U.S. Department of Labor Re-Proposes Rules Governing the Definition of “Fiduciary”—Part 3: The Impact on Large Retirement Plans
Wednesday, May 27, 2015

In Part 1 of this series, we reported on recently proposed regulations issued by the U.S. Department of Labor amending the definition of the term “fiduciary” under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (the “Code”). Part 2 of the series covered a key feature of the Department’s proposed regulatory scheme—the “Best Interest Contract” Exemption—that allows advisers to small retirement plans and IRA investors to receive commission-based compensation without triggering a fiduciary breach or incurring excise tax exposure under rules governing prohibited transactions. This post focuses on the proposal’s impact on large plans, i.e., plans with more than 100 participants or more than $100 million in assets.

While the fiduciary and prohibited transaction rules set out in ERISA and the Code impact small and large plans alike, the practical compliance requirements applicable to these two cohorts of plans could not be more different. Individuals who act as fiduciaries for large plans tend to be more sophisticated on the general subject of investing than their small-plan counterparts. The Department of Labor has recognized this to be the case in its proposed regulations and drafted the regulations accordingly.

The proposed regulations adopt a broad definition of “fiduciary” that would sweep in any adviser with the ability to vary the adviser’s compensation based on the recommendation of a particular investment alternative. Under current law, most financial advisers and institutions can sidestep fiduciary status without too much effort, leaving them free to recommend investments that vary their compensation. This will change—dramatically so—if the proposed regulations are adopted. Recognizing that the new definition of fiduciary “could sweep in some relationships that are not appropriately regarded as fiduciary in nature,” the proposed regulations include a number of carve-outs to the general definition, certain of which will be of particular interest to large plans. These include the following:

The Seller’s Exemption

An important carve-out applies to “[s]tatements or recommendations made to a ‘large plan investor with financial expertise’ by a counterparty acting in an arm’s length transaction.” Under this carve-out, investment recommendations made to independent fiduciaries of large plans would not be treated as fiduciary advice if made in an arm’s length transaction where there is generally no expectation of fiduciary investment advice and provided that the specific conditions of the carve-out are satisfied. While called a “seller’s carve-out,” a footnote in the preamble to the proposed regulations clarifies that the carve-out:

“is not limited to sales but rather would apply to incidental advice provided in connection with an arm’s length sale, purchase, loan, or bilateral contract between a plan investor with financial expertise and an adviser.”

Large plans are typically overseen by a fiduciary committee appointed by the plan sponsor’s board and increasingly governed by a formal, written charter. Fiduciary committees tend to be advised by external professional consultants who readily accept fiduciary status as part of the services that they provide. A principal duty of these consultants is to help plan sponsors curate the menu of investment options made available to participants. While not required by current law to be fiduciaries, the market for these services generally demands that consultants act as fiduciaries. Consultants who acknowledge fiduciary status will not need to take advantage of the seller’s carve-out.

Consultants who do not acknowledge fiduciary status should be little affected if the proposed regulations are adopted. Some commentators have, however, raised concerns that the seller’s carve-out is not sufficiently broad to include consulting services relating to the selection and monitoring of an investment menu for a 401(k) plan since the carve-out does not extend to “services.” The relevant text of the proposed regulations refers to (and carves out) the rendering of advice or other communications in instances in which the person provides:

“advice to a plan fiduciary who is independent of such person and who exercises authority or control respecting the management or disposition of the plan’s assets, with respect to an arm’s length sale, purchase, loan or bilateral contract between the plan and the counterparty, or with respect to a proposal to enter into such a sale, purchase, loan or bilateral contract. . . .”

Department of Labor representatives have informally stated that the seller’s carve-out is intended to include consulting services. One would hope the scope of the seller’s carve-out will be clarified once (and if) the rule is adopted.

Action item: Revise contracts with outside consultants and advisers if qualification for the seller’s carve-out is desired.  This will include obtaining certain written representations from the plan fiduciary and informing the fiduciary of the adviser’s financial interests in the transaction.

Recommendations by employees

Under the carve-out for “statements or recommendations provided to a plan fiduciary of an ERISA plan by an employee of the plan sponsor,” an employee of a plan sponsor would not be treated as a fiduciary with respect to advice provided to the fiduciaries of the sponsor’s plan as long as the employee receives no compensation for the advice beyond the employee’s normal compensation as an employee of the plan sponsor. This carve-out recognizes that internal employees (e.g., members of a company’s human resources department), routinely develop reports and recommendations for investment committees. The employee carve-out permits this practice to continue.

Action item: Ensure that the requirements of the carve-out are satisfied, i.e., that the employees that are providing advice receive “no compensation for the advice beyond their normal compensation as employees of the plan sponsor.”

Certain appraisals and fairness opinions for reporting and disclosure purposes

Large plans will be able to obtain appraisals or fairness opinions for reporting and disclosure purposes without imposing fiduciary status on the vendor who furnishes the appraisal or opinion. This is an exception to the proposed regulation’s general rule imposing fiduciary status on persons who provide any “appraisal, fairness opinion, or similar statement whether verbal or written concerning the value of securities. . . .”

ESOP appraisals are also included in the carve-out for certain appraisals and fairness opinions. In the preamble to the proposed regulations, the Department explained that it:

“has decided not to extend fiduciary coverage to valuations or appraisals for ESOPs relating to employer securities at this time because the Department has concluded that its concerns in this space raise unique issues that are more appropriately addressed in a separate regulatory initiative.”

Action item: Ensure that the purpose of an appraisal or opinion relating to the plan is for “reporting and disclosure purposes.”

Investment education

In a 1996 interpretive bulletin (IB 96-1) the Department of Labor established a rule under which a plan sponsor may provide investment education to plan participants and beneficiaries without becoming a fiduciary. IB 96-1 set out four categories of protected advice: plan information; general financial, investment and retirement information; asset allocation models; and interactive investment materials. Under IB 96-1, a plan sponsor was permitted to recommend specific investment products or managers, e.g., as examples of the sorts of investments that would fit a particular criteria or need. The proposed regulations dispense with this rule. Instead, to qualify for the investment education carve out, the advice must not include “advice or recommendations as to specific investment products, specific investment managers, or the value of particular securities or other property.”

Action item: Revise educational programs to steer clear of any advice or recommendations that might implicate specific investment products, specific investment managers, or express a view as to the value of particular securities or other property.

 

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