On April 6, 2016, the Department of Labor (“DOL”) issued its final rule expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (“ERISA”). The rule, which is effective April 10, 2017, has already had significant impact on the wealth management business and advisers should be particularly aware of changes to recruitment and compensation.
The rule modifies the Best Interest Contract Exemption (“BIC”), under which the DOL permits financial advisers and their firms to engage in otherwise prohibited transactions. When the rule was issued last year, many firms were concerned that the revised BIC would create unacceptable liability risk on commission-based retirement accounts and prohibit back-end performance-based incentives altogether. The DOL has now confirmed that the back-end incentives, such as bonuses for meeting asset or sales targets, will no longer be exempted under the BIC.
On October 27, the Department issued a FAQ regarding the new rule. Question 12 addressed recruitment incentives:
Such back-end awards can create acute conflicts of interest that are inconsistent with the full BIC Exemption’s requirement that financial institutions adopt policies and procedures reasonably and prudently designed to ensure that individual advisers adhere to the exemption’s impartial conduct standards. In particular, under the full BIC Exemption, financial institutions may not use or rely on bonuses, 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.’
(Department of Labor, Conflict of Interest Exemptions FAQs, Q12). Of chief concern to the DOL is the “all or nothing” production targets of these awards, which tie a significant percentage of an adviser’s compensation to the advice he or she gives individual clients, “particularly as the adviser approaches the target.” This can pit a client’s interest in a given investment decision, which may be comparatively minor in dollar terms, against the adviser’s interest in a grossly disproportionate bonus. Accordingly, the FAQ distinguishes between front-end signing bonuses and incremental commission formulas, which do not create these disproportionate incentives, and back-end awards that tie large jumps in compensation to specific performance targets.
Recognizing that these back-end bonuses are common in the industry and were previously lawful, the DOL has advised that deals predating its guidance will be grandfathered. To qualify, however, a back-end bonus cannot be discretionary. More seriously, the firms are required to adopt “special policies and procedures specifically aimed at the conflicts of interest introduced by the arrangements and designed to protect investors from harm. These policies and procedures should establish an especially strict system of supervision and monitoring of conflicts of interest, particularly as the adviser approaches sales targets.”
For advisers with current deals whose firms face this new regulatory burden, there may be pressure to renegotiate or surrender awards. Advisers moving or contemplating moving, meanwhile, will face a new recruiting environment, as firms cope with the expanded fiduciary rule in different ways. Morgan Stanley will continue to offer commission-based retirement accounts with a narrower platform of products, for example, while Merrill Lynch has already announced that it will eliminate the commission-based option entirely.
The attorneys at Lax & Neville LLP have extensive experience navigating compensation and regulatory issues on behalf of investment advisers. If you have an employment compensation agreement with deferred compensation or back-end bonuses based upon performance metrics, or are currently moving firms or considering moving firms, please contact us at 212-696-1999 to schedule a consultation.