Capital Group Policy Spotlight
Initially a more controversial part of the initial DOL proposal, the final rule includes a Best Interest Contract exemption that allows a financial institution to receive variable compensation. But it must take steps to mitigate potential conflicts of interest, such as incentives for product recommendations that pay the firm more in compensation.
Jason Bortz: What is the Best Interest Contract exemption? The basic idea is it allows a financial institution like a broker-dealer firm to receive variable compensation — things like commissions, trail payments, even forms of revenue sharing. The firm has to take steps to mitigate any potential conflicts of interest, meaning any incentives to give recommendations of products that pay the firm more in compensation. The way it works is the firm agrees that it and the financial advisor are going to act as fiduciaries, so they’re going to act in the best interests of their clients when they make recommendations and they’re going to adopt impartial conduct standards so no misrepresentations to your clients — the compensation you charge your client is reasonable.
Then the firm is going to adopt conflicts of interest mitigation policies, so they’re going to have policies to make sure that advisors don’t recommend products based on the compensation the product pays to the firm. One of the big parts of that is it actually may require changes in the ways that individual advisors are compensated, so it may actually require changes in the internal practices of broker-dealer firms, and it’s called the Best Interest Contract exemption for a reason.
The Department of Labor doesn’t have jurisdiction over IRAs. Their jurisdiction is really over 401(k) plans and other kinds of employer-sponsored retirement plans, but they have interpretative authority for the law over IRAs. But without enforcement authority, it would be odd to create a rule that they couldn’t enforce, so what they’ve done is they said, “Hey, if you’re going to give advice when you work with an IRA that’s potentially conflicted, then you need to enter into a contract with that IRA owner that allows them to enforce these new rules, that you will act according to a fiduciary standard of conduct, that the firm will have these impartial conduct standards, that the conflicts of interest mitigation policies will be in place.” That’s the contract piece to create a directly enforceable best interest standard of care for investors.
The securities laws have a general idea that an investment advisor needs to try and avoid conflicts of interest, but if they can’t avoid the conflict they can just disclose the conflict and the investor can make a decision about whether to go forward. The ERISA rules take a very different approach. They say, “Hey, if there’s a conflict of interest, you can’t engage in that activity.” You can’t make a recommendation if you have an interest that could affect your judgment as a fiduciary, and the only way you can go forward is if you comply with the terms of an exemption.
There’s this new exemption called the Best Interest Contract exemption that advisors are going to have to comply with if they want to receive commissions when they sell a mutual fund or a variable annuity, if they want to receive trail payments like a 12b-1 fee, or if they want to recommend rollovers, and they can only advise on rollovers held on their advisory platform or on their brokerage platform. So it’s really going to be the path that folks need to go down if they have any potential conflict of interest.
The Best Interest Contract exemption was probably the most controversial part of the Department of Labor’s proposal. It was for the first time establishing new requirements that advisors who work on commission would have to satisfy in order to give recommendations. It was widely panned by the financial services sector — I mean widely panned.
There were really three big criticisms:
The final Best Interest Contract got a lot better on all three fronts. On disclosure it got much less costly. They entirely eliminated these point-of-sale disclosure requirements and the annual disclosure requirement is completely gone. They also did some things to mitigate the potential liability. They allowed for mandatory arbitration of individual disputes and some limitations on liability. The private right of action is still there. The plaintiffs’ bar will be able to enforce some of this so it's not completely gone.
Then they really improved the timing issue. They pushed back the general effective date to 12 months. They created this phase in where many of the rules don’t go into effect until January of 2018, and then probably most importantly they created a grandfather rule for preexisting assets that are outstanding on the day the rule goes into effect, something that allows advisors to continue servicing their existing clients that are in commissionable investments. It’s definitely a big improvement, but I think the jury is still out on whether firms are going to use the Best Interest Contract exemption. It does involve risk. It is still costly, and there is still liability.
I think it’ll take a little while for all of us to digest the more than a thousand pages of rules, make sure the cost benefit analysis is done, so I think more to come on how workable the Best Interest Contract exemption is.
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