A “curate’s egg” is a cliché derived from a mid-19th century cartoon, in which a timid young clergy member was served a rotten egg at the bishop’s table. In the cartoon, the young man does his best to assure his host that “parts of the egg were quite good” despite the unavoidably bad experience. At the end of 2007, the U.S. Department of Labor (“DOL”) has delivered such a “curate’s egg” to plan sponsors and third party administrators in the form of proposed regulations that alter the information that must be disclosed under agreements between these parties.
As part of the federal government’s movement toward disclosure and regulation of fees associated with employee retirement plans, in December 2007 the DOL proposed amendments to regulations that will enhance disclosure of the fees paid to plan service providers and other third parties. Along with the recently-promulgated revisions to Form 5500 that enhance governmental reporting of indirect compensation to service providers, the proposed regulations alter the prohibited transaction exemption for benefit plan services by requiring additional disclosure to plan sponsors of indirect compensation received by third-party service providers.
Although the burden of the disclosures falls on service providers, the proposed changes create a structure by which plan sponsors and service providers can jointly fulfill their obligations to plan participants and avoid causing prohibited transactions through the service arrangements.
The Previous Regulations
The proposed revisions are made to existing regulations under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974 (“ERISA”). ERISA’s broad prohibited transaction rules generally prohibit, among other things, the furnishing of goods, services and facilities between a plan and a party-in-interest to the plan. Without an exemption from ERISA’s statutory prohibition, most plan sponsors could not contract with outside parties for services for the plan, including basic accounting, actuarial and investment management. The primary relief from this prohibition is in ERISA Section 408(b)(2) and the previous regulations under that Section, which provide that a contractual arrangement between a plan and a party-in-interest to the plan is permissible so long as the contract is reasonable and the service provider is paid no more than reasonable compensation.
With one exception, ERISA does not offer guidance to help a plan sponsor determine what types of contractual arrangement are reasonable. The sole rule is that the service contracts must be voidable on short notice without penalty. The previous ERISA regulations contain no guidance regarding either the specific type of information service providers must provide to plan fiduciaries or the need to identify any third-parties to whom the service provider pays or from whom the service provider directly or indirectly receives fees or compensation.
Who Is Covered by the Proposed Regulations
Although the proposed regulations may dramatically alter the plan’s relationship with many service providers, only contractual relationships between a plan and one of three categories of service providers are required to meet the disclosure requirements. The categories of service providers covered by the proposed regulation include:
Category 1: Service providers that serve as a fiduciary under either ERISA or the Investment Advisors Act of 1940;
Category 2: Service providers that provide investment advisory, investment management, recordkeeping, banking, consultant, custodial, or insurance services or third party administration services; and
Category 3: Service providers that receive compensation indirectly in connection with providing accounting, actuarial, appraisal, auditing, legal or valuation services.
Other services are not affected by the proposal, including services provided to individual retirement accounts (“IRAs”) – IRAs are subject to Internal Revenue Code section 4975 but generally are excluded from coverage under ERISA.
Disclosure Requirements
The preamble to the proposed regulations provides that, in order for the compensation to be “reasonable” for purposes of qualifying for the prohibited transaction exemption, a contract made between a benefit plan and service provider that is included in one these three categories must satisfy the regulatory disclosure requirements, regardless of the nature of any other services provided between the parties. As part of the release of the proposed regulations, the DOL issued a “Fact Sheet” describing the proposed regulations. The Fact Sheet addresses the disclosure requirement in the following manner:
- Disclosure of Services and Compensation The terms of the contract between a plan sponsor and a service provider must require that the provider disclose information regarding all services to be performed and all compensation or fees that will be received either directly from the plan or indirectly from parties other than the plan or plan sponsor. The proposal includes a definition of “compensation or fees,” rules for bundled service providers, and rules for estimating the amount of prospective compensation.
- Disclosure of Conflicts of Interest Service providers also must disclose information about relationships or interests that may raise conflicts of interest for the service provider in performing plan services. Specifically, service providers must describe: Any participation or interest of the service provider in transactions to be entered into by the plan pursuant to the contract; Any material relationships with other parties that may create conflicts of interest; Any compensation the service provider may receive that it can affect without prior approval by an independent fiduciary; and Any policies or procedures in place to address potential conflicts of interest.
- Ongoing Disclosure Obligations The proposal includes ongoing disclosure obligations relating to: Material Changes: During the term of the contract, a service provider must disclose material changes to information previously furnished within 30 days of such changes. Reporting and Disclosure Requirements: Service providers must disclose compensation or other information related to the contract or arrangements that are requested by the responsible plan fiduciary or plan administrator in order to comply with ERISA’s reporting and disclosure requirements. Actual Performance: The proposal also includes an explicit requirement that service providers actually make the required disclosures.
The proposed regulations especially will affect financial service institutions that provide large, complex, and inter-related services to plan sponsors. For example, disclosing fees and conflicts of interest will create important new internal tracking challenges as service providers adapt their systems to meet the new requirements. In addition, the requirement that material changes be disclosed to the plan sponsor within 30 days of the change may prove difficult for service providers that offer multiple, integrated services (such as investment management and third-party administration) to a plan.
A New Prohibited Transaction Class Exemption
To protect innocent plan sponsors and to avoid penalizing them for the failure of service providers to comply with the proposed regulations, the DOL also released a proposed prohibited transaction class exemption. Under this exemption, the DOL recognizes “there may be circumstances when a plan fiduciary enters into a contract arrangement that appears to meet the requirements of [the proposed regulations] but unbeknownst to the plan fiduciary, the service provider fails to disclosure information consistent with the terms of the regulations.”
As long as the plan fiduciary (i) attempted to obtain the information, (ii) had reason to believe compliance by the service provider, and (iii) was unaware that the service provider had failed to comply with the proposed regulations, the plan fiduciary will be exempt from any prohibited transaction that could result. This relief is only available if the plan fiduciary diligently demands compliance with the disclosure requirements where a failure to disclose is discovered. Furthermore, if the service provider is determined not to be in compliance and does not come into compliance within 90 days, the plan’s fiduciary is required to notify the DOL, which will result in an administrative investigation of the service provider to determine if a prohibitive transaction had occurred.
A Mixed Blessing
In delivering the proposed regulations, the DOL has provided plan sponsors with a path that will clearly lead to better disclosure of fee information from service providers. However, the DOL’s requirements fall far short of those proposed in several Congressional bills. Those bills would require even more information be provided to both plan sponsors and participants. Accordingly, the DOL’s guidance may soon be superseded by additional legislation. Furthermore, the cost of the additional disclosures inevitably will be passed on to plans in the form of higher overall costs associated with plan administration.
Thus, the proposed regulations, while providing guidance on the steps required to satisfy fiduciary responsibilities, nevertheless leave many issues unanswered. These askew regulatory and legislative efforts by the federal government to require additional disclosure serve to both resolve and create issues for anyone providing or receiving employee benefit services.