DOL fiduciary rule will modify the structured product industry landscape, lawyers say

By Emma Trincal

New York, Aug. 26 – The Department of Labor’s new fiduciary rules will have a particularly strong impact on the structured products space, said lawyers from Morrison & Foerster LLP in a recent note published earlier this month and in an interview with Prospect News.

The DOL issued its final rule in April requiring investment advisers servicing retirement accounts to adopt the fiduciary standard, which prohibits them from receiving a commission payment.

The rule provides three exemptions but qualifying for any of these appears to be a challenge and merits careful analysis, the lawyers said.

Checklist

Morrison Foerster presented a “checklist” for its clients in a recent issue of the law firm’s newsletter “Structured Thoughts” designed to help investment banks and distributors navigate the complex ruling.

The two-and-a-half-page list allows clients to determine whether or not they fall under one of the three exemptions. If they do, the investment adviser may continue to receive a commission on retirement account sales.

But interpreting and implementing the new rules will not be easy.

“It’s going to be difficult for banks to sell structured notes to IRA accounts,” said Hillel Cohn, a partner at Morrison & Foerster, who spoke with Prospect News.

Principal exemption

The first exemption – the principal exemption – would seem like the natural way for the industry to continue to pay its salesforce a commission but actually it is not.

A broker dealer acts as a principal when it takes inventory from the bank and makes the commitment to sell it to investors.

“The principal exemption has serious limitations, “said Paul Borden, another partner at the firm, during the interview.

“It doesn’t apply if the product is issued by you or an affiliate or if you participate in the underwriting.”

It is easy to imagine how those limits may give issuers and distributors pause. Banks often sell structured notes internally and it is not uncommon for an intermediary to be part of the selling syndicate.

“The principal exemption is not useful for the underwritten distribution of structured products or most other securities,” said Cohn.

Possible trends

Could the restrictive exemption force the industry to evolve in different directions? Changes in the distribution chain involving new developments in the relationships between issuers, underwriters and brokers are to be expected, the lawyers said without being in a position to make predictions.

For instance: the structured product market operates as a primary market. But this could slowly evolve.

“The principal exemption would be more useful for secondary trading by and large. It has very little use in the context of underwritten distribution,” said Borden.

Agency sales – when a broker dealer sells some of the products of another bank on a non-commitment basis – may also carry more weight.

“The principal exemption has limited usefulness. A lot of deals that used to be sold on a principal basis may need to be revised to be sold on an agency basis,” said Cohn.

Transaction criteria

Another issue with the principal exemption is the product itself.

The principal exemption is a “narrow exemption” only available for the sale of “limited classes of securities,” said Cohn.

The securities must meet certain criteria, which are not always clearly defined.

The adviser must determine that the note being purchased possesses no greater than a “moderate credit risk” and is “sufficiently liquid” to allow the product to be sold “at or near its carrying value within a reasonably short period of time,” according to the DOL fiduciary rule.

If they want to find solutions to these new problems, issuers and brokers will have to examine and rethink their distribution methods, the lawyers said.

Since the principal exemption is not very useful, sellsiders should consider the two other exemptions created by the rule.

None of those however appear to provide much more help than the principal exemption, at least for retail accounts.

Big guys

The first one, the “seller’s exemption” is easy enough to understand. But by definition, it excludes retail sales.

This exemption covers institutional investors such as larger professionally managed retirement plans, insurance plans or investment managers.

“For big institutional clients, the model won’t have to change that much,” said Cohn.

“Certainly from a legal perspective, it’s a lot easier to sell to institutional accounts than to retail. A lot easier.”

Best Interest Contract

The third and final exemption – the Best Interest Contract exemption – known as “BIC” offers some limited relief.

The BIC exemption does not change the new fiduciary status. But brokers have the possibility of continuing to get commissions if they meet certain conduct and disclosure standards.

Unfortunately the “principal” conundrum comes into play.

“You can’t use the BIC if you sell as a principal,” said Cohn.

In addition, the BIC exemption presents a number of disadvantages.

Brokers have to sign a contract with their clients pledging to abide by the higher fiduciary standard, which may open the door to lawsuits. That’s because the requirements to adhere to impartial conduct and other standards can easily be disputed, said Borden.

Interpreting this complex set of rules and exceptions will take time. Not all exemptions are available to all parties at the same time. The exceptions to the rule vary in usefulness depending on who the parties are and how they relate to one another, the nature of the product being sold and the specific clients who purchase the products for their retirement account.

One thing appears clear: only the seller’s exemption, which is available to large institutional sales, is easy to use and understand. But its scope is limited at least for now, which is not encouraging for an industry primarily engaged in the retail market.

“The principal transaction exemption is often not available because it cannot be used by a party that has issued the product or is participating in its underwriting, and BIC is a challenge because it cannot be used for principal transactions,” said Borden.

As the range of options narrows, some methods of distribution may gain prevalence.

“It seems like you’d have to sell as an agency only and that you can’t be affiliated with the issuer.”

The lawyers concluded that the entire industry has to reinvent itself to adjust to these new rules.

“The DOL fiduciary rules are forcing everyone who wants to sell to retail retirement accounts to reconsider how they distribute products,” said Cohn.

The rule will be fully effective on Jan. 1, 2018 with a transition period for implementation beginning in April 2017.

© 2015 Prospect News.
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