department's heightened concerns
regarding pricing, transparency and liquidity, Financial Institutions
may generate higher levels of compensation with respect to lower
quality debt securities, generating additional conflicts that would
otherwise be absent from principal transactions and riskless principal
transactions. Finally, the Department notes that other prohibited
transaction exemptions granted by the Department permitting principal
transactions between plans and plan fiduciaries also contain similar
credit standards.\55\
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\55\ See PTE 75-1, Part IV, Exemptions from Prohibitions
Respecting Certain Classes of Transactions Involving Employee
Benefit Plans and Certain Broker-Dealers, Reporting Dealers and
Banks, 40 FR 50845 (Oct. 31, 2006), proposed amendment pending, 78
FR 37572 (Friday, June 21, 2013).
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c. Agreement, Arrangement or Understanding
Section III(b) provides that a principal transaction or a riskless
principal transaction may not be part of an agreement, arrangement, or
understanding designed to evade compliance with ERISA or the Code, or
to otherwise impact the value of the principal traded asset. Such a
condition protects against the Adviser or Financial Institution
manipulating the terms of the principal transaction or a riskless
principal transaction, either as an isolated transaction or as a part
of a
[[Page 21121]]
series of transactions, to benefit themselves or their Affiliates.
Further, this condition would also prohibit an Adviser or Financial
Institution from engaging in principal transactions with Retirement
Investors for the purpose of ridding inventory of unwanted or poorly
performing principal traded assets. The Department did not receive
comments on this condition, and it has been adopted as proposed, with
the substitution of the term ``principal traded asset'' for ``debt
security.''
d. Cash
Section III(c) requires that the purchase or sale of the principal
traded asset must be for no consideration other than cash. By limiting
a purchase or sale to cash consideration, the Department intends that
relief will not be provided for a principal transaction or a riskless
principal transaction that is executed on an in-kind basis. The
limitation to cash reflects the Department's concern that in-kind
transactions create complexity and additional conflicts of interest
because of the need to value the in-kind asset involved in the
transaction. The Department did not receive comments on this condition,
and it was adopted as proposed.
e. Proposed Pricing Condition
Section III(d) of the proposal addressed the pricing of the
principal transaction by proposing that the purchase or sale occur at a
price that (1) the Adviser and Financial Institution reasonably believe
is at least as favorable to the plan, participant or beneficiary
account, or IRA, as the price available in a transaction that is not a
principal transaction, and (2) is at least as favorable to the plan,
participant or beneficiary account, or IRA, as the contemporaneous
price for the security, or a similar security if a price is not
available for the same security, offered by two ready and willing
counterparties that are not Affiliates of the Adviser or Financial
Institution. The proposal further provided that when comparing the
prices, the Adviser and Financial Institution could take into account
commissions and mark-ups/mark-downs.
Many commenters raised concerns regarding the practicality of the
two quote process outlined in proposed Section III(d)(2). A number of
commenters did not believe that the two quote process would be
workable. They said that two quotes may not be available on all
securities, particularly corporate debt securities. They further
expressed uncertainty about the meaning of the ``similar securities''
that could be substituted. In addition, commenters indicated that the
time needed to go through the two quote process could interfere with a
Financial Institution's duty of best execution under FINRA rule 5310,
or in any event could slow the execution of a transaction, to the
detriment of the Retirement Investor. FINRA suggested the exemption
should be conditioned on FINRA rule 5310 instead of the proposed two
quote requirement.
Further, the Department has come to believe that the quotes
themselves may not be reliable measure of fair price because they are
solicited as comparisons rather than with the intent to purchase or
sell. A Financial Institution might be less than rigorous in its
solicitation of the two quotes, perhaps seeking quotes that simply
validate the Financial Institution's opinion of the appropriate price
for the principal transaction. In light of such comments and concerns,
the Department did not adopt the two quote requirement.
However, in order to address the Department's concern about the
price of the transaction, as discussed in more detail above, the
exemption requires that Advisers and Financial Institutions engaging in
the transactions seek to obtain the best execution reasonably available
under the circumstances. For FINRA members, the final exemption
provides that they must comply with FINRA rules 2121 and 5310. These
rules provide for best execution and fair pricing, and they will ensure
that the Financial Institution does not use its relationship with a
plan or IRA to benefit financially to the detriment of the plan or IRA.
One commenter expressed strong support for the intent behind the
pricing conditions to protect Retirement Investors. The commenter
expressed concern, however, that Financial Institutions could work
around the proposed pricing conditions, resulting in the conditions
failing to provide the anticipated protections to Retirement Investors.
The commenter suggested that Financial Institutions be required to
articulate why the principal transaction is in the Retirement
Investor's Best Interest and provide current market data, available
from FINRA's TRACE system, for example, to back up such articulation.
Another commenter also suggested that specific pricing information
could be made available on request.
The Department believes that the Department's approach in Section
II(c)(2) of the final exemption Impartial Conduct Standards implements
the intent of the pricing condition proposed in Section III(d)(1). The
Department did not adopt the suggestion to require the provision of
current market data based upon its concern that the additional costs
would likely outweigh the benefits, particularly for retail investors.
Because of the nature of the marketplace for principal traded assets,
current market data is often difficult to analyze and apply to an
individual transaction involving the same asset. Such difficulties are
particularly problematic with respect to less sophisticated Retirement
Investors who will not have the analytic tools at their disposal to
interpret any market data that could be provided to them. Consequently,
disclosure of such data would likely be of limited value to retail
investors. To the extent that the information would be useful to more
sophisticated Retirement Investors, such Retirement Investors typically
have the information and necessary analytic tools already available.
10. Disclosure Requirement (Section IV)
a. Pre-Transaction Disclosure
Section IV(a) of the exemption requires that, prior to or at the
same time as the execution of the transaction, the Adviser or Financial
Institution must provide the Retirement Investor, orally or in writing,
a disclosure of the capacity in which the Financial Institution may act
with respect to the transaction. By ``capacity in which the Financial
Institution may act,'' the Department means that the Financial
Institution must notify the Retirement Investor if it may act as
principal in the transaction. This requirement is intended to harmonize
with the SEC's Temporary Rule 206(3)-3T, which has a similar pre-
transaction requirement. Such a harmonization allows for a streamlined
disclosure requirement, which places less burden on the Financial
Institutions.
In the proposal, Section IV(a) would have required the Adviser or
Financial Institution to provide a statement, prior to engaging in the
principal transaction, that the purchase or sale would be executed as a
principal transaction. A few commenters indicated that they would not
always know if the transaction would be executed as a principal
transaction prior to the transaction. These commenters suggested that
the Department adopt the approach in the SEC's Temporary Rule 206(3)-
3T, which a commenter said, requires that an investment adviser inform
the client ``of the capacity in which it may act with respect to such
transaction.'' A commenter said this formulation recognized that the
investment adviser may not know at
[[Page 21122]]
that time whether the transaction would be executed as a principal
transaction. The Department concurs with this comment and has revised
the pre-transaction disclosure to more closely match the language in
the SEC's Temporary Rule.
Some commenters indicated that the Department's requirement in
Section IV(a) was burdensome in that they perceived it to require the
Retirement Investor's affirmative consent to the specific terms of the
transaction in advance of the execution. In response, the Department
notes that the proposal did not, and the final exemption does not,
contemplate such consent. However, the Department notes that the
exemption is limited to Advisers and Financial Institutions that act in
a non-discretionary capacity.
The proposed pre-transaction disclosure also would have required
disclosure of the two quotes received from unrelated counterparties and
the mark-up, mark-down or other payment to be applied to the principal
transaction.\56\ Commenters pointed to logistical problems involved in
determining a true mark-up/mark-down amount when multiple, unrelated
brokers facilitate the principal transaction. They asserted that, in
the absence of contextual information, the disclosure of the mark-up/
mark-down may not be useful to Retirement Investors. A few commenters
suggested that the Department require the disclosure of the maximum and
minimum possible mark-up or mark-down, with one commenter suggesting
that more specific information could be made available upon request.
The preamble to the proposed exemption discussed the possibility of
defining the mark-up/mark-down by reference to FINRA rule 2121 and the
related guidance, and asked for comment on the approach. One commenter,
however, said the Department did not provide any methodology for the
mark-up/mark-down disclosure requirement and, as a result, the
Department's approach would lead to confusion and inconsistent
application of the pricing condition. Other commenters suggested that
the Department defer to other regulatory and legislative initiatives
regarding mark-up/mark-down disclosure--in particular, FINRA's proposed
disclosures in FINRA Regulatory Notice 14-52.
---------------------------------------------------------------------------
\56\ As discussed above, the proposed two quote requirement was
not adopted in the final exemption.
---------------------------------------------------------------------------
The Department was persuaded by the commenters that required
disclosure of the mark-up or mark-down might introduce significant
complexity to compliance with the exemption, in particular with respect
to transactions that could be covered by FINRA's pending disclosure
requirement, and therefore has not adopted the mark-up/mark-down
disclosure requirement in the final exemption. Commenters' suggestions
to require disclosure of the minimum and maximum mark-up/mark-down were
not adopted because the Department believes that this disclosure would
not be specific enough to benefit Retirement Investors.
b. Confirmation
Section IV(b) of the proposal would have required a written
confirmation in accordance with Rule 10b-10 under the Exchange Act,
that also includes disclosure of the mark-up, mark-down or other
payment to be applied to the principal transaction. A number of
comments noted that Rule 10b-10 does not currently include disclosure
of the mark-up or mark-down, and making the change would be costly.
There were also significant comments, discussed elsewhere, as to the
practicality of the mark-up or mark-down disclosure, such that the
Department determined not to require the disclosure as discussed above.
As a result, the requirement to include a mark-up or mark-down as part
of the confirmation has been eliminated. Section IV(b) now simply
requires the issuance of a confirmation of the transaction. The
requirement to provide a confirmation may be met by compliance with the
existing Rule 10b-10, or any successor rule in effect at the time of
the transaction, or for Advisers and Financial Institutions not subject
to the Exchange Act, similar requirements imposed by another regulator
or self-regulatory organization.
c. Annual Disclosure
Section IV(c) sets forth a requirement under which the Adviser or
Financial Institution must provide certain written information clearly
and prominently in a single written disclosure to the Retirement
Investor on an annual basis. The annual disclosure must include: (1) A
list identifying each principal transaction and riskless principal
transaction executed in the Retirement Investor's account in reliance
on this exemption during the applicable period and the date and price
at which the transaction occurred; and (2) a statement that (i) the
consent required pursuant to Section II(e)(2) is terminable at will
upon written notice, without penalty to the Plan or IRA, (ii) the right
of a Retirement Investor in accordance with Section II(e)(3)(ii) to
obtain, free of charge, information about the Principal Traded Asset,
including its salient attributes, (iii) model contract disclosures or
other model notice of the contractual terms which are reviewed for
accuracy no less than quarterly updated within 30 days as necessary are
maintained on the Financial Institution's Web site, and (iv) the
Financial Institution's written description of its policies and
procedures adopted in accordance with Section II(d) are available free
of charge on the Financial Institution's Web site.
With respect to this requirement, Section IV(d) of the exemption
includes a good faith compliance provision, under which the Financial
Institution will not fail to satisfy Section IV solely because it,
acting in good faith and with reasonable diligence, makes an error or
omission in disclosing the required information or if the Web site is
temporarily inaccessible, provided that (i) in the case of an error or
omission on the web, the Financial Institution discloses the correct
information as soon as practicable, but not later than 7 days after the
date on which it discovers or reasonably should have discovered the
error or omission, and (ii) in the case of other disclosures, the
Financial Institution discloses the correct information as soon as
practicable, but not later than 30 days after that date on which it
discovers or reasonably should have discovered the error or omission.
In addition, to the extent compliance with the annual disclosure
requires Advisers and Financial Institutions to obtain information from
entities that are not closely affiliated with them, the exemption
provides that they may rely in good faith on information and assurances
from the other entities, as long as they do not know that the materials
are incomplete or inaccurate. This good faith reliance applies unless
the entity providing the information to the Adviser and Financial
Institution is (1) a person directly or indirectly through one or more
intermediaries, controlling, controlled by, or under common control
with the Adviser or Financial Institution; or (2) any officer,
director, employee, agent, registered representative, relative (as
defined in ERISA section 3(15)), member of family (as defined in Code
section 4975(e)(6)) of, or partner in, the Adviser or Financial
Institution.
The proposal included an annual disclosure requirement in Section
IV(c) that would have included the following elements:
(1) A list identifying each principal transaction engaged in
during the applicable period, the prevailing market price at which
the Debt Security was purchased or sold, and
[[Page 21123]]
the applicable mark-up or mark-down or other payment for each Debt
Security; and
(2) A statement that the consent required pursuant to Section
II(e)(2) is terminable at will, without penalty to the Plan or IRA.
The disclosure would have been required to be made within 45 days
after the end of the applicable year.
As finalized, the annual disclosure now includes a list of the
principal transactions and riskless principal transactions entered into
in reliance on this exemption, and the date and price at which they
occurred. As discussed elsewhere in this preamble, the final exemption
does not include the disclosure of the mark-up or mark-down in this
final exemption. However, the disclosure in the final exemption
includes a reminder of the Retirement Investor's right (in accordance
with Section II(e)(3)(ii) of the exemption) to obtain, free of charge,
information about the principal traded asset, including its salient
attributes.
The final exemption also more closely harmonizes with the SEC's
Temporary Rule 206(3)-3T, as requested by some commenters. First, the
Department removed the proposed condition that the annual disclosure be
provided within 45 days after the end of the applicable year, in favor
of the language used in the Temporary Rule that the disclosure be
provided ``no less frequently than annually.'' Second, the Department
added the requirement that the annual disclosure provide the date on
which the transaction occurred, and a clarification that the disclosure
is only required with respect to principal transactions and riskless
principal transactions entered into pursuant to this exemption. These
elements also harmonize with the SEC's Temporary Rule. As with the pre-
transaction disclosure, the harmonization of the annual disclosure
should ease compliance for Financial Institutions.
The Department adopted the annual disclosure, despite comments
indicating it was unnecessary and duplicative of other disclosures. The
annual disclosure provides a summary of the principal transactions and
riskless principal transactions entered into during the reporting
period and serves a unique purpose in collecting the information
provided in the other disclosures. The annual disclosure provides
Retirement Investors with the opportunity to review and evaluate all of
the principal transactions and riskless principal transactions that
occurred under the terms of the exemption during that period. The
information provided may give Retirement Investors perspective that
they do not gain from the individual confirmations.
Finally, a few commenters objected to Section IV(d) of the
proposal, which would have required disclosure of information about the
debt security and its purchase or sale, upon reasonable request of the
Retirement Investor. Such right of request was viewed as unbounded. The
Department concurs with the commenters and has deleted Section IV(d).
The Department believes the provision in Section IV(c)(2), that a
notice must be provided of the Retirement Investor's right to obtain,
free of charge, information about the Principal Traded Asset, including
its salient attributes, serves the same function. As discussed above,
one commenter requested that the information must be reasonably
available and in the Financial Institution's possession. The Department
believes that no additional limitation need be placed on the rights of
the Retirement Investor to request information because, if a Financial
Institution is advising a Retirement Investor to enter into a principal
transaction or a riskless principal transaction, it should have all of
the salient information available when providing that advice.
11. Recordkeeping (Section V)
Under Section V(a) and (b) of the exemption, the Financial
Institution must maintain for six years records necessary for the
Department and certain other entities, including plan fiduciaries,
participants, beneficiaries and IRA owners, to determine whether the
conditions of the exemption have been satisfied. Some commenters stated
that they were unsure what information would have to be saved for six
years. The Department notes that the language requires that records
necessary to demonstrate compliance with the exemption's conditions
must be maintained.
The final exemption includes changes to the recordkeeping provision
made in accordance with comments on other exemption proposals in
connection with the Regulation. First, the text was revised to make
clear that the records must be ``reasonably accessible for
examination,'' to remove the subjective views of the person requesting
to examine or audit the records. The section also clarifies that
fiduciaries, employers, employee organizations, participants and their
employees and representatives only have access to information
concerning their own plans. In addition, Financial Institutions are not
required to disclose privileged trade secrets or privileged commercial
or financial information to any of the parties other than the
Department, as was also true of the proposal. Financial Institutions
are also not required to disclose records if such disclosure would be
precluded by 12 U.S.C. 484, relating to visitorial powers over national
banks and federal savings associations.\57\ As revised, the exemption
requires the records be ``reasonably'' available, rather than
``unconditionally available.'' Finally, additional language was added
to clarify that any failure to maintain the required records with
respect to a given transaction or set of transactions does not affect
the relief for other transactions.
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\57\ A commenter with respect to the Best Interest Contract
Exemption raised concerns that the Department's right to review a
bank's records under that exemption could conflict with federal
banking laws that prohibit agencies other than the Office of the
Comptroller of the Currency (OCC) from exercising ``visitorial''
powers over national banks and federal savings associations. To
address the comment, Financial Institutions are not required to
disclose records if the disclosure would be precluded by 12 U.S.C.
484. A corresponding change was made in this exemption.
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The recordkeeping provision in the exemption is necessary to
demonstrate compliance with the terms of the exemption and therefore
should represent prudent business practices in any event. The
Department notes that similar language is used in many other exemptions
and has been the Department's standard recordkeeping requirement for
exemptions for some time.
12. Definitions (Section VI)
Section VI of the exemption provides definitions of the terms used
in the exemption. Most of the definitions received no comment, and they
are finalized as proposed. Those terms that have been revised or
received comment are below. Additional comments on definitions, such as
``Best Interest,'' ``Principal Transaction'' and ``Material Conflict of
Interest,'' are discussed above in their respective sections.
a. Adviser
The exemption contemplates that an individual person, an Adviser,
will provide advice to the Retirement Investor. An Adviser must be an
investment advice fiduciary of a plan or IRA who is an employee,
independent contractor, agent, or registered representative of a
Financial Institution, and the Adviser must satisfy the applicable
federal and state regulatory and licensing requirements of banking and
securities laws with respect to the covered transaction.\58\ Advisers
may be, for example, registered representatives
[[Page 21124]]
of broker-dealers registered under the Exchange Act.
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\58\ See Section VI(a) of the exemption.
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One commenter suggested that applicable federal and state
regulatory and licensing language, similar to that in the Best Interest
Contract Exemption proposal, be added to the definition. The Department
agrees with the commenter, and the exemption contains the suggested
language.
b. Financial Institutions
A Financial Institution is the entity that employs an Adviser or
otherwise retains the Adviser as an independent contractor, agent or
registered representative and customarily purchases or sells Principal
Traded Assets for its own account in the ordinary course of its
business.\59\ Financial Institutions must be investment advisers
registered under the Investment Advisers Act of 1940 or state law,
banks, or registered broker-dealers.
---------------------------------------------------------------------------
\59\ See Section VI(e) of the exemption.
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The Department specifically requested comment on whether there are
other types of Financial Institutions that should be included in the
definition. No comments were received regarding the need for additional
entities to be included. The only comments regarding the definition
that were received addressed the language in the proposal that would
have required that advice by a bank be delivered through the bank's
trust department. Commenters indicated that the language serves no
material purpose. As a result, the definition is finalized as proposed
with the exception of the removal of the trust requirement.
c. Debt Securities and Principal Traded Assets
As discussed in detail above with respect to the scope of the
exemption, the Department heard from many commenters that wanted to
expand the scope of the assets that would be eligible to participate in
principal transactions under the exemption. After a review of
individual investments, the Department revised the proposal to include
asset backed securities, CDs, UITs and additional investments later
determined to be added through individual exemptions. Further, with
respect to sales by a plan or IRA in a principal transaction or a
riskless principal transaction, all securities or other property are
provided exemptive relief. The Department operationalized these
additions by revising the proposed definition of a debt security to
include asset backed securities guaranteed by an agency or a government
sponsored enterprise, both within the meaning of FINRA rule 6710.
Further, in order to capture the remaining investments, the new defined
term ``principal traded asset'' was included in Section VI. The
definition of a principal traded asset encompasses both the definition
of ``debt security'' and the other investments listed herein.
In addition to the comments discussed above, one commenter stated
that requiring that a debt security be offered pursuant to a
registration statement under the Securities Act of 1933 was difficult
to comply with operationally in the secondary market. The commenter
argued that the requirement could be eliminated in reliance on the Best
Interest standard. The Department does not agree, and the language is
finalized as proposed. Requiring that a security be registered is a
straightforward mechanism by which the Department can ensure a base
level of regulatory compliance and quality. An Adviser or Financial
Institution should be able to verify the registration of a particular
debt security by using a variety of sources.
d. Affiliate
Section VI(b) defines ``Affiliate'' of an Adviser or Financial
Institution as:
(1) Any person directly or indirectly through one or more
intermediaries, controlling, controlled by, or under common control
with the Adviser or Financial Institution. For this purpose, the
term ``control'' means the power to exercise a controlling influence
over the management or policies of a person other than an
individual;
(2) Any officer, director, partner, employee, or relative (as
defined in ERISA section 3(15)), of the Adviser or Financial
Institution; or
(3) Any corporation or partnership of which the Adviser or
Financial Institution is an officer, director, or partner of the
Adviser or Financial Institution.
The Department received a comment requesting that this definition
adopt a securities law definition. The commenter expressed the view
that use of a separate definition would make compliance more difficult
for broker-dealers. The Department did not accept this comment.
Instead, the Department made minor adjustments so that the definition
is identical to the affiliate definition incorporated in prior
exemptions under ERISA and the Code, that are applicable to broker
dealers,\60\ as well as the definition that is used in the Regulation.
Therefore, the definition should not be new to the broker-dealer
community, and is consistent with other applicable laws.
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\60\ See, e.g., PTE 75-1, Part II, 40 FR 50845 (Oct. 31, 1975),
as amended at 71 FR 5883 (Feb. 3, 2006).
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e. Independent
The term Independent is used in Section I(c)(2)(ii), which
precludes Financial Institutions and Advisers from relying on the
exemption if they are the named fiduciary or plan administrator, as
defined in ERISA section 3(16)(A), with respect to an ERISA-covered
plan, unless such Financial Institutions or Advisers are selected to
provide advice to the plan by a plan fiduciary that is Independent of
the Financial Institutions or Advisers.
In the proposed exemption, the definition of Independent provided
that the person (e.g., the independent fiduciary appointing the Adviser
or Financial Institution under Section I(c)(2)(ii)) could not receive
any compensation or other consideration for his or her own account from
the Adviser, the Financial Institution or an Affiliate. A commenter
indicated that as a result, a number of parties providing services to
the Financial Institution, and receiving compensation in return, could
not satisfy the Independence requirement. The commenter suggested
defining entities that receive less than 5% of their gross income from
the fiduciary as Independent.
In response, the Department revised the definition of Independent
so that it provides that the person's compensation from the Financial
Institution may not be in excess of 2% of the person's annual revenues
based on the prior year. This approach is consistent with the
Department's general approach to fiduciary independence. For example,
the prohibited transaction exemption procedures provide a presumption
of independence for appraisers and fiduciaries if the revenue they
receive from a party is not more than 2% of their total annual
revenue.\61\ The Department has revised the definition accordingly.\62\
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\61\ 29 CFR 2570.31(j).
\62\ The same commenter also requested clarification that an IRA
owner will not be deemed to fail the Independence requirement simply
because he or she is an employee of the Financial Institution.
However, the Independence is not applicable to IRA owners.
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C. Good Faith
Commenters requested that the exemption continue to apply in the
event of a Financial Institution's or Adviser's good faith failure to
comply with one or more of the conditions. In the commenters' views,
the exemption was sufficiently complex and the implementation timeline
sufficiently short to justify such a provision. For example, FINRA
suggested that the Department include a provision for continued
application of the exemption
[[Page 21125]]
despite a failure to comply with ``any term, condition or requirement
of this exemption . . . if the failure to comply was insignificant and
a good faith and reasonable attempt was made to comply with all
applicable terms, conditions and requirements.'' Several commenters
specifically supported FINRA's suggestion.
The Department has reviewed the exemption's requirements with these
comments in mind and has included a good faith correction mechanism for
the disclosure requirements in the exemption. These provisions take a
similar approach to the provisions in the Department's regulations
under ERISA sections 404 and 408(b)(2). In addition, as discussed
above, the Department has eliminated a condition requiring compliance
with other federal and state laws, which many commenters had argued
could expose them to loss of the exemption based on small or technical
violations. The Department has also facilitated compliance by
streamlining the contracting process (and eliminating the contract
requirement for ERISA plans), reducing the disclosure burden, and
extending the time for compliance with many of the exemption's
conditions. These and other changes should reduce the need for a self-
correction process for excusing violations.
The Department declines to permanently adopt a broader unilateral
good faith provision for Financial Institutions and their Advisers that
could undermine fiduciaries' incentive to comply with the fundamental
standards imposed by the exemption. The exemption's primary purpose is
to combat harmful conflict of interest. If the exemption is too
forgiving of abusive conduct, however, it runs the risk of permitting
those same conflicts of interest to play a role in the design of
policies and procedures, the use and oversight of adviser-incentives,
the supervision of Adviser conduct, and the substance of investment
recommendations. At the very least, it could encourage Financial
Institutions and Advisers to resolve doubts on such questions in favor
of their own financial interests rather than the interests of the
Retirement Investor. Given the dangers posed by conflicts, the
Department has deliberately structured this exemption to provide a
strong counter-incentive to such conduct.
Additionally, many of the exemption's standards, such as the Best
Interest standard and the pricing condition, already have a built-in
reasonableness or prudence standard governing compliance. It would be
inappropriate, in the Department's view, to create a self-correction
mechanism for conduct that was imprudent or unreasonable. For example,
the Best Interest standard requires that the Adviser and Financial
Institution providing the advice act with the care, skill, prudence,
and diligence under the circumstances then prevailing that a prudent
person acting in a like capacity and familiar with such matters would
use in the conduct of an enterprise of a like character and with like
aims, based on the investment objectives, risk tolerance, financial
circumstances, and needs of the Retirement Investor, without regard to
the financial or other interests of the Adviser, Financial Institution
or any Affiliate, Related Entity, or other party. Similarly, the
policies and procedures requirement under Section II(d) turns to a
significant degree on adherence to standards of prudence and
reasonableness. Thus, under Section II(d)(1), the Financial Institution
is required to adopted and comply with written policies and procedures
reasonably and prudently designed to ensure that its individual
Advisers adhere to the Impartial Conduct Standards set forth in Section
II(c).
Additionally, the provision allowing mandatory arbitration of
individual claims is also responsive to the practicalities of resolving
disputes over small claims. The Department also stresses that
violations of the exemption's conditions with respect to a particular
Retirement Investor or transaction, eliminates the availability of the
exemption for that investor or transaction. Such violations do not
render the exemption unavailable with respect to other Retirement
Investors or other transactions.
D. Jurisdiction
The Department received a number of comments questioning the
Department's jurisdiction and legal authority to proceed with the
proposal. A number of commenters focused on the Department's authority
to impose certain conditions as part of this exemption, specifically
including the contract requirement and the Impartial Conduct Standards.
Some commenters asserted that by requiring a contract for all
Retirement Investors, and thereby facilitating contract claims by such
parties, the proposal would expand upon the remedies established by
Congress under ERISA and the Code. Commenters stated that ERISA
preempts state law actions, including breach-of-contract actions. With
respect to IRAs and non-ERISA plans, commenters stated that Congress
provided that the enforcement of the prohibited transaction rules
should be carried out by the Internal Revenue Service, not private
plaintiffs. These commenters argued that the Department's proposal
would impermissibly create a private right of action in violation of
Congressional intent.
Commenters' arguments regarding the Impartial Conduct Standards
were based generally on the fact that the standards, as noted above,
are consistent with longstanding principles of prudence and loyalty set
forth in ERISA section 404, but which have no counterpart in the Code.
Commenters took the position that because Congress did not choose to
impose the standards of prudence and loyalty on fiduciaries with
respect to IRAs and non-ERISA plans, the Department exceeded its
authority in proposing similar standards as a condition of relief in a
prohibited transaction exemption.
With respect to ERISA plans, commenters stated that Congress'
separation of the duties of prudence and loyalty (in ERISA section 404)
from the prohibited transaction provisions (in ERISA section 406),
showed an intent that the two should remain separate. Commenters
additionally questioned why the conduct standards were necessary for
ERISA plans, when such plans already have an enforceable right to
fiduciary conduct that is both prudent and loyal. Commenters asserted
that imposing the Impartial Conduct Standards as conditions of the
exemption improperly created strict liability for prudence violations.
Some commenters additionally took the position that Congress, in
the Dodd-Frank Act, gave the SEC the authority to establish standards
for broker-dealers and investment advisers and therefore, the
Department did not have the authority to act in that area.
The Department disagrees that the exemption exceeds its authority.
The Department has clear authority under ERISA section 408(a) and the
Reorganization Plan \63\ to grant administrative exemptions from the
prohibited transaction provisions of both ERISA and the Code. Congress
gave the Department broad discretion to grant or deny exemptions and to
craft conditions for those exemptions, subject only to the overarching
requirement that the exemption be administratively feasible, in the
interests of plans, plan participants and beneficiaries and IRA owners,
and protective of their rights.\64\ Nothing in ERISA or the Code
suggests
[[Page 21126]]
that, in exercising its express discretion to fashion appropriate
conditions, the Department cannot condition exemptions on contractual
terms or commitments, or that, in crafting exemptions applicable to
fiduciaries, the Department is forbidden to borrow from time-honored
trust-law standards and principles developed by the courts to ensure
proper fiduciary conduct.
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\63\ See fn. 1, supra, discussing of Reorganization Plan No. 4
of 1978 (5 U.S.C. app. at 214 (2000)).
\64\ See ERISA section 408(a) and Code section 4975(c)(2).
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In addition, this exemption does not create a cause of action for
plan fiduciaries, participants or IRA owners to directly enforce the
prohibited transaction provisions of ERISA and the Code in a federal or
state-law contract action. Instead, with respect to ERISA plans and
participants and beneficiaries, the exemption facilitates the existing
statutory enforcement framework by requiring Financial Institutions to
acknowledge in writing their fiduciary status and the fiduciary status
of their Advisers. With respect to IRAs and non-ERISA plans, the
exemption requires Advisers and Financial Institutions to make certain
enforceable commitments to the advice recipient. Violation of the
commitments can result in contractual liability to the Adviser and
Financial Institution separate and apart from the legal consequences of
a non-exempt prohibited transaction (e.g., an excise tax).
There is nothing new about a prohibited transaction exemption
requiring certain written documentation between the parties. The
Department's widely-used exemption for Qualified Professional Asset
Managers (QPAM), requires that an entity acting as a QPAM acknowledge
in a written management agreement that it is a fiduciary with respect
to each plan that has retained it.\65\ Likewise, PTE 2006-16, an
exemption applicable to compensation received by fiduciaries in
securities lending transactions, requires the compensation to be paid
in accordance with the terms of a written instrument.\66\ Surely, the
terms of these documents can be enforced by the parties. In this
regard, the statutory authority permits, and in fact requires, that the
Department incorporate conditions in administrative exemptions designed
to protect the interests of plans, participants and beneficiaries, and
IRA owners. The Department has determined that the contract requirement
in the final exemption serves a critical protective function.
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\65\ See Section VI(a) of PTE 84-14, 49 FR 9494, March 13, 1984,
as amended at 70 FR 49305 (August 23, 2005) and as amended at 75 FR
38837 (July 6, 2010).
\66\ See Section IV(c) of PTE 2006-16, 71 FR 63786 (Oct. 31,
2006).
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Likewise, the Impartial Conduct Standards represent, in the
Department's view, baseline standards of fundamental fair dealing that
must be present when fiduciaries make conflicted investment
recommendations to Retirement Investors. After careful consideration,
the Department determined that broad relief could be provided to
investment advice fiduciaries receiving conflicted compensation only if
such fiduciaries provided advice in accordance with the Impartial
Conduct Standards--i.e., if they provided prudent advice without regard
to the interests of such fiduciaries and their Affiliates and Related
Entities, in exchange for reasonable compensation and without
misleading investors. These Impartial Conduct Standards are necessary
to ensure that Advisers' recommendations reflect the Best interest of
their Retirement Investor customers, rather than the conflicting
financial interests of the Advisers and their Financial Institutions.
As a result, Advisers and Financial Institutions bear the burden of
showing compliance with the exemption and face liability for engaging
in a non-exempt prohibited transaction if they fail to provide advice
that is prudent or otherwise in violation of the standards. The
Department does not view this as a flaw in the exemption, as commenters
suggested, but rather as a significant deterrent to violations of
important conditions under an exemption that accommodates a wide
variety of potentially dangerous compensation practices.
The Department similarly disagrees that Congress' directive to the
SEC in the Dodd-Frank Act limits its authority to establish appropriate
and protective conditions in the context of a prohibited transaction
exemption. Section 913 of the Dodd-Frank Act directs the SEC to conduct
a study on the standards of care applicable to brokers-dealers and
investment advisers, and issue a report containing, among other things:
an analysis of whether [sic] any identified legal or regulatory
gaps, shortcomings, or overlap in legal or regulatory standards in
the protection of retail customers relating to the standards of care
for brokers, dealers, investment advisers, persons associated with
brokers or dealers, and persons associated with investment advisers
for providing personalized investment advice about securities to
retail customers.\67\
\67\ Dodd-Frank Act, sec. 913(d)(2)(B).
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Section 913 of the Dodd-Frank Act authorizes, but does not require,
the SEC to issue rules addressing standards of care for broker-dealers
and investment advisers for providing personalized investment advice
about securities to retail customers.\68\ Nothing in the Dodd-Frank Act
indicates that Congress meant to preclude the Department's regulation
of fiduciary investment advice under ERISA or its application of such a
regulation to securities brokers or dealers. To the contrary, the Dodd-
Frank Act in directing the SEC study specifically directed the SEC to
consider the effectiveness of existing legal and regulatory standard of
care under other federal and state authorities.\69\ The Dodd-Frank Act
did not take away the Department's responsibility with respect to the
definition of fiduciary under ERISA and in the Code; nor did it qualify
the Department's authority to issue exemptions that are
administratively feasible, in the interests of plans, participants and
beneficiaries, and IRA owners, and protective of the rights of
participants and beneficiaries of the plans and IRA owners. If the
Department were unable to rely on contract conditions and trust-law
principles, it would be unable to grant broad relief under this
exemption from the rigid application of the prohibited transaction
rules. This enforceable standards-based approach enabled the Department
to grant relief to a much broader range of practices and compensation
structures than would otherwise have been possible.
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\68\ 15 U.S.C. 80b-11(g)(1).
\69\ Dodd-Frank Act, sec. 913(b)(1) and (c)(1).
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Additionally, the Department notes that nothing in ERISA or the
Code requires any Adviser or Financial Institution to use this
exemption. Exemptions, including this class exemption, simply provide a
means to engage in a transaction otherwise prohibited by the statutes.
The conditions to an exemption are not equivalent to a regulatory
mandate that conflicts with or changes the statutory remedial scheme.
If Advisers or Financial Institutions do not want to be subject to
contract claims, they can (1) change their trading practices and avoid
committing a prohibited transaction, (2) use the statutory exemptions
in ERISA section 408(b)(14) and section 408(g), or Code section
4975(d)(17) and (f)(8), or (3) apply to the Department for individual
exemptions tailored to their particular situations.
E. Defer to the Securities and Exchange Commission
Many commenters suggested that a uniform standard applicable to all
retail accounts would be preferable to the Department's proposal, and
that the Department should work with other
[[Page 21127]]
regulators, such as the SEC and FINRA, to fashion such an approach.
Others suggested that the Department should wait and defer to the SEC's
determination of an appropriate standard for broker-dealers under the
Dodd-Frank Act. Still others suggested that the Department should
provide exemptions based on fiduciary status under securities laws, or
based on compliance with other applicable laws or regulations. FINRA
indicated that the proposal should be based on existing principles in
federal securities laws and FINRA rules but acknowledged that
additional rulemaking would be required.
The Department disagrees with the commenters, and believes it is
important to move forward with this proposal to remedy the ongoing
injury to Retirement Investors as a result of conflicted advice
arrangements. ERISA and the Code create special protections applicable
to investors in tax qualified plans. The fiduciary duties established
under ERISA and the Code are different from those applicable under
securities laws, and would continue to differ even if both regimes were
interpreted to attach fiduciary status to exactly the same parties and
activities. Reflecting the special importance of plan and IRA
investments to retirement and health security, this statutory regime
flatly prohibits fiduciaries from engaging in transactions involving
self-dealing and conflicts of interest unless an exemption applies.
Under ERISA and the Code, the Department of Labor has the authority to
craft exemptions from these stringent statutory prohibitions, and the
Department is specifically charged with ensuring that any exemptions it
grants are in the interests of Retirement Investors and protective of
these interests. Moreover, the fiduciary provisions of ERISA and the
Code broadly protect all investments by Retirement Investors, not just
those regulated by the SEC. As a consequence, the Department uniquely
has the ability to assure that these fiduciary rules work in harmony
for all Retirement Investors, regardless of whether they are investing
in securities, insurance products that are not securities, or other
types of investments.
The Department has taken very seriously its obligation to harmonize
the Department's regulation with other applicable laws, including the
securities laws. In pursuing its consultations with other regulators,
the Department aimed to coordinate and minimize conflicting or
duplicative provisions between ERISA, the Code and federal securities
laws. The Department has coordinated--and will continue to coordinate--
its efforts with other federal agencies to ensure that the various
legal regimes are harmonized to the fullest extent possible. The
resulting exemption provides Advisers and Financial Institutions with a
choice to provide advice on an unconflicted basis or comply with this
exemption or another exemption, which now all require advice to be
provided in accordance with basic fiduciary norms. Far from confusing
investors, the standards set forth in the exemption ensure that
Retirement Investors can uniformly expect to receive advice that is in
their best interest with respect to their retirement investments.
Moreover, the best interest standard reflects what many investors have
believed they were entitled to all along, even though it was not
legally required.
In this regard, waiting for the SEC to act, as some commenters
suggested, would delay the implementation of these important, updated
safeguards to plan and IRA investors, and impose substantial costs on
them as current harms from conflicted advice would continue.
F. Applicability Date and Transition Rules
The Regulation will become effective June 7, 2016 and this
exemption is issued on this same date. The Regulation is effective at
the earliest possible date under the Congressional Review Act. For the
exemption, the issuance date serves as the date on which the exemption
is intended to take effect for purposes of the Congressional Review
Act. This date was selected to provide certainty to plans, plan
fiduciaries, plan participants and beneficiaries, IRAs, and IRA owners
that the new protections afforded by the final rule are now officially
part of the law and regulations governing their investment advice
providers, and to inform financial services providers and other
affected service providers that the rule and exemption are final and
not subject to further amendment or modification without additional
public notice and comment. The Department expects that this effective
date will remove uncertainty as an obstacle to regulated firms
allocating capital and other resources toward transition and longer
term compliance adjustments to systems and business practices.
The Department has also determined that, in light of the importance
of the Regulation's consumer protections and the significance of the
continuing monetary harm to retirement investors without the rule's
changes, an Applicability Date of April 10, 2017, is appropriate for
plans and their affected service providers to adjust to the basic
change from non-fiduciary to fiduciary status. This exemption has the
same Applicability Date; parties may rely on it as of the Applicability
Date.
Section VII provides a transition period under which relief from
the prohibited transaction provisions of ERISA and the Code is
available for Financial Institutions and Advisers during the period
between the Applicability Date and January 1, 2018 (the ``Transition
Period''). For the Transition Period, full relief under the exemption
will be available for Financial Institutions and Advisers subject to
more limited conditions than the full set of conditions described
above. This period is intended to provide Financial Institutions and
Advisers time to prepare for compliance with the conditions of Section
II-IV set forth above, while safeguarding the interests of Retirement
Investors. The Transition Period conditions set forth in Section VII
are subject to the same exclusions in Section I(c), for advice from
fiduciaries with discretionary authority over the customer's
investments and specified advice concerning in-house plans.
The transitional conditions of Section VII require the Financial
Institution and its Advisers to comply with the Impartial Conduct
Standards when making recommendations regarding principal transactions
and riskless principal transactions to Retirement Investors. The
Impartial Conduct Standards required in Section VII are the same as
required in Section II(c) but are repeated for ease of use.
During the Transition Period, the Financial Institution must
additionally provide a written notice to the Retirement Investor prior
to or at the same time as the execution of the principal transaction or
riskless principal transaction, which may cover multiple transactions
or all transactions taking place within the Transition Period,
affirmatively stating its and its Adviser(s) fiduciary status under
ERISA or the Code or both with respect to the recommendation. The
Financial Institution must also state in writing that it and its
Advisers will comply with the Impartial Conduct Standards. Further, the
Financial Institution's notice must disclose the circumstances under
which the Adviser and Financial Institution may engage in principal
transactions and riskless principal transactions with the Plan,
participant or beneficiary account or IRA, and its Material Conflicts
of Interest. The disclosure may be provided in person, electronically
or by mail, and it may be provided in the same document as the
[[Page 21128]]
notice required in the transition period for exemption in Section IX of
the Best Interest Contract Exemption.
Similar to the disclosure provisions of Section II(e), the
transitional exemption in Section VII provides for exemptive relief to
continue despite errors and omissions in the disclosures, if the
Financial Institution acts in good faith and with reasonable diligence.
In addition, the Financial Institution must designate a person or
persons, identified by name, title or function, responsible for
addressing Material Conflicts of Interest and monitoring Advisers'
adherence to the Impartial Conduct Standards.
Finally, the Financial Institution must comply with the
recordkeeping provision of Section V(a) and (b) of the exemption
regarding the transactions entered into during the Transition Period.
After the Transition Period, however, the exemption provided in
Section VII will no longer be available. After that date, Financial
Institutions and Advisers must satisfy all of the applicable conditions
described in Sections II-V for the relief in Section I(b) to be
available for any prohibited transactions occurring after that date.
This includes the requirement to enter into a contract with a
Retirement Investor, where required. Financial Institutions relying on
the negative consent procedure set forth in Section II(a)(1)(ii) must
provide the contractual provisions to Retirement Investors with
Existing Contracts prior to January 1, 2018, and allow those Retirement
Investors 30 days to terminate the contract. If the Retirement Investor
does terminate the contract within that 30-day period, this exemption
will provide relief for 14 days after the date on which the termination
is received by the Financial Institution.
The proposed exemption, with the proposed Best Interest Contract
Exemption, the proposed Regulation and other exemption proposals,
generally set forth an Applicability Date of eight months, although the
proposals sought comment on a phase in of conditions. As with other
sections of this preamble, the Department is addressing comments
regarding the Applicability Date as a cohesive whole. Some commenters,
concerned about the ongoing harm to Retirement Investors, urged the
Department to implement the Regulation and related exemptions quickly.
However, the majority of industry commenters requested a two- to three-
year transition period. These commenters requested time to enter into
contracts with Retirement Investors (including developing and
implementing the policies and procedures and incentive practices that
meet the terms of Section II(d)). Some commenters requested the
Department allow good faith compliance during the transition period.
Others requested the Department phase in the requirements over time.
One commenter requested the Best Interest standard become effective
immediately, with the other conditions becoming effective within one
year. Another comment expressed concern about phasing in the conditions
over time, referring to this as a ``piecemeal'' approach, which would
not be helpful to implementing a system to protect Retirement
Investors. Other commenters wrote that the Department should re-propose
the exemption or adopt it as an interim final exemption and seek
additional comments.
The transition provisions in Section VII of the final exemption
respond to commenters' concerns about ongoing economic harm to
Retirement Investors during the period in which Financial Institutions
develop systems to comply with the exemption. The provisions require
prompt implementation of certain core protections of the exemption in
the form of the acknowledgment of fiduciary status, compliance with the
Impartial Conduct Standards, and certain important disclosures, to
safeguard Retirement Investors' interests. The provisions recognize,
however, that the Financial Institutions will need time to develop
policies and procedures and supervisory structures that fully comport
with the requirements of the final exemption. Accordingly, during the
Transition Period, Financial Institutions are not required to execute
the contract or give Retirement Investors warranties or disclosures on
their anti-conflict policies and procedures. While the Department
expects that Advisers and Financial Institutions will, in fact, adopt
prudent supervisory mechanisms to prevent violations of the Impartial
Conduct Standards (and potential liability for such violations), the
exemption will not require the Financial Institutions to make specific
representations on the nature or quality of the policies and procedures
during this Transition Period. The Department will be available to
respond to Financial Institutions' request for guidance during this
period, as they develop the systems necessary to comply with the
exemption's conditions.
The transition provisions also accommodate Financial Institutions'
need for time to prepare for full compliance with the exemption, and
therefore full compliance with all the final exemption's applicable
conditions is delayed until January 1, 2018. The Department selected
that period, rather than two to three years, as requested by some
commenters, in light of the significant adjustments in the final
exemption that significantly eased compliance burdens. Although the
Department believes that the conditions of the exemption set forth in
Section II-V are required to support the Department's findings required
under ERISA section 408(a), and Code section 4975(c)(2) over the long
term, the Department recognizes that Financial Institutions may need
time to achieve full compliance with these conditions. The Department
therefore finds that the provisions set forth in Section VII satisfy
the criteria of ERISA section 408(a) and Code section 4975(c)(2) for
the transition period because they provide the significant protections
to Retirement Investors while providing Financial Institutions with
time necessary to achieve full compliance. A similar transition period
is provided for the companion Best Interest Contract Exemption due to
the corresponding provisions in that exemption that may require time
for Financial Institutions to begin compliance.
The Department considered, but did not elect, delaying the
application of the rule defining fiduciary investment advice until such
time as Financial Institutions could make the changes to their
practices and compensation structures necessary to comply with Sections
II through V of this exemption. The Department believed that delaying
the application of the new fiduciary rule would inordinately delay the
basic protections of loyalty and prudence that the rule provides.
Moreover, a long period of delay could incentivize Financial
Institutions to increase efforts to provide conflicted advice to
Retirement Investors before it becomes subject to the new rule. The
Department understands that many of the concerns regarding the
applicability date of the rule are related to the prohibited
transaction provisions of ERISA and the Code rather than the basic
fiduciary standards. This transition period exemption addresses these
concerns by giving Financial Institutions and Advisers necessary time
to fully comply with Sections II-V of the exemption.
The Department also considered the views of commenters that
requested re-proposal of the Regulation and exemptions, or issuing the
rule and exemptions as interim final rules with requests for additional
comment. After reviewing all the comments on the 2015 proposal, which
was itself a re-proposal, the Department has concluded that it is in a
position to publish a final rule and
[[Page 21129]]
exemptions. It has carefully considered and responded to the
significant issues raised in the comments in drafting the final rule
and exemptions. Moreover, the Department has concluded that the
difference between the final documents and the proposals are also
responsive to the commenters' concerns and could be reasonably foreseen
by affected parties.
No Relief From ERISA Section 406(a)(1)(C) or Code Section 4975(c)(1)(C)
for the Provision of Services
This exemption will not provide relief from a transaction
prohibited by ERISA section 406(a)(1)(C), or from the taxes imposed by
Code section 4975(a) and (b) by reason of Code section 4975(c)(1)(C),
regarding the furnishing of goods, services or facilities between a
plan and a party in interest. The provision of investment advice to a
plan under a contract with a fiduciary is a service to the plan and
compliance with this exemption will not relieve an Adviser or Financial
Institution of the need to comply with ERISA section 408(b)(2), Code
section 4975(d)(2), and applicable regulations thereunder.
Paperwork Reduction Act Statement
In accordance with the requirements of the Paperwork Reduction Act
of 1995 (PRA) (44 U.S.C. 3506(c)(2)), the Department solicited comments
on the information collections included in the proposed Exemption for
Principal Transactions in Certain Debt Securities Between Investment
Advice Fiduciaries and Employee Benefit Plans and IRAs. 80 FR 21989
(Apr. 20, 2015). The Department also submitted an information
collection request (ICR) to OMB in accordance with 44 U.S.C. 3507(d),
contemporaneously with the publication of the proposal, for OMB's
review. The Department received two comments from one commenter that
specifically addressed the paperwork burden analysis of the information
collections. Additionally many comments were submitted, described
elsewhere in this preamble and in the preamble to the accompanying
final rule, which contained information relevant to the costs and
administrative burdens attendant to the proposals. The Department took
into account such public comments in connection with making changes to
the prohibited transaction exemption, analyzing the economic impact of
the proposals, and developing the revised paperwork burden analysis
summarized below.
In connection with publication of this prohibited transaction
exemption, the Department is submitting an ICR to OMB requesting
approval of a new collection of information under OMB Control Number
1210-0157. The Department will notify the public when OMB approves the
ICR.
A copy of the ICR may be obtained by contacting the PRA addressee
shown below or at http://www.RegInfo.gov. PRA ADDRESSEE: G. Christopher
Cosby, Office of Policy and Research, U.S. Department of Labor,
Employee Benefits Security Administration, 200 Constitution Avenue NW.,
Room N-5718, Washington, DC 20210. Telephone: (202) 693-8410; Fax:
(202) 219-4745. These are not toll-free numbers.
As discussed in detail below, the class exemption will permit
principal transactions and riskless principal transactions in certain
principal traded assets between a plan, participant or beneficiary
account, or an IRA, and an Adviser or Financial Institution, and the
receipt of a mark-up or mark-down or other payment by the Adviser or
Financial Institution for themselves or Affiliates as a result of
investment advice. The class exemption will require Financial
Institutions to enter into a contractual arrangement with Retirement
Investors regarding principal transactions and riskless principal
transactions with IRAs and plans not subject to Title I of ERISA (non-
ERISA plans), adopt written policies and procedures, make disclosures
to Retirement Investors (including with respect to ERISA plans), and on
a publicly available Web site, and maintain records necessary to prove
that the conditions of the exemption have been met for a period of six
(6) years from the date of each principal transaction or riskless
principal transaction. In addition, the exemption provides a transition
period from the Applicability Date, to January 1, 2018. As a condition
of relief during the transition period, Financial Institutions must
make a disclosure (transition disclosure) to all Retirement Investors
(in ERISA plans, IRAs, and non-ERISA plans) prior to or at the same
time as the execution of recommended transactions. These requirements
are ICRs subject to the PRA.
The Department has made the following assumptions in order to
establish a reasonable estimate of the paperwork burden associated with
these ICRs:
51.8 percent of disclosures to Retirement Investors with
respect to ERISA plans \70\ and 44.1 percent of contracts with and
disclosures to Retirement Investors with respect to IRAs and non-ERISA
plans \71\ will be distributed electronically via means already used by
respondents in the normal course of business and the costs arising from
electronic distribution will be negligible, while the remaining
contracts and disclosures will be distributed on paper and mailed at a
cost of $0.05 per page for materials and $0.49 for first class postage;
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\70\ According to data from the National Telecommunications and
Information Agency (NTIA), 33.4 percent of individuals age 25 and
over have access to the internet at work. According to a Greenwald &
Associates survey, 84 percent of plan participants find it
acceptable to make electronic delivery the default option, which is
used as the proxy for the number of participants who will not opt
out that are automatically enrolled (for a total of 28.1 percent
receiving electronic disclosure at work). Additionally, the NTIA
reports that 38.9 percent of individuals age 25 and over have access
to the internet outside of work. According to a Pew Research Center
survey, 61 percent of internet users use online banking, which is
used as the proxy for the number of internet users who will opt in
for electronic disclosure (for a total of 23.7 percent receiving
electronic disclosure outside of work). Combining the 28.1 percent
who receive electronic disclosure at work with the 23.7 percent who
receive electronic disclosure outside of work produces a total of
51.8 percent who will receive electronic disclosure overall.
\71\ According to data from the NTIA, 72.4 percent of
individuals age 25 and older have access to the internet. According
to a Pew Research Center survey, 61 percent of internet users use
online banking, which is used as the proxy for the number of
internet users who will opt in for electronic disclosure. Combining
these data produces an estimate of 44.1 percent of individuals who
will receive electronic disclosures.
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Financial Institutions will use existing in-house
resources to distribute required contracts and disclosures;
Tasks associated with the ICRs performed by in-house
personnel will be performed by clerical personnel at an hourly wage
rate of $55.21;\72\
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\72\ For a description of the Department's methodology for
calculating wage rates, see http://www.dol.gov/ebsa/pdf/labor-cost-inputs-used-in-ebsa-opr-ria-and-pra-burden-calculations-march-2016.pdf. The Department's methodology for calculating the overhead
cost input of its wage rates was adjusted from the proposed PTE to
the final PTE. In the proposed PTE, the Department based its
overhead cost estimates on longstanding internal EBSA calculations
for the cost of overhead. In response to a public comment stating
that the overhead cost estimates were too low and without any
supporting evidence, the Department incorporated published U.S.
Census Bureau survey data on overhead costs into its wage rate
estimates.
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Financial Institutions will hire outside service providers
to assist with nearly all other compliance costs;
Outsourced legal assistance will be billed at an hourly
rate of $335.00;\73\
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\73\ This rate is the average of the hourly rate of an attorney
with 4-7 years of experience and an attorney with 8-10 years of
experience, taken from the Laffey Matrix. See http://www.justice.gov/sites/default/files/usao-dc/legacy/2014/07/14/Laffey%20Matrix_2014-2015.pdf
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Approximately 6,000 Financial Institutions \74\ will
utilize the exemption
[[Page 21130]]
to engage in principal transactions and riskless principal
transactions.
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\74\ One commenter questioned the basis for the Department's
assumption regarding the number of Financial Institutions likely to
use the exemption. According to the ``2015 Investment Management
Compliance Testing Survey,'' Investment Adviser Association, cited
in the regulatory impact analysis for the accompanying rule, 63
percent of Registered Investment Advisers service ERISA-covered
plans and IRAs. The Department conservatively interprets this to
mean that all of the 113 large Registered Investment Advisers
(RIAs), 63 percent of the 3,021 medium RIAs (1,903), and 63 percent
of the 24,475 small RIAs (15,419) work with ERISA-covered plans and
IRAs. The Department assumes that all of the 42 large broker-
dealers, and similar shares of the 233 medium broker-dealers (147)
and the 3,682 small broker-dealers (2,320) work with ERISA-covered
plans and IRAs. According to SEC and FINRA data, cited in the
regulatory impact analysis, 18 percent of broker-dealers are also
registered as RIAs. Removing these firms from the RIA counts
produces counts of 105 large RIAs, 1,877 medium RIAs, and 15,001
small RIAs that work with ERISA-covered plans and IRAs and are not
also registered as broker-dealers. Further, according to Hung et al.
(2008) (see Regulatory Impact Analysis for complete citation),
approximately 13 percent of RIAs report receiving commissions.
Additionally, 20 percent of RIAs report receiving performance based
fees; however, at least 60 percent of these RIAs are likely to be
hedge funds. Thus, as much as 8 percent of RIAs providing investment
advice receive performance based fees. Combining the 8 percent of
RIAs receiving performance based fees with the 13 percent of RIAs
receiving commissions creates a conservative estimate of 21 percent
of RIAs that might need exemptive relief. Although the Department
believes that very few RIAs that are not also broker-dealers engage
in principal transactions and riskless principal transactions, its
data to support this belief is limited, so the Department is
conservatively assuming that the same RIAs that receive performance-
based fees and commissions are the types of RIAs that might engage
in principal transactions and riskless principal transactions. In
total, the Department estimates that 2,509 broker-dealers and 3,566
RIAs receiving performance-based fees and commissions will use this
exemption. As described in detail in the regulatory impact analysis,
the Department believes a de minimis number of banks may also use
the exemption.
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Compliance Costs for Financial Institutions
The Department believes that nearly all Financial Institutions will
contract with outside service providers to implement the various
compliance requirements of this exemption. As described in the
regulatory impact analysis, per-Financial Institution costs for broker-
dealers (BDs) were calculated by allocating the total cost reductions
in the medium assumptions scenario across the Financial Institution
size categories, and then subtracting the cost reductions from the per-
Financial Institution average costs derived from the Oxford Economics
study. The methodology for calculating the per-Financial Institution
costs for registered investment advisers (RIAs) is described in detail
in the regulatory impact analysis. The Department is attributing 50
percent of the compliance costs for BDs and RIAs to this Exemption and
50 percent of the compliance costs for BDs and RIAs to the Best
Interest Contract Exemption, published elsewhere in today's Federal
Register. With the above assumptions, the per-Financial Institution
costs are as follows:
Start-Up Costs for Large BDs: $3.7 million
Start-Up Costs for Large RIAs: $3.2 million
Start-Up Costs for Medium BDs: $889,000
Start-Up Costs for Medium RIAs: $662,000
Start-Up Costs for Small BDs: $278,000
Start-Up Costs for Small RIAs: $219,000
Ongoing Costs for Large BDs: $918,000
Ongoing Costs for Large RIAs: $803,000
Ongoing Costs for Medium BDs: $192,000
Ongoing Costs for Medium RIAs: $143,000
Ongoing Costs for Small BDs: $60,000
Ongoing Costs for Small RIAs: $47,000
In order to engage in transactions and receive compensation covered
under this exemption, Section II requires Financial Institutions to
acknowledge, in writing, their fiduciary status and adopt written
policies and procedures designed to ensure compliance with the
Impartial Conduct Standards. Financial Institutions must make certain
disclosures to Retirement Investors. Financial institutions must
generally enter into a written contract with Retirement Investors with
respect to principal transactions and riskless principal transactions
with IRAs and non-ERISA plans with certain required provisions,
including affirmative agreement to adhere to the Impartial Conduct
Standards and, if they are FINRA members, to comply with FINRA rules
2121 and 5310.
Section IV requires Financial Institutions and Advisers to make
certain disclosures to the Retirement Investor. These disclosures
include: (1) A pre-transaction disclosure; (2) a disclosure, on demand,
of information regarding the principal traded asset, including its
salient attributes; (3) an annual disclosure; (4) transaction
confirmations; and (5) a web-based disclosure.
Section VII requires Financial Institutions to make a transition
disclosure, acknowledging their fiduciary status and that of their
Advisers with respect to the Advice, stating the Best Interest standard
of care, and describing the circumstances under which principal
transactions and riskless principal transactions may occur and the
associated Material Conflicts of Interest, prior to engaging in any
transactions during the transition period from the Applicability Date
to January 1, 2018. The transition disclosure can cover multiple
transactions, or all transactions occurring in the transition period.
The Department is able to disaggregate an estimate of many of the
legal costs from the costs above; however, it is unable to disaggregate
any of the other costs. The Department received a comment on the
proposed PTE stating that the estimates for legal professional time to
draft disclosures were not supported by any empirical evidence. The
Department also received multiple comments on the proposed PTE stating
that its estimate of 60 hours of legal professional time during the
first year a financial institution used the exemption and then no legal
professional time in subsequent years was too low.
In response to a recommendation made during the Department's August
2015, public hearing on the proposed rule and exemptions, and in an
attempt to create estimates with a clearer empirical evidentiary basis,
the Department drafted certain portions of the required disclosures,
including a sample contract, the one-time disclosure to the Department,
and the transition disclosure. The Department believes that the time
spent updating existing contracts and disclosures in future years would
be no longer than the time necessary to create the original contracts
and disclosures. The Department did not attempt to draft the complete
set of required disclosures because it expects that the amount of time
necessary to draft such disclosures will vary greatly among firms. For
example, the Department did not attempt to draft sample policies and
procedures, pre-transaction disclosures, disclosures regarding the
principal traded assets, or confirmation slips. The Department expects
the amount of time necessary to complete these disclosures will vary
significantly based on a variety of factors including the nature of a
firm's compensation structure, and the extent to which a firm's
policies and procedures require review and signatures by different
individuals. The Department further believes that pre-transaction
disclosures will be provided orally at de minimis cost, facts and
circumstances will vary too widely to accurately depict the disclosures
regarding the principal traded assets, and providing confirmation slips
is a regular and customary business practice
[[Page 21131]]
producing de minimis additional burden.
Considered in conjunction with the estimates provided in the
proposal, the Department estimates that outsourced legal assistance to
draft standard contracts, contract disclosures, annual disclosures, and
transition disclosures will cost an average of $3,676 per Financial
Institution for a total of $22.3 million during the first year. In
subsequent years, it will cost an average of $2,978 per Financial
Institution for a total of $18.1 million annually to update the
contracts, contract disclosures, and annual disclosures.
The legal costs of these disclosures were disaggregated from the
total compliance costs because these disclosures are expected to be
relatively uniform. Although the tested disclosures generally took less
time than many of the commenters said they would, the Department
acknowledges that the disclosures that were not tested are those that
are expected to be the most time consuming. Importantly, as explained
in greater detail in section 5.3 of the regulatory impact analysis, the
Department is primarily relying on cost data provided by the Securities
Industry and Financial Markets Association (SIFMA) and the Financial
Services Institute (FSI) to calculate the total cost of the legal
disclosures, rather than its own internal drafting of disclosures.
Accordingly, in the event that any of the Department's estimates
understate the time necessary to create and update the disclosures, it
does not impact the total burden estimates. The total burden estimates
were derived from SIFMA and FSI's all-inclusive costs. Therefore, in
the event that legal costs are understated, other cost estimates in
this analysis would be overstated in an equal manner.
In addition to legal costs for creating the contracts and
disclosures, the start-up cost estimates include the costs of
implementing and updating the IT infrastructure, creating the web
disclosures, gathering and maintaining the records necessary to produce
the various disclosures, developing policies and procedures, addressing
material conflicts of interest, monitoring Advisers' adherence to the
Impartial Conduct Standards, and any other steps necessary to ensure
compliance with the conditions of the Exemption not described
elsewhere. In addition to legal costs for updating the contracts and
disclosures, the ongoing cost estimates include the costs of updating
the IT infrastructure, updating the web disclosures, reviewing
processes for gathering and maintaining the records necessary to
produce the various disclosures, reviewing the policies and procedures,
producing the detailed disclosures regarding principal traded assets on
request, monitoring investments as agreed upon with the Retirement
Investor, addressing material conflicts of interest, monitoring
Advisers' adherence to the Impartial Conduct Standards, and any other
steps necessary to ensure compliance with the conditions of the
exemption not described elsewhere. These costs total $1.9 billion
during the first year and $412.2 million in subsequent years. These
costs do not include the costs of producing of distributing disclosures
and contracts, which are discussed below.
Distribution of Disclosures and Contracts
The Department estimates that 14,000 Retirement Investors with
respect to ERISA plans and 2.4 million Retirement Investors with
respect to IRAs and non-ERISA plans will receive a three-page
transition disclosure during the first year. Additionally, 14,000
Retirement Investors with respect to ERISA plans will receive a
fifteen-page contract disclosure, and 2.4 million Retirement Investors
with respect to IRAs and non-ERISA plans will receive a fifteen-page
contract during the first year. In subsequent years, 4,000 Retirement
Investors with respect to ERISA plans will receive a fifteen-page
contract disclosure and 490,000 Retirement Investors with respect to
IRAs and non-ERISA plans will receive a fifteen-page contract. To the
extent that Financial Institutions use both the Best Interest Contract
Exemption and the Principal Transactions Exemption, these estimates may
represent overestimates because significant overlap exists between the
requirements of the transition disclosure and the contract for both
exemptions. If Financial Institutions choose to use both exemptions
with the same clients, they will probably combine the documents.
The transition disclosure will be distributed electronically to
51.8 percent of ERISA plan investors and 44.1 percent of IRAs and non-
ERISA plan investors during the first year. Paper disclosures will be
mailed to the remaining 48.2 percent of ERISA plan investors and 55.9
percent of IRAs and non-ERISA plan investors. The contract disclosure
will be distributed electronically to 51.8 percent of the ERISA plan
investors during the first year or during any subsequent year in which
the plan investor begins a new advisory relationship. Paper contract
disclosures will be mailed to 48.2 percent of ERISA plan investors. The
contract will be distributed electronically to 44.1 percent of IRAs and
non-ERISA plan participants during the first year or during any
subsequent year in which the investor begins a new advisory
relationship. Paper contracts will be mailed to 55.9 percent of IRAs
and non-ERISA plan investors. The Department estimates that electronic
distribution will result in de minimis cost, while paper distribution
will cost approximately $2.5 million during the first year and $342,000
during subsequent years. Paper distribution will also require two
minutes of clerical time to print and mail the disclosure or
contract,\75\ resulting in 85,000 hours at an equivalent cost of $4.7
million during the first year and 9,000 hours at an equivalent cost of
$508,000 during subsequent years.
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\75\ One commenter questioned the basis for this estimate. The
Department worked with clerical staff to determine that most notices
and disclosures can be printed and prepared for mailing in less than
one minute per disclosure. Therefore, an estimate of two minutes per
disclosure is a conservative estimate.
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The Department estimates that 2.5 million Retirement Investors for
ERISA plans, IRAs and non-ERISA plans will receive a two-page annual
disclosure during the second year and all subsequent years. The
disclosure will be distributed electronically to 51.8 percent of ERISA
plan investors and 44.1 percent of IRA holders and non-ERISA plan
investors. Paper statements will be mailed to 48.2 percent of ERISA
plan investors and 55.9 percent of IRA owners and non-ERISA plan
participants. The Department estimates that electronic distribution
will result in de minimis cost, while paper distribution will cost
approximately $812,000.\76\ Paper distribution will also require two
minutes of clerical time to print and mail the statement, resulting in
46,000 hours at an equivalent cost of $2.5 million annually.
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\76\ This cost includes $0.05 per page for materials and $0.49
per mailing for postage.
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The Department estimates that Financial Institutions will receive
ten requests per year for more detailed principal traded asset
information during the second year and all subsequent years. The
detailed disclosures will be distributed electronically for 51.8
percent of the ERISA plan investors and 44.1 percent of the IRA holders
and non-ERISA plan participants. The Department believes that requests
for additional information will be proportionally likely with each
Retirement Investor type. Therefore, approximately 34,000 detailed
disclosures will be distributed on paper. The Department estimates that
electronic distribution will result in de minimis cost, while paper
distribution
[[Page 21132]]
will cost approximately $25,000. Paper distribution will also require
two minutes of clerical time to print and mail the statement, resulting
in 1,000 hours at an equivalent cost of $62,000 annually.
Overall Summary
Overall, the Department estimates that in order to meet the
conditions of this Exemption, Financial Institutions and Advisers will
distribute approximately 4.9 million disclosures and contracts during
the first year and 3.0 million disclosures and contracts during
subsequent years. Distributing these disclosures and contracts will
result in a total of 85,000 hours of burden during the first year and
56,000 hours of burden in subsequent years. The equivalent cost of this
burden is $4.7 million during the first year and $3.1 million in
subsequent years. This exemption will result in an outsourced labor,
materials, and postage cost burden of $2.0 billion during the first
year and $431.5 million during subsequent years.
These paperwork burden estimates are summarized as follows:
Type of Review: New collection.
Agency: Employee Benefits Security Administration, Department of
Labor.
Titles: (1) Prohibited Transaction Exemption for Principal
Transactions in Certain Assets between Investment Advice Fiduciaries
and Employee Benefit Plans and IRAs and (2) Final Investment Advice
Regulation.
OMB Control Number: 1210-0157.
Affected Public: Businesses or other for-profits; not for profit
institutions.
Estimated Number of Respondents: 6,075.
Estimated Number of Annual Responses: 4,927,605 during the first
year and 3,018,574 during subsequent years.
Frequency of Response: When engaging in exempted transaction;
Annually.
Estimated Total Annual Burden Hours: 85,457 hours during the first
year and 56,197 hours in subsequent years.
Estimated Total Annual Burden Cost: $1,956,129,694 during the first
year and $431,468,619 in subsequent years.
Regulatory Flexibility Act
This exemption, which is issued pursuant to ERISA section 408(a)
and Code section 4975(c)(2), is part of a broader rulemaking that
includes other exemptions and a final regulation published in today's
Federal Register. The Regulatory Flexibility Act (5 U.S.C. 601 et seq.)
imposes certain requirements with respect to Federal rules that are
subject to the notice and comment requirements of section 553(b) of the
Administrative Procedure Act (5 U.S.C. 551 et seq.), or any other laws.
Unless the head of an agency certifies that a final rule is not likely
to have a significant economic impact on a substantial number of small
entities, section 604 of the RFA requires that the agency present a
final regulatory flexibility analysis (FRFA) describing the rule's
impact on small entities and explaining how the agency made its
decisions with respect to the application of the rule to small
entities.
The Secretary has determined that this rulemaking, including this
exemption, will have a significant economic impact on a substantial
number of small entities. The Secretary has separately published a
Regulatory Impact Analysis (RIA) which contains the complete economic
analysis for this rulemaking including the Department's FRFA for the
rule and the related prohibited transaction exemptions. This section of
this preamble sets forth a summary of the FRFA. The RIA is available at
www.dol.gov/ebsa.
As noted in section 6.1 of the RIA, the Department has determined
that regulatory action is needed to mitigate conflicts of interest in
connection with investment advice to Retirement Investors. The
Regulation is intended to improve plan and IRA investing to the benefit
of retirement security. In response to the proposed rulemaking,
organizations representing small businesses submitted comments
expressing particular concern with three issues: the carve-out for
investment education, the Best Interest Contract Exemption, and the
carve-out for persons acting in the capacity of counterparties to plan
fiduciaries with financial expertise. Section 2 of the RIA contains an
extensive discussion of these concerns and the Department's response.
As discussed in section 6.2 of the RIA, the Small Business
Administration (SBA) defines a small business in the Financial
Investments and Related Activities Sector as a business with up to
$38.5 million in annual receipts. In response to a comment received
from the SBA's Office of Advocacy on our Initial Regulatory Flexibility
Analysis, the Department contacted the SBA, and received from them a
dataset containing data on the number of Financial Institutions by
NAICS codes, including the number of Financial Institutions in given
revenue categories. This dataset would allow the estimation of the
number of Financial Institutions with a given NAICS code that fall
below the $38.5 million threshold and therefore be considered small
entities by the SBA. However, this dataset alone does not provide a
sufficient basis for the Department to estimate the number of small
entities affected by the rule. Not all Financial Institutions within a
given NAICS code would be affected by this rule, because being an ERISA
fiduciary relies on a functional test and is not based on industry
status as defined by a NAICS code. Further, not all Financial
Institutions within a given NAICS code work with ERISA-covered plans
and IRAs.
Over 90 percent of broker-dealers, registered investment advisers,
insurance companies, agents, and consultants are small businesses
according to the SBA size standards (13 CFR 121.201). Applying the
ratio of entities that meet the SBA size standards to the number of
affected entities, based on the methodology described at greater length
in the RIA, the Department estimates that the number of small entities
affected by this rule is 2,438 BDs, 16,521 RIAs, 496 Insurers, and
3,358 other ERISA service providers.
For purposes of the RFA, the Department continues to consider an
employee benefit plan with fewer than 100 participants to be a small
entity. Further, while some large employers may have small plans, in
general small employers maintain most small plans. The definition of
small entity considered appropriate for this purpose differs, however,
from a definition of small business that is based on size standards
promulgated by the SBA. These small pension plans will benefit from the
rule, because as a result of the rule, they will receive non-conflicted
advice from their fiduciary service providers. The 2013 Form 5500
filings show nearly 595,000 ERISA covered retirement plans with less
than 100 participants.
Section 6.5 of the RIA summarizes the projected reporting,
recordkeeping, and other compliance costs of the rule and exemptions,
which are discussed in detail in section 5 of the RIA. Among other
things, the Department concludes that it is likely that some small
service providers may find that the increased costs associated with
ERISA fiduciary status outweigh the benefits of continuing to service
the ERISA plan market or the IRA market. The Department does not
believe that this outcome will be widespread or that it will result in
a diminution of the amount or quality of advice available to small or
other retirement savers, because some Financial Institutions will fill
the void and provide services the ERISA plan and IRA market. It is also
possible that the economic impact of the
[[Page 21133]]
rule and exemptions on small entities would not be as significant as it
would be for large entities, because anecdotal evidence indicates that
small entities do not have as many business arrangements that give rise
to conflicts of interest. Therefore, they would not be confronted with
the same costs to restructure transactions that would be faced by large
entities.
Section 5.3.1 of the RIA includes a discussion of the changes to
the proposed rule and exemptions that are intended to reduce the costs
affecting both small and large business. These include elimination of
data collection and annual disclosure requirements in the Best Interest
Contract Exemption, and changes to the implementation of the contract
requirement in the exemption. Section 7 of the RIA discusses
significant regulatory alternatives considered by the Department and
the reasons why they were rejected.
Congressional Review Act
This exemption, along with related exemptions and a final rule
published elsewhere in this issue of the Federal Register, is part of a
rulemaking that is subject to the Congressional Review Act provisions
of the Small Business Regulatory Enforcement Fairness Act of 1996 (5
U.S.C. 801, et seq.) and, will be transmitted to Congress and the
Comptroller General for review. This rulemaking, including this
exemption is treated as a ``major rule'' as that term is defined in 5
U.S.C. 804, because it is likely to result in an annual effect on the
economy of $100 million or more.
General Information
The attention of interested persons is directed to the following:
(1) The fact that a transaction is the subject of an exemption
under ERISA section 408(a) and Code section 4975(c)(2) does not relieve
a fiduciary or other party in interest or disqualified person with
respect to a plan or IRA from certain other provisions of ERISA and the
Code, including any prohibited transaction provisions to which the
exemption does not apply and the general fiduciary responsibility
provisions of ERISA section 404 which require, among other things, that
a fiduciary act prudently and discharge his or her duties respecting
the plan solely in the interests of the participants and beneficiaries
of the plan. Additionally, the fact that a transaction is the subject
of an exemption does not affect the requirement of Code section 401(a)
that the plan must operate for the exclusive benefit of the employees
of the employer maintaining the plan and their beneficiaries;
(2) The Department finds that the exemption is administratively
feasible, in the interests of the plan and of its participants and
beneficiaries, and protective of the rights of participants and
beneficiaries of the plan;
(3) The exemption is applicable to a particular transaction only if
the transaction satisfies the conditions specified in the exemption;
and
(4) The exemption is supplemental to, and not in derogation of, any
other provisions of ERISA and the Code, including statutory or
administrative exemptions and transitional rules. Furthermore, the fact
that a transaction is subject to an administrative or statutory
exemption is not dispositive of whether the transaction is in fact a
prohibited transaction.
Exemption
Section I--Exemption
(a) In general. ERISA and the Internal Revenue Code prohibit
fiduciary advisers to employee benefit plans (Plans) and individual
retirement plans (IRAs) from self-dealing, including receiving
compensation that varies based on their investment recommendations.
ERISA and the Code also prohibit fiduciaries from engaging in
securities purchases and sales with Plans or IRAs on behalf of their
own accounts (Principal Transactions). This exemption permits certain
persons who provide investment advice to Retirement Investors (i.e.,
fiduciaries of Plans, Plan participants or beneficiaries, or IRA
owners) to engage in certain Principal Transactions and Riskless
Principal Transactions as described below.
(b) Exemption. This exemption permits an Adviser or Financial
Institution to engage in the purchase or sale of a Principal Traded
Asset in a Principal Transaction or Riskless Principal Transaction with
a Plan, participant or beneficiary account, or IRA, and receive a mark-
up, mark-down or other similar payment as applicable to the transaction
for themselves or any Affiliate, as a result of the Adviser's and
Financial Institution's advice regarding the Principal Transaction or
Riskless Principal Transaction. As detailed below, Financial
Institutions and Advisers seeking to rely on the exemption must
acknowledge fiduciary status, adhere to Impartial Conduct Standards in
rendering advice, disclose Material Conflicts of Interest associated
with Principal Transactions and Riskless Principal Transactions and
obtain the consent of the Plan or IRA. In addition, Financial
Institutions must adopt certain policies and procedures, including
policies and procedures reasonably designed to ensure that individual
Advisers adhere to the Impartial Conduct Standards; and retain certain
records. This exemption provides relief from ERISA section 406(a)(1)(A)
and (D) and section 406(b)(1) and (2), and the taxes imposed by Code
section 4975(a) and (b), by reason of Code section 4975(c)(1)(A), (D),
and (E). The Adviser and Financial Institution must comply with the
conditions of Sections II-V.
(c) Scope of this exemption: This exemption does not apply if:
(1) The Adviser: (i) Has or exercises any discretionary authority
or discretionary control respecting management of the assets of the
Plan, participant or beneficiary account, or IRA involved in the
transaction or exercises any discretionary authority or control
respecting management or the disposition of the assets; or (ii) has any
discretionary authority or discretionary responsibility in the
administration of the Plan, participant or beneficiary account, or IRA;
or
(2) The Plan is covered by Title I of ERISA and (i) the Adviser,
Financial Institution or any Affiliate is the employer of employees
covered by the Plan, or (ii) the Adviser or Financial Institution is a
named fiduciary or plan administrator (as defined in ERISA section
3(16)(A)) with respect to the Plan, or an Affiliate thereof, that was
selected to provide investment advice to the plan by a fiduciary who is
not Independent.
Section II--Contract, Impartial Conduct, and Other Conditions
The conditions set forth in this section include certain Impartial
Conduct Standards, such as a Best Interest standard, that Advisers and
Financial Institutions must satisfy to rely on the exemption. In
addition, this section requires Financial Institutions to adopt anti-
conflict policies and procedures that are reasonably designed to ensure
that Advisers adhere to the Impartial Conduct Standards, and requires
disclosure of important information about the Principal Transaction or
Riskless Principal Transaction. With respect to IRAs and Plans not
covered by Title I of ERISA, the Financial Institutions must agree that
they and their Advisers will adhere to the exemption's standards in a
written contract that is enforceable by the Retirement Investors. To
minimize compliance burdens, the exemption provides that the contract
terms may be incorporated into account opening
[[Page 21134]]
documents and similar commonly-used agreements with new customers, and
the exemption permits reliance on a negative consent process with
respect to existing contract holders. The contract does not need to be
executed before the provision of advice to the Retirement Investor to
engage in a Principal Transaction or Riskless Principal Transaction.
However, the contract must cover any advice given prior to the contract
date in order for the exemption to apply to such advice. There is no
contract requirement for recommendations to Retirement Investors about
investments in Plans covered by Title I of ERISA, but the Impartial
Conduct Standards and other requirements of Section II(b)-(e) must be
satisfied in order for relief to be available under the exemption, as
set forth in Section II(g). Section II(a) imposes the following
conditions on Financial Institutions and Advisers:
(a) Contracts with Respect to Principal Transactions and Riskless
Principal Transactions Involving IRAs and Plans Not Covered by Title I
of ERISA. If the investment advice resulting in the Principal
Transaction or Riskless Principal Transaction concerns an IRA or a Plan
that is not covered by Title I, the advice is subject to an enforceable
written contract on the part of the Financial Institution, which may be
a master contract covering multiple recommendations, that is entered
into in accordance with this Section II(a) and incorporates the terms
set forth in Section II(b)-(d). The Financial Institution additionally
must provide the disclosures required by Section II(e). The contract
must cover advice rendered prior to the execution of the contract in
order for the exemption to apply to such advice and related
compensation.
(1) Contract Execution and Assent.
(i) New Contracts. Prior to or at the same time as the execution of
the Principal Transaction or Riskless Principal Transaction, the
Financial Institution enters into a written contract with the
Retirement Investor acting on behalf of the Plan, participant or
beneficiary account, or IRA, incorporating the terms required by
Section II(b)-(d). The terms of the contract may appear in a standalone
document or they may be incorporated into an investment advisory
agreement, investment program agreement, account opening agreement,
insurance or annuity contract or application, or similar document, or
amendment thereto. The contract must be enforceable against the
Financial Institution. The Retirement Investor's assent to the contract
may be evidenced by handwritten or electronic signatures.
(ii) Amendment of Existing Contracts by Negative Consent. As an
alternative to executing a contract in the manner set forth in the
preceding paragraph, the Financial Institution may amend Existing
Contracts to include the terms required in Section II(b)-(d) by
delivering the proposed amendment and the disclosure required by
Section II(e) to the Retirement Investor prior to January 1, 2018, and
considering the failure to terminate the amended contract within 30
days as assent. An Existing Contract is an investment advisory
agreement, investment program agreement, account opening agreement,
insurance contract, annuity contract, or similar agreement or contract
that was executed before January 1, 2018, and remains in effect. If the
Financial Institution elects to use the negative consent procedure, it
may deliver the proposed amendment by mail or electronically, provided
such means is reasonably calculated to result in the Retirement
Investor's receipt of the proposed amendment, but it may not impose any
new contractual obligations, restrictions, or liabilities on the
Retirement Investor by negative consent.
(2) Notice. The Financial Institution maintains an electronic copy
of the Retirement Investor's contract on the Financial Institution's
Web site that is accessible by the Retirement Investor.
(b) Fiduciary. The Financial Institution affirmatively states in
writing that the Financial Institution and the Adviser(s) act as
fiduciaries under ERISA or the Code, or both, with respect to any
investment advice regarding Principal Transactions and Riskless
Principal Transactions provided by the Financial Institution or the
Adviser subject to the contract, or in the case of an ERISA Plan, with
respect to any investment advice regarding Principal Transactions and
Riskless Principal Transactions between the Financial Institution and
the Plan or participant or beneficiary account.
(c) Impartial Conduct Standards. The Financial Institution states
that it and its Advisers agree to adhere to the following standards
and, they in fact, comply with the standards:
(1) When providing investment advice to a Retirement Investor
regarding the Principal Transaction or Riskless Principal Transaction,
the Financial Institution and Adviser provide investment advice that
is, at the time of the recommendation, in the Best Interest of the
Retirement Investor. As further defined in Section VI(c), such advice
reflects the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent person acting in a like
capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims, based on the
investment objectives, risk tolerance, financial circumstances, and
needs of the Retirement Investor, without regard to the financial or
other interests of the Adviser, Financial Institution, or any Affiliate
or other party;
(2) The Adviser and Financial Institution seek to obtain the best
execution reasonably available under the circumstances with respect to
the Principal Transaction or Riskless Principal Transaction.
(i) Financial Institutions that are FINRA members shall satisfy
this Section II(c)(2) if they comply with the terms of FINRA rules 2121
(Fair Prices and Commissions) and 5310 (Best Execution and
Interpositioning), or any successor rules in effect at the time of the
transaction, as interpreted by FINRA, with respect to the Principal
Transaction or Riskless Principal Transaction.
(ii) The Department may identify specific requirements regarding
best execution and/or fair prices imposed by another regulator or self-
regulatory organization relating to additional Principal Traded Assets
pursuant to Section VI(j)(1)(iv) in an individual exemption that may be
satisfied as an alternative to the standard set forth in Section
II(c)(2) above.
(3) Statements by the Financial Institution and its Advisers to the
Retirement Investor about the Principal Transaction or Riskless
Principal Transaction, fees and compensation related to the Principal
Transaction or Riskless Principal Transaction, Material Conflicts of
Interest, and any other matters relevant to a Retirement Investor's
decision to engage in the Principal Transaction or Riskless Principal
Transaction, will not be materially misleading at the time they are
made.
(d) Warranty. The Financial Institution affirmatively warrants, and
in fact complies with, the following:
(1) The Financial Institution has adopted and will comply with
written policies and procedures reasonably and prudently designed to
ensure that its individual Advisers adhere to the Impartial Conduct
Standards set forth in Section II(c);
(2) In formulating its policies and procedures, the Financial
Institution has specifically identified and documented its Material
Conflicts of Interest associated with Principal Transactions and
Riskless Principal Transactions;
[[Page 21135]]
adopted measures reasonably and prudently designed to prevent Material
Conflicts of Interest from causing violations of the Impartial Conduct
Standards set forth in Section II(c); and designated a person or
persons, identified by name, title or function, responsible for
addressing Material Conflicts of Interest and monitoring Advisers'
adherence to the Impartial Conduct Standards;
(3) The Financial Institution's policies and procedures require
that neither the Financial Institution nor (to the best of the
Financial Institution's knowledge) any Affiliate uses or relies on
quotas, appraisals, performance or personnel actions, bonuses,
contests, special awards, differential compensation or other actions or
incentives that are intended or would reasonably be expected to cause
individual Advisers to make recommendations regarding Principal
Transactions and Riskless Principal Transactions that are not in the
Best Interest of the Retirement Investor. Notwithstanding the
foregoing, the requirement of this Section II(d)(3) does not prevent
the Financial Institution or its Affiliates from providing Advisers
with differential compensation (whether in type or amount, and
including, but not limited to, commissions) based on investment
decisions by Plans, participant or beneficiary accounts, or IRAs, to
the extent that the policies and procedures and incentive practices,
when viewed as a whole, are reasonably and prudently designed to avoid
a misalignment of the interests of Advisers with the interests of the
Retirement Investors they serve as fiduciaries;
(4) The Financial Institution's written policies and procedures
regarding Principal Transactions and Riskless Principal Transactions
address how credit risk and liquidity assessments for Debt Securities,
as required by Section III(a)(3), will be made.
(e) Transaction Disclosures. In the contract, or in a separate
single written disclosure provided to the Retirement Investor or Plan
prior to or at the same time as the execution of the Principal
Transaction or Riskless Principal Transaction, the Financial
Institution clearly and prominently:
(1) Sets forth in writing (i) the circumstances under which the
Adviser and Financial Institution may engage in Principal Transactions
and Riskless Principal Transactions with the Plan, participant or
beneficiary account, or IRA, (ii) a description of the types of
compensation that may be received by the Adviser and Financial
Institution in connection with Principal Transactions and Riskless
Principal Transactions, including any types of compensation that may be
received from third parties, and (iii) identifies and discloses the
Material Conflicts of Interest associated with Principal Transactions
and Riskless Principal Transactions;
(2) Except for Existing Contracts, documents the Retirement
Investor's affirmative written consent, on a prospective basis, to
Principal Transactions and Riskless Principal Transactions between the
Adviser or Financial Institution and the Plan, participant or
beneficiary account, or IRA;
(3) Informs the Retirement Investor (i) that the consent set forth
in Section II(e)(2) is terminable at will upon written notice by the
Retirement Investor at any time, without penalty to the Plan or IRA,
(ii) of the right to obtain, free of charge, copies of the Financial
Institution's written description of its policies and procedures
adopted in accordance with Section II(d), as well as information about
the Principal Traded Asset, including its purchase or sales price, and
other salient attributes, including, as applicable: The credit quality
of the issuer; the effective yield; the call provisions; and the
duration, provided that if the Retirement Investor's request is made
prior to the transaction, the information must be provided prior to the
transaction, and if the request is made after the transaction, the
information must be provided within 30 business days after the request,
(iii) that model contract disclosures or other model notice of the
contractual terms which are reviewed for accuracy no less than
quarterly and updated within 30 days as necessary are maintained on the
Financial Institution's Web site, and (iv) that the Financial
Institution's written description of its policies and procedures
adopted in accordance with Section II(d) is available free of charge on
the Financial Institution's Web site; and
(4) Describes whether or not the Adviser and Financial Institution
will monitor the Retirement Investor's investments that are acquired
through Principal Transactions and Riskless Principal Transactions and
alert the Retirement Investor to any recommended change to those
investments and, if so, the frequency with which the monitoring will
occur and the reasons for which the Retirement Investor will be
alerted.
(5) The Financial Institution will not fail to satisfy this Section
II(e), or violate a contractual provision based thereon, solely because
it, acting in good faith and with reasonable diligence, makes an error
or omission in disclosing the required information, or if the Web site
is temporarily inaccessible, provided that (i) in the case of an error
or omission on the web, the Financial Institution discloses the correct
information as soon as practicable, but not later than 7 days after the
date on which it discovers or reasonably should have discovered the
error or omission, and (ii) in the case of other disclosures, the
Financial Institution discloses the correct information as soon as
practicable, but not later than 30 days after the date on which it
discovers or reasonably should have discovered the error or omission.
To the extent compliance with this requires Advisers and Financial
Institutions to obtain information from entities that are not closely
affiliated with them, they may rely in good faith on information and
assurances from the other entities, as long as they do not know that
the materials are incomplete or inaccurate. This good faith reliance
applies unless the entity providing the information to the Adviser and
Financial Institution is (1) a person directly or indirectly through
one or more intermediaries, controlling, controlled by, or under common
control with the Adviser or Financial Institution; or (2) any officer,
director, employee, agent, registered representative, relative (as
defined in ERISA section 3(15)), member of family (as defined in Code
section 4975(e)(6)) of, or partner in, the Adviser or Financial
Institution.
(f) Ineligible Contractual Provisions. Relief is not available
under the exemption if a Financial Institution's contract contains the
following:
(1) Exculpatory provisions disclaiming or otherwise limiting
liability of the Adviser or Financial Institution for a violation of
the contract's terms;
(2) Except as provided in paragraph (f)(4) of this section, a
provision under which the Plan, IRA or the Retirement Investor waives
or qualifies its right to bring or participate in a class action or
other representative action in court in a dispute with the Adviser or
Financial Institution, or in an individual or class claim agrees to an
amount representing liquidated damages for breach of the contract;
provided that, the parties may knowingly agree to waive the Retirement
Investor's right to obtain punitive damages or rescission of
recommended transactions to the extent such a waiver is permissible
under applicable state or federal law; or
(3) Agreements to arbitrate or mediate individual claims in venues
that are distant or that otherwise unreasonably limit the ability of
the Retirement
[[Page 21136]]
Investors to assert the claims safeguarded by this exemption.
(4) In the event provision on pre-dispute arbitration agreements
for class or representative claims in paragraph (f)(2) of this section
is ruled invalid by a court of competent jurisdiction, this provision
shall not be a condition of this exemption with respect to contracts
subject to the court's jurisdiction unless and until the court's
decision is reversed, but all other terms of the exemption shall remain
in effect.
(g) ERISA Plans. For recommendations to Retirement Investors
regarding Principal Transactions and Riskless Principal Transactions
with Plans that are covered by Title I of ERISA, relief under the
exemption is conditioned upon the Adviser and Financial Institution
complying with certain provisions of Section II, as follows:
(1) Prior to or at the same time as the execution of the Principal
Transaction or Riskless Principal Transaction, the Financial
Institution provides the Retirement Investor with a written statement
of the Financial Institution's and its Advisers' fiduciary status, in
accordance with Section II(b).
(2) The Financial Institution and the Adviser comply with the
Impartial Conduct Standards of Section II(c).
(3) The Financial Institution adopts policies and procedures
incorporating the requirements and prohibitions set forth in Section
II(d)(1)-(4), and the Financial Institution and Adviser comply with
those requirements and prohibitions.
(4) The Financial Institution provides the disclosures required by
Section II(e).
(5) The Financial Institution and Adviser do not in any contract,
instrument, or communication purport to disclaim any responsibility or
liability for any responsibility, obligation, or duty under Title I of
ERISA to the extent the disclaimer would be prohibited by ERISA section
410, waive or qualify the right of the Retirement Investor to bring or
participate in a class action or other representative action in court
in a dispute with the Adviser or Financial Institution, or require
arbitration or mediation of individual claims in locations that are
distant or that otherwise unreasonably limit the ability of the
Retirement Investors to assert the claims safeguarded by this
exemption.
Section III--General Conditions
The Adviser and Financial Institution must satisfy the following
conditions to be covered by this exemption:
(a) Debt Security Conditions. Solely with respect to the purchase
of a Debt Security by a Plan, participant or beneficiary account, or
IRA:
(1) The Debt Security being purchased was not issued by the
Financial Institution or any Affiliate;
(2) The Debt Security being purchased is not purchased by the Plan,
participant or beneficiary account, or IRA in an underwriting or
underwriting syndicate in which the Financial Institution or any
Affiliate is an underwriter or a member;
(3) Using information reasonably available to the Adviser at the
time of the transaction, the Adviser determines that the Debt Security
being purchased:
(i) Possesses no greater than a moderate credit risk; and
(ii) Is sufficiently liquid that the Debt Security could be sold at
or near its carrying value within a reasonably short period of time.
(b) Arrangement. The Principal Transaction or Riskless Principal
Transaction is not part of an agreement, arrangement, or understanding
designed to evade compliance with ERISA or the Code, or to otherwise
impact the value of the Principal Traded Asset.
(c) Cash. The purchase or sale of the Principal Traded Asset is for
cash.
Section IV--Disclosure Requirements
This section sets forth the Adviser's and the Financial
Institution's disclosure obligations to the Retirement Investor.
(a) Pre-Transaction Disclosure. Prior to or at the same time as the
execution of the Principal Transaction or Riskless Principal
Transaction, the Adviser or the Financial Institution informs the
Retirement Investor, orally or in writing, of the capacity in which the
Financial Institution may act with respect to such transaction.
(b) Confirmation. The Adviser or the Financial Institution provides
a written confirmation of the Principal Transaction or Riskless
Principal Transaction. This requirement may be satisfied by compliance
with Rule 10b-10 under the Securities Exchange Act of 1934, or any
successor rule in effect in effect at the time of the transaction, or
for Advisers and Financial Institutions not subject to the Securities
Exchange Act of 1934, similar requirements imposed by another regulator
or self-regulatory organization.
(c) Annual Disclosure. The Adviser or the Financial Institution
sends to the Retirement Investor, no less frequently than annually,
written disclosure in a single disclosure:
(1) A list identifying each Principal Transaction and Riskless
Principal Transaction executed in the Retirement Investor's account in
reliance on this exemption during the applicable period and the date
and price at which the transaction occurred; and
(2) A statement that (i) the consent required pursuant to Section
II(e)(2) is terminable at will upon written notice, without penalty to
the Plan or IRA, (ii) the right of a Retirement Investor in accordance
with Section II(e)(3)(ii) to obtain, free of charge, information about
the Principal Traded Asset, including its salient attributes, (iii)
model contract disclosures or other model notice of the contractual
terms, which are reviewed for accuracy no less frequently than
quarterly and updated within 30 days if necessary, are maintained on
the Financial Institution's Web site, and (iv) the Financial
Institution's written description of its policies and procedures
adopted in accordance with Section II(d) are available free of charge
on the Financial Institution's Web site.
(d) The Financial Institution will not fail to satisfy this Section
IV solely because it, acting in good faith and with reasonable
diligence, makes an error or omission in disclosing the required
information, or if the Web site is temporarily inaccessible, provided
that (i) in the case of an error or omission on the web, the Financial
Institution discloses the correct information as soon as practicable,
but not later than 7 days after the date on which it discovers or
reasonably should have discovered the error or omission, and (ii) in
the case of other disclosures, the Financial Institution discloses the
correct information as soon as practicable, but not later than 30 days
after the date on which it discovers or reasonably should have
discovered the error or omission. To the extent compliance with the
disclosure requires Advisers and Financial Institutions to obtain
information from entities that are not closely affiliated with them,
the exemption provides that they may rely in good faith on information
and assurances from the other entities, as long as they do not know
that the materials are incomplete or inaccurate. This good faith
reliance applies unless the entity providing the information to the
Adviser and Financial Institution is (1) a person directly or
indirectly through one or more intermediaries, controlling, controlled
by, or under common control with the Adviser or Financial Institution;
or (2) any officer, director, employee, agent, registered
representative, relative (as defined in ERISA section 3(15)), member of
family (as defined in Code section 4975(e)(6)) of, or partner in, the
Adviser or Financial Institution.
(e) The Financial Institution prepares a written description of its
policies and
[[Page 21137]]
procedures and makes it available on its Web site and additionally, to
Retirement Investors, free of charge, upon request. The description
must accurately describe or summarize key components of the policies
and procedures relating to conflict-mitigation and incentive practices
in a manner that permits Retirement Investors to make an informed
judgment about the stringency of the Financial Institution's
protections against conflicts of interest. Additionally, Financial
Institutions must provide their complete policies and procedures to the
Department upon request.
Section V--Recordkeeping
This section establishes record retention and availability
requirements that a Financial Institution must meet in order for it to
rely on the exemption.
(a) The Financial Institution maintains for a period of six (6)
years from the date of each Principal Transaction or Riskless Principal
Transaction, in a manner that is reasonably accessible for examination,
the records necessary to enable the persons described in Section V(b)
to determine whether the conditions of this exemption have been met,
except that:
(1) If such records are lost or destroyed, due to circumstances
beyond the control of the Financial Institution, then no prohibited
transaction will be considered to have occurred solely on the basis of
the unavailability of those records; and
(2) No party other than the Financial Institution that is engaging
in the Principal Transaction or Riskless Principal Transaction shall be
subject to the civil penalty that may be assessed under ERISA section
502(i) or to the taxes imposed by Code sections 4975(a) and (b) if the
records are not maintained or are not available for examination as
required by Section V(b).
(b)(1) Except as provided in Section V(b)(2) or as precluded by 12
U.S.C. 484, and notwithstanding any provisions of ERISA sections
504(a)(2) and 504(b), the records referred to in Section V(a) are
reasonably available at their customary location for examination during
normal business hours by:
(i) Any duly authorized employee or representative of the
Department or the Internal Revenue Service;
(ii) any fiduciary of the Plan or IRA that was a party to a
Principal Transaction or Riskless Principal Transaction described in
this exemption, or any duly authorized employee or representative of
such fiduciary;
(iii) any employer of participants and beneficiaries and any
employee organization whose members are covered by the Plan, or any
authorized employee or representative of these entities; and
(iv) any participant or beneficiary of the Plan, or the beneficial
owner of an IRA.
(2) None of the persons described in subparagraph (1)(ii) through
(iv) are authorized to examine records regarding a Prohibited
Transaction involving another Retirement Investor, or trade secrets of
the Financial Institution, or commercial or financial information which
is privileged or confidential; and
(3) Should the Financial Institution refuse to disclose information
on the basis that such information is exempt from disclosure, the
Financial Institution must by the close of the thirtieth (30th) day
following the request, provide a written notice advising the requestor
of the reasons for the refusal and that the Department may request such
information.
(4) Failure to maintain the required records necessary to determine
whether the conditions of this exemption have been met will result in
the loss of the exemption only for the transaction or transactions for
which records are missing or have not been maintained. It does not
affect the relief for other transactions.
Section VI--Definitions
For purposes of this exemption:
(a) ``Adviser'' means an individual who:
(1) Is a fiduciary of a Plan or IRA solely by reason of the
provision of investment advice described in ERISA section 3(21)(A)(ii)
or Code section 4975(e)(3)(B), or both, and the applicable regulations,
with respect to the Assets involved in the transaction;
(2) Is an employee, independent contractor, agent, or registered
representative of a Financial Institution; and
(3) Satisfies the applicable federal and state regulatory and
licensing requirements of banking, and securities laws with respect to
the covered transaction.
(b) ``Affiliate'' of an Adviser or Financial Institution means:
(1) Any person directly or indirectly, through one or more
intermediaries, controlling, controlled by, or under common control
with the Adviser or Financial Institution. For this purpose, the term
``control'' means the power to exercise a controlling influence over
the management or policies of a person other than an individual;
(2) Any officer, director, partner, employee, or relative (as
defined in ERISA section 3(15)) of the Adviser or Financial
Institution; or
(3) Any corporation or partnership of which the Adviser or
Financial Institution is an officer, director, or partner of the
Adviser or Financial Institution.
(c) Investment advice is in the ``Best Interest'' of the Retirement
Investor when the Adviser and Financial Institution providing the
advice act with the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent person acting in a like
capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims, based on the
investment objectives, risk tolerance, financial circumstances, and
needs of the Retirement Investor, without regard to the financial or
other interests of the Adviser, Financial Institution, any Affiliate or
other party.
(d) ``Debt Security'' means a ``debt security'' as defined in Rule
10b-10(d)(4) of the Exchange Act that is:
(1) U.S. dollar denominated, issued by a U.S. corporation and
offered pursuant to a registration statement under the Securities Act
of 1933;
(2) An ``Agency Debt Security'' as defined in FINRA rule 6710(l) or
its successor;
(3) An ``Asset Backed Security'' as defined in FINRA rule 6710(m)
or its successor, that is guaranteed by an Agency as defined in FINRA
rule 6710(k) or its successor, or a Government Sponsored Enterprise as
defined in FINRA rule 6710(n) or its successor; or
(4) A ``U.S. Treasury Security'' as defined in FINRA rule 6710(p)
or its successor.
(e) ``Financial Institution'' means the entity that (i) employs the
Adviser or otherwise retains such individual as an independent
contractor, agent or registered representative, and (ii) customarily
purchases or sells Principal Traded Assets for its own account in the
ordinary course of its business, and that is:
(1) Registered as an investment adviser under the Investment
Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) or under the laws of the
state in which the adviser maintains its principal office and place of
business;
(2) A bank or similar financial institution supervised by the
United States or state, or a savings association (as defined in section
3(b)(1) of the Federal Deposit Insurance Act (12 U.S.C. 1813(b)(1)));
and
[[Page 21138]]
(3) A broker or dealer registered under the Securities Exchange Act
of 1934 (15 U.S.C. 78a et seq.).
(f) ``Independent'' means a person that:
(1) Is not the Adviser or Financial Institution or an Affiliate;
(2) Does not receive or is not projected to receive within the
current federal income tax year, compensation or other consideration
for his or her own account from the Adviser, Financial Institution or
an Affiliate in excess of 2% of the person's annual revenues based upon
its prior income tax year; and
(3) Does not have a relationship to or an interest in the Adviser,
Financial Institution or an Affiliate that might affect the exercise of
the person's best judgment in connection with transactions described in
this exemption.
(g) ``Individual Retirement Account'' or ``IRA'' means any account
or annuity described in Code section 4975(e)(1)(B) through (F),
including, for example, an individual retirement account described in
Code section 408(a) and a health savings account described in Code
section 223(d).
(h) A ``Material Conflict of Interest'' exists when an Adviser or
Financial Institution has a financial interest that a reasonable person
would conclude could affect the exercise of its best judgment as a
fiduciary in rendering advice to a Retirement Investor.
(i) ``Plan'' means an employee benefit plan described in ERISA
section 3(3) and any plan described in Code section 4975(e)(1)(A).
(j) ``Principal Traded Asset'' means:
(1) For purposes of a purchase by a Plan, participant or
beneficiary account, or IRA,
(i) a Debt Security, as defined in subsection (d) above;
(ii) a certificate of deposit (CD);
(iii) an interest in a Unit Investment Trust, within the meaning of
Section 4(2) of the Investment Company Act of 1940, as amended; or
(iv) an investment that is permitted to be purchased under an
individual exemption granted by the Department under ERISA section
408(a) and/or Code section 4975(c), after the effective date of this
exemption, that provides relief for investment advice fiduciaries to
engage in the purchase of the investment in a Principal Transaction or
a Riskless Principal Transaction with a Plan or IRA under the same
conditions as this exemption; and
(2) for purposes of a sale by a Plan, participant or beneficiary
account, or IRA, securities or other investment property.
(k) ``Principal Transaction'' means a purchase or sale of a
Principal Traded Asset in which an Adviser or Financial Institution is
purchasing from or selling to a Plan, participant or beneficiary
account, or IRA on behalf of the Financial Institution's own account or
the account of a person directly or indirectly, through one or more
intermediaries, controlling, controlled by, or under common control
with the Financial Institution. For purposes of this definition, a
Principal Transaction does not include a Riskless Principal Transaction
as defined in Section VI(m).
(l) ``Retirement Investor'' means:
(1) A fiduciary of a non-participant directed Plan subject to Title
I of ERISA or described in Code section 4975(c)(1)(A) with authority to
make investment decisions for the Plan;
(2) A participant or beneficiary of a Plan subject to Title I of
ERISA or described in Code section 4975(c)(1)(A) with authority to
direct the investment of assets in his or her Plan account or to take a
distribution; or
(3) The beneficial owner of an IRA acting on behalf of the IRA.
(m) ``Riskless Principal Transaction'' means a transaction in which
a Financial Institution, after having received an order from a
Retirement Investor to buy or sell a Principal Traded Asset, purchases
or sells the asset for the Financial Institution's own account to
offset the contemporaneous transaction with the Retirement Investor.
Section VII--Transition Period for Exemption
(a) In general. ERISA and the Internal Revenue Code prohibit
fiduciary advisers to employee benefit plans (Plans) and individual
retirement plans (IRAs) from receiving compensation that varies based
on their investment recommendations. ERISA and the Code also prohibit
fiduciaries from engaging in securities purchases and sales with Plans
or IRAs on behalf of their own accounts (Principal Transactions). This
transition period provides relief from the restrictions of ERISA
section 406(a)(1)(A) and (D) and section 406(b)(1) and (2), and the
taxes imposed by Code section 4975(a) and (b), by reason of Code
section 4975(c)(1)(A), (D), and (E) for the period from April 10, 2017,
to January 1, 2018 (the Transition Period) for Advisers and Financial
Institutions to engage in certain Principal Transactions and Riskless
Principal Transactions with Plans and IRAs subject to the conditions
described in Section VII(d).
(b) Covered transactions. This provision permits an Adviser or
Financial Institution to engage in the purchase or sale of a Principal
Traded Asset in a Principal Transaction or a Riskless Principal
Transaction with a Plan, participant or beneficiary account, or IRA,
and receive a mark-up, mark-down or other similar payment as applicable
to the transaction for themselves or any Affiliate, as a result of the
Adviser's and Financial Institution's advice regarding the Principal
Transaction or the Riskless Principal Transaction, during the
Transition Period.
(c) Exclusions. This provision does not apply if:
(1) The Adviser: (i) Has or exercises any discretionary authority
or discretionary control respecting management of the assets of the
Plan or IRA involved in the transaction or exercises any discretionary
authority or control respecting management or the disposition of the
assets; or (ii) has any discretionary authority or discretionary
responsibility in the administration of the Plan or IRA; or
(2) The Plan is covered by Title I of ERISA, and (i) the Adviser,
Financial Institution or any Affiliate is the employer of employees
covered by the Plan, or (ii) the Adviser or Financial Institution is a
named fiduciary or plan administrator (as defined in ERISA section
3(16)(A)) with respect to the Plan, or an Affiliate thereof, that was
selected to provide advice to the Plan by a fiduciary who is not
Independent;
(d) Conditions. The provision is subject to the following
conditions:
(1) The Financial Institution and Adviser adhere to the following
standards:
(i) When providing investment advice to the Retirement Investor
regarding the Principal Transaction or Riskless Principal Transaction,
the Financial Institution and the Adviser(s) provide investment advice
that is, at the time of the recommendation, in the Best Interest of the
Retirement Investor. As further defined in Section VI(c), such advice
reflects the care, skill, prudence, and diligence under the
circumstances then prevailing that a prudent person acting in a like
capacity and familiar with such matters would use in the conduct of an
enterprise of a like character and with like aims, based on the
investment objectives, risk tolerance, financial circumstances, and
needs of the Retirement Investor, without regard to the financial or
other interests of the Adviser, Financial Institution or any Affiliate
or other party;
(ii) The Adviser and Financial Institution will seek to obtain the
best execution reasonably available under the circumstances with
respect to the
[[Page 21139]]
Principal Transaction or Riskless Principal Transaction. Financial
Institutions that are FINRA members shall satisfy this requirement if
they comply with the terms of FINRA rules 2121 (Fair Prices and
Commissions) and 5310 (Best Execution and Interpositioning), or any
successor rules in effect at the time of the transaction, as
interpreted by FINRA, with respect to the Principal Transaction or
Riskless Principal Transaction; and
(iii) Statements by the Financial Institution and its Advisers to
the Retirement Investor about the Principal Transaction or Riskless
Principal Transaction, fees and compensation related to the Principal
Transaction or Riskless Principal Transaction, Material Conflicts of
Interest, and any other matters relevant to a Retirement Investor's
decision to engage in the Principal Transaction or Riskless Principal
Transaction, are not materially misleading at the time they are made.
(2) Disclosures. The Financial Institution provides to the
Retirement Investor, prior to or at the same time as the execution of
the recommended Principal Transaction or Riskless Principal
Transaction, a single written disclosure, which may cover multiple
transactions or all transactions occurring within the Transition
Period, that clearly and prominently:
(i) Affirmatively states that the Financial Institution and the
Adviser(s) act as fiduciaries under ERISA or the Code, or both, with
respect to the recommendation;
(ii) Sets forth the standards in paragraph (d)(1) of this section
and affirmatively states that it and the Adviser(s) adhered to such
standards in recommending the transaction; and
(iii) Discloses the circumstances under which the Adviser and
Financial Institution may engage in Principal Transactions and Riskless
Principal Transactions with the Plan, participant or beneficiary
account, or IRA, and identifies and discloses the Material Conflicts of
Interest associated with Principal Transactions and Riskless Principal
Transactions.
(iv) The disclosure may be provided in person, electronically or by
mail. It does not have to be repeated for any subsequent
recommendations during the Transition Period.
(v) The Financial Institution will not fail to satisfy this Section
VII(d)(2) solely because it, acting in good faith and with reasonable
diligence, makes an error or omission in disclosing the required
information, provided the Financial Institution discloses the correct
information as soon as practicable, but not later than 30 days after
the date on which it discovers or reasonably should have discovered the
error or omission. To the extent compliance with this Section VII(d)(2)
requires Advisers and Financial Institutions to obtain information from
entities that are not closely affiliated with them, they may rely in
good faith on information and assurances from the other entities, as
long as they do not know, or unless they should have known, that the
materials are incomplete or inaccurate. This good faith reliance
applies unless the entity providing the information to the Adviser and
Financial Institution is (1) a person directly or indirectly through
one or more intermediaries, controlling, controlled by, or under common
control with the Adviser or Financial Institution; or (2) any officer,
director, employee, agent, registered representative, relative (as
defined in ERISA section 3(15)), member of family (as defined in Code
section 4975(e)(6)) of, or partner in, the Adviser or Financial
Institution.
(3) The Financial Institution must designate a person or persons,
identified by name, title or function, responsible for addressing
Material Conflicts of Interest and monitoring Advisers' adherence to
the Impartial Conduct Standards.
(4) The Financial Institution complies with the recordkeeping
requirements of Section V(a) and (b).
Signed at Washington, DC, this 1st day of April, 2016.
Phyllis C. Borzi,
Assistant Secretary, Employee Benefits Security Administration,
Department of Labor.
[FR Doc. 2016-07926 Filed 4-6-16; 11:15 am]
BILLING CODE 4510-29-P