- The Department of Labor’s 2016 Final Fiduciary and Conflict of Interest Regulations: The New Fiduciary Standard
- June 17, 2016 | Author: Alden J. Bianchi
- Law Firm: Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. - Boston Office
With this post, we begin our substantive explanation of the Department of Labor’s suite of final fiduciary and conflict of interest regulations. For the financial services industry, and for the retirement plans and IRAs, there are game-changing rules. This post covers the definition of what constitutes and “investment advice fiduciary.” Future posts will examine the remaining regulations (dealing principally with conflicts of interest) and their impact on stakeholders.
The enactment, on Labor Day 1974, of the Employee Retirement Income Security Act (“ERISA”) capped a decade-long Congressional effort to protect private pensions and other employee benefits plans. Among other things, ERISA prescribes strict standards-referred to as “fiduciary” standards-to which those with responsibility for the maintenance and operation of employee benefit plans and the investment of plan assets must adhere. ERISA also bars certain transactions, called “prohibited transactions,” which Congress determined to pose special dangers to benefit security. Prohibited transactions include “party in interest” transactions with, and fiduciary self-dealing with respect to, ERISA-covered plans. Parallel provisions of the Internal Revenue Code (“Code”) apply similar prohibited transaction rules to transactions involving individual retirement accounts (“IRAs”). The ERISA and Code-based prohibited transaction rules apply broadly in the absence of a statutory or regulatory exemption.
In a suite of recently issued final regulations published in the Federal Register on April 8, 2016, the Department of Labor (the “Department”) broadened the class of individuals who are deemed as ERISA fiduciaries as a result of giving investment advice to an ERISA-covered retirement plan or its participants or beneficiaries and to IRAs. The Department also introduced a new prohibited transaction class exception (referred to as the “Best Interest Contract” exemption) meant to preserve many existing compensation practices common to the financial services industry, and made conforming changes to a series of existing prohibited transaction exemptions, all designed to align interests of financial advisers with those of plan participants and IRA owners.
The new fiduciary and related rules take effect on June 7, 2016, which is the earliest date permitted under the Congressional Review Act. (Under this law, Congress has 60 days following the publication of a final rule with an economic impact of more than $100 million to adopt a joint resolution of disapproval effectively stopping the regulation. The House or Representatives recently passed H.J. Res. 88, which would nullify the rule under the Congressional Review Act, but even if the Senate agreed the President would in all likelihood veto the measure.) The Department has announced that it will not apply the rule until April 10, 2017, which is referred to as the rule’s “applicability date.”
This post explains the Department’s new regulation - the “Fiduciary Regulation” - defining the term fiduciary, which is the first of seven final regulations all issued on the same day. (For a list of and links to all seven final regulations, please see our post of April 11, 2016.)
II. An Overview of ERISA fiduciary, self-dealing, and prohibited transaction rules
The ERISA fiduciary standards take as their starting point traditional notions of trust law that have their origins in the English common law. But unlike the common law, ERISA treats as fiduciaries not only persons formally named or designated as such but also persons who act in a fiduciary capacity. The approach adopted under ERISA for the purpose of identifying a fiduciary is often referred to as a “functional” definition. While persons identified as fiduciaries in the relevant plan or IRA documents are clearly fiduciaries, a person not identified in a plan or IRA document can nevertheless qualify as a fiduciary by virtue of his or her role or function. Specifically, ERISA section 3(21)(A) provides that a person is a fiduciary with respect to a plan to the extent he or she:
(i) exercises any discretionary authority or discretionary control with respect to management of such plan or exercises any authority or control with respect to management or disposition of its assets;
(ii) renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or,
(iii) has any discretionary authority or discretionary responsibility in the administration of such plan.
It is the second of these three prongs, relating to “investment advice” that is the subject of the Fiduciary Regulation.
Parallel rules governing fiduciary conduct and conflicts of interest appear in ERISA Title I and in the Internal Revenue Code (“Code”). ERISA governs “employee benefit plans,” while the Code governs tax-qualified (and other) retirement plans, many of which also qualify as ERISA-covered employee benefit plans. The Code also regulates certain arrangements that are not subject to ERISA, such as IRAs, Health Savings Accounts (HSAs), Archer Medical Savings Accounts and Coverdell Education Savings Accounts.. Subsequent to ERISA, in a 1978 Presidential order that was later codified, the power to prescribe IRA conflict of interest rules was transferred to the Department of Labor.
ERISA imposes on fiduciaries the obligation to manage plan assets prudently and with undivided loyalty to plans, and their participants and beneficiaries. The law also includes conflict of interest standards that bar fiduciaries from self-dealing and require fiduciaries and other interested persons to refrain from engaging in prohibited transactions, in each case absent an applicable statutory or administrative exemption. Prohibited transactions include sales and exchanges between plans and parties with certain connections to the plan such as fiduciaries, other service providers, and employers of the plan’s participants. In contrast to the ERISA fiduciary rule, the statute’s conflict of interest rules are not based in the common law. Rather, they were included in ERISA because Congress determined that these practices posed special dangers to the security of retirement, health, and other benefit plans.
Recognizing that there might be instances in which relief from the self-dealing and prohibited transaction rules might be warranted, Congress provided for certain statutory exemptions. For example, payments to service providers, which would be barred as a prohibited transaction, are nevertheless permitted where the vendor’s compensation is reasonable and other safeguards are observed. Congress also delegated to the Department the power to grant administrative exemptions, either by “class” or individually, provided that the Department finds that the exemption is in the interests of plan participants, protective of their rights, and administratively feasible.
ERISA Title I generally provides for the recovery of losses from, and imposition of civil penalties on, fiduciaries who engage in prohibited transactions, while the parallel provisions of the Code impose excise taxes on persons engaging in the prohibited transactions. When fiduciaries violate ERISA’s conflict of interest rules, they may be held personally liable for any losses resulting from the breach. These violations also give rise to excise taxes under the Code and civil penalties under ERISA.
III. The back story to the Fiduciary Regulation
The Fiduciary Regulation amends a prior, 1975 regulation specifying when a person is a “fiduciary” under ERISA and the Code by reason of the provision of investment advice for a fee or other compensation to a retirement plan or IRA. For a detailed explanation of this regulation see our post of May 14, 2015. By way of summary, under the 1975 regulation, for advice to constitute “investment advice”:
- The adviser must render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
- On a regular basis;
- Pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary that:
- The advice will serve as a primary basis for investment decisions with respect to plan assets; and
- That the advice will be individualized based on the particular needs of the plan.
In the preamble to the Fiduciary Regulation, the Department made clear why it felt that it was time to revisit this rule:
“The market for retirement advice has changed dramatically since the Department promulgated the 1975 regulation. . . . In 1975, 401(k) plans did not yet exist and IRAs had just been authorized as part of ERISA’s enactment the prior year.
. . .
“These changes in the marketplace, as well as the Department’s experience with the rule since 1975, support the Department’s efforts to reevaluate and revise the rule through a public process of notice and comment rulemaking. As the marketplace for financial services has developed in the years since 1975, the five-part test now undermines, rather than promotes, the statute’s text and purposes. The narrowness of the 1975 regulation allows advisers, brokers, consultants, and valuation firms to play a central role in shaping plan and IRA investments, without ensuring the accountability that Congress intended for persons having such influence and responsibility. Even when plan sponsors, participants, beneficiaries, and IRA owners clearly rely on paid advisers for impartial guidance, the regulation allows many advisers to avoid fiduciary status and disregard ERISA’s fiduciary obligations of care and prohibitions on disloyal and conflicted transactions. As a consequence, these advisers can steer customers to investments based on their own self-interest (e.g., products that generate higher fees for the adviser even if there are identical lower-fee products available), give imprudent advice, and engage in transactions that would otherwise be prohibited by ERISA and the Code without fear of accountability under either ERISA or the Code.” [Footnotes omitted]
The Department first proposed amending the definition of “fiduciary” in 2010, but the proposed rule was shelved after withering criticism, principally from the financial services industry. (The regulation was not actually formally withdrawn until the issuance of the 2015 proposed regulation discussed below.) Little noticed in the 2010 proposal was a single, passing reference in the “Summary” section to IRA rollovers, which read:
Upon adoption, the proposed rule would affect sponsors, fiduciaries, participants, and beneficiaries of pension plans and individual retirement accounts, as well as providers of investment and investment advice related services to such plans and accounts. (Emphasis added).
At the time, few anticipated that the Department was planning to repudiate its position, taken in Advisory Opinion 2005-23A,that the recommendation by a financial advisor to take a rollover distributions or to otherwise entrust plan or IRA assets to the advisers would not give rise to fiduciary status.
The 2010 regulation was formally withdrawn and re-proposed in April 20, 2015. At the same time the Department proposed new and amended exemptions from ERISA’s and the Code’s prohibited transaction rules designed to allow certain broker-dealers, insurance agents and others to receive commission compensation that would otherwise be prohibited. Public feedback on the proposed rule resulted in important changes being made to the final regulations. The changes are summarized in a chart prepared by the Department.
IV. Variable compensation, commissions, and prohibited transactions
Under ERISA, any time an advisor provides investment advice to a plan fiduciary or participant, and that advice is individualized based on the particular needs of the plan fiduciary or participant, the advisor will be deemed to be a fiduciary. The narrowness 1975 definition of “fiduciary” allowed many if not most retail and other financial advisors to evade fiduciary status. This was particularly important to advisors who were paid commissions. The Fiduciary Regulations no longer allow financial advisors to sidestep fiduciary status so easily.
If a plan or IRA pays an additional fee to a fiduciary, or to a person connected to the fiduciary, under circumstances that might affect the exercise of the fiduciary’s best judgment as a fiduciary, a prohibited transaction results. The result is the same if a fiduciary receives compensation from third parties in connection with a transaction involving the plan or IRA. This is would occur any time the advisor’s recommendation, when acted on by the investor, results in the payment of an “additional fee.” Investment advisors in the retail market often receive compensation for services to retirement investors through commission and other arrangements-e.g., sales loads, 12b-1 fees, revenue sharing and other third party payments. The receipt of the commission in this instance (i.e., the payment of an additional fee) would result in a prohibited transaction, since the fiduciary has dealt with plan assets for his or her own account, absent an exemption.
Since the late 1990s, the Department of Labor has recognized and singled out so-called “fee-leveling” arrangements for special treatment. Generally, under a fee-leveling approach, neither the investment advisor nor his or her employer receives any fees or other compensation based on the investment option selected by a plan participant or IRA investor. Thus, for example, where the advisor applies commissions and other fees to offset fees that the plan or IRA is otherwise required to pay, the prohibited transaction rules are not transgressed, since the advisor is not deemed to be dealing with plan assets for his or her own account. The Pension Protection Act of 2006 added a separate fee-leveling rule, and also rules that permit what has become to be known as “robo-advice,” i.e., advice provided by a computer model.
Where the only fee or compensation received by a financial institution or investment advisor in connection with advisory or investment management services is a level fee under either the Department advisory opinions on the subject or the statutory fee leveling rules, neither the financial institution nor the advisor are thereby deemed to be fiduciaries. This does not mean that an advisor who is paid under a level-fee arrangement need not be concerned about the fiduciary rules, however. A conflict of interest nevertheless exists when a fee-level advisor makes a recommendation to a participant to roll money out of a retirement plan into a fee-based IRA account. As a consequence of the recommendation, the advisor will be paid ongoing fees that he or she would not otherwise receive, even if the fees going-forward do not vary with the assets recommended or invested. Similarly, a recommendation to switch from a low activity commission-based account to an account that charges a fixed percentage of assets under management on an ongoing basis would result in a prohibited transaction. Thus, even fee-level advisors may become fiduciaries under these circumstances.
V. The Departments new, final fiduciary standard
The Fiduciary Regulation first defines what it means to be an investment advice fiduciary, then recognizes a series of exceptions that do not result in fiduciary status. The 2015 proposed regulations referred to these exceptions as “carve-outs.” According to the preamble to the Fiduciary Regulation, the Department abandoned the reference to carve-outs from the scope of the fiduciary definition, since (in the Department’s view) they “are better understood as specific examples of communications that are non-fiduciary because they fall short of constituting ‘recommendations’” (as discussed below).
- Fiduciary status as a result of rendering investment advice for a fee
- To a plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner; and
- Consists of the following types of advice for a fee or other compensation, direct or indirect:
- A recommendation as to the advisability of acquiring, holding, disposing of, or exchanging, securities or other investment property, or a recommendation as to how securities or other investment property should be invested after the securities or other investment property are rolled over, transferred, or distributed from the plan or IRA;
- NOTE: This is a straightforward rule that applies to a recommendation to buy or sell an individual issue or mutual fund share, whether in a retirement plan or IRA, or in an IRA following a rollover from a retirement plan. It is directed at advice that relates to how assets ought to be invested.
- A recommendation as to the management of securities or other investment property, including, among other things, recommendations on investment policies or strategies, portfolio composition, selection of other persons to provide investment advice or investment management services, selection of investment account arrangements (e.g., brokerage versus advisory); or recommendations with respect to rollovers, transfers, or distributions from a plan or IRA, including whether, in what amount, in what form, and to what destination such a rollover, transfer, or distribution should be made.
- NOTE: This provision identifies and deals with recommendations relating to strategy, and it encompasses the choice of an investment advisor or manager. Among other things, it is intended to clarify that a consultant that makes recommendations relating to the menu of investment options under a self-directed 401(k) plan is a fiduciary.
- In addition, the recommendation must be made either directly or indirectly (e.g., through or together with any affiliate) by a person who:
- Represents or acknowledges that it is acting as a fiduciary within the meaning of the Act or the Code;
- NOTE: The purpose of this requirement, according to the Department, is to ensure that the advisor could not attempt to deny fiduciary status once the advisor has acknowledged his, her, or its status as such.
- Renders the advice pursuant to a written or verbal agreement, arrangement, or understanding that the advice is based on the particular investment needs of the advice recipient; or
- Directs the advice to a specific advice recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of the plan or IRA.
[A] “recommendation” means a communication that, based on its content, context, and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action. The determination of whether a “recommendation” has been made is an objective rather than subjective inquiry. In addition, the more individually tailored the communication is to a specific advice recipient or recipients about, for example, a security, investment property, or investment strategy, the more likely the communication will be viewed as a recommendation. Providing a selective list of securities to a particular advice recipient as appropriate for that investor would be a recommendation as to the advisability of acquiring securities even if no recommendation is made with respect to any one security. Furthermore, a series of actions, directly or indirectly (e.g., through or together with any affiliate), that may not constitute a recommendation when viewed individually may amount to a recommendation when considered in the aggregate. It also makes no difference whether the communication was initiated by a person or a computer software program.
The Department underscores in the preamble to the Fiduciary Regulation that paid advice as to the selection of money managers or mutual funds rises to the level of a recommendation. In a welcome and much needed clarification, the Department also said that a consultant or advisor does not become a fiduciary by advertising investment advice or investment management services or by responding to an RFP. This so-called “hire me” exemption is not without limits, however. Generally, an advisor or consultant will not become a fiduciary merely by engaging in the normal activity of marketing himself, herself or itself (or an affiliate) to be selected by a plan fiduciary or IRA owner. Accordingly, a person or firm can tout the quality of his, her, or its own advisory or investment management services or consulting services, or those of an affiliate, without triggering fiduciary obligations. But this rule does not exempt a person from being a fiduciary with respect to investment recommendations otherwise covered by the final rule. Thus, for example, an adviser can recommend that a retirement investor enter into an advisory relationship with the adviser without acting as a fiduciary. When the adviser recommends that the investor pull money out of a plan or invest in a particular fund, however, that advice is given in a fiduciary capacity even if it is part of a marketing pitch or RFP. According to the preamble,
“[W]hen a recommendation to ‘hire me’ effectively includes a recommendation on how to invest or manage plan or IRA assets (e.g., whether to roll assets into an IRA or plan or how to invest assets if rolled over), that recommendation would need to be evaluated separately under the provisions in the final rule.”
- What is not a “recommendation”-Platform Service Providers
While welcome, this exemption may not be all that easy to apply. Platform providers are deemed fiduciaries if they create a tailored list of investments from which the plan sponsor can choose, although these same providers may, without triggering fiduciary status, identify “offered investment alternatives meeting objective criteria specified by the plan fiduciary.” What the Department has in mind here is the making available of platforms segmented based on objective criteria such as different platforms for small, medium, and large plans. In the Department’s view, this type of activity is “more akin to product development and is within the provider’s discretion as a matter of business judgment.” Where one draws the line is not clear. At what point does a platform provider cease to exercise business judgment and begin to create a list of investments that the plan sponsor can choose between or among? The conundrum is illustrated in the following passage from the preamble:
Of course, a provider could find itself providing investment advice depending on the particular marketing technique used to promote a segmented platform. For example, if a provider were to communicate to the plan fiduciary of a small plan that a particular platform has been designed for small plans in general, and is appropriate for this plan in particular, the communication would likely constitute advice based on the individual needs of the plan and, therefore, very likely would be considered a recommendation.
- What is not a “recommendation”- Selection and monitoring
This provision also permits service providers to respond to RFPs that identify a limited or sample set of investment alternatives based on the size of the employer or plan, the current investment alternatives designated under the plan, or both. To qualify, the response must be in writing and must disclose whether the person identifying the limited or sample set of investment alternatives has a financial interest in any of the alternatives, and if so the precise nature of such interest. As is the case with platform providers, the contours of this exception are at least modestly worrisome. How does a vendor ensure that the limited or sample set of investment alternatives is based on the “size of the employer or plan?”
Lastly, a service provider is allowed to provide objective financial data and comparisons with independent benchmarks to a plan fiduciary.
- What is not a “recommendation”-General Communications
- What is not a “recommendation”-Investment Education
The exception in the final rule for investment education allows specific investment alternatives to be included as examples in presenting hypothetical asset allocation models or in interactive investment materials intended to educate participants and beneficiaries as to what investment options are available under the plan so long as they are designated investment alternatives selected or monitored by an independent plan fiduciary and other conditions are met. This rule applies only to plans, not IRAs. The Department reasoned that, in contrast to plans, there is no independent fiduciary in the IRA context. Thus, for IRAs, the investment education provision in the rule does not treat asset allocation models and interactive investment materials with references to specific investment alternatives as merely “education.”
Lastly, the Fiduciary Regulation clarifies that “education” will not rise to the level of fiduciary advice regardless of who provides the educational information (e.g. the plan sponsor or service provider), the frequency with which the information is shared, or the form in which the information and materials are provided (e.g. on an individual or group basis, in writing or orally, via a call center, or by way of video or computer software).
VI. The Seller’s exemption
The 2015 propose rules included a “seller’s carve-out” that exempted arm’s-length dealings between sophisticated fiduciaries of large plans and financial institutions acting as counterparties. The carve-out was intended to permit investment product sales pitches to a plan. The seller’s carve-out, as proposed, applied only to plans and not IRAs. The final rule extends the exemption to IRAs.
The proposed rule would have applied to plans with an independent fiduciary (i.e., a plan fiduciary independent of the financial adviser) with at least 100 participants, as well as plans with an independent fiduciary who is responsible for managing at least $100 million in plan assets, as sufficiently sophisticated to engage in arm’s-length dealings with financial advisers without the need for additional ERISA fiduciary protection. 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.”
The proposed rules raised concerns that the seller’s carve-out would not cover 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.” While dropping the reference to a “carve-out,” the final rule retains the seller’s exemption with some modifications. In so doing, the Department sought to define boundaries between fiduciary advice and sales activity directed at independent fiduciaries with financial expertise.
Under the final rule, the provision of any advice by a person to a fiduciary of the plan or IRA who is independent of the person providing the advice with respect to an arm’s length sale, purchase, loan, exchange, or other transaction related to the investment of securities or other investment property is not thereby rendered a fiduciary if certain requirements are satisfied. The independent fiduciary of the plan or IRA must be either a bank, an insurance carrier, a registered investment adviser, or a broker-dealer, or an independent fiduciary that holds, or has under management or control, total assets of at least $50 million.
NOTE: While the total assets have been reduced to $50 million from $100 million in the proposed rule, the “100 participant” threshold has been eliminated in the final rule. Thus, the final rule significantly narrows the standard set out in the proposed rule.
In addition, the person providing the advice must (i) know or reasonably believe that the independent fiduciary of the plan or IRA is capable of evaluating investment risks; (ii) inform the independent fiduciary that he or she is not undertaking to provide impartial investment advice; (iii) know or reasonably believe that the independent fiduciary of the plan or IRA is a fiduciary under ERISA or the Code, or both, with respect to the transaction and is responsible for exercising independent judgment in evaluating the transaction; and (iv) not receive a fee or other compensation directly from the plan, plan fiduciary, plan participant or beneficiary, IRA, or IRA owner for the provision of investment advice (as opposed to other services) in connection with the transaction.
VII. Swap and security-based swap transactions
The exception for “swap and security-based swap transactions” is narrowly targeted to permit advice and other communications by counterparties in connection with certain swap or security-based swap transactions under the Commodity Exchange Act or the Securities Exchange Act. The exemption for swaps applies only to retirement plans and not to IRAs or individual participants. As proposed, the swap carve-out did not appear to extend to pooled funds that hold plan assets.
The exception allows swap dealers, security-based swap dealers, major swap participants and security-based major swap participants who make recommendations to plans to avoid becoming fiduciaries when acting as counterparties to a swap or security-based swap transaction. To qualify for the exception, a plan must be represented by a fiduciary under ERISA independent of the swap dealer, security-based swap dealer, major swap participant, major security-based swap participant, or a swap clearing firm. If the person providing recommendations is a swap dealer or security-based swap dealer, it must not act as an adviser to the plan. Nor may the person receive a fee or other compensation directly from the plan or plan fiduciary for the provision of investment advice (as opposed to other services) in connection with the transaction.
Before providing any recommendations with respect to the transaction, the person providing recommendations must obtain a written representation from the plan fiduciary that the fiduciary understands that the person is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, in connection with the transaction and that the independent fiduciary is exercising independent judgment in evaluating the recommendation.
VIII. Employees’ exemption
Under this exemption, employees of plan sponsors, affiliates, employee benefit plans, employee organizations or plan fiduciaries will not be treated as fiduciaries 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 employees of the plan sponsor. Nor will employees be considered fiduciaries when they communicate information to other employees about the plan and distribution options under the plan, so long as (i) an employee’s job or position does not involve the provision of investment advice or investment recommendations, (ii) an employee is not registered or licensed under federal or state securities or insurance law, (iii) the advice he or she provides does not require the employee to be registered or licensed under federal or state securities or insurance laws, and (iv) the employee does not receive compensation beyond his or her normal pay for work performed for the employer.
IX. Who is affected?
The Fiduciary Regulation and its accompanying suite of final rules will have the largest impact on financial advisors, including broker-dealers/registered representatives, Registered Investment Advisors (RIAs), and insurance agents and brokers, who advise IRA investors. It will also affect, in different ways, sponsors of large and small retirement plans, including both committee directed and participant directed arrangements; mainstream and specialty financial services vendors (or “manufactures”), other IRA service providers; promotors of alternative investments; and even REITs and venture, private equity and hedge funds that seek investments from IRAs or ERISA-covered plans. Future posts will, in turn, examine the impact on Department‘s final fiduciary and accompanying rules each of these stakeholders.