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Final 408(b)(2) Regulation: Impact on Investment Managers

This bulletin discusses the impact of the U.S. Department of Labor’s (DOL) final 408(b)(2) disclosure regulation on discretionary investment managers – that is, investment advisers with the authority to manage the assets of ERISA-governed retirement plans.  The final regulation requires various disclosures to be made by an investment adviser to its ERISA plan clients prior to July 1, 2012.  Failure to comply with these new disclosures could result in substantial penalties, excise taxes and forfeiture of investment advisory fees.  We would be happy to assist you in drafting or reviewing these new disclosures.

The new disclosure rules apply to any discretionary asset manager for an ERISA-covered retirement plan who reasonably expects to receive $1,000 or more of direct or indirect compensation in connection with its services to a plan.  Covered plans include both defined benefit and defined contribution plans, including ERISA-covered 403(b) plans—covered plans do not include IRAs or retirement plans that allow employers to contribute to IRAs set up for employees (referred to as SEPs or SIMPLEs).  Discretionary managers include those hired directly by the plan to manage all or some of its assets, and also the fiduciary managers of “plan asset vehicles”—investments that are themselves subject to ERISA, and in which a plan invests.  Such investments include collective investment funds or trusts offered by banks, the separate accounts of insurance companies or certain other investment vehicles (e.g., hedge funds) if more than 25% of the funds being managed come from ERISA plans and other “benefit plan investors.”  The disclosure rule does not apply to investment advisers for mutual funds because the investments in mutual funds are not considered ERISA plan assets.

More information is available from earlier Drinker Biddle alerts addressing DOL Reg. §408(b)(2):

Key Considerations for Investment Managers

Overview

The final 408(b)(2) regulation requires detailed disclosures that must be satisfied by an investment manager that enters into a contract or arrangement to provide “covered services” to an ERISA-covered retirement plan, such as a 401(k) plan, a defined benefit pension plan, a non-participant-directed profit sharing plan or an ERISA-covered 403(b) plan.  Covered services include investment management services provided directly to an ERISA-covered retirement plan as an ERISA fiduciary.  Covered services also include services provided as an ERISA fiduciary to a Plan Asset Vehicle.  Finally, covered services include services provided by a registered investment adviser.  For these services, the disclosure must be provided to the responsible plan fiduciaries of the ERISA-covered retirement plans.

The disclosures are enforced through the prohibited transaction rules.  Because service providers are “parties in interest” under ERISA, an exemption from the prohibited transaction rules is necessary in order for a plan to engage a service provider without committing a prohibited transaction.  ERISA section 408(b)(2) is the prohibited transaction exemption that permits a plan to engage a service provider that is a party in interest if the contract or arrangement is “reasonable.”  The final 408(b)(2) regulation adds disclosure requirements as new elements of “reasonableness.”  As a result, a failure by a covered service provider to provide the disclosures will result in a prohibited transaction under ERISA and the Internal Revenue Code.  This means that the investment manager will be subject to excise taxes and must correct the violation, which may mean refunding the investment manager’s compensation plus interest on that amount.  In addition, if the DOL recovers the compensation for the plan through either a settlement agreement or a court order, an additional 20 percent penalty may be imposed.

The disclosures must provide detailed information about the investment manager’s services, direct and indirect compensation, ERISA fiduciary status, and whether the manager is an investment adviser registered under the Investment Advisers Act of 1940 or state law.  Also, they  must be written in a manner that facilitates the 

  • The disclosures need to be provided in writing to the “responsible plan fiduciary,” defined as the fiduciary of an ERISA-covered retirement plan with the authority to cause the plan to enter into a service arrangement with the investment manager.
     
  • The compliance date is fast approaching– For existing service arrangements, the disclosures must be provided no later than July 1, 2012. 
     
  • For new, post-June 30 service arrangements, the disclosures need to be provided reasonably in advance of entering into the arrangements.
     
  • These disclosures are new requirements for the prohibited transaction exemption that permits reasonable arrangements with ERISA retirement plans—failure to provide the disclosures results in a prohibited transaction.
     
  • Investment managers who are subject to these rules and who fail to comply will be subject to excise taxes, may need torefund the compensation, plus interest, they receive under the covered service arrangement, and could be subject to an additional 20 percent penalty imposed by the Department of Labor.
     
  • The rules apply to any discretionary investment manager that provides services as an ERISA fiduciary directly to an ERISA-covered retirement plan or that manages a Plan Asset Vehicle, such as a common or collective trust fund of a bank, a separate account of an insurance company, or certain other investment vehicles if more than 25 percent of the funds being managed come from ERISA plans and other “benefit plan investors.”
     
  • If an investment manager provides ERISA fiduciary services to a Plan Asset Vehicle that is also a “designated investment alternative” (DIA) in an ERISA-covered retirement plan, then the investment manager must also disclose the total operating expenses and certain other information in its possession relating to the performance and fees or expenses of the Plan Asset Vehicle.  A DIA is any investment alternative designated by the ERISA-covered retirement plan into which participants can direct the investment of their plan accounts.
     
  • Arrangements with third-party payers that result in indirect compensation payments (e.g., soft dollars or other non-monetary compensation) to the investment manager must be described in sufficient detail that the responsible plan fiduciaries can evaluate their reasonableness.

Overview

The final 408(b)(2) regulation requires detailed disclosures that must be satisfied by an investment manager that enters into a contract or arrangement to provide “covered services” to an ERISA-covered retirement plan, such as a 401(k) plan, a defined benefit pension plan, a non-participant-directed profit sharing plan or an ERISA-covered 403(b) plan.  Covered services include investment management services provided directly to an ERISA-covered retirement plan as an ERISA fiduciary.  Covered services also include services provided as an ERISA fiduciary to a Plan Asset Vehicle.  Finally, covered services include services provided by a registered investment adviser.  For these services, the disclosure must be provided to the responsible plan fiduciaries of the ERISA-covered retirement plans.

The disclosures are enforced through the prohibited transaction rules.  Because service providers are “parties in interest” under ERISA, an exemption from the prohibited transaction rules is necessary in order for a plan to engage a service provider without committing a prohibited transaction.  ERISA section 408(b)(2) is the prohibited transaction exemption that permits a plan to engage a service provider that is a party in interest if the contract or arrangement is “reasonable.”  The final 408(b)(2) regulation adds disclosure requirements as new elements of “reasonableness.”  As a result, a failure by a covered service provider to provide the disclosures will result in a prohibited transaction under ERISA and the Internal Revenue Code.  This means that the investment manager will be subject to excise taxes and must correct the violation, which may mean refunding the investment manager’s compensation plus interest on that amount.  In addition, if the DOL recovers the compensation for the plan through either a settlement agreement or a court order, an additional 20 percent penalty may be imposed.

The disclosures must provide detailed information about the investment manager’s services, direct and indirect compensation, ERISA fiduciary status, and whether the manager is an investment adviser registered under the Investment Advisers Act of 1940 or state law.  Also, they  must be written in a manner that facilitates the responsible plan fiduciary’s evaluation of the information.  The disclosures must be made reasonably in advance of the date the service contract is entered into, but no later than July 1 in the case of existing arrangements.

This bulletin focuses on those changes made by the final regulation that impact investment managers.

1)    Effective Date.  The compliance effective date of the final regulation was extended from April 1 to July 1, 2012.  The delay benefits investment managers who may not recognize that they are covered service providers and who therefore may not have taken steps to comply, such as:

a.  Investment managers that provide ERISA fiduciary services to Plan Asset Vehicles; and

b.  Investment managers who manage all or part of the assets of an ERISA-covered retirement plan such as a profit sharing or pension plan, but who are not otherwise involved in the retirement plan community.

2)    Additional Investment Disclosure for Designated Investment Alternatives. As stated above, a DIA is generally “any investment alternative designated by the covered plan into which participants and beneficiaries may direct the investment of assets held in, or contributed to, their individual accounts,” but does not include brokerage windows, self-directed brokerage accounts, or similar plan arrangements that allow participants to select investments not otherwise offered under the plan menu.  The final regulation requires additional disclosures from investment managers that provide ERISA fiduciary services to a Plan Asset Vehicle that is offered as a DIA in a participant-directed, individual account plan—such as a 401(k) plan allowing participant direction of contributions into a collective investment fund.  (These additional disclosure requirements of DIA fiduciary managers, therefore, only apply in the context of participant-directed, individual account plans, and not to investments made by traditional pension plans or defined contribution plans in which there is no participant direction.)

Under the final regulation, the investment manager of a DIA is required to disclose the total annual operating expenses of the Plan Asset Vehicle and, if within the control of or reasonably available to the investment manager, performance data and fee and expense information required in order for the responsible plan fiduciary to satisfy the participant-disclosure rules (DOL Reg. §2550.404a-5(d)(1)). This means that the investment manager will need to provide (i) information on the DIA’s average annual total return for the one-, five- and 10-calendar year periods ending in the most recently completed calendar year, (ii) an appropriate benchmark, (iii) fee and expense information, (iv) the DIA’s principal strategies and principal risks, and (v) the DIA’s portfolio turnover rate.  If the investment manager does not provide this information, the responsible plan fiduciary is required to terminate the relationship so as to avoid engaging in a prohibited transaction.

3)    Disclosure of Indirect Compensation Arrangements and Compensation Paid to AffiliatesThe final regulation includes disclosure requirements for indirect compensation.  Indirect compensation means compensation received by the investment manager from any source other than the plan, the plan sponsor, or an affiliate of the manager, and includes non-monetary compensation.  Under these definitions, indirect compensation includes soft dollars provided by a broker-dealer to an investment manager in exchange for the investment manager’s executing of securities transactions through the broker-dealer.  Indirect compensation could also include non-monetary compensation, such as gifts, awards and trips.  The compensation must be quantified in the disclosure (e.g., a dollar amount, a formula based upon plan assets, or a per-participant charge) so that the responsible plan fiduciary can evaluate the total amount of compensation, both direct and indirect, that the investment manager will receive.

In addition to describing the indirect compensation the investment manager expects to receive, the investment manager must describe the services for which the indirect compensation will be received, the payer of the indirect compensation, and the “arrangement” with the payer.  Thus, in the example above, the investment manager would need to describe the arrangement with the broker-dealer under which the broker-dealer provides soft dollars to the investment manager in exchange for executing transactions.  An investment manager also must disclose payments among itself and its subcontractors or affiliates, such as an affiliated broker-dealer and subcontractors, that are either set on a transaction basis (e.g., soft dollars, commissions, finder’s fees) or that are charged directly against the covered plan’s investment and reflected in the net value (e.g., Rule 12b-1 fees).

The DOL has stated in the preamble to the final regulation that it “intends the concept of compensation to be received by a covered service provider, or its affiliates or subcontractors, ‘in connection with’ a particular contract or arrangement for services [to] be construed broadly.”  The preamble provides the example of a conference offered by a covered service provider to its plan clients in which the clients pay a small fee for attendance and another institution pays a larger “subsidy fee” to defray a portion of the cost of the conference.  The preamble indicates that in some instances the subsidy fee could be considered compensation received by the covered service provider in connection with the covered service provider’s arrangement with the plan client.

4)    Responsible Plan Fiduciary’s Obligation to Terminate the Service Contract Upon Failure to Disclose.  Under ERISA’s prohibited transaction rules, the responsible plan fiduciary is prohibited from permitting a plan to enter into an arrangement with a service provider unless the arrangement is “reasonable” – which means the disclosure requirements of the final regulation are satisfied.  This means that in order to avoid engaging in a prohibited transaction, the responsible plan fiduciary must make sure that each covered service provider furnishes it with the disclosures and that the disclosures contain the requisite information regarding services, compensation, fiduciary status and registration status under the Investment Advisers Act or state law.

Accordingly, the final regulation provides an exemption process for responsible plan fiduciaries where a service provider fails to provide the required information.  By satisfying the conditions of this exemption, the plan fiduciary will not be liable for the prohibited transaction.  Among the conditions is a requirement that the responsible plan fiduciary request the information in writing as soon as it learns of the failure to disclose, and that it identify the service provider to the DOL if the service provider fails to provide the information within 90 days of the written request.

The interim final regulation also required that the responsible plan fiduciary evaluate whether it should terminate or continue the arrangement if the service provider failed or refused to provide the requested information.  In other words, termination was permissive and in the discretion of the responsible plan fiduciary.  The rule now states that, “If the requested information relates to future services (i.e., services that will be performed after the end of the 90-day period…) and is not disclosed promptly after the end of the 90-day period, then the responsible plan fiduciary shall terminate the contract or arrangement as expeditiously as possible, consistent with such duty of prudence.”  (Emphasis added.) 

5)    Disclosure of Changes The final regulation continues to require that the investment manager disclose changes in information related to its services, status as a fiduciary and a registered investment adviser, and compensation within 60 days after the investment manager is informed of the change.  Changes to the investment information, however, may be provided annually.

6)    Disclosures for Reporting and Disclosure Purposes.  The interim final regulation required that information needed by the plan administrator of a covered plan to enable it to comply with its reporting and disclosure obligations under ERISA had to be provided within 60 days after a written request.  The final rule modifies this to specify that the information must be provided “reasonably in advance” of the date the plan administrator states in its written request that it must comply with its reporting and disclosure requirement.  For example, the plan administrator must state when it expects to file its Form 5500, and the investment manager must provide the information “reasonably in advance” of that date.  This presupposes that the plan administrator has made its written request in time for the investment manager to do so. investment manager also must disclose payments among itself and its subcontractors or affiliates, such as an affiliated broker-dealer and subcontractors, that are either set on a transaction basis (e.g., soft dollars, commissions, finder’s fees) or that are charged directly against the covered plan’s investment and reflected in the net value (e.g., Rule 12b-1 fees).

The DOL has stated in the preamble to the final regulation that it “intends the concept of compensation to be received by a covered service provider, or its affiliates or subcontractors, ‘in connection with’ a particular contract or arrangement for services [to] be construed broadly.”  The preamble provides the example of a conference offered by a covered service provider to its plan clients in which the clients pay a small fee for attendance and another institution pays a larger “subsidy fee” to defray a portion of the cost of the conference.  The preamble indicates that in some instances the subsidy fee could be considered compensation received by the covered service provider in connection with the covered service provider’s arrangement with the plan client.

Conclusion

The final regulation should have limited impact on those investment managers that already recognize they are covered service providers.  However, we are concerned that many investment managers do not realize that they are subject to these new requirements.  Also, investment managers that provide ERISA fiduciary services to a Plan Asset Vehicle may not have recognized that they are covered service providers and will need to act swiftly to comply with these disclosure obligations by July 1 for their existing service contracts.  Such investment managers should also take care to understand and comply with the expanded requirement in the final regulation to disclose investment information in their possession regarding designated investment alternatives (DIAs) associated with participant-directed, individual account plans.  An investment manager’s failure to comply with these rules could result in serious consequences, including imposition of an excise tax, refunding the investment manager’s compensation plus interest on that amount, and imposition of a 20 percent penalty.

©2019 Drinker Biddle & Reath LLP. All Rights Reserved

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About this Author

Fred Reish, Drinker Biddle Law Firm, Los Angeles, Labor and Employment Law Attorney
Partner

Fred Reish represents clients in fiduciary issues, prohibited transactions, tax-qualification and Department of Labor, Securities and Exchange Commission and FINRA examinations of retirement plans and IRA issues.

Fred works with both private and public sector entities and their plans and fiduciaries and represents plans, employers and fiduciaries before federal agencies such as the DOL and IRS. He consults with banks, trust companies, insurance companies and mutual fund management companies on 401(k) recordkeeping services, investment products and...

(310) 203-4047
Joan M. Neri, Counsel, Drinker Biddle, Employee Benefits, Executive Compensation
Counsel

Her practice focuses on all aspects of employee benefits counseling.  Joan represents plan service providers (including registered investment advisers, third party administrators, and recordkeepers) in fulfilling their obligations under ERISA.  Joan also represents plan sponsor clients on the design of qualified retirement plans (including ESOPs), nonqualified executive compensation plans and welfare benefit plans, day-to-day plan administrative issues and transactional planning involving benefit plan acquisitions, plan mergers and plan terminations.  Joan has represented major publicly-held corporations, closely held corporations, U.S. affiliates of foreign corporations and tax-exempt organizations in various matters involving benefits and compensation matters.

In General.  Joan received her bachelor's degree in economics from Douglass College in 1983, where she graduated in three years Phi Beta Kappa with high honors, her J.D. from Seton Hall University in 1986, where she was associate editor of the Seton Hall Law Reviewand published three articles.

973-549-7393
Bruce Ashton, Drinker Biddle Law Firm, Los Angeles, Employment Benefits Attorney
Partner

Bruce L. Ashton has more than 35 years of experience handling employee benefits matters. His practice concentrates on representing plan service providers (including RIAs, independent record-keepers, third-party administrators, broker-dealers and insurance companies) in fulfilling their obligations under ERISA. His experience includes representing public and private sector plans and their sponsors, negotiating the resolution of plan qualification issues under IRS remedial correction programs, advising and defending fiduciaries on their obligations and...

310-203-4048
Bradford Campbell, Drinker Biddle Law Firm, Washington DC, Labor and Employment Attorney
Partner

Bradford P. Campbell is a nationally recognized figure in employer-sponsored retirement plans. He is the former Assistant Secretary of Labor for Employee Benefits and former head of the Employee Benefits Security Administration. As ERISA’s former “top cop” and primary federal regulator, Brad provides his clients with insight and knowledge across a broad range of ERISA-plan related issues. He provides employee benefits advice to financial service providers and plan sponsors, particularly in relation to ERISA Title I issues, including fiduciary conduct and...

202-230-5159