In October 2010, the Department of Labor (DOL) issued a proposed regulation setting forth a new, broader interpretation of the statutory definition of a “fiduciary” under the Employee Retirement Income Security Act (ERISA), 29 U.S.C. § 1001, et seq. After nearly a year of public criticism and intervention by numerous members of Congress, DOL announced last month that it will withdraw its initial proposal and re-propose a revised regulation in early 2012. In doing so, DOL has pledged to address concerns that its original proposal was overbroad, would raise administrative costs of ERISA plans, and might force many smaller service providers out of business.
Under Section 3(21)(A) of ERISA,2
… a person is a fiduciary with respect to a plan to the extent
- he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets,
- he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or
- he has any discretionary authority or discretionary responsibility in the administration of such plan. Such term includes any person designated under section 1105(c)(1)(B) of this title.
In 1975, DOL issued an interpretive regulation elaborating on fiduciary status attained by those who provide “investment advice for a fee.”3 This regulation specifies that a person provides fiduciary investment advice only if the person wields direct or indirect discretionary authority over the plan’s purchases or sales of securities or other investment property, or, alternatively, if the person satisfies a multi-part test set forth in the regulation. This test provides that an investment adviser is a fiduciary only if the adviser provides investment advice (1) on a regular basis, (2) pursuant to a mutual understanding that (3) the advice will serve as the primary basis for investment decisions, and (4) the advice itself is based on the particular needs of the plan.4
In the thirty-five years since DOL first issued that regulation, the landscape of retirement plans has changed substantially. In 1975, private defined-benefit plans covered over 27 million participants, with assets totaling nearly $186 billion. Defined-contribution plans covered 11 million participants, with assets of $74 billion. By 2008, however, defined-contribution plans covered 67 million participants, while the number of participants in defined-benefit plans had slipped to just 19 million. In addition, the proportion of participant-directed accounts rose dramatically: for example, as of 2008, there were approximately 60 million participants in 401(k) plans, of whom ninety-five percent bore some responsibility for directing the investment of their accounts.5
DOL’s Proposal to Expand the Definition of the Term “Fiduciary”
Accompanying the evolution in retirement plan vehicles have been equally dramatic changes in the plan investment services. The types of products and services available to investors have become considerably more numerous and more complex.6 These changes, coupled with the trend towards more defined-contribution plans offering greater participant control, created concerns at DOL over the potential for conflicts-of-interest and self-dealing.7 As one example, DOL posited that financial services firms advising plans on mutual-fund options frequently recommend mutual funds that made revenue-sharing payments to recommending firms.8 Consequently, in October 2010, DOL proposed an amended version of the regulation governing fiduciary investment advice.
The supplementary information accompanying the proposed regulation makes it clear that DOL seeks to depart from its earlier interpretation of ERISA’s “investment advice for a fee” provision, and to broaden the circumstances in which fiduciary status is attained. DOL took pains to justify the proposed departure from thirty-five years of practice, characterizing the earlier regulation as narrowing ERISA’s application in ways not warranted by the statutory text.9 In addition, DOL decried the original regulation’s effects, insofar as it permitted advisers to avoid attribution of ERISA fiduciary status (and therefore ERISA liability) in cases where advice was not provided on a regular basis,10 or was not given pursuant to a mutual understanding that such advice would serve as the primary basis for investment decisions, yet still played a significant role in plan investment decisions.11
The regulation proposed in October 2010 identifies three categories of activity that constitute “advice” for purposes of evaluating fiduciary status: (1) appraisals and fairness opinions; (2) recommendations regarding the advisability of purchasing, holding, or selling investment assets; and (3) recommendations regarding the management of securities or other investment property. Under the proposed regulation, persons who receive a fee for these types of advice are ERISA fiduciaries if they give advice to plans, plan fiduciaries, participants, or beneficiaries and (1) represent themselves as acting as an ERISA fiduciary; (2) already exercise authority as an ERISA fiduciary; (3) are an investment adviser under the Investment Adviser Act of 1940 (1940 Act); or (4) provide advice that, pursuant to an agreement or understanding, “may be considered in connection with” an investment decision.12 The proposed regulation thus purports to modify past practice in several significant ways, including:
Appraisals and Fairness Opinions – The text of the proposed regulation expressly includes “appraisals and fairness opinions.” This revision represents an intentional departure from past practice, and expressly seeks to supersede a prior DOL advisory opinion13 indicating that valuation services provided to an employee stock ownership plan (ESOP) in connection with the purchase of closely held employer securities do not qualify as fiduciary investment advice. In contrast to prior practice, the proposed regulation would treat such services as fiduciary advice. Additionally, appraisals and fairness opinions would be treated as fiduciary advice in contexts beyond employer securities, such as the provision of real estate valuation.14
Advice to Participants and Beneficiaries – The proposed regulation also codifies the long-standing DOL view that fiduciary status may flow from providing advice or recommendations to plan participants and beneficiaries. In proposing the new regulation, however, DOL specifically requested comment on whether to exclude advice given to plan participants regarding otherwise-permitted plan distributions from the category of fiduciary investment advice.15
Expansion of Existing “Investment Advice” Status – Under the current regulation, a person giving advice is an ERISA fiduciary only if each part of the multi-step test is satisfied. Under the proposed regulation, however, fiduciary status can be established without examining all of the relationship’s characteristics, such as when the adviser purports to be an ERISA fiduciary, or when the adviser already serves as an adviser under the 1940 Act. Thus, the proposed regulation relaxes the existing test for fiduciary adviser status in several ways. First, the advice need not be given on a “regular basis,” as previously required; rather, a single instance of advice can support a finding of fiduciary conduct. Second, under the proposed regulation, fiduciary status no longer depends on a mutual understanding that the advice serve as the “primary basis” for an investment decision. Rather, the proposed regulation will treat advice as fiduciary advice where the adviser is aware that the advice may be “considered” in connection with an investment decision.16
Limitations on the Term “Advice” – The proposed regulation sets forth several limitations on fiduciary “advice” as well. For instance, it states that providing “investment education information and materials” does not constitute fiduciary investment advice. The act of providing a plan fiduciary with “general financial information and data” to assist in the selection of plan investment options is also excluded from the definition of “advice,” so long as the information is accompanied by a disclosure that the information is not intended to be impartial investment advice.17
The proposed regulation not only expands the reach of ERISA’s fiduciary provisions to previously unaffected arrangements, but also represents a marked departure from thirty-five years of industry practice established in reliance on DOL’s existing interpretation. It is not surprising, then, that the proposed regulation has met with stiff resistance. The public comments covered a host of issues, but many of them focused on concerns over increased compliance costs borne by service providers, which, in turn, would raise plans’ administrative costs. Many commentators warned of other unintended consequences, such as depriving participants of useful resources or the possibility that compliance burdens would force smaller plan-service providers (e.g., appraisers) out of business. Numerous members of Congress also criticized the proposed regulation, both in substance and on the grounds that DOL had not followed proper regulatory procedures. In some cases, these Congressional critics also called for DOL to withdraw and re-propose the regulation after further consideration and economic analysis.18
In addition, many written comments took issue with the proposed application of fiduciary status to individual retirement account (IRA) advisers, and an apparent failure by DOL to coordinate ERISA’s fiduciary standards with standards imposed by other regulatory agencies, such as the Securities & Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). As a result, commentators feared that the proposed regulation would subject a wide array of financial professionals to inconsistent or conflicting standards of conduct.
On September 19, 2011, DOL relented, and announced it was withdrawing the proposed regulation. Citing a need for further public comment and economic analysis, the DOL announcement suggests several areas where revision of the regulatory proposal is likely:
[T]he agency anticipates revising provisions of the rule including, but not restricted to, clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule’s application to arm’s length commercial transactions, such as swap transactions.
Also anticipated are exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarifying the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The agency will carefully craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.19
Prior to the announcement, DOL had also indicated that it was reevaluating the impact of its proposals in several other areas. These included a review of the regulation’s impact on appraisal and valuation services, including those offered to plans in connection with employer securities, so as not to “cause unnecessary harm or cost to small businesses.” DOL has also indicated its intention to make a clearer distinction between fiduciary investment advice and non-fiduciary investment education.20
DOL’s Next Steps
DOL’s announcement predicted that DOL would re-propose a revised version of the regulation in early 2012. Although the precise nature of the expected revisions remains unclear, it is possible to discern some likely areas where a modified proposal is likely. For example, much attention was given to compensation arrangements in advisory relationships. In this regard, DOL is coordinating its efforts with the SEC and CFTC to ensure that advisory professionals are not subjected to conflicting pronouncements regarding adviser compensation and the corresponding standards of conduct. In announcing its plans, DOL also hinted that it would address fee-related concerns through a combination of regulatory revisions and prohibited-transaction exemptions.
With regard to such compensation arrangements, one area of special interest in the ERISA services industry involves those service providers giving advice on selection of an investment “menu” for use with participant-directed retirement plan accounts in plans for which those providers provide other services. The now-withdrawn regulation suggested that advice on “menu” selections must be accompanied by an awkward, and arguably self-defeating, disclosure that the provider’s interests are adverse to the plan’s interests. This provision was the subject of specific industry criticism. It is unclear whether, and to what extent, there might be revisions to DOL’s initial proposal. DOL has pledged to develop a better understanding of industry compensation practices and to determine how those practices should be addressed in the revised regulation, or alternatively, by a prohibited transaction exemption. DOL has, however, communicated its determination to ferret out what it calls abusive advisory practices, so the revised proposal will undoubtedly expand the types of advisory activities that are subject to ERISA’s fiduciary duties.
Another area where DOL has indicated it might revisit its proposed regulation involves the inclusion of appraisal and valuation specialists in the category of fiduciary advisers. In many cases, such advisers are retained for isolated or non-routine transactions, and, as such, do not provide advice on a “regular basis,” as required under the existing regulation. Based on DOL’s reaction to related criticisms, it seems likely that the law will expand to encompass some of these actors within ERISA’s definition of a “fiduciary.” There is reason to believe, however, that providers furnishing “routine” appraisal or valuation services (i.e., for purposes other than investment transactions) may receive some relief in the new proposal.
A third area where DOL is considering modifications to its initial proposal involves service providers that furnish education materials to plan fiduciaries, participants and/or beneficiaries. Many commentators expressed fear that the broader regulation would confuse the distinction between educational materials and fiduciary advice, which is recognized under existing law. This confusion gives rise to a concern, shared by DOL, that providers will withhold helpful educational information for fear of fiduciary exposure. DOL has indicated it did not intend to restrict existing exemptions for educational materials, but it remains uncertain how the re-proposed regulation will address the potential for confusion noted in the public comments to DOL.
DOL defended its sweeping proposals as necessary to protect plan participants and beneficiaries from conflicts-of-interest and self-dealing by unscrupulous advisers. In crafting its originally proposed regulation, however, DOL broadened ERISA’s definition of “fiduciary” substantially, which in turn, challenged thirty-five years of established investment industry practice related to retirement assets. The volume and breadth of the public criticism of the proposed regulation underscores the significance of the proposed changes to the current application of ERISA’s “investment advice for a fee” language.
The industry’s reaction reveals the practical problems inherent in a slow regulatory reaction to marketplace changes. Industry adjustments to regulation are more readily made, and more warmly received, when change comes at a gradual and timely pace. In the case of the investment adviser regulation, a more modest set of changes, coupled with more regular review of industry practice in the future, would seem better suited to serve the public interest and the salutary goals DOL hopes to achieve.
DOL seems to have taken cognizance of the public’s concerns, and is taking steps to address them. However, the aggressive nature of DOL’s initial proposal suggests that aspects of current industry practice may not survive in their present form. And while DOL has evinced some willingness to consider a more measured approach, the precise contours of that approach remain a mystery. The public has DOL’s assurance that it does not want to disadvantage plans or plan participants, but the new proposal’s impact on advisers and other service providers will not be fully appreciated until the revised regulation is re-proposed.