This update is published by Ferenczy Benefits Law Center LLP to provide information about recent developments to our
clients and friends. It is intended to be informational and does not constitute legal advice for any particular situation. It also
may be considered to be "attorney advertising" under the rules of certain states.
The New Fiduciary Regulation Proposal, Part II:
The Facts, Ma'am, Just the Facts
In The New Fiduciary Regulation Proposal, Part I: All It Was Cracked Up to Be?, in our
FlashPoint of April 22, 2015, we gave you a quick outline of what the DOL’s proposed fiduciary
regulations and prohibited transaction exemptions (the “Proposal”) did, and our first impressions
of the effect of those releases.
This FlashPoint is intended to provide those who are interested with more information about the
technical details of the Proposal.
Part III, which will come in the next several days, will provide some more analysis, a summary of
how we are seeing the industry react, and any conclusions we have drawn.
More Detail on the Background of the Proposal
The Proposal is the DOL’s latest effort to regulate the standards of conduct and the compensation
paid in relation to retirement plan-related investment advice. In particular, the DOL wants
financial advisors to retirement plans to act in the best interests of their clients, and not with
regard to their self-interests. Called by many the “Conflict of Interest Regulation,” the Proposal
seeks to balance the needs of retirement plan investors to get needed advice with the
compensation structures commonly used by and for investment advisors.
The Proposal modifies—and expands—the category of people who are considered to be
fiduciaries by virtue of giving investment advice. The affected advice may be given to an
employer-sponsored plan, to a participant in the plan, or—and this is the biggest and most
controversial change—to an IRA-holder. (Historically, the DOL has had no jurisdiction over
IRAs and those who provide services to them.) Fiduciaries under retirement plan law are subject
to obligations to their clients. Therefore, by including an advisor or Financial Institution in the
category of being a fiduciary, the DOL is extending the legal obligations to that person or
organization.
Having broadened the definition of who is a fiduciary, the DOL then offers some “carve-outs,”
i.e., types of situations in which the new rules will not apply.
Fiduciaries are not permitted to have a compensation structure under which the amount they
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receive varies in some measure among the investment recommendations made. If compensation
varies in this manner, the DOL believes, the advisor is encouraged to recommend only
investments that pay more to them; in other words, the advisor recommends to the client
investments that pay the most, even if they are not the best options for the investor. The DOL
considers this to be “self-dealing,” i.e., a fiduciary acting in his or her own best interest, and
prohibits this practice for fiduciaries.
This prohibition does not permit the fiduciary advisor to receive the types of compensation that
investment providers normally use: commissions, 12b-1 fees, and other revenue sharing, which
vary from product to product. As a result, fiduciary advisors customarily are paid a percentage of
plan assets that is unaffected by the actual investments selected. This is commonly referred to as
a “level fee” arrangement.
The inability of a fiduciary to get paid the way that investment professionals “normally” do has
been one of the reasons why many advisors have assiduously avoided being classified as
fiduciaries. It is also the basis for why many in the industry believe that broadening the group of
advisors who are fiduciaries will prevent smaller plans and IRA holders from getting the advice
they need. In particular, if the assets in the plan or IRA are low enough that the normal level fee
is insufficient to compensate the advisor, no advisor will take the work. However, if the “normal”
forms of compensation and revenue sharing are available from the investment issuer, the advisor
can be paid a reasonable amount for his or her services.
In response to this concern, the DOL has provided an important exemption from the normal
prohibitions on self-dealing that will permit the payment of this type of variable compensation in
relation to advice to participants, beneficiaries, and small plans, so long as the fiduciary advisor is
acting in the “best interests” of the client and fulfills certain additional requirements.
More Details: The Proposed Redefinition of “Fiduciary”
Many of you know this history by heart, but in case you don’t: ERISA, when passed in 1974,
contained a very broad definition of “fiduciary.” One part of the definition includes as fiduciaries
those who provide investment advice for a fee or other compensation. This very expansive rule
was almost immediately narrowed by the DOL in regulations issued the following year in
1975. Under those regulations, an individual needed to meet the following five-part test to be a
fiduciary advisor:
1. the advisor has to render advice to the plan as to the value of or advisability of buying,
selling, or investing in securities or other property;
2. on a regular basis;
3. pursuant to a mutual agreement, arrangement, or understanding, written or otherwise,
between the fiduciary advisor and the plan or plan fiduciary;
4. with the understanding that the fiduciary advice will serve as a primary basis for the
investment decision; and
5. with the understanding that the advice is individualized to the plan, based on the
particular needs of the plan.
This regulation excluded, for example, people who gave one-time advice, or those who were one
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of many, and not a primary, advisor.
The Proposal changes this five-part test. First, the Proposal provides a broader four-part test to
determine whether the activity of the advisor constitutes the type of advice (called “Covered
Advice”) that may give rise to fiduciary status. In particular, to be a fiduciary, the advisor must
provide:
1. a recommendation regarding the advisability of acquiring, holding, disposing, or
exchanging securities or other property, including a recommendation to take a distribution
or to invest securities or other property to be distributed and/or rolled over from the plan or
IRA;
2. a recommendation as to the management of securities or other property, including
recommendations as to the management of amounts to be rolled over or otherwise
distributed;
3. an appraisal, fairness opinion, or similar statement (verbal or written) concerning the
value of securities or other property if provided in connection with a specific transaction or
series of transactions involving the acquisition, disposition, or exchange of such securities
or other property by the plan or IRA; or
4. a recommendation of a person who is going to receive a fee or other compensation for
providing any of these types of services.
Second, under the Proposal, someone who provides this kind of advice would be a fiduciary if he
or she either:
(a) represents or acknowledges that he or she is a fiduciary; or
(b) renders the advice pursuant to a written or verbal agreement, arrangement, or
understanding that the advice is individualized to, or that such advice is specifically
directed to, the advice recipient for consideration in making investment or management
decisions with respect to securities or other property of the plan or IRA.
Note all the references to “IRAs,” and not just employer-provided plans. The DOL does not
generally have jurisdiction over IRAs. However, the DOL has stretched its arms over the IRA
market through the fact that it was delegated the authority by Executive Order in 1978 to write
regulations relating to the prohibited transaction rules of Internal Revenue Code (“IRC”) Section
4975. These rules nearly parallel the prohibited transaction rules found in the Labor Code …
except for the fact that the IRC rules also apply to IRAs. By applying the current regulations to
both the DOL rules and the IRC rules, the DOL has found a means by which it can exercise
jurisdiction over those who advise IRAs.
In sum, you are a fiduciary if you exercise the right kind of advice and you either admit you are a
fiduciary or render the advice pursuant to an agreement that encompasses certain elements.
The Carve-Outs
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If a carve-out applies, the person giving the advice will not be considered to be a fiduciary, even if
the above requirements are met. These carve-outs have very limited applicability to the
professional fiduciary unless the plan is large.
Counterparty Transactions. This carve-out applies to someone giving advice to a plan fiduciary
who is very astute and experienced with investments. In particular, the recipient of the advice
must be responsible for managing at least $100 million in plan assets. The advisor has obligations
to provide certain disclosures to the plan fiduciary and not take compensation directly from the
plan or the plan’s fiduciary in connection with the transaction. A counterparty to a swap
transaction may also fall within this carve-out.
Employees. Individuals who are employees of the plan sponsor are not fiduciary advisors if they
receive no fee or compensation for their advice other than their normal compensation for their
work for the company. (Note that this applies just to investment advice; this does not prevent plan
sponsor employees from being regular fiduciaries to the plan because they exercise discretion as
to the management of the plan or its assets.)
Platform Providers. Investment platforms provide plans with the structure for individual
investment direction by plan participants. Customarily, such platforms offer a large array of
investments to the plans, and then the plan sponsors or plan fiduciaries select the specific options
among which the participants may invest. The platform then also provides the mechanism for the
participants to actually exercise their participant direction, giving buy or sell orders, or getting
information about their accounts.
The Platform Provider carve-out states that a platform provider is not a fiduciary if it discloses in
writing to the plan fiduciary that it is not undertaking to provide impartial investment advice in a
fiduciary capacity.
Selection and Monitoring Assistance. A person is not a fiduciary to the extent that he or she
simply identifies investment alternatives that meet objective criteria specified by the plan
fiduciary. For example, if the plan sponsor were to tell an investment advisor, “Which options
available on the platform have had a return in excess of 5% over the last five years?” the advisor
could identify those items without becoming a fiduciary.
Financial Reports and Valuations. Appraisals, valuations, and fairness opinions in relation to the
purchase or sale of employer stock in an ESOP or investment fund or to a plan solely to comply
with ERISA’s reporting and disclosure requirements are not fiduciary advice. However, the
preamble to the Proposal makes it clear that the DOL will be offering separate guidance in the
future regarding ESOP valuations and those who do them.
Investment Education. Long considered to be separate from fiduciary advice, providing
educational assistance that does not make recommendations as to any given investment does not
give rise to fiduciary status. Information about the plan, general financial and investment
information, asset allocation models, and interactive investment materials that meet certain
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criteria fall within this category.
The Best Interest Contract Prohibited Transaction Exemption (PTE)
This may be the most interesting and potentially useful portion of the Proposal, as it preserves the
right of investment advisors to receive variable compensation under certain circumstances. It may
also be the most controversial, because of its significant—some have said burdensome—
disclosure obligations.
As noted earlier, when a fiduciary gives advice that increases his or her own compensation
without regard to the interests of the client, he or she is considered to be “self-dealing,” which is a
prohibited transaction. Fiduciaries engaging in self-dealing are subject to excise taxes, and can
also be considered to be in breach of their ERISA duties to the plan or participant. Furthermore,
this serious type of breach is generally not subject to any exemptions offered by the DOL.
Because the Proposal regulates not only employer-provided plans, but also IRAs under IRC
Section 4975, this prohibited transaction exemption will provide relief to IRA advisors, as well as
those who counsel qualified plans.
Under this PTE, an individual (such as a broker-dealer or insurance agent) who is a fiduciary
under the Proposal may receive compensation that varies based on the investment
recommendation if certain requirements are met. Affected advisors include employees,
independent contractors, agents, or registered representatives of “Financial Institutions,” as well
as the institutions themselves and their affiliates and related entities. For this purpose, Financial
Institutions include registered investment advisors, banks, insurance companies, and regulated
broker-dealers. Affiliates and related entities are those who control, are controlled by, or are
under common control with the Financial Institution.
The PTE applies only to advice given to individual participants and beneficiaries of employer
plans, holders of IRAs, or plan fiduciaries for plans with fewer than 100 participants that do not
permit participant-directed investments. These categories of advice recipients are called
“Retirement Investors” in the PTE. The DOL calls the approach taken in this PTE a “standardsbased” approach, as opposed to one that concentrates on the type of transaction, as do most
PTEs. In particular, the PTE will apply so long as certain standards are maintained, regardless of
the type of transaction involved.
The point of the PTE requirements is to try to reduce the impact that a “Material Conflict of
Interest” has on the behavior of the investment advisor and financial institution. A Material
Conflict of Interest is defined to be a financial interest that could affect the exercise of the
fiduciary’s best judgment in making investment recommendations. In other words, the PTE
requirements are an attempt to encourage the fiduciary to disregard his or her financial selfinterest in favor of the interests of the advice recipient, notwithstanding the fact that the
compensation being received will vary based on which recommendation the recipient accepts
when investing. This is particularly interesting when one considers that it is specifically the
existence of this conflict that has given rise to the Proposal.
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Specific Requirements of the Best Interest Contract PTE
There are four categories of requirements to qualify for the PTE: written contract requirements,
impartial conduct standards, requirements that the advisor warranty certain things, and disclosure
requirements.
1. Written contract requirement: The advisor and Financial Institution must enter into a
written contract with the Retirement Investor that contains certain promises and standards;
and then comply with those promises and standards. These standards are outlined below.
Furthermore, the contract must acknowledge the fiduciary status of the advisor and
Financial Institution. This means that, if an advisor is taking advantage of the PTE, the
ability to argue that he or she is not a fiduciary is off the table.
2. Impartial Conduct Standards: The advisor and Financial Institution must:
a. Provide investment advice that is in the best interests of the retirement
investor. This means that the advice will:
(i) Reflect the care, skill, prudence and diligence under the circumstances that a
prudent person would exercise;
(ii) Be based on the investment objectives, risk tolerance, financial circumstances,
and needs of the retirement investor; and
(iii) Be without regard for the financial or other interests of the advisor, Financial
Institution, affiliate, or related entity.
b. Receive only reasonable compensation in connection to the services provided.
c. Not make misleading statements about the assets, fees, material conflicts of interest,
or any other matters relevant to the investment decisions.
3. Warranties:
a. The advisor and the Financial Institution must promise to comply (and actually
comply) with all applicable federal and state laws regarding investment advice,
investment transactions, and the payment of compensation.
b. The Financial Institution must adopt written policies and procedures designed to
prevent the Material Conflicts of Interest. This includes promising not to have quotas,
appraisals, performance or personnel actions, bonuses, contests, awards, differential
compensation, or other incentives to encourage advisors to make recommendations
that are not in the best interests of their clients.
4. Disclosure Requirements:
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a. Disclosures to the Advice Recipient in the Contract: The contract must:
(i) Specifically identify the Material Conflicts of Interest;
(ii) Inform the investor that he or she has a right to obtain complete fee
information;
(iii) Disclose whether the Financial Institution offers proprietary products or
receives third-party payments in relation to an asset;
(iv) Provide the address of a publicly available website that contains:
A. the direct and indirect compensation payable to the advisor, Financial
Institution, and affiliates for services provided in connection with each asset;
B. the source of the compensation and how it varies within and among the
assets.
In addition, prior to the purchase of any asset, the advisor must provide the investor
with a chart containing the total dollar cost of investing in each recommended asset
for 1-, 5-, and 10-year periods based on the amount of the recommended
investment and reasonable assumptions about the investment performance (and
disclose the assumptions). For this purpose, the “total cost” includes acquisition
costs (e.g., loads, commissions, mark-ups, account operating fees), ongoing costs
(e.g., expense ratios and account fees, including sub-TA fees and sub-accounting
fees), disposition costs (e.g., back-end loads, surrender fees, mark-downs on assets
sold to dealers, and closing fees), and any other fees not included in those three
categories. The DOL provides a model chart for this purpose.
b. Annual Disclosures to Advice Recipient: The advisor and Financial Institution must
also provide a written “succinct, single” disclosure within 45 days of the end of the
year containing:
(i) a list identifying each asset purchased or sold during the year and the price at
which it was purchased or sold;
(ii) a statement of the total dollar amount of fees and expenses paid by the advice
recipient with respect to each asset purchased or sold during the year; and
(iii) a statement of the total dollar amount of compensation received by the advisor
and Financial Institution, directly or indirectly, from any party as a result of each
asset purchased, sold, or held by the investor during the year.
c. Disclosure to the DOL: Before receiving any of the otherwise prohibited
compensation, the Financial Institution must advise the DOL that it intends to rely on
this exemption. The disclosure does not need to identify any plan or IRA that will be
the recipient of the covered advice. Furthermore, the Financial Institution must keep
certain records and make them available for examination by the DOL upon request.
Two Other Prohibited Transaction Exemptions
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The Proposal also provides two more prohibited transaction exemptions to help providers of
advice:
1. Insurance and Annuity Contract Exemption
A PTE similar to the Best Interests Contract PTE is available for sellers of insurance and
annuity contracts who are service providers to IRA holders or beneficiaries or small plans
without participant account-direction. The purchase must be in the ordinary course of the
insurer’s business, for cash, for reasonable compensation, and under terms that are at least
as favorable as are normal arms-length transactions with unrelated parties.
2. Preexisting Transaction Exemption
The DOL proposed a PTE relating to the receipt of variable compensation by advisors and
Financial Institutions that would not have been fiduciaries prior to the Proposal, in relation
to nonprohibited sales of assets that occurred prior to the finalization of the
Proposal. However, the exemption requires that no additional transactions that would not
be covered under the Best Interest Contract PTE occur after the Proposal is finalized.
Conclusion
As you can see, these proposals are quite detailed. Public comments are due to the DOL by 75
days after publication in the Federal Register, which occurred on April 20, 2015, so comments are
due by July 4, 2015 (insert your best “Independence Day” joke here). In addition, the DOL has
asked for comments about many subsidiary issues. Secretary of Labor Perez has been quite vocal
that this short time for comment on such a significant and complex regulation will not be
extended, much to the dismay of the practitioner community. It took the DOL several years to
come up with the Proposal; 75 days seems hardly enough time to digest and analyze the
provisions, and also to make constructive suggestions for modifications. Nonetheless, there is a
long way to go before the Proposal is finalized.
As will be discussed in the third part of this series, many practitioners are already objecting to the
significant disclosure requirements of the PTE. The amount of work needed to comply—and the
cost of that compliance—may make this exemption unworkable in many situations. Practitioners
would say that this will prevent the advice from being available to those the DOL sought to
encompass in the PTE.
More to come in Part III. Stay tuned!
Sorry you missed the Pensions on Peachtree Conference!
Join us next year!
April 25-26, 2016, in Atlanta, GA
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© 2015 Ferenczy Benefits Law Center LLP
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