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DOL Take Three: ‘Five-Part Test’ Officially Reinstated; Proposed Investment Advice Exemption

August 14, 2020

Just as broker-dealers and investment advisers finalized their initial implementation plans for the US Securities and Exchange Commission (SEC) Form CRS and Regulation Best Interest (Reg. BI), the US Department of Labor (DOL) announced a final rule[1] and proposed class exemption[2] as the next step in the now 10-year-long “DOL Fiduciary Rule” saga.

While the “Five-Part Test” is back on the books, the DOL’s interpretations may limit ability to disclaim fiduciary status. Effective July 7, 2020, the DOL’s final rule, “Conflict of Interest Rule—Retirement Investment Advice: Notice of Court Vacatur,” restored the “five-part” test of “investment advice” fiduciary status to the Code of Federal Regulations. According to the DOL, this technical amendment was necessary to officially reflect the US Court of Appeals for the Fifth Circuit decision in 2018 vacating the DOL’s 2016 fiduciary rule (the 2016 Rule). As such, the DOL’s view is that the final rule does not affect legal rights or impose costs, permitting it to be effective on publication in the Federal Register.

Under the five-part test, a person is an “investment advice” fiduciary with respect to a plan (including an IRA) under the Employee Retirement Income Security Act of 1974, as amended (ERISA) and the prohibited transaction rules of the Internal Revenue Code (Code) when: (1) providing advice or recommendations regarding purchasing or selling, or the value of, securities or other property for a fee, (2) on a regular basis, (3) pursuant to a mutual understanding that (4) the investment advice will serve as a primary basis for an investment decision, and (5) the advice is individualized. Note that this test does not apply to discretionary advice—any discretion over plan assets (other than limited discretion over the time and price at which transactions are executed) generally results in fiduciary status.

Historically, it has been a common practice for broker-dealers, insurance agents, and others to take the position that investment recommendations provided in brokerage and other relationships did not give rise to fiduciary status under ERISA or the Code, by disclaiming in writing the investor’s ability to rely on such recommendations and advice as a primary basis of an investment decision. The DOL’s vacated fiduciary rule, which had replaced the five-part test, made such disclaimers ineffective and caused many brokerage and other episodic investment advice relationships to become fiduciary in nature.

While the final rule reinstates the five-part test, the DOL’s interpretations of this test in the preamble to the proposed class exemption call into question firms’ ability to rely on the historic disclaimer to negate fiduciary status, stating: “Written statements disclaiming a mutual understanding or forbidding reliance on the advice as a primary basis for investment decisions are not determinative, although such statements are appropriately considered in determining whether a mutual understanding exists.”[3] Rather, says the DOL, whether there is a “mutual agreement, arrangement, or understanding” about the fiduciary nature of the advice “is appropriately based on the reasonable understanding of each of the parties.”[4] The DOL goes on to examine fiduciary status under the five-part test in several relationships, notably:

  • Brokerage – The DOL states, “When financial services professionals make recommendations to a Retirement Investor, particularly pursuant to a best interest standard such as the one in the SEC’s Regulation Best Interest, or another requirement to provide advice on the individualized needs of the Retirement Investor, the parties should reasonably understand that the advice will serve as at least a primary basis for the investment decision.”[5]
  • Rollovers – In evaluating whether a rollover recommendation is fiduciary investment advice (see discussion below of the current status of rollover recommendations), the DOL would focus on all the elements of the five-part test in evaluating whether fiduciary status is triggered by a rollover recommendation, including the regular basis prong. An “isolated, independent transaction” would fail to constitute a regular basis, but where the rollover is the first step in a “more lengthy financial relationship” in which advice will be given, that could constitute a regular basis.[6] A recommendation by a person who has been giving recommendations as part of an “ongoing advice relationship” or “preexisting advice relationship” would also generally be viewed as satisfying the regular basis prong.[7]
  • Bank Networking/Referral Arrangements – The DOL stated its understanding that banks commonly use “networking arrangements” to sell retail non-deposit investment products, such as equity securities and variable annuities, limiting bank employees to performing only clerical or ministerial functions in connection with these transactions, and that banks operate under similar restrictions in referring customers to insurance agents and investment advisers. The DOL said that because of these limitations, it believes that “in most cases such referrals will not constitute fiduciary investment advice.”[8]

Observations: As a regulatory interpretation in the preamble to a proposed exemption, we note that the DOL’s statements regarding the five-part test carry less legal authority than a final regulation. Nonetheless, such statements may be given deference by courts that are considering issues of fiduciary status under ERISA and may also be indicative of positions the DOL may take in its investigations and enforcement actions.

“Deseret Letter” withdrawn; rollover recommendations can be fiduciary investment advice. Issued in 2005, DOL Advisory Opinion 2005-23A, commonly referred to as the Deseret Letter, generally concluded that rollover guidance is not viewed as fiduciary “investment advice” under ERISA or the Code, absent a person who is already a fiduciary “exercising discretionary authority respecting management of the plan” in connection with the rollover or certain other limited circumstances. Under the 2016 Rule, any “recommendation” to roll over or take a distribution of plan assets was to be treated as fiduciary investment advice. Once the 2016 Rule was vacated, many firms took the position, and the DOL informally acknowledged, that the Deseret Letter was again the controlling DOL interpretation on fiduciary implications of rollover guidance.[9]

In the preamble to the proposed exemption, the DOL stated its view that its prior guidance in the Deseret Letter was incorrect and the letter is now withdrawn. As such, whether a particular rollover recommendation would be viewed as fiduciary investment advice would now be based on an analysis of the facts and circumstances under the five-part test, including the “regular basis” prong (as discussed above).

Observations: Firms will want to consider the impact of this new interpretation on their current rollover practices and compliance processes. We note in this regard that whether particular rollover guidance is considered fiduciary advice will depend on the application of the five-part test as currently interpreted to the particular facts and circumstances. Moreover, where a firm provides investment education on rollover options, rather than rollover recommendations, fiduciary status should not be triggered. Additionally, where a rollover recommendation is provided, the facts and circumstances may indicate that one or more of the prongs of the five-part test – such as “regular basis” – were not met with respect to a particular recommendation. Where a firm believes a rollover recommendation is fiduciary in nature, the firm will want to consider whether there is currently an available prohibited transaction exemption, or whether the recommendation can currently qualify for the DOL’s non-enforcement relief (issued after the 2016 Rule was vacated) or the proposed exemption once finalized.

Current prohibited transaction exemptions and participant investment education guidance are available in their “pre-fiduciary rule” form. In addition to reinstating the five-part test, the DOL’s final rule officially rescinds amendments to exemptions and other guidance in connection with the 2016 Rule. These amendments had significantly limited the availability of certain exemptions and had imposed new conditions, including, in particular, compliance with the “impartial conduct standards.” Additionally, the amendments had made certain revisions to the DOL’s guidance on participant investment education. The final rule confirms that these exemptions and guidance can be relied on in their pre-2016 form, creating a number of potential opportunities in managing the issues of fiduciary status that had been foreclosed by the 2016 Rule approach.

Observations: A significant impact the 2016 Rule was to make a number of commonly-used exemptions unavailable to cover certain prohibited transactions arising from non-discretionary investment advice and to force firms receiving transaction-based compensation to rely on the “Best Interest Contract Exemption” (BIC Exemption, widely viewed as fraught with liability and unusable). Under this new ruleset, firms should consider the availability, conditions, and flexibility of these other exemptions before fully adopting the new proposed exemption (discussed below), including in particular:

  • PTE 77-4 for compensation received in connection with investments in proprietary mutual funds
  • PTE 84-24 for insurance and annuity transactions (including variable annuities) and certain transactions involving mutual funds
  • PTE 86-128 for receiving certain compensation in connection with brokerage transactions

Firms may also consider certain statutory exemptions unaffected by these changes, including for deposits in affiliated banks (e.g., ERISA section 408(b)(4)), the Pension Protection Act exemption for level-fee fiduciaries and computer-generated advice (ERISA section 408(g)), and ERISA Section 408(b)(2) for reasonable services arrangements (and the parallel provisions under Code Section 4975)).

Similar to the now-vacated BIC Exemption (and current non-enforcement relief), the proposed exemption would provide prohibited transaction relief for certain investment advice fiduciaries, subject to meeting its conditions. The proposed class exemption “Improving Investment Advice for Workers and Retirees” would provide relief for certain “Financial Institutions” and their “Investment Professionals” to receive reasonable compensation (including in connection with agency trades) and to engage in “riskless” and “covered” principal transactions in connection with fiduciary investment advice.

In announcing the proposed exemption, the DOL indicated its intention that its standards align with those of other regulators, including the SEC. Read a comparison of the conditions of the proposed exemption to the standards of the SEC’s Reg. BI. Key conditions of the exemption include the following:

  • Covered Financial Institutions and Advice Arrangements: The proposed exemption would be available to state- and SEC-registered investment advisers, banks, savings associations, certain insurance companies, and broker-dealers that are not “disqualified or barred from making investment recommendations by any insurance, banking, or securities law or regulatory authority (including any self-regulatory authority).”[10] As proposed, other entities may apply for individual prohibited transaction exemptions that include the same conditions as the proposed exemption.

    The proposed exemption would not apply to the financial institution’s in-house plan, to discretionary investment management, or to computer-generated advice (which seems to include digital acquisition portals) without personal interaction with an investment professional (“robo-advice”), nor would it be available to plan administrators and named fiduciaries absent independent fiduciary approval of the advice services.

  • Fiduciary Acknowledgment: To be able to rely on the exemption, a financial institution must acknowledge its fiduciary status under ERISA or Section 4975 of the Internal Revenue Code, as applicable, and describe in writing the services it will provide.
    • Observation: Many commentators on the proposed exemption found this condition to be particularly problematic as it would make the exemption unavailable to “inadvertent fiduciaries,” result in investor confusion, and potentially open the door to litigation by an aggressive plaintiffs’ bar.
  • Principal Transactions: Principal transactions fall into two categories: “riskless principal transactions” and “Covered Principal Transactions.” In the case of Covered Principal Transactions, where the ERISA plan or IRA is the buyer, the types of assets covered are limited to, for example, only certain types of corporate debt securities, US Treasuries, and municipal securities.
    • Observation: Other than in “riskless principal transactions,” investment advice fiduciaries would not be able to sell equity securities to plans and IRAs under the exemption as proposed. This is similar to the treatment of equity securities under the 2016 Rule exemption for principal trades, and has been criticized in comments as making it challenging for plans and IRAs to engage in these transactions.
  • Impartial Conduct Standards: The “Impartial Conduct Standards” would apply to financial institutions and investment professionals when providing investment advice:
    • Best Interest Advicemust reflect “care, skill, prudence, and diligence” and not place the financial or other interests of the advisor “ahead of the interests of the Retirement Investor, or subordinate the Retirement Investor’s interests to their own.”[11]
      • Observation: The “ahead of the interests” language is a change from the approach under the 2016 Rule, which had required the advice to be provided “without regard to the financial or other interests” of the advisor. Despite the DOL’s explanation that this was intended to be consistent with the ERISA duty of loyalty standard, there were concerns that the “without regard to” standard in fact went beyond the ERISA duty of loyalty and would prove difficult to demonstrate in practice. The current proposal emphasizes that this wording is, in addition to being based on longstanding ERISA concepts, to be interpreted and applied consistent with the standard in the Reg. BI and the SEC’s investment adviser interpretation.
    • Reasonable Compensationthe compensation received, directly or indirectly, by the advisor, its affiliates, and related entities for their services must not exceed “reasonable compensation” as defined under ERISA. In addition, as required by federal securities laws, the advisor must seek to obtain best execution of the investment transaction reasonably available under the circumstances.
      • Observation: “Reasonable compensation” is explained in the notice as generally being a market-based test, as it had been described in the prior exemptions. The “best execution” standard had been the equivalent condition for “reasonable compensation” in the Principal Transactions Exemption, but now both conditions are described as applying for all transactions under the exemption. Importantly, the DOL specifically noted that this standard does not require using the product or service with the lowest cost.
    • No Misleading StatementsStatements by the financial institution and investment professional to the retirement investor about the recommended transaction, and other relevant matters may not be materially misleading at the time they are made.
      • Observation: While this proposed exemption does not include the contract provision requirements from the BIC Exemption that prohibited the use of exculpatory clauses or indemnification, the DOL said that it would consider the inclusion of such provisions to be “materially misleading” because they are prohibited by applicable law (although that is the case with respect to ERISA plans but not necessarily with respect to IRAs).
  • Disclosure: The exemption would require the financial institution to provide certain disclosures to the retirement investor prior to engaging in a transaction pursuant to the exemption, consisting of a written acknowledgment of fiduciary status and a written, accurate description of the services to be provided and their material conflicts of interest.
    • Observation: In the BIC Exemption, the disclosure requirement had applied to “Material Conflicts of Interest,” a defined term described as a financial interest that a reasonable person would conclude “could affect” the exercise of a person’s best judgment in rendering advice. The proposal uses the defined term “Conflict of Interest,” defined as an interest that “might incline” a person to make a recommendation not in a retirement investor’s “best interest,” and then adds the “material” qualifier in the condition itself.
  • Policies and Procedures: The financial institution would be required to establish, maintain, and enforce written policies and procedures “prudently designed” to ensure compliance with the Impartial Conduct Standards. With regard to conflicts of interest, the policies and procedures should be “prudently designed to avoid misalignment of the interests” of the institution and its investment professionals with the interests of retirement investors. The proposed exemption would also require documentation of the specific reasons that rollover recommendations are in the retirement investor’s best interest, including rollovers
    • from one plan to another plan;
    • from a plan to an IRA or from an IRA to a plan;
    • from an IRA to an IRA; and
    • from one account type to another account type.[12]

    While the exemption itself does not go into detail on the specific steps that the policies and procedures must take to mitigate conflicts, the explanation of this condition provides an array of steps as examples for the financial institution to consider.

    • Rollovers: The DOL indicates that the firm must consider the following for a plan-to-IRA rollover recommendation:
      • Alternatives to a rollover, including leaving money in the plan and selecting different investment options;
      • The fees and expenses associated with the plan and the IRA (including an assessment of the plan fees, assuming the reallocation of the plan account to the recommended allocation, vs. the IRA recommendation);
      • Whether the employer pays for some or all of the plan’s expenses; and
      • Different levels of available services and investments.

      For a rollover from an IRA to another IRA, or an account-type recommendation, the fiduciary must consider and document the services that would be provided under the new arrangement.

      The DOL indicates that the firm must make “diligent and prudent efforts to obtain information” about the plan and the participant’s interests in the plan, and may only rely on estimates of expenses, risks, returns, and asset values if the participant is unwilling to provide the information. Any estimates must include an explanation of the assumptions used and their limitations.[13]

      • Observation: Commentators on the proposed exemption have noted many challenges in the DOL’s rollover documentation and analysis requirements, particularly with the requirement to compare the actual expenses and investments of the plan to those of an IRA. In particular, it is unclear how a firm representative would make this comparison, particularly as the DOL seems to require the firm to first reallocate the participant’s plan investments into a recommended allocation within the plan before doing the comparisons to the IRA, and how the firm would weigh the many subjective investor preferences in a rollover decision against these objective factors.
    • Commission-Based Compensation Arrangements: The DOL indicates that financial institutions would be encouraged to focus on financial incentives and supervisory oversight, indicating that there would be flexibility to “adjust the stringency of each component” appropriately in satisfying the exemption’s standards.[14] The DOL goes on to describe a series of approaches to addressing conflicts that commission-based compensation arrangements can create under Reg. BI that may be appropriate under the proposed exemption, including:
      • Avoiding thresholds that disproportionately increase compensation based on incremental increases in sales;
      • Minimizing compensation incentives for investment professionals to favor specific accounts, products, product types, proprietary products, preferred provider products, or principal transactions—including by establishing differential compensation based on “neutral factors;”
      • Eliminating incentives within comparable product lines, e.g., by capping the credit an investment professional may receive across mutual funds;
      • Supervising and monitoring recommendations near or involving compensation thresholds, thresholds for firm recognition, higher compensating products, proprietary products, principal trades, rollovers, and changes in product classes;
      • Adjustments of compensation for investment professionals who do not adequately manage conflicts; and
      • Limiting the types of customers for whom a product or strategy may be recommended.

      The DOL goes on to indicate that firms should consider minimizing incentives at the financial institution level. The DOL indicates that similar to Reg. BI, sales contests of certain investments within a limited period of time would not be permitted under the proposed exemption, and then goes on to indicate that firms “would be required to carefully consider performance and personnel actions and practices that could encourage violation of the Impartial Conduct Standards.”[15]

      • Observation: The DOL’s proposed approaches to mitigating conflicts associated with commission-based compensation arrangements builds on the approaches under the prior BIC Exemption to incorporate approaches adopted by the SEC under Reg. BI, which were in part based on the elements of the BIC Exemption, as well as other approaches developing in the industry. This may indicate a degree of flexibility in how firms address conflicts to comply with the proposed exemption, at least under the DOL’s current interpretation. But the concern is that this is a different and separate approach to conflicts than that of the SEC and no matter how correlated they are today, over time they may deviate, leaving firms responsible for meeting potentially diverging standards.
  • Retrospective Review: The financial institution must conduct an annual retrospective review designed to detect and prevent violations of the Impartial Conduct Standards and the policies and procedures, resulting in a written report that is retained for six years and available to the DOL upon request. The condition further requires that the financial institution’s CEO (or equivalent officer) certify the report.
    • Observation: The DOL said that this is based on FINRA rules governing how broker-dealers supervise associated persons. While there are similar requirements and practices for advisers, banks, and insurance companies, there are some differences that may need to be considered when operationalizing the exemption. Moreover, it is unclear whether the DOL has the ability to request this report with respect to IRA transactions given that the DOL’s enforcement jurisdiction is limited to ERISA plans. Several commenters requested that this condition be deleted.
  • Potential Loss of Eligibility: Investment professionals and financial institutions could become ineligible to rely on the exemption for 10 years following either (1) a criminal conviction arising out of the person’s provision of investment advice to retirement investors, involving any of the crimes listed in ERISA Section 411 that potentially disqualify a person from serving as an ERISA fiduciary, or (2) a determination by the DOL Office of Exemption Determinations that, on account of a “systematic pattern or practice” of violation the exemption’s conditions, intentionally violating the conditions or providing materially misleading information to the DOL regarding its conduct under the exemption, the person is ineligible to use the exemption. The exemption’s provisions include a process and procedures for such determinations. In the case of a criminal conviction, ineligibility is automatic, effective immediately for an investment professional and 10 days after conviction for a financial institution, unless the DOL grants a petition to permit continued reliance. There is a one-year wind-down period following the ineligibility date. In the case of a financial institution, ineligibility could also be triggered by a similar determination for a member of the institution’s “Control Group,” defined by an 80% ownership test.
    • Observation: This is an unusual condition for an exemption. The precedent is the QPAM Exemption, which makes a financial institution ineligible to use the exemption if convicted of certain crimes, including those listed in ERISA Section 411 and several others as well. The main difference is that the scope of affiliates whose convictions trigger disqualification in the QPAM Exemption is based on an ownership test going as low as 5%, and there is no wind-down period. Moreover, the QPAM exemption’s disqualifying crimes are broader in that they are not limited to those arising out of the provision of investment advice to retirement investors, but the QPAM Exemption does not have a disqualification for a “systematic pattern or practice” of violating the exemption as determined by the DOL. This seems to grant DOL exemption staff significant discretion on how to wield this authority and choose who can operate in the transaction-based compensation model as a fiduciary. A number of comments requested that this condition be removed.
  • Recordkeeping: Records demonstrating compliance must be kept for six years and must be made available to: (1) the DOL; (2) any fiduciary or contributing employer of, or employee organization whose members are covered by, a plan that engaged in a transaction pursuant to the exemption; and (3) any plan participant, plan beneficiary, or IRA owner that engaged in an investment transaction pursuant to the exemption.
    • Observation: The requirement to make records available to plan participants and beneficiaries and IRA owners is novel and may create significant operational burdens for financial institutions that rely on the exemption, if finalized as proposed. It also raises the question why plan participants and IRA owners are entitled to this information, if no private rights of action are to be created under this exemption. A number of comments were critical of this feature of the recordkeeping condition.

What’s next? Comments on the proposed exemption were due on August 6, 2020. As of the date of this writing, the Federal eRulemaking Portal indicated that 107 comments were received on the proposal—far fewer than the many thousands of comments the DOL received on the 2016 Rule package. We note that the short, 30-day comment period indicates that the proposed exemption is on a fast-track through the regulatory process, which strongly suggests a final exemption may be published sometime this fall. Given the pace of the rulemaking, firms may want to consider developing an initial compliance strategy that considers:

  • Rollovers
    • What are the risks and benefits of assuming fiduciary status for rollovers?
    • Can an education-only approach be operationalized?
    • Can fiduciary status be disclaimed where rollover recommendations are provided?
    • Can the proposed exemption’s conditions be satisfied, particularly the requirement to compare investments and costs of the plan to those of an IRA?
    • Are other exemptions available?
  • Brokerage (and Other Transaction-Based Compensation Models)
    • Can fiduciary status be disclaimed? What are the risks and benefits for IRAs? For plans?
    • What are the risks and benefits of operationalizing the exemption as proposed?
    • To what extent can the firm’s Reg. BI compliance strategy be leveraged to comply with the proposed exemption? Are there any gaps, or different risk perspectives?
    • What are the implications of relying on the exemption under other applicable law, including Reg. BI and state fiduciary laws (i.e., Massachusetts)?
    • Are other exemptions available to cover brokerage transactions when acting as a fiduciary?
  • Advisory
    • Are there benefits to operationalizing the exemption in nondiscretionary advice relationships in advisory programs?
    • To what extent do current compliance systems support compliance with the proposed exemption’s conditions?
  • Bank/Trust Services
    • As the proposed exemption was intended to align with Reg. BI, are there any additional steps to take to rely on the exemption in nondiscretionary bank/trust relationships?
    • Where are banks and trust departments acting as fiduciaries under the five-part test and where are they not? Consider, in particular, rollover recommendations to different products and services (e.g., Bank CDs vs. discretionary relationships and services).
    • Are other exemptions available (e.g., ERISA section 408(b)(4) for deposits)?
    • What special issues are raised for dual-hatted bank/broker-dealer representatives? For bank employees referring customers to bank affiliates?
  • Insurance
    • Noting that PTE 84-24 is restored in its pre-fiduciary rule form without limitations on the types of annuities and insurance products it covers, are there transactions for which reliance on the proposed exemption as compared to PTE 84-24 would be beneficial?
    • Where are insurance companies and their agents acting as fiduciaries with respect to retirement investors under the five-part test?

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Lisa H. Barton
Michael D. Blanchard
David C. Boch
Timothy P. Burke
Jason S. Pinney
T. Peter R. Pound

Chicago
Marla J. Kreindler
Michael M. Philipp
Julie K. Stapel

Hartford
Michael D. Blanchard

New York
Craig A. Bitman
Susan F. DiCicco
Ben A. Indek
Barbara D. Klippert
Christine M. Lombardo

Philadelphia
Robert L. Abramowitz
Jeremy P. Blumenfeld
G. Jeffrey Boujoukos
Brian J. Dougherty
Christine M. Lombardo
Vivian S. McCardell
David B. Zelikoff

Pittsburgh
John G. Ferreira
R. Randall Tracht

Washington, DC
John V. Ayanian
Brian J. Baltz
Rosina Barker
Michael Gorman
Ivan P. Harris
Susan Harthill
Charles M. Horn
Lindsay B. Jackson
Michael Kenneally
Daniel R. Kleinman
Amy Natterson Kroll
Monica L. Parry
Michael B. Richman
Steven W. Stone
Natalie R. Wengroff
Kyle D. Whitehead



[1] Conflict of Interest Rule – Retirement Investment Advice: Notice of Court Vacatur, 85 Fed. Reg. 40,589 (July 7, 2020) (to be codified at 29 C.F.R. pt 2509 and 2510).

[2] Improving Investment Advice for Workers & Retirees, Proposed Class Exemption, 85 Fed. Reg. 40,834 (July 7, 2020).

[3] Id. at 40,840.

[4] Id.

[5] Id.

[6] Id. at 40,839.

[7] Id. at 40,840.

[8] Id. at 40,853.

[10] Id. at 40,865.

[11] Id. at 40,842.

[12] Id. at 40,845.

[13] Id.

[14] Id. at 40,846.

[15] Id. at 40,847.