September 27, 2016

How the DOL’s Impartial Conduct Standard Affects Exemptions Used by Financial Services Companies

In conjunction with its issuance in April 2016 of a new regulation redefining the concept of “investment advice” for purposes of fiduciary status under ERISA and Section 4975 of the Code, the Department of Labor amended a number of existing prohibited transaction class exemptions that are frequently used by financial services companies in conducting certain aspects of their business. In particular, the amended exemptions include Prohibited Transaction Exemption (PTE) 86-128 relating to agency transactions involving an affiliated broker-dealer, PTE 77-4 relating to investments in affiliated mutual funds, Parts III and IV of PTE 75-1 relating to certain underwritten offerings and market-making transactions, PTE 84-24 relating to certain purchases of insurance or annuity contracts or mutual fund shares, PTE 80-83 relating to the use of proceeds of a securities issuance to repay indebtedness to a fiduciary or its affiliate and PTE 83-1 relating to certain sales of certificates of interest in a mortgage pool. Like the investment advice regulation, these amendments have an “applicability date” of April 10, 2017.

Because all of these exemptions provide relief with respect to ERISA Section 406(b)(1) (i.e., self-dealing), the DOL determined that additional conditions should be imposed on the availability of each of these exemptions in order to adequately protect the plan. In each case, the DOL has imposed a so-called “impartial conduct standard” that must be satisfied for the exemption to be available.

To meet this new standard, the following requirements must be satisfied by the fiduciary who causes the plan to engage in the covered transaction:

  1. The fiduciary must act in the “best interest” of the plan. To act in the “best interest” of the plan, the fiduciary must satisfy the prudent man standard without regard to the financial or other interest of the fiduciary or its affiliates.
  2. The aggregate compensation received by the fiduciary and its affiliates must not be in excess of “reasonable” compensation.
  3. The fiduciary’s statements about the transaction, fees and compensation, material conflicts of interest and any other matters relevant to the plan’s investment decisions must not be materially misleading at the time they are made. Failure to disclose a material conflict of interest is deemed to be a misleading statement.

In the context of ERISA plans, these standards do not, as a practical matter, materially expand the fiduciary’s obligations beyond its existing obligations under ERISA’s general fiduciary standards as set forth in Section 404(a) of ERISA. However, it is important to note that these standards will now be a condition to a prohibited transaction exemption and that, in a litigation context, the availability of an exemption is typically treated as an affirmative defense as to which the defendant fiduciary, rather than the plaintiff, has the burden of proof. By contrast, a plaintiff claiming, for example, a breach of the prudent man standard under Section 404(a) has the burden of proof. Moreover, affirmative defenses such as the availability of an exemption are often not available in the context of a motion to dismiss, which may enable a plaintiff to get to the discovery stage of litigation more easily to the extent that including a prohibited transaction allegation becomes easier.

In the non-ERISA context (i.e., most IRAs and Keogh plans), utilization of these exemptions will have the additional consequence of effectively imposing ERISA fiduciary obligations in situations where those obligations would not otherwise be applicable. In other words, while, for example, non-ERISA accounts are not subject to the prudent man standard, they would become subject to that standard with respect to the covered transaction as a condition to utilizing any of these exemptions in the context of such an IRA or Keogh plan.

Finally, in addition to imposing the impartial conduct standard as a new condition, the DOL revised certain of the existing conditions of PTE 86-128 and eliminated the provision of PTE 86-128 that made most of the conditions of that exemption inapplicable to non-ERISA IRAs and Keogh plans.  The DOL also amended PTE 84-24 in certain other respects.

In view of the foregoing, any financial services company that utilizes any of the above PTEs should consider whether its existing practices will be consistent with the amended exemption and, in particular, whether it will be able to demonstrate, if challenged, that it has satisfied the “impartial conduct standard,” notwithstanding the potential conflict of interest that may be present when any of these exemptions is being utilized, with respect to transactions occurring on or after April 10, 2017.