The U.S. Department of Labor (DOL) recently released long-awaited, re-proposed regulations that would broaden the “fiduciary” definition under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (Code) to include a much wider array of persons who provide investment advice or recommendations to employee benefit plans, plan fiduciaries, plan participants/beneficiaries or Individual Retirement Account (IRA) owners. In addition, the DOL proposed two new prohibited transaction class exemptions and proposed to amend several existing prohibited transaction exemptions as part of the overall scheme to regulate investment advice activity. In a number of respects, the combination of the proposed regulations and the prohibited transaction exemptions would impose more stringent standards upon those found to be a “fiduciary” under the broader definition.
Scope of Reproposal
These regulations clarify that persons will be deemed to be a “fiduciary” if they provide investment advice or recommendations with respect to employee benefit plans subject to ERISA, or with respect to IRAs as described in Code Section 4975(e). This means the new “fiduciary” definition applies not only in the context of traditional IRA accounts and annuities, but also with respect to Roth IRAs, Archer medical savings accounts, Coverdell education savings accounts and Health Savings Accounts (HSAs).
Current Definition of Fiduciary
Under ERISA and the Code, a person is a fiduciary with respect to a plan or IRA to the extent that it engages in certain specific plan activities, such as providing investment advice for a fee or other compensation, direct or indirect, with respect to any plan assets. In 1975, the DOL issued a regulation that interpreted the scope of the statutory definition of fiduciary investment advice based on a five-part test. Among other things, the test requires an adviser to provide advice on a regular basis, pursuant to a mutual agreement with the plan or plan fiduciary that the advice would serve as a primary basis for investment decisions with respect to plan assets, and the advice would be individualized based on the particular needs of the plan. This meant that an adviser could escape fiduciary status as long as one of the requirements was not met (e.g., the parties did not have a mutual agreement that the advice would serve as a primary basis for investment decisions).
Proposed New Definition of Fiduciary
The proposed regulations would broaden the scope of persons who will be deemed to be a fiduciary by providing that the following types of advice may be considered fiduciary “investment advice” if the adviser receives a direct or indirect fee or other compensation in connection with the advice:
- Investment recommendation, including whether to take a distribution or how to invest a rollover or distribution from a plan or IRA
- Asset management recommendation (e.g., proxy voting)
- Valuation of asset in a specific transaction
- Recommendation of a paid adviser to do any of the above
Note that the regulations define “recommendation” broadly to mean 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.” In formulating this definition of “recommendation,” the DOL consulted with other agencies with rulemaking authority over investment advisers and broker-dealers such as the Financial Industry Regulatory Authority (FINRA).
However, such advice will only be considered fiduciary “investment advice” if the adviser either directly or indirectly (e.g., through or together with an affiliate):
- Represents or acknowledges that it is acting as a fiduciary with respect to the advice
- Provides the advice pursuant to a written or verbal agreement, arrangement or understanding that the advice is individualized or specifically directed to the recipient for consideration in making investment or management decisions with respect to the securities or other property of the plan or IRA.
An investment advice fiduciary would no longer be required to provide advice on a regular basis — one-time or episodic recommendations could be covered. The recommendation need not serve as the primary basis for the decision. The recommendation need not be individualized, as long as it is specifically directed to the recipient.
Carve-Outs From the General Definition
The DOL has recognized that in many situations parties may receive recommendations or appraisals that should not be treated as fiduciary investment advice, and therefore the proposed regulations include the following carve-outs (but only if the adviser has not represented or acknowledged it is acting as a fiduciary):
Carve-Outs Available With Respect to ERISA Plans Only
- Seller transactions to large plan investors — Recommendations made to a large plan investor (100 or more participants) with financial expertise by a counterparty acting in an arm’s length transaction
- Swap counterparty — Communications from a counterparty (swap dealer or swap participant) in connection with a swap or security-based swap transaction
- Employees of a plan sponsor — Recommendations provided to an ERISA plan fiduciary by an employee of the plan sponsor (if no additional fee received beyond normal compensation)
- ERISA plan platform provider — Marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan
- Selection and monitoring assistance — Identification of investment alternatives that meet objective criteria specified by an ERISA plan fiduciary or the provision of objective financial data to such fiduciary
Carve-Outs Available With Respect to Both IRAs and ERISA Plans
- Financial reports and valuations — Appraisals for ESOP transactions (which will remain the subject of a separate DOL regulatory project), appraisals or valuations provided to collective investment funds or pooled separate accounts, or valuations provided solely for purposes of meeting reporting and disclosure requirements
- Investment education — General investment and retirement information is not considered investment advice, but any reference to specific investment products, managers or asset values can take the communication out of this carve-out
Note that several of the carve-outs listed above are subject to the satisfaction of certain additional conditions that are beyond the scope of this legal update (e.g., fairly informing the independent plan fiduciary of the nature of the person’s financial interests in the transaction, etc.).
Prohibited Transaction Class Exemptions
In addition to proposing a new definition of “fiduciary” (and allowing certain carve-outs), the DOL has also proposed certain new administrative prohibited transaction class exemptions as well as amendments to previously adopted exemptions. These proposed changes would allow certain broker-dealers, insurance agents and others that act as investment advice fiduciaries to continue to receive a variety of forms of compensation that would otherwise violate prohibited transaction rules and trigger excise taxes.
The most important of these proposed changes is the new “Best Interest Contract” prohibited transaction exemption, which is a standards-based exemption that applies to the receipt of compensation by advisers and their financial institutions as a result of investment advice provided to retail “Retirement Investors.” For purposes of the exemption, “Retirement Investors” are plan sponsors of ERISA plans with less than 100 participants, plan participants and IRA owners; and an eligible “financial institution” is a registered investment adviser, bank, insurance company or registered broker-dealer. (Note that this exemption is designed to address retail investor situations outside the scope of the “Seller Transactions carve-out” referenced above.)
To qualify for the “Best Interest Contract” exemption, there must be a written contract with the Retirement Investor where the investment adviser and the adviser’s financial institution does all of the following:
- Acknowledges their fiduciary status
- Commits to basic standards of impartial conduct, which generally incorporate an ERISA fiduciary standard of care for prudence and loyalty (which opens them to contractual liability for failure to meet that standard of care)
- Warrants that the financial institution has adopted written policies and procedures designed to mitigate conflicts of interest and ensure adherence to standards of impartial conduct (which includes not authorizing compensation or incentive systems that would tend to encourage recommendations not in the best interest of the Retirement Investor)
- Warrants compliance with applicable federal and state laws (which opens them to contractual liability for failure to comply with applicable law)
- Discloses material conflicts of interest (e.g., whether offering proprietary products or receiving third party payments) and information about fees (the proposed exemption provides a model disclosure form)
- Does not include certain prohibited contract provisions, such as exculpatory provisions disclaiming or limiting liability, or requiring the Retirement Investor to waive its right to participate in class action litigation (although agreement to binding arbitration with respect to individual contract claims would be permissible)
In addition, the financial institution must give advance notice to the DOL of reliance on this exemption and report certain data requested by the DOL (which could open unprecedented new reporting requirements, possibly including information the financial institution had considered confidential proprietary information).
The amendments to the already existing prohibited transaction class exemptions generally serve to narrow those exemptions in order to redirect investment adviser fiduciaries with respect to IRAs toward reliance on the Best Interest Contract exemption.
Implications for Investment Advice to IRA Owners (“ERISAfication” of IRAs)
One result of the proposed regulations and accompanying prohibited transaction exemptions is the “ERISAfication” of IRAs. By statute, the ERISA fiduciary duty rules do not apply to IRAs, and the DOL does not have enforcement authority with respect to fiduciary duties for IRAs. However, the DOL can define the scope of exemptions for purposes of Code Section 4975 (i.e., the excise tax on prohibited transactions for fiduciary self-dealing and receipt of third party payments).
The broader definition of investment advice fiduciaries, combined with the exclusion of communications to IRA owners from the carve-outs for seller transactions, platform providers and selection and monitoring assistance, would sweep more relationships with IRA owners into exposure to prohibited transaction excise taxes. The proposed amendments to current prohibited transaction exemptions would drive advisers to IRA owners toward reliance on the new proposed Best Interest Contract Exemption, which makes investment advisers agree to the same fiduciary standards as apply under ERISA and gives IRA owners enforceable rights under the contracts required for the Best Interest Contract Exemption. Thus, under the proposed DOL scheme, what is not required by statute will be imposed by contract.
The DOL has these proposals on a fast track and is soliciting comments on them until July 6, 2015. The Obama administration has made this a high priority to complete during the President’s term. There are still a number of controversial aspects of these proposals (from the financial industry perspective), so it remains to be seen what final rules will emerge. However, because of the significant changes in operation that might be required for investment advisers and other plan consultants, it is important to anticipate how these proposals could impact current practices.
Doug Heffernan was a co-panelist for the webinar, "How the Proposed Changes to the DOL Fiduciary Definition Will Affect You," on May 1, 2015, sponsored by the Bank Insurance & Securities Association. An archived copy of the webinar slides is available on the BISA website.