The US Department of Labor has issued proposed regulations that may have a significant effect on those who recommend or market investment products and services to employee benefit plans and individual retirement accounts.  

The proposal would change the definition of a “fiduciary” under the Employee Retirement Income Security Act of 1974 (ERISA) to expand the class of persons and entities that would be subject to strict fiduciary duties and prohibited transaction rules under ERISA and the Internal Revenue Code.  The new proposal follows an earlier similar proposal, which was withdrawn.

Highlights of the DOL proposal

  • The definition of “fiduciary” would be broadened to cover those who make investment pitches and provide other “one-time” recommendations to plans and IRAs in exchange for direct or indirect compensation.  A recommendation that is directed to a plan or IRA would not have to be individualized to the needs of that plan or IRA in order to result in fiduciary status.  Also, a recommendation to take a distribution from a plan or IRA, or to roll over assets, would result in fiduciary status. For purposes of the new DOL proposals, an “IRA” includes an individual retirement account, an individual retirement annuity, an Archer MSA, a health savings account and a Coverdell education savings account.
  • Investment recommendations to large plans could still be made without resulting in fiduciary status under a “seller’s exception,” subject to conditions.  Similarly, investment education could still be provided in a non-fiduciary capacity, but new restrictions would apply.  For example, the investment education could not identify specific investment products.
  • Recommendations to small plans and IRAs could continue to be made pursuant to a new “best interest contract exemption.”  Under that prohibited transaction exemption, brokers, insurance agents, and other marketers to small plans and IRAs would be required to acknowledge fiduciary status and act in the “best interest” of plan participants and beneficiaries or IRA owners.
  • The best interest contract exemption would be available only for the marketing and sale of certain products: mutual funds, publicly traded securities, treasury or agency securities, annuities and certain other “approved” investment products.  The exemption would not apply to non-traded securities or privately offered interests in investment funds.
  • The DOL also proposed another new prohibited transaction exemption and proposed to amend several existing exemptions in an attempt to accommodate certain existing practices relating to the sale of debt instruments, mutual funds and annuities.  In most cases, the amended exemptions impose a “best interest” standard, and some of the amended exemptions would permit only direct compensation (i.e., commissions and up-front sales loads).

Explanation of proposals

New definition of “fiduciary.” Under the existing definition of “fiduciary,” a person (or entity) will be a “fiduciary” if the person provides investment advice to a plan or IRA (1) on a regular basis, (2) pursuant to a mutual agreement, arrangement or understanding, written or otherwise, (3) that the advice will serve as a primary basis for investment decisions and (4) that the advice will be individualized based on the particular needs of the plan or IRA.  Under this definition, it has been widely assumed that brokers, insurance agents and other persons selling investment products to plans and IRAs are not fiduciaries, although the DOL has noted that in some situations such persons may be fiduciaries.  Also, sponsors of investment funds that do not hold “plan assets” generally have not been thought to be fiduciaries for plans and IRAs when they recommend an investment in their funds.

In contrast, the proposed regulation defines “fiduciary” broadly to include any person who provides to a plan, a plan fiduciary, plan participant or beneficiary, IRA or IRA owner, the following types of advice in exchange for a fee, whether direct or indirect:

  1. a recommendation of the advisability of acquiring, holding, disposing or exchanging securities or other property, including a recommendation to take benefits from a plan or IRA, or a recommendation as to the investment of securities or other assets to be rolled over or otherwise distributed from a plan or IRA
  2. a recommendation as to the management of securities or other property, including recommendations as to the management of securities or other property to be rolled over or otherwise distributed from the plan or IRA
  3. an appraisal, fairness opinion or similar statement whether verbal or written concerning the value of securities or other property if provided in connection with a specific transaction or
  4. a recommendation of a person who is also going to receive a fee or other compensation for providing any of the types of advice described in (i) to (iii) above.

To result in fiduciary status, the advice must be provided pursuant to a written or verbal understanding, arrangement or understanding that the advice is specifically directed at the recipient for the recipient’s consideration, but the advice does not have to be individualized for the recipient or provided on the basis that the recipient will in fact rely on the advice in making investment decisions.  Also, the advice does not have to be provided on a regular basis to result in fiduciary status.  Thus, one-time contacts with a plan or IRA may result in fiduciary status.

The requirement that the advice be provided for a fee, direct or indirect, would include compensation paid to affiliates of the person providing the advice in connection with the investment.

Finally, if a person dealing with a plan or IRA claims to be a fiduciary, the person would be treated as a fiduciary without regard to the above definition.

Consequences of fiduciary status.  If a person is a fiduciary under the proposed definition, the person will have to make investment recommendations that are in the “best interest” of the plans and IRAs, without regard to the fiduciary’s financial or other interests or those of their affiliates.  Also, such a fiduciary will be prohibited from engaging in certain transactions with the plans and IRAs.  Most significantly, in the absence of a specific exemption, the fiduciary will not be permitted to recommend investments with respect to which the fiduciary or an affiliate will receive fees or other direct or indirect compensation.  That would constitute “self-dealing,” a prohibited transaction.

Carve-outs and exemptions.  How can anyone recommend and sell investments to plans and IRAs and still receive fees if the proposed definition of fiduciary becomes effective?  The proposed regulation includes a number of “carve-outs” or exceptions from the definition of a fiduciary, i.e., situations in which the DOL does not believe fiduciary status is warranted.  Also, the proposed regulation was accompanied by the issuance of proposed new and amended prohibited transaction exemptions.  Together, the carve-outs and the prohibited transaction exemptions cover many (but not all) typical investment situations, subject in most cases to stringent conditions and requirements designed to raise the level of protection for plans and IRAs.

Seller’s carve-outFor plans that have at least 100 participants or for plans with at least US$100 million in assets, the proposed regulation includes a “seller’s carve-out” that permits a “counterparty” to provide advice or recommendation to a plan in connection with a sale, purchase, loan or other bilateral contract with the plan.  To qualify for the carve-out, the counterparty must obtain a written representation from an independent fiduciary for the plan that the fiduciary is not relying on the counterparty to act in the best interest of the plan, to give impartial advice or to give advice as a fiduciary.  For plans that have at least 100 participants but do not have $100 million in assets, the counterparty must also know or reasonably believe that the independent plan fiduciary has sufficient expertise to evaluate the transaction and to determine whether it is prudent and in the best interest of participants.  The counterparty may not receive a fee from the plan or plan fiduciary for providing investment advice (as opposed to other services) in connection with the transaction.  If this exception applies, merely making a pitch to a prospective plan client that is at or above the size thresholds – and receiving fees from the investment – will not result in fiduciary status for the counterparty. 

Other carve-outsThe proposed definition of a fiduciary contains additional carve-outs, including exceptions for:

  • advice provided by swap counterparties
  • advice provided by employees of a plan sponsor for no additional consideration beyond their regular compensation
  • advice provided to participant-directed plans (but not to IRAs) by service providers that offer a “platform” or selection of investment vehicles, including general information, but not recommendations, about the investment choices
  • certain appraisals and valuation reports including appraisals for investment funds and appraisals or valuation reports for purposes of plan reporting and disclosure and
  • advice that constitutes “investment education,” although the education may not refer to specific investment products or investment alternatives by name.

As under current law, brokers, dealers and banks that merely execute securities transactions and do not make recommendations would not be treated as fiduciaries.

Best interest contract exemption.  This proposed prohibited transaction exemption applies to fiduciaries (under the new definition) of “retirement investors.”  A “retirement investor” is defined to include  (1) plan participants and beneficiaries who make decisions (including rollover decisions) about their plan accounts, (2) non-participant directed plans with fewer than 100 participants and (3) IRAs.  The DOL said it intended this exemption to apply to “retail investors.”

The best interest contract exemption is available only to “advisers,” “financial institutions” and their affiliates and related entities, with respect to advice provided by the advisers.   An “adviser” is an individual who (i) is a fiduciary with respect to a plan or IRA solely because of the provision of investment advice, and (ii) is an employee, independent contractor, agent or registered representative of a financial institution.  A “financial institution” is defined to include only a registered investment adviser, a bank or similar financial institution, an insurance company or a registered broker-dealer.

The exemption allows advisers and their related financial institutions to receive compensation for services performed in connection with the purchase, sale or holding of an “asset” by the retirement investor as a result of the advice or recommendation of the adviser, if certain conditions are satisfied.  The compensation may be direct or indirect, and may be paid by a third party.  Without this exemption, the receipt of such compensation by a fiduciary with respect to an investment that it recommended would be a prohibited transaction.

The conditions for application of the best interest contract exemption are quite restrictive and go beyond existing practices.  The adviser must acknowledge its fiduciary status in writing.  In addition, the adviser must commit in a written contract to basic standards of impartial conduct (the “Impartial Conduct Standards”), as follows:

  1. the adviser must act in the “best interest” of the plan or IRA
  2. the adviser must receive no more than reasonable compensation and
  3. the adviser must not make any misleading statements about the investments, its fees or material conflicts of interest it may have.

The adviser must also disclose conflicts of interest, warrant that the adviser has adopted practices designed to mitigate the conflicts of interest, and disclose the costs of the adviser’s services. The contract may include an arbitration provision, but may not preclude class actions. Additional requirements apply if the adviser does not recommend a broad range of investments.  Advisers must maintain certain data and make it available to the DOL upon request.

Advisers must notify the DOL in advance if they are relying on the best interest contract exemption.  Thus, the exemption would provide no relief for an adviser that is inadvertently a fiduciary under the revised definition. 

The most restrictive provision of the best interest contract exemption is the definition of the “assets” that qualify for the exemption.  Under the exemption, an eligible “asset” includes only the following investment products:  (i) bank deposits; (ii) certificates of deposit; (iii) shares or interests in registered investment companies; (iv) bank collective funds; (v) insurance company separate accounts; (vi) exchange-traded REITs; (vii) exchange-traded funds; (viii) corporate bonds offered pursuant to a registration statement under the Securities Act of 1933; (ix) agency debt securities as defined in FINRA Rule 6710(l) or its successor; (x) US Treasury securities as defined in FINRA Rule 6710(p) or its successor; (xi) insurance and annuity contracts; (xii) guaranteed investment contracts; and (xiii) equity securities within the meaning of 17 CFR 242.600 (generally, exchange-traded equity securities).  Excluded from this definition is any equity security that is a security future or a put, call, straddle or other option or privilege of buying an equity security from or selling an equity security to another without being bound to do so.

Principal transaction exemption.  This proposed prohibited transaction exemption allows broker-dealers and other advisers to sell debt securities to plans, participants and beneficiaries and IRAs in a principal transaction, i.e., the sale is out of the seller’s own inventory.  The exemption would require adherence to the impartial conduct standards that apply under the proposed best interest contract exemption described above.  In addition, the exemption includes specific conditions related to the pricing of the debt securities, and the seller would be required to disclose to the purchaser the amount of compensation (e.g., a mark-up) it will receive on the transaction.

Other exemptions.  The DOL also proposed another new prohibited transaction exemption and proposed amendments to some existing exemptions.  These proposals are intended to enable investment advisers, broker-dealers and insurance agents to continue to receive common forms of compensation for existing practices without violating ERISA.  However, the new and revised exemptions are in some respects more restrictive than the existing rules.  For example, in several cases, the exemptions require adherence to the impartial conduct standards that apply under the best interest contract exemption, described above.  The new and amended prohibited transaction exemptions (PTEs) include (among others) the following:

PTE 77-4.  Discretionary asset management fiduciaries that sell proprietary mutual funds to plans and IRAs must adhere to the impartial conduct standards.

PTE 84-24.  This exemption has historically covered mutual fund shares and insurance or annuity contracts sold to plans or IRAs by non-discretionary pension consultants, insurance agents, brokers, and mutual fund principal underwriters who receive commissions from the sales.  This exemption would be amended to require adherence to the impartial conduct standards.  Also, under the amendment the exemption would not apply to sales to IRAs of variable annuities or mutual funds; those sales would have to qualify for exemption under the best interest contract exemption.

PTE 86-128.  This exemption, which historically has allowed the execution of securities transactions by a broker affiliated with the fiduciary adviser, would now require adherence to the impartial conduct standards, and would not permit indirect compensation.  The exemption would be extended to cover principal transactions in non-proprietary mutual funds.  Also, the exemption would no longer be available for non-discretionary advisers to IRA owners, who would be limited to the relief in the new best interest contract exemption.

Outside the carve-outs and exemptions.  If the proposals are implemented as proposed, brokers, investment advisers, insurance agents and others in the financial industry who are involved with the investments of plans and IRAs will, at a minimum, be subject to additional compliance requirements that will affect their businesses.  For brokers, investment advisers, fund sponsors and others selling investment services and products that are not on the list of approved “assets” in the best interest contract exemption, it may take some time to determine whether they can continue to market services and products to retirement investors (i.e., small plans and IRAs), and if so, what alterations in current practices will be necessary.

Next steps

Comment period and anticipated effective date Comments on the proposed regulation and prohibited transaction exemption changes must be submitted to the Department of Labor by July 6, 2015.  Within 30 days after the comment period, the Department of Labor will hold an administrative hearing and plans to “reopen the record” for additional input after that hearing.  The DOL will then issue the final regulation and the exemptions, with a proposed effective date eight months after the date of issuance.

Specific requests for comments.  The DOL requested input from interested parties on all aspects of the proposals.  Of particular interest to those involved with privately offered investments, the DOL requested comments on the proposed definition of assets eligible for the best interest contract exemption, and asked:

  • Do commenters agree we have identified all common investments of retail investors?
  • Have we defined individual investment products with enough precision that parties will know if they are complying with this aspect of the exemption?
  • Should additional investments be included in the scope of the exemption?  Commenters urging addition of other investment products should fully describe the characteristics and fee structures associated with the products, as well as data supporting their position that the product is a common investment for retail investors.

The DOL also stated:

“The [DOL] encourages parties to apply to the [DOL] for individual or class exemptions for types of investments not covered by the [proposed best interest contract exemption] to the extent that they believe the proposed package of exemptions does not adequately cover beneficial investment practices for which appropriate protections could be crafted in an exemption.”