The DOL’s New Proposal on ERISA Fiduciary Status for Investment Advisers

April 22, 2015

Last week, the U.S. Department of Labor (DOL) issued its widely anticipated re-proposed rules for defining fiduciary status under the Employee Retirement Income Security Act of 1974 (ERISA) for providers of investment advice for a fee. The rules would substantially modify existing rules for determining whether a party provides investment advice for a fee or other compensation that would make it a fiduciary of the employee benefit plan to which the advice relates. The DOL first proposed revisions to the current investment advice rules in 2010. That proposal resulted in more than 300 sets of comments, including comments submitted by members of Congress. In 2011, the DOL abandoned the proposal, promising to modify and reissue it at a later time.

The new proposal, like the original proposal, would completely revamp the existing five-part test for determining whether a party is providing investment advice which would make it an ERISA fiduciary. A party is treated as providing ERISA fiduciary investment advice under the current rule if each of the following conditions is met:

  1. The adviser provides asset valuations or makes recommendations as to the advisability of investing in, selling or purchasing of assets or other property,
  2. The advice is provided on a regular basis,
  3. The advice is provided pursuant to a mutual agreement, arrangement or understanding with an ERISA employee benefit plan or with a fiduciary of the plan,
  4. The advice will serve as a primary basis for investment decisions for plan assets, and
  5. The advice is individualized based on the particular needs of the plan.

The proposed new rules broaden the circumstances under which an advice provider will be treated as providing investment advice for purposes of ERISA and thus be a fiduciary. The proposal would also expand the scope of the rule to cover advice provided to individual retirement accounts (IRAs) and their owners.

The broadened definition of investment advice is somewhat softened by a limited set of exceptions, which relate to certain types of communications or communications provided in specific contexts. In addition, the proposal includes a new prohibited transaction exemption that would allow an investment adviser fiduciary to receive certain forms of otherwise prohibited compensation without violating ERISA’s restrictions against self-dealing if the investment adviser fiduciary agreed to be subject to a “best interest” standard of conduct. The proposal also includes another new prohibited transaction exemption for principal transactions involving debt securities. Finally, the proposal includes modifications to a variety of existing prohibited transaction exemptions, many of which are regularly relied upon for a wide range of investment activities involving ERISA plans and IRAs.

Definition of Fiduciary Investment Advice

The proposed new regulation would dramatically revise the current definition. Under the new definition, a party that provides (1) investment recommendations, (2) investment management recommendations, (3) appraisals of investments, or (4) recommendations of persons to provide investment advice for a fee or to manage plan assets would be a covered fiduciary if they receive a fee or other compensation (either directly or indirectly) for such advice and if either of the following conditions are met:

  • They represent that they are acting as a fiduciary under ERISA (or under the Internal Revenue Code of 1986 (Code)), or
  • They provide their advice under an agreement, arrangement or understanding that the advice is individualized or specifically directed to the recipient for purposes of making investment or investment management decisions regarding plan or IRA assets.

The proposed regulation would broadly define “investment recommendations” to include a recommendation to take a distribution from a plan or IRA, as well as a recommendation as to the investment of assets distributed or rolled over from a plan or IRA. Thus, the proposed rules would supersede existing DOL guidance which holds that a party does not give fiduciary investment advice when it makes a recommendation as to distribution options even if that recommendation includes a recommendation as to investment of the distribution.[1]

The proposed regulation includes a similarly broad definition of a direct or indirect “fee or other compensation.” It would include any fee or compensation that is received from any source for the advice, as well as any fee or compensation “incident to the transaction in which the investment advice has been or will be rendered.” Brokerage fees and sales commissions are listed as examples of covered compensation.

Exceptions

The proposed regulation includes limited exceptions under which a party would be treated as not being a fiduciary by virtue of the communications it makes to a plan or IRA, plan fiduciaries, an IRA owner or plan participants and beneficiaries, as applicable. The exceptions are only available to the extent that the party does not otherwise acknowledge that it is a fiduciary under ERISA.

  • Arm’s Length Transactions with Expert Plan Fiduciaries. This exception applies to communications made in connection with an arm’s length sale, purchase, loan or bilateral contract (or a proposal to enter into one of those transactions) by an adviser to an independent fiduciary for the plan. There are two alternative sets of conditions that must be met to qualify for this exception. One set of conditions applies where the transaction is with a plan that has 100 or more participants and the counterparty knows or has reason to know that the independent fiduciary acting on behalf of the plan “has sufficient expertise to evaluate the transaction.” The other set of conditions applies to transactions with plans represented by an independent fiduciary with responsibility for managing at least $100 million in employee benefit plan assets (either of the plan involved in the transaction or of multiple plans on an aggregated basis).
  • Swap Transactions. The counterparty to a swap transaction with a plan (regardless of the plan’s size or the assets the independent fiduciary has under management) is covered by an exception from fiduciary status if the plan’s independent fiduciary provides a written representation that it is not relying on recommendations provided by the swap counterparty, and if other conditions are met.
  • Employees of the Plan Sponsor or its Affiliates. Many commentators on the initial proposal noted that the expanded fiduciary definition could potentially cause employees of a plan sponsor or of one of its affiliates to be treated as fiduciaries if they were engaged in advising the plan’s fiduciaries on plan investment matters (such as by developing reports and recommendations for plan investment committees). Because of the broad nature of the newly proposed definition, the DOL is proposing an exception for such employees provided that they receive no fee or other compensation that is directly or indirectly related to their advice activity for their employer plan, beyond their “normal compensation.”
  • Platform Providers – Marketing and Offering Activities. This exception is for a party that markets or offers investments through a platform to participant-directed individual account plans (such as plan recordkeeprs and other providers of plan investment platforms). The exception is available where a provider offers a platform (or “similar mechanism”) from which a plan fiduciary may select or monitor investment alternatives for participants and beneficiaries to direct the investment of their plan accounts, so long as the provider conducts its activities without regard to the individualized needs of the plan (or its participants and beneficiaries) and the provider discloses in writing to the plan fiduciary that it is not giving impartial investment advice or advice in a fiduciary capacity. This exception would not apply to IRAs.
  • Platform Providers – Selection and Monitoring Activities. An additional exception allows plan platform providers for participant-directed individual account plans to provide information limited to (1) investment alternatives that meet objective criteria specified in advance by the plan fiduciary (such as funds of a certain asset class or with expense ratios within certain parameters) and (2) objective financial data and comparisons with independent benchmarks (such as historical return information for various asset classes or the investment alternatives offered on the provider’s platform). This exception similarly would not apply to IRAs.
  • Providers of Certain Financial Reports and Valuations. Although asset appraisals, valuations and fairness opinions generally are considered the rendering of investment advice under the proposed new definition, providers of valuations and fairness opinions for employer stock in connection with an ESOP, or providers of appraisals and valuations for collective investment funds or pooled separate accounts that hold assets of multiple, unaffiliated plans are excepted from fiduciary status. In addition, a provider of valuation information to a plan, plan fiduciary, plan participant or beneficiary or an IRA or IRA owner would not be a fiduciary under this exception where such information is used solely for complying with reporting requirements applicable to the plan or IRA or in communications furnished to comply with applicable disclosure requirements.
  • Investment Education. The DOL has long recognized that certain classes of information provided to participants and beneficiaries in 401(k) and other types of ERISA participant-directed individual account plans are in the nature of investment education and not investment advice, and thus such information should not be treated as fiduciary investment advice. In 1996, the DOL published guidance outlining the types of information which would not be considered fiduciary investment advice.[2] The proposed rules include a similar exception for the same general types of information not treated as investment advice under the 1996 guidance (i.e., plan information; general financial, investment and retirement information; asset allocation models; and interactive investment material). However, the new exception differs from the 1996 guidance in a number of respects. First, it adds an explicit condition that the information cannot include any advice or recommendations concerning specific investment products, investment managers or the value of investments. Second, asset allocation models cannot include any of the specific investment alternatives offered under the plan, and interactive investment materials can include specific plan investment alternatives only if such alternatives are specifically selected by the participant. Thus, education materials that include asset allocation models or interactive investment tools cannot identify specific investment alternatives available under the plan for those materials to come within this exception. In addition, the DOL also expanded the scope of the exception to apply to IRAs and to ERISA plans that do not provide for participant-directed investment, and to cover communications to plan fiduciaries and IRA owners.

The proposed regulation leaves largely intact existing rules relating to transactions performed by brokers at the direction of plan clients and other parties. The proposal expands the scope of those rules to also apply to IRAs.

Prohibited Transaction Exemptions

The proposal would create two new prohibited transaction class exemptions, as well as amend several existing class exemptions that are particularly relevant to broker-dealers and other investment advice fiduciaries.

Proposed Best Interest Contract Exemption

The proposed “best interest contract” exemption (BICE) would provide relief from ERISA and Code prohibited transaction rules for the receipt of compensation by investment advice fiduciaries and their affiliated financial institutions for services provided in connection with the purchase, sale, or holding of certain investments by participants and beneficiaries, IRAs, and certain plans with fewer than 100 participants (Retirement Investors).

The exemption is designed to address the issue that the receipt by a fiduciary adviser (or his or her financial institution) of certain types of compensation from a plan (such as a commission) or from third parties (such as 12b-1 fees, revenue sharing, sales loads, etc.) would typically violate the ERISA prohibited transaction restrictions against self-dealing because the amount or when such compensation is received by the fiduciary adviser would be affected by the advice the fiduciary adviser provides.

BICE would apply only to transactions involving assets that are bank deposits, CDs, mutual fund shares, bank collective funds, insurance company separate accounts, exchange-traded REITs and ETFs, publicly-offered corporate bonds, certain government agency debt securities and U.S. Treasury securities, certain types of insurance and annuity contracts and exchange-traded equity securities. Other types of investments (such as, for example, unregistered hedge fund interests) would not be covered by the exemption.

The fiduciary adviser and affiliated financial institution would be required to enter into a written contract with the Retirement Investor prior to recommending any investment. The DOL intends for this contract to be the cornerstone of BICE, creating a basis upon which the Retirement Investor could enforce rights through a private lawsuit for breach of contract. Among the various items of information that must be incorporated into the contract are (1) an acknowledgement by the adviser and financial institution of their fiduciary status under ERISA or the Code with respect to any investment recommendations and (2) their agreement to provide investment advice that is in the Retirement Investor’s “best interest” (the Best Interest Standard). This means that the adviser and financial institution must act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the Retirement Investor’s investment objectives, risk tolerance, financial circumstances, and needs. The advisor would therefore be required to make its investment recommendations without consideration of its own interests, the interests of the financial institution or of their affiliates or any other party.

The exemption would also require a number of disclosures to the Retirement Investor. These disclosures include descriptions of material conflicts of interest, a statement informing the Retirement Investor that it has the right to obtain complete information about all fees related to its investment, and a statement as to whether the financial institution offers any proprietary products or receives any third-party payments with respect to any underlying investments.

Whether BICE applies would be determined on a transaction-by-transaction basis. Therefore, the effect of noncompliance with one of the conditions discussed above would depend on whether that condition applies to a single transaction or multiple transactions. For example:

  • If an adviser fails to provide a required transaction disclosure with respect to an investment purchased by a plan, BICE relief would be unavailable only for the otherwise prohibited compensation received in connection with that specific investment.
  • If an adviser and financial institution fail to enter into a contract with a Retirement Investor, BICE relief would be unavailable solely with respect to that Retirement Investor’s investments – not all Retirement Investors to which the adviser and financial institution provide advice.
  • If a financial institution fails to comply with a condition necessary for all transactions involving investment advice (such as maintenance of a website disclosing certain compensation-related information), BICE relief would be unavailable for all prohibited transactions entered into during the period in which the failure to comply existed.

This proposed exemption contains a number of additional conditions and requirements, such as prohibited contract terms; other disclosures that advisers and financial institutions must make; and recordkeeping by financial institutions regarding transactions effected for plans and IRAs.

Proposed Exemption for Principal Transactions in Certain Debt Securities

The proposal would add a new class exemption for principal transactions in certain debt securities. In proposing this new exemption, the DOL noted that debt securities may need to be sold on a principal basis because particular bond issues may be sold by only one or a limited number of financial institutions. Accordingly, without an exemption there would be a reduced choice in the market for fixed-income securities.

The exemption would permit financial institutions that are registered investment advisers, banks, and registered broker-dealers (i.e., entities that commonly sell debt securities out of inventory) and fiduciary advisers to engage in the purchase and sale of certain debt securities in a principal transaction with a plan, participant or beneficiary account or IRA and receive a mark-up, mark-down or other payment for themselves or any affiliate, as a result of the fiduciary adviser’s and financial institution’s advice.

To obtain this relief, the adviser and financial institution would have to enter into a written contract similar to that required for BICE under which they would acknowledge fiduciary status and agree to adhere to the Best Interest Standard. In addition, disclosure, recordkeeping and other requirements similar to those under BICE would apply.

The debt securities being purchased or sold must possess no greater than a moderate credit risk, be sufficiently liquid that they could be sold at or near their fair market value within a reasonably short time period, and meet certain pricing requirements.

Proposed Amendments to Existing Class Exemptions

Several existing prohibited transaction class exemptions (PTEs) that are particularly relevant to broker-dealers and other investment advice fiduciaries would be amended by the proposal.

PTE 75-1: Certain Transactions Involving Broker-Dealers, Reporting Dealers, and Banks

PTE 75-1 was granted shortly after ERISA’s passage to provide certainty over the extent to which ordinary transactions between broker-dealers and plans or IRAs would be subject to ERISA’s prohibited transaction rules. PTE 75-1 consists of five exemptions covering securities transactions with broker-dealers, reporting dealers, and banks. The proposed rules would amend PTE 75-1 in the following ways:

  • Agency Transactions and Services. PTE 75-1, Part I(b) permits certain non-fiduciary broker-dealers who are parties in interest or disqualified persons to a plan or IRA to effect certain securities transactions on behalf of such plan or IRA as agent, including clearance, settlement or custodial functions incidental to such transactions. Similarly, PTE 75-1, Part I(c) permits such broker-dealers to also furnish advice regarding securities or other property. The new rules would revoke these two provisions because they are duplicated by the exemptive relief provided under Code Section 4975(d)(2), ERISA Section 408(b)(2) and the regulations thereunder, which clarified the scope of relief for service providers to plans and IRAs.
  • Principal Transactions. PTE 75-1, Part II relates to principal transactions and generally permits the purchase or sale of securities between a plan and registered broker-dealers, reporting dealers, or banks, provided such entities are not fiduciaries. It contains a limited exception in Part II(2) for mutual fund transactions, in which certain fiduciaries may act as principals in selling mutual fund shares to plans and IRAs and to receive commissions for doing so. The proposed rules would revoke Part II(b) because identical relief would be incorporated into PTE 86-128, which would contain additional safeguards that would make the exemption more consistent with recent exemptions that similarly provide broad relief from fiduciary self-dealing and conflicts of interest (see below).
  • Underwritings. Plans often purchase underwritten securities in public offerings because the pricing is usually more favorable than the net cost to the plan for the same securities in the secondary market immediately following the public offering. PTE 75-1, Part III generally permits a fiduciary to cause a plan or IRA to purchase securities from a member of an underwriting syndicate other than the fiduciary, when the fiduciary also is a member of such syndicate. The proposed rules would require any fiduciary relying on this exemption to comply with the Best Interest Standard, among other requirements. The existing exemption otherwise would remain in place.
  • Market-Making. Many financial institutions that offer investment advice to plans and IRAs also regularly maintain markets in securities (directly or indirectly). PTE 75-1, Part IV generally permits a plan or IRA to purchase securities in a principal transaction from a fiduciary that is a “market-maker” with respect to such securities. Like the proposed amendments to PTE 75-1, Part III, the proposed rules would require any fiduciary relying on this exemption to comply with the Best Interest Standard, among other requirements. The existing exemption otherwise would remain in place.
  • Extensions of Credit. PTE 75-1, Part V generally permits the extension of credit to a plan or IRA by a broker-dealer in connection with the settlement of certain securities transactions (such as short sales, options contracts, and the purchasing of securities on margin). However, it does not permit the receipt of compensation for an extension of credit by broker-dealers that are fiduciaries with respect to the assets involved in the transaction. The proposed rules would amend PTE 75-1, Part V to permit investment advice fiduciaries to receive compensation when they lend money or otherwise extend credit to plans or IRAs to avoid the failure of a purchase or sale of a security as long as the fiduciary is not responsible for the potential failure of the purchase or sale, the credit terms are at least as favorable to the plan or IRA as otherwise available in an arm’s length transaction between unaffiliated persons, and certain disclosures are provided to the plan or IRA.

PTE 84-24: Certain Transactions Involving Insurance Agents and Brokers, Pension Consultants, Insurance Companies and Investment Company Principal Underwriters

PTE 84-24 permits insurance agents, insurance brokers, insurance companies and pension consultants that are fiduciaries to purchase insurance or annuity contracts for a plan or IRA and to receive commissions on the sales. It also permits mutual fund principal underwriters that are fiduciaries to sell mutual fund shares to plans or IRAs and to receive commission on those sales.

The proposed rules would require any fiduciary relying on this exemption to comply with the Best Interest Standard, among other requirements. It also would require exemptive relief for IRA transactions involving variable annuity contracts and other contracts that are securities under federal law and mutual fund shares to be obtained under BICE.

The proposed rules also would provide new definitions for “insurance commission” and “mutual fund commission,” as well as update the exemption’s recordkeeping requirements to require the fiduciary engaging in the covered transaction to maintain records necessary to determine whether the exemption’s conditions have been met.

PTE 86-128: Securities Transactions Involving Broker-Dealers

PTE 86-128 generally provides an exemption for certain fiduciaries and their affiliates to receive fees from plans or IRAs for effecting or executing securities transactions as agents on behalf of plans or IRAs, but only if trading is not excessive in frequency or amount. It also permits certain “agency cross transactions,” in which the fiduciary acts as agent both for the plan or IRA and for another party (and to receive reasonable compensation from the other party).

The proposed rules would require any fiduciary relying on this exemption to comply with the Best Interest Standard, among other requirements. It also would require investment advice fiduciaries to IRAs to obtain relief under BICE instead of PTE 86-128, thereby ensuring that IRA owners would have contract-based claims to hold their investment advisers accountable if need be.

As discussed above, the proposed rules would add a new Section I(b) to PTE 86-128 providing relief for a broker-dealer fiduciary to use its authority to cause a plan or IRA to purchase mutual fund shares from the broker-dealer acting as principal, when such shares are acquired solely to cover the plan or IRA’s prior order, and for the receipt of a commission by such fiduciary in connection with the transaction. Since this relief would be added as a new section of PTE 86-128, the proposed rules would revoke PTE 75-1, Part II(2).

The proposed rules would provide a new recordkeeping requirement for a fiduciary engaging in a transaction covered by the exemption to maintain records necessary to determine whether the exemption’s conditions have been met.

Other PTE Amendments

The following class exemptions also would be amended to require fiduciaries to comply with the Best Interest Standard:

  • PTE 77-4, which generally provides relief for a plan’s or IRA’s purchase or sale of open-end investment company shares where the investment adviser for such company is also a fiduciary to the plan or IRA
  • PTE 80-83, which generally provides relief for a fiduciary causing a plan or IRA to purchase a security when the proceeds of the securities issuance may be used by the issuer to retire or reduce indebtedness to the fiduciary or an affiliate
  • PTE 83-1, which generally provides relief for the sale of certificates in an initial issuance by the sponsor of a mortgage pool to a plan or IRA, when the sponsor, trustee, or insurer of the mortgage pool is a fiduciary with respect to the plan or IRA assets invested in such certificates

Request for Comment Regarding a Low-Cost Investment Exemption

The proposal invites comments on whether an additional exemption should be developed for certain low-fee investments that would allow investment advice fiduciaries and their financial institutions to accept payments that might otherwise be prohibited when recommending the lowest-fee products in a given investment class.

What’s Next?

The proposed rules are subject to a comment period that ends on July 6, 2015. It is anticipated that there will be a large number of comments on the proposal. Subscribers to our employee benefits WorkCites will continue to be kept abreast of further developments regarding the proposal.

For further information, please contact either of the authors, Jeffrey R. Capwell and Robert B. Wynne, or any other member of McGuireWoods’ employee benefits team.


NOTES:

1. See DOL Advisory Opinion 2005-23A.

2. See DOL Interpretive Bulletin 96-1.

 

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