The Department of Labor (“DOL“) has responded to the concerns of the broker-dealer community as expressed in myriad comment letters concerning the 2010 proposed fiduciary regulations by adding the Best Interest Contract (BIC) exemption to the new proposed rule. The DOL suggests that this addition will minimize compliance costs and allow firms to set their own compensation structures (meaning commission-based fees, revenue sharing, 12b-1 fees and subTA fees) while acting in their client’s best interest. This exemption will be available when advising IRA owners, plan participants and small plans.
Here’s the catch that has drawn a mostly negative reaction from the broker-dealer community:
First: The BIC will be a formal contract committing the advisor and her firm to act with the care, skill, prudence and diligence that a prudent person would exercise based on the circumstances. The advisor and her firm must avoid misleading statements about fees and conflicts of interest. The DOL requires compliance with “impartial conduct standards.” These standards also mandate reasonable compensation for the service rendered.
The concerns: This is a roadmap for the plaintiffs bar as prudent persons can disagree on what is prudent in various circumstances, and reasonable fees may be reasonable to some and not to others. The high cost of “fee litigation” is already a known quantity. Besides, this is a contract, and contracts can be expensive on the front end to negotiate and on the back end when someone alleges a breach.
Second: The firm must warrant that it has adopted policies and procedures designed to mitigate conflicts of interest. This would require that the firm warrant that it has identified its conflicts and fee structures that might encourage an advisor to make recommendations not in the client’s best interest and has adopted measures to mitigate any harmful result that might occur due to the conflicts of interest. The DOL theory is that these warranties and fulfillment of their objectives will permit the firm to continue its compensation practices.
The concerns: This is a form of guarantee, and guarantees can be expensive to defend. Going through the process to “clean up” will be expensive as well and will likely require significant changes in the way many firms do business. This is a complex “answer” to a problem that will have many unexpected consequences, but one consequence that the industry expects is a broad refusal to advise small plans and IRAs since the cost of doing so will be prohibitive.
Third: There are required disclosures that must met in the BIC: (1) identify material conflicts of interest; (2) advise the client that the client can get information about all fees and recommended assets; (3) disclose whether proprietary products are being used and whether third party payments are being received; and (4) identify the required website that discloses the compensation structure between the firm and the advisor.
The concerns: This will add significant additional cost to the process. There is also some concern about potential anti-competitive hiring when compensation structures are disclosed.
Fourth: Two things cannot be in the contract: (1) exculpatory provisions limiting liability and (2) waiver of any right to participate in a class action or other representative court case.
The concerns: Being unable to limit exposure may be cost prohibitive when it comes to small plans and small accounts.
The DOL believes that the concerns are not so severe as to create the impact that the advisor industry believes will result. In fact, the DOL takes the position that this approach provides flexibility to “accommodate a broad range of business practices, while minimizing the harmful impact of conflicts of interest on the quality of advice.” It will surely be interesting to read the upcoming comment letters and to consider the testimony at hearings on the proposed regulation.