From late 2010 to the present, the Department of Labor's Employee Benefits Security Administration (DOL) has been making significant changes to the rules that govern the relationship between employee benefit plans and those that provide investment advice and other financial services to plans and their participants. As a result, brokers and brokerage houses, appraisers and valuation firms, and various types of financial advisors face a changing regulatory landscape and may soon become exposed to new liabilities.
Specifically, the DOL recently: (1) proposed rules that would more broadly define the circumstances under which a person is considered a "fiduciary" by reason of giving investment advice to an employee benefit plan or to a plan's participants; (2) published rules for greater disclosure of service provider fees and other plan expenses and fees; and (3) clarified rules pertaining to specific types of asset managers. What follows is a brief summary of these new developments and their implications for financial advisors.
DOL Proposes (and Reexamines) Rules Expanding Definition of "Fiduciary"
In October 2010, the DOL proposed a regulation to expand the definition of "fiduciary," set forth in ERISA § 3(21)(A), to include any individual who provides advice regarding the value, management or purchasing or selling of securities or other property to an ERISA plan, even if that advice was not delivered on a regular basis or was not the primary reason for the plan's investment decision, as the rules currently require.
In March and April of this year, the EBSA held hearings and collected comments from stakeholders on the roles and duties of fiduciaries in order to better understand the implications of their proposed changes to the definition. A final "fiduciary definition" regulation is expected to be issued by the end of the year.
Impact Of The Definition Expansion
The proposed definition change will likely lead to greater exposure to liability for brokers, appraisers, financial advisors and others who service employee benefit plans because they will likely find that as a result of the expansion of what constitutes "investment advice" in the new rules, they are in a fiduciary relationship with the benefit plans they are servicing and are therefore exposed to additional liability.
With regard to the definition of "investment advice," the new regulation:
eliminates the requirement (for fiduciary status) that the investment advice be rendered on a regular basis;
provides that any advice that may be considered in connection with investment or management decisions is now covered;
provides that the advice no longer needs to be provided pursuant to a mutual agreement; and
provides that fairness opinions and appraisals are specifically included as covered types of investment advice.
It is important to note that an individual or entity can become a fiduciary based on actions alone. Under ERISA's functional definition of "fiduciary," a person or entity may be deemed a fiduciary of a plan solely as a result of the functions the person performs with respect to the plan, regardless of whether the person is a "named fiduciary" on plan documents.
Impact On Valuation Firms/Appraisers
Although the specific implications of the expanded "fiduciary" definition are not entirely clear for all financial advisors, firms and individuals providing valuation and appraisal services are likely to suffer economically from the proposed regulatory modification.
In a 1976 Advisory Opinion,1 the DOL found that a valuation of closely held employer securities that an employee stock ownership plan (ESOP) would rely on in deciding the adequate consideration for purchase of the securities did not constitute investment advice, and therefore, fiduciary status did not attach to the valuation firm. The opinion clarified that when valuation firms provided advice to sponsors of ESOPs or ESOPs themselves, such advice would not serve as the primary basis for investment decisions with respect to plan assets; nor would it constitute advice as to the value of securities within the meaning of the regulation. The proposed regulation explicitly overturns the DOL's 1976 Advisory Opinion.
As a result, valuation firms, such as those that provide fairness opinions to ESOPs, may soon acquire the status of "fiduciary." This new status will, among other things, compel them to procure fiduciary liability insurance, expose them to litigation for potential breach of fiduciary duties and require greater disclosure. These new costs may drive many of these firms out of the marketplace.
DOL Releases Regulations On Fee Disclosure
Adding to the regulatory burden on financial advisors, the DOL has released two new rules on fee disclosures for retirement plans--the "Section 408(b)(2)" regulations and the "Participant-Directed" regulations.2 What follows is a brief discussion of each of the new regulations.
Last year, the DOL released interim final rules under ERISA § 408(b)(2) concerning required disclosures in connection with services rendered to ERISA plans. The regulations cover plans within the meaning of ERISA § 3(2)(A). Thus, the rules apply to both defined benefit and participant-directed pension plans, but do not apply to individual retirement accounts, individual retirement annuities, simplified employee pensions, simple retirement accounts and Keogh plans. The rules were initially set to be effective in July 2011, but a Notice published by the DOL in the Federal Register on June 1, 2011, proposes to extend the effective date of the rules to January 1, 2012.
Section 408(b)(2) of ERISA requires that certain service provider arrangements with ERISA plans, and related compensation, be "reasonable" in order to be exempt from being deemed a "prohibited transaction" under ERISA § 406 and corresponding Internal Revenue Code provisions. Generally, a "prohibited transaction" is a self-interested or conflicted transaction between a plan and an individual or entity that results in liability for those involved due to the type of self-dealing or conflict of interest involved.
The rules provide that an arrangement will not be considered "reasonable" unless the service provider discloses in writing certain fee and compensation information to a plan. The goal of the regulation is to ensure that all service provider fees, including hidden and indirect fees, are provided to plans. Included in the rules is an obligation on service providers receiving requests from plan administrators in connection with Schedule C, Form 5500 compliance. Further, the rules provide a class exemption for plan fiduciaries that notify the DOL when service providers fail to comply with the disclosure rules.
Participant-Directed Fee Disclosure Regulations
New "participant-directed" plan fee disclosure regulations were released by the DOL in October 2010. The new rules were initially applicable for the first plan year beginning on or after November 1, 2011, and for calendar year plans - January 1, 2012. However, the DOL effectively extended the applicability date of the rules to January 1, 2012 (or beyond, depending on the start of the plan year) by extending the date by which initial disclosures must be provided (from 60 to 120 days).
These rules require fiduciaries of participant-directed individual account plans, such as 401(k) plans, to disclose certain plan and investment-related information, including fee and expense information, to plan participants and beneficiaries.
Other New Rules
In February and April of this year, the DOL clarified rules pertaining to prohibited transaction exemptions for specific types of service providers. Specifically, on April 1, 2011, the DOL adopted an amendment to Prohibited Transaction Exemption 96-23 (PTE 96-23), a class exemption that permits various transactions involving employee benefit plans whose assets are managed by in-house asset managers (INHAMS), provided the conditions of the exemption are met. Among other changes, the amendment expands the exemption's definition of INHAM to include a subsidiary that is 80 percent or more owned by the employer or parent company and increases the exemption's required amount of plan assets under management from $50 million to $85 million to account for changes in the Consumer Price Index. With the exception of a provision pertaining to "co-joint venturers," which is retroactively effective to April 10, 1996, the remaining provisions of the amended exemption are effective April 1, 2011.
In both February and April, the DOL released Advisory Opinions pertaining to a prohibited transaction exemption applicable to asset managers. Specifically, the February Advisory Opinion discussed and clarified the "prohibited transaction" and "party in interest" rules pertaining to broker-dealers that provide services to ERISA plans. Among other clarifications, the Advisory Opinion makes clear that Prohibited Transaction Exemption 84-14, Part I (providing an exemption for plan asset transactions determined by independent qualified professional asset managers), provides an exemption only from violations of ERISA § 406(a) (pertaining to transactions between plans and parties in interest) and does not extend relief to transactions that violate ERISA § 406(b) (pertaining to transactions between plans and fiduciaries).
The DOL revisited this prohibited transaction exemption in April, clarifying rules pertaining to transactions occurring in the context of a stable value program, where a stable value manager is responsible for negotiating stable value wrap contracts with various banks or insurance companies.
Changing Regulatory Landscape
There is no question that financial advisors in the retirement plan industry must now operate under new rules. Advisors have a lot at stake if they fail to make appropriate disclosures and meet their new obligations. Failure to comply with these new requirements could result in penalties, monetary damages and the inability to continue providing advice and other financial services to benefit plans.
Daniel N. Kuperstein is a labor and employment and employee benefits attorney at Fox Rothschild in Roseland, N.J., and he can be reached at firstname.lastname@example.org or 973-994-7579.
1 Dep't of Labor, Advisory Op. 76-65 (June 7, 1976).
2 The DOL has long considered fee disclosure to be among its most important regulatory initiatives, and since the summer of 2008, it has been sharing information and working closely with the Securities and Exchange Commission (SEC) on ensuring clear fee disclosure language pursuant to a Memorandum of Understanding formed between the agencies.