Section 406(a)(1)(C) of the Employee Retirement Income Security Act of 1974, as amended (ERISA), prohibits the furnishing of services between an ERISA plan and a party in interest to the plan, such as someone who is already a service provider or an affiliate thereof, unless there is an applicable exemption. With respect to service contracts or arrangements, such an exemption is provided by Section 408(b)(2) of ERISA, which exempts service contracts or arrangements from the prohibited transaction rules if (i) the contract or arrangement is reasonable, (ii) the services are necessary for the establishment or operation of the plan, and (iii) no more than reasonable compensation is paid for the services. The current regulation issued under ERISA Section 408(b)(2), at 29 CFR § 2550.408b-2 (the “Regulation”), states only that a contract or arrangement is not reasonable unless it permits the plan to terminate without penalty and on reasonably short notice. On December 13, 2007, the Department of Labor (the “DOL”) published a proposed amendment to the Regulation, proposing to add that, in order for a contract or arrangement for services to be reasonable, it must require that the service provider furnish, and the service provider must in fact furnish, certain information to the responsible plan fiduciary (the “Proposed Amendment”).1 Specifically, the DOL believes that in order to satisfy their ERISA fiduciary obligations, plan fiduciaries need information concerning (i) all compensation to be received by the service provider (directly or indirectly) and (ii) any conflicts of interest that may adversely affect the service provider’s performance under the contract or arrangement.
The Scope of the Proposed Amendment
The DOL specifies that the additional disclosure requirement applies only to service providers that fall within one or more of three enumerated categories, i.e., to service providers who:
1. provide services as a fiduciary under ERISA or under the Investment Advisers Act of 1940;
2. provide banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping, securities or other investment brokerage, or third party administration services; or
3. receive any indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal, or valuation services.
The DOL has stated that responsible plan fiduciaries may in some situations be able to evaluate the reasonableness of the service provider’s compensation without requiring additional disclosures to be made by the service providers. For this reason, the DOL limits the applicability of the Proposed Amendment to the above listed categories of service providers. In fact, as can be readily discerned, the class of service providers subject to the new rules is fairly comprehensive.
In addition, it should be noted that the Proposed Amendment applies regardless of the nature of any other services provided to the plan, and regardless of whether the ERISA plan is a pension plan, 401(k) plan, or group health plan, or other type of welfare benefit plan
The Disclosures Required by the Proposed Amendment
If a contract or arrangement for services falls within the scope of the Proposed Amendment, the service provider must comply with the following requirements:
- the contract or arrangement must be in writing;
- the terms of the contract or arrangement must specifically require the service provider to disclose, in writing and to the best of its knowledge, the required information. However, it should be noted that (a) the proposal does not prescribe the manner in which such disclosures should be presented to the responsible plan fiduciary and (b) does not require that all of the required disclosures be contained in the same document, as long as the documents, collectively, contain all of the elements of disclosure required by the Proposed Amendment and are incorporated by reference in the contract or arrangement in question;
- the contract or arrangement must include a representation by the service provider that, before the contract or arrangement was entered into, all required information was provided to the responsible plan fiduciary; and
- the contract or arrangement must require that the service provider notify the responsible plan fiduciary if any of the previously disclosed information materially changes.2
I. Disclosure Concerning Compensation and Services
To facilitate the responsible plan fiduciary’s determination that the service provider will receive no more than reasonable compensation, the contract or arrangement must require the service provider to disclose:
1. all services it will provide to the plan;
2. all compensation or fees it will receive in connection with the services; and
3. the manner of receipt of compensation (e.g., whether the service provider will bill the plan, deduct fees directly from plan accounts, or reflect a charge against the plan investment), and how any pre-paid fees will be calculated and refunded when the contract or arrangement terminates.
The proposal broadly defines compensation or fees to include money and any other items of monetary value received (or to be received), directly or indirectly, by the service provider or its affiliate, in connection with the services provided to the plan or the financial products in which plan assets are invested. The examples include, but are not limited to: gifts, awards, trips for employees, research, finder’s fees, placement fees, commissions or other fees related to investment products, sub-transfer agency fees, shareholder servicing fees, Rule 12b-1 fees, soft dollar payments, float income, fees deducted from investment returns, fees based on a share of gains or appreciation of plan assets, and fees based upon a percentage of the plan’s assets. Hence, the service providers must disclose compensation or fees received by their affiliates from third parties.3
However, if a service provider cannot disclose compensation or fees in terms of a specific monetary amount, then the service provider may disclose compensation or fees by using a formula, a percentage of the plan’s assets, or a per capita charge for each participant or beneficiary – so long as the description enables a responsible plan fiduciary to evaluate the reasonableness of the compensation or fees.
In addition, the proposal acknowledges the fact that in many cases, administrative and investment services are provided to employee benefit plans in “bundled” arrangements, either directly by the service providers, or through their affiliates or subcontractors. These bundled services can be priced to the plan by a single service provider as a package, rather than on a service-by-service basis. In such case, only the service provider offering the bundle of services must provide the required disclosures concerning all services to be provided in the bundle, regardless of who provides the separate services. The bundled service provider must disclose the aggregate direct compensation or fees that will be paid for the bundle, as well as all indirect compensation that will be received by the service provider, or its affiliates or subcontractors within the bundle, from third parties.
II. Disclosure Concerning Potential Conflicts of Interest
The Proposed Amendment also provides that a contract or arrangement must require that the service provider disclose specific information regarding potential conflicts of interest for the service provider in its performance of services for the plan. More specifically, the service provider must:
- identify whether it will provide services to the plan as a fiduciary, either as an ERISA fiduciary under Section 3(21) of ERISA or as a fiduciary under the Investment Advisers Act of 1940, as amended;
- disclose any financial or other interest in transactions in which the plan will partake in connection with the contract or arrangement;
- describe any material financial, referral, or other relationship it has with various parties (such as investment professionals, other service providers, or clients) that creates or may create a conflict of interest for the service provider in performing services pursuant to the contract or arrangement;
- identify whether the service provider or its affiliate can affect its own compensation or fees (from whatever source) without the prior approval of an independent plan fiduciary and describe the nature of this compensation;4 and
- state whether or not the service provider has policies or procedures to manage the real or potential conflicts of interest, and, if it does, provide an explanation of these policies or procedures and how they address conflicts of interest.
III. Additional Reporting and Disclosure Requirements
In addition to all of the above-mentioned disclosures, the Proposed Amendment requires that a reasonable contract or arrangement obligate the service provider to furnish all information related to the contract or arrangement and the service provider’s receipt of compensation or fees thereunder, when such information is required by the responsible plan fiduciary (or plan administrator) in order to comply with the reporting and disclosure requirements of Title I of ERISA and the regulations, forms, and schedules issued thereunder. This provision would obligate the service provider to furnish information that is necessary for the plan administrator to complete the annual report on Form 5500 and for the responsible plan fiduciary to comply with disclosure obligations to plan participants and beneficiaries.
The Compliance Required by Service Providers
The proposal provides explicitly that a service provider must comply with its obligations under the contract or arrangement as described in the Proposed Amendment. This requirement is twofold: not only must a contract or arrangement require disclosure from the service provider, but the service provider must actually provide all of the required disclosures in order for the contract or arrangement to be reasonable. Similarly, it is not enough for a service provider to commit in the written contract to later notify the responsible plan fiduciary of material changes to the disclosures contained in the contract, but the service provider must in fact provide such notification
The Consequences of Failure to Comply and the Proposed Class Exemption
Under the Proposed Amendment, if the contract or arrangement fails to require disclosure of the information described in the proposal, or if the service provider fails to disclose such information, then the contract or arrangement will not be “reasonable”; hence provision of the service will not qualify for the relief from ERISA’s prohibited transaction rules provided by Section 408(b)(2). Therefore, a resulting prohibited transaction could have consequences for both the responsible plan fiduciary and the service provider – specifically:
- the responsible plan fiduciary, by participating in the prohibited transaction, will have violated Section 406(a)(1)(C) of ERISA’s prohibited transaction rules; and
- the service provider, as a “disqualified person” under the Internal Revenue Code’s prohibited transaction rules, could be subject to the excise taxes on prohibited transactions.
However, the Proposed Amendment incorporates reference to a proposed class exemption, which provides relief to a responsible plan fiduciary when, unbeknownst to the responsible plan fiduciary, a service provider fails to comply with the disclosure requirements.
The Proposed Class Exemption Relief
The proposed class exemption, if granted, would relieve a responsible plan fiduciary from engaging in a transaction that constitutes a prohibited furnishing of services to an employee benefit plan, even though a service provider fails to comply with its disclosure obligations. To avail itself of the relief offered by the proposed class exemption, a responsible plan fiduciary must satisfy the following conditions:
- at the time the contract or arrangement was entered into, the responsible plan fiduciary reasonably believed that the contract or arrangement met the requirements of the Proposed Amendment, and did not know (or have reason to know), that the service provider failed (or would fail) to comply with its disclosure obligations;
- upon discovering that the service provider failed to comply with its disclosure obligations, the responsible plan fiduciary must request in writing that the service provider furnish the required information;
- if the service provider fails to comply with such request within 90 days, the responsible plan fiduciary must notify the DOL. Such notification must contain the information prescribed by the proposed class exemption, and be given no later than 30 days following the expiration of the above-mentioned 90 day period or following the service provider’s refusal to comply with the request, whichever is earlier; and
- the responsible plan fiduciary must determine whether to terminate or continue the contract or arrangement with such service provider. In making this determination, the responsible plan fiduciary must consider – among other factors – the nature of the particular failure to disclose; the responsiveness of the service provider in furnishing the missing information; and the availability, qualifications, and costs of a potential replacement service provider. However, it should be noted that this requirement does not abrogate or supersede the duties imposed upon the fiduciary by Section 404(a) of ERISA, which also requires the fiduciary to consider the necessary steps in responding to the service provider’s failure to comply with its disclosure obligations.
The Proposed Amendment, as well as the proposed class exemption, would be effective 90 days after publication of the final regulation in the Federal Register. Written comments on the Proposed Amendment and on the proposed class exemption should be received by the DOL no later than February 11, 2008.
It should be noted that the Proposed Amendment, together with the changes to the Form 5500, are the DOL’s attempt to (i) help plan sponsors and fiduciaries to better understand fees paid (directly or indirectly) by ERISA plans and determine their reasonableness, thereby increasing efficiency and competition in the service provider market and generating benefits to plans and plan participants, as well as to (ii) defuse Congressional legislative efforts at reforms relating to fees. However, the DOL’s proposed changes would clearly create significant new disclosure burdens on service providers to ERISA plans.
Note especially: There are numerous exemptions which can exempt the provision of services to a plan by a party in interest, besides Section 408(b)(2) of ERISA. For example, in appropriate circumstances, an exemption may be available under DOL Prohibited Transaction Class Exemption 84-14, for transactions between a party in interest and an investment fund managed by an independent Qualified Professional Asset Manager (QPAM). Yet the Proposed Amendment and the proposed class exemption seem to ignore this possibility. The existence of other exemptions either constitutes a significant exception to the need to comply with the new proposals, or the DOL needs to publish significant further guidance which might cast a shadow on the breadth of these other exemptions.