Following a multi-year regulatory project intended to address conflicts of interest in the investment advice area, the Department of Labor (the DOL) has published a Final Rule that modifies the test for determining when a person is a fiduciary under the Employee Retirement Income Security Act (ERISA). At the same time, the DOL issued two new class prohibited transaction exemptions and modified several existing exemptions.
Under ERISA Section 3(21)(A)(ii), a fiduciary with respect to a plan includes any person “who renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan.” The Final Rule describes the types of advice and relationships that give rise to fiduciary status. The rule applies to plans covered by ERISA as well as plans covered by Section 4975 of the Internal Revenue Code of 1986, as amended (the Code), including among others, individual retirement accounts and annuities (IRAs) (collectively, non-ERISA Plans). The DOL emphasized that one reason for the Final Rule, new exemptions and amended exemptions is to provide protection to IRAs and other non-ERISA Plans.
Under the Final Rule, only “recommendations” are considered fiduciary investment advice. Generally, a “recommendation” is a communication that – based on its content, context, and presentation – would reasonably be viewed as a suggestion that an individual may engage in or refrain from taking a particular course of action. Importantly, the more tailored a communication is to a specificadvice recipient, the more likely it is to be seen as a recommendation. For example, providing a selective list of securities to a particular advice recipient, as appropriate for that investor, would be treated as a recommendation even if no recommendation is made with respect to any one security. In addition, 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 be treated as a recommendation when considered in the aggregate. Finally, it makes no difference whether the communication was initiated by a person or a computer software program.
A recommendation can be any of the following:
- A recommendation as to the advisability of buying, holding, selling, or exchanging securities or other investment property, including recommendations as to investments following a rollover, transfer, or distribution from a plan or IRA;
- 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 persons to provide investment advice, or investment management services, or selection of investment account arrangements (e.g., brokerage versus advisory); and
- A recommendation 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.
A person who makes a recommendation in exchange for a direct or indirect fee or other compensation will be a fiduciary if the person:
- Represents or acknowledges that they are acting as a fiduciary within the meaning of ERISA or the Code; or
- Renders advice pursuant to a written or verbal agreement, arrangement, or understanding that the advice is based on the particular investment needs of the recipient; or
- Directs the advice to a specific recipient or recipients regarding the advisability of a particular investment or management decision with respect to securities or other investment property of a plan or IRA.
Fees or other compensation include fees and compensation from any source and include, among others, commissions, loads, finder’s fees, and revenue sharing payments.
Denominated as “carve-outs” in the proposed rule, the final rule contains examples of the kinds of communications that are not considered fiduciary recommendations. These include the following:
- Platform Providers. Communications by a third party administrator or record-keeper that markets or makes a platform of investment alternatives available to a plan fiduciary without regard to the individualized needs of the plan, its participants, or beneficiaries do not constitute recommendations if the plan fiduciary is independent of the service provider, and the provider represents in writing to the plan fiduciary that it is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity. Some of the activities that platform providers may undertake include identifying investment alternatives that meet objective criteria established by the plan fiduciary, responding to a plan fiduciary’s request for information or a request for proposal, provided certain conditions are met, and providing objective financial data and comparisons with independent benchmarks.
- General Communications. Furnishing or making available general communications that a reasonable person would not view as an investment recommendation, including general circulation newsletters, commentary in publicly-broadcast talk shows, remarks and presentations in widely-attended speeches and conferences, research or news reports prepared for general distribution, general marketing materials, and general market data.
- Investment Education. Furnishing or making available educational information such as plan information, general financial, investment, and retirement information, asset allocation models, and other interactive investment materials irrespective of who provides the educational information (e.g., the plan sponsor, fiduciary, or service provider). These educational materials must comply with specific requirements and may not include recommendations with respect to specific investment products or specific plan or IRA alternatives, or recommendations with respect to investment management of a particular security or securities or other investment property except in limited circumstances.
Unless undertaken by a person who acknowledges fiduciary status, persons engaging in the following activities will not be fiduciaries by reason of such activities.
- Transactions with Independent Plan Fiduciaries with Financial Expertise. Provided that certain conditions are met, fiduciary obligations are not imposed on advisers when communicating with independent plan fiduciaries if the adviser knows or reasonably believes that the independent fiduciary is a licensed and regulated provider of financial services (i.e., banks, insurance companies, registered investment advisers, brokerdealers) or has responsibility for the management of $50 million in assets.
- Swap and Security-Based Swap Transactions. Communications and activities made by advisers to ERISA-covered employee benefit plans in swap or security-based swap transactions do not result in the advisers becoming investment advice fiduciaries to the plan if certain conditions are met. These include the following: (i) the swap dealer or security-based swap dealer is not acting as an advisor to the plan; (ii) the plan is represented in the transaction by an independent plan fiduciary; (iii) the dealer does not receive a fee or other compensation directly from the plan or plan fiduciary for the provision of investment advice in connection with the transaction, and (iv) before providing any recommendation with respect to a swap or security-based swap transaction, the dealer providing the recommendation must obtain from the independent fiduciary, a written representation that the independent plan fiduciary understands that the person is not undertaking to provide impartial investment advice, or to give advice in a fiduciary capacity, and that the independent plan fiduciary is exercising independent judgment in evaluating the recommendation.
- Employees of Plan Sponsors, Affiliates, Employee Benefit Plans, Employee Organizations, or Plan Fiduciaries. Employees working in a company’s payroll, accounting, human resources, and financial departments who routinely develop reports and recommendations for the company and other named fiduciaries of an employer’s plans are not investment advice fiduciaries if the employees receive no fee or other compensation in connection with any recommendations beyond their normal compensation for work performed for their employer.
New Prohibited Transaction Exemptions
In connection with the issuance of the Final Rule, the DOL issued two new prohibited transaction exemptions and modified several existing prohibited transaction exemptions in order to ensure uniform application of the Impartial Conduct Standard (defined below).
The two new prohibited transaction exemptions include the “Best Interest Contract” (BIC) Exemption and the “Principal Transactions” Exemption:
- The BIC Exemption permits fiduciaries, such as registered investment advisers, broker-dealers and insurance companies and their agents, representatives, and employees to continue to rely on many current compensation and fee practices that present a conflict. These include variable compensation over which the investment advice fiduciary has control. Specific conditions must be met, which are intended to ensure that financial institutions mitigate conflicts of interest and that they, and their individual advisers, provide investment advice that is in the best interests of their “retirement investors.” Retirement investors include plan participants and beneficiaries, IRA owners, and non-institutional (or “retail”) fiduciaries. Among other conditions, the contract must meet the “Impartial Conduct Standard.” Some of the provisions of this standard include: (i) the adviser provides investment advice that is, at the time of the recommendation, in the “best interest” of the retirement investor; (ii) the adviser’s compensation will not exceed “reasonable compensation” as defined in ERISA; (iii) statements made at the time the contract is entered into may not be materially misleading; (iv) the contract must include certain warranties regarding the implementation of detailed policies and procedures; (v) specific disclosures must be made; and (vi) the contract may not contain exculpatory provisions.
- The “Principal Transactions” Exemption permits investment advice fiduciaries to sell or purchase certain recommended debt securities and other investments out of their own inventories to or from ERISA and non-ERISA plans. This exemption requires, among other things: (i) acknowledgement of fiduciary status with respect to any investment advice regarding principal transactions; (ii) adherence to the Impartial Conduct Standard; (iii) provision of advice that is in the “best interest” of the retirement investor; (iv) seeking to obtain the best execution reasonably available under the circumstances; (v) making no misleading statements about investment transactions, compensation, and conflicts of interest; and (vi) implementation of certain policies and procedures.
Amended Class Prohibited Transaction Exemptions
Certain existing class prohibited transaction exemptions were amended to include the Impartial Conduct Standard and other provisions. These exemptions are listed below.
- Class Prohibited Transaction Exemption (PTE) 75–1. This PTE exempts certain transactions between employee benefit plans and certain broker-dealers, reporting dealers, and banks. Part V of the existing PTE permits the extension of credit to a plan or IRA by a non-fiduciary broker-dealer in connection with the purchase or sale of securities. As amended, it permits investment advice fiduciaries to receive compensation when they extend credit to plans and IRAs to avoid a failed securities transaction.
- PTE 86-128. This PTE permits, subject to multiple conditions, a fiduciary to engage in, and be compensated for agency transactions. As amended, certain provisions of the PTE will no longer apply to IRAs as the DOL has deemed those provisions to be insufficient for the protection of IRA owners. Instead, investment advice fiduciaries must now rely on the Best Interest Contract Exemption.
- PTE 75-1. Part II(2) of this PTE provided relief so that investment advice fiduciaries could receive commissions from a plan or mutual fund in connection with mutual fund transactions involving plans. That provision has been revoked. Investment advice fiduciaries may now rely on the Best Interest Contract Exemption.
- In addition to the existing conditions for each of the following exemptions, the DOL has added the additional requirement that fiduciaries follow the Impartial Conduct Standard in each of the exemptions:
- PTE 75-1, Part III permits a fiduciary to cause a plan or IRA to purchase securities from a member of an underwriting syndicate other than the fiduciary, when the fiduciary is also a member of the syndicate;
- PTE 75-1, Part IV permits a plan or IRA to purchase securities in a principal transaction from a fiduciary that is a market maker with respect to those securities;
- PTE 77-4 provides relief for a plan’s or IRA’s purchase or sale of open-end investment company shares where the investment adviser for the open-end investment company is also a fiduciary to the plan or IRA;
- – PTE 80-83 provides relief for a fiduciary causing a plan or IRA to purchase a security when the proceeds of the securities issuance may be used by the issuer to retire or reduce indebtedness to the fiduciary or an affiliate; and
- PTE 83-1 provides relief for the sale of certificates in an initial issuance of certificates, by the sponsor of a mortgage pool to a plan or IRA, when the sponsor, trustee or insurer of the mortgage pool is a fiduciary with respect to the plan or IRA assets invested in such certificates.
- PTE 84-24 historically provided relief for certain parties to receive commissions when plans and IRAs purchased recommended insurance and annuity contracts and mutual fund shares). As amended, it will provide an exemption to prohibited transactions that occur when investment advice fiduciaries (and other service providers) receive compensation for their recommending the purchase of “Fixed Rate Annuity Contracts” (as defined in the exemption) and insurance contracts. It will also provide an exemption for prohibited transactions that occur when investment advice fiduciaries and other service providers receive compensation as a result of recommendations that plans purchase investment company securities. Finally, the exemption will also cover prohibited transactions that occur when an insurance company selling a Fixed Rate Annuity Contract or insurance contract is a party in interest or disqualified person with respect to the plan or IRA.
The Final Rule goes into effect on June 7, 2016. However, compliance with the final rule is not required until April 10, 2017. The DOL has adopted a phased implementation approach for the prohibited transaction exemptions. Both exemptions provide for a transition period, from the April 2017 applicability date to January 1, 2018, under which fewer conditions apply to the exemptions.
This client memo provides only a brief review of the multiple and complicated provisions of the Final Rule, new class prohibited transaction exemptions and amended class prohibited transaction exemptions.
In the coming year, as we approach the implementation of these provisions, individuals and entities that advise retirement plans will need to determine whether their actions with respect to both ERISA plans and IRAs will be fiduciary in nature. They will also have to begin to draft the contracts, disclosures, policies, and procedures that will be required to implement the Impartial Conduct Standard and other new requirements. Plan sponsors should become familiar with the Final Rule and exemptions so that they can monitor compliance with them.