I. INTRODUCTION

On October 21, 2010, the Department of Labor (Department) proposed a wholesale revision to its regulation that defines the term “fiduciary” under ERISA and the Internal Revenue Code. The definition will affect whether consultants, appraisers, insurance agents, retail securities brokers, prime brokers, institutional trading desks, swap dealers, currency dealers, futures commission merchants, banks and custodians, hedge funds, private equity funds, other investment providers and others who work with pension and 401(k) plans and IRAs will be deemed to be fiduciary investment advisors. The consequences of being a fiduciary include a difference in the duty of care applicable to one’s conduct, prohibitions on receipt of additional fees, prohibitions against recommending affiliated products or services, and prohibitions against engaging in principal transactions.

The current regulation was issued in 1975, shortly after ERISA’s enactment. The current regulation covers advice regarding purchases and sales of securities or other property and advice “regarding such matters as, among other things, investment policies or strategy, overall portfolio composition, or diversification of plan assets.” The proposed regulation broadens the scope of the regulation to cover advice, appraisals, or the giving of a fairness opinion concerning the value of securities or other property; recommendations regarding the advisability of investing in, purchasing, holding, or selling securities or other property; or advice or recommendations regarding the management of securities or other property. The new definition is intended to sweep in ESOP and real estate appraisers, consultants who help plans find managers or devise asset allocation strategies, plan transitions, or analyze portfolio strategies, particularly in connection with defined benefit plans. It is also intended to sweep in insurance agents and securities brokers and consultants who might currently fall outside the current regulation, depending on their conduct.

The preamble to the proposed rule indicates that the Department now thinks that its current regulation is wrong, ill-advised, not protective of participants and perhaps most importantly, an impediment to its enforcement program, making it too hard and too costly for the Department to prove fiduciary status. Thus, the Department’s intent is to make it significantly easier for the Department or a private plaintiff to prove that someone is providing fiduciary investment advice.

The preamble to the proposed rule notes:

In this regard, we note that recent Department enforcement initiatives indicate there are a variety of circumstances, outside those described in the current regulation, under which plan fiduciaries seek out impartial assistance and expertise of persons such as consultants, advisers and appraisers to advise them on investment-related matters. These persons significantly influence the decisions of plan fiduciaries, and have a considerable impact on plan investments. However, if these advisers are not fiduciaries under ERISA, they may operate with conflicts of interest that they need not disclose to the plan fiduciaries who expect impartiality and often must rely on their expertise, and have limited liability under ERISA for the advice they provide. Recent testimony by the Government Accountability Office noted an association between pension consultants with undisclosed conflicts of interest and lower returns for their client plans.

The Department does not believe that the current approach to fiduciary status is compelled by the statutory language. Nor does the Department believe the current framework represents the most effective means of distinguishing persons who should be held accountable as fiduciaries from those who should not. For these reasons, the Department believes it is appropriate to update the “investment advice” definition to better ensure that persons in fact providing investment advice to plan fiduciaries and/or plan participants and beneficiaries are subject to ERISA’s standards of fiduciary conduct.

II. COMPARISON OF THE CURRENT RULE AND THE PROPOSED RULE

The proposed rule significantly expands the conduct that is captured by the regulation. Under the current regulation, a person must provide advice (1) regarding the value of securities or other property or make recommendations as to the advisability of investing in, purchasing or selling securities or other property; (2) on a regular basis; (3) pursuant to a mutual understanding, arrangement or agreement; (4) that will serve as a primary basis for the client’s investment decisions; and (5) that is individualized based on the particular needs of the plan.

Under the proposed rule, a person is a fiduciary if he either directly or indirectly (e.g., through or together with any affiliate)[1]—

  1. Represents or acknowledges that it is acting as a fiduciary within the meaning of the Act with respect to providing advice or making recommendations;
  2.  Is a fiduciary with respect to the plan because it has discretionary authority over plan investment or plan administration;
  3.  Is an investment adviser within the meaning of section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)(11))(which includes the exclusion for brokers whose recommendations are merely incidental to the brokerage); or
  4.  Provides advice or makes recommendations described in paragraph (c)(1)(i) of this section pursuant to an agreement, arrangement or understanding, written or otherwise, between such person and the plan, a plan fiduciary, or a plan participant or beneficiary that such advice may be considered in connection with making investment or management decisions with respect to plan assets, and will be individualized to the needs of the plan, a plan fiduciary, or a participant or beneficiary (which does not appear to include the exclusion for merely incidental recommendations).

Thus, a person will be deemed to be a fiduciary if he or his documents say he is a fiduciary, if he has discretionary authority or control, or if he is registered as an investment advisor and acts as an adviser within the meaning of section 202(a)(11) of the Advisers Act (but presumably not if the advice is merely incidental to brokerage). Note that this “incidental to brokerage” exception only covers registered investment advisors to the extent that they are also brokers; it offers no comfort to brokers who are not dual registered, nor to appraisers, consultants, or insurance agents. Similarly, under the “registered as an advisor” test, the information provided to the plan need not be individualized. Thus, if a dual registered broker provides generic research reports to a client, it may become a fiduciary, even if the research is not individualized. In addition to the alternative conditions described above, a person is a fiduciary if he provides advice or makes recommendations that satisfy a significantly relaxed version of the basic test of the current regulation. Under this relaxed test:

  • The understanding need not be mutual
  • The regular basis test is gone – it can be one-time advice
  • The advice need not be “a primary basis” for the plan’s investment decision; instead, a person is a fiduciary if the advice “may be considered”
  • The advice need not be based on the particularized needs of the plan, but must only be provided pursuant to an understanding that it will be individualized.

Under the current regulation, the burden is on the plaintiff to prove that a person is a fiduciary under the regulation. Under the proposal, in order to avoid fiduciary status, the person giving advice must demonstrate that the recipient of the advice knows or, under the circumstances, reasonably should know, that such person (a) is providing the advice or making the recommendation in its capacity as counterparty, agent, or appraiser, (b) has interests that are adverse to the interests of the plan or its participants or beneficiaries, and (c) is not undertaking to provide impartial investment advice. While this language may be helpful in the institutional dealing context, it is problematic in the retail world.

The proposed rule would carve out (a) investment education under the Department’s bulletin[2]; (b) marketing or making available a platform of options, without regard to the individualized needs of the plan, its participants, or beneficiaries, if the person making available such investments discloses in writing to the plan fiduciary that the person is not undertaking to provide impartial investment advice; and (c) providing analytics in connection with such platform, if the person providing such information or data discloses in writing to the plan fiduciary that the person is not undertaking to provide impartial investment advice.

Under the proposed rule, one is not deemed to be providing investment advice, appraisals or fairness opinions when the person is providing valuation of assets for purposes of government reporting such as the Form 5500 or the IRS form 5498 for IRAs and Form 1099 for distributions, but this exception does not apply if such report involves assets for which there is not a generally recognized market and serves as a basis on which a plan may make distributions to plan participants and beneficiaries. Thus, administrators or managers of private equity funds and hedge funds may become fiduciaries for valuation purposes, as may anyone valuing a real estate investment or other hard to value asset. The consequences of such status may be far reaching and are described in more detail below.

The proposed rule does not change the exception to fiduciary status in current law for acting as agent in a securities transaction, so long as the client specifies the security, a price range and a time span not to exceed five days. It is unclear how many brokers are scrupulous in meeting these requirements; if they are not, they can be treated as a fiduciary for having acted as the plan’s agent with discretion. Also, the Department has indicated that the exception does not cover principal transactions, although we have seen no enforcement action taking this position.

III. MARKET SPECIFIC CONCERNS

Securities Brokerage

The proposed regulation is very troublesome for the retail securities brokerage business. Retail brokers will find it difficult to provide any kind of client service without running afoul of this expanded definition. Any stray comment that a broker may make could be considered by the plan, making the broker a fiduciary under the proposal. In addition, it is particularly troubling that the word “mutual” is omitted from the phrase mutual agreement, arrangement or understanding. While it is hard for an agreement or arrangement not to be mutual, it is quite easy for an understanding to be one-sided, giving the plan a put to the broker any time a trade doesn’t turn out as well as the plan expected.

To the extent that brokers are valuing assets for purposes of statements that will be used for tax or annual reporting, and those assets are “hard to value,” the broker becomes a fiduciary for that function. It is unclear whether that fiduciary status bleeds into anything other than the valuation, although a plaintiff may argue that he or she relied on that valuation in deciding whether to hold or sell the asset, or in determining what price to accept in a sale. It is not hard to see the Madoff connection for which the Department may have been aiming.

Manager of Managers programs may be hard pressed to avoid fiduciary status and the familiar shield of providing at least three choices to avoid the conclusion that the client was relying on the advice as a primary basis for the client’s investment decisions may be a thing of the past. Clearly, helping with investment policies, attending (and commenting at) plan investment committee meetings, and reviewing manager performance in anything other than the most factually descriptive way may be problematic. Brokers who publish a list of “preferred” mutual funds that they claim to track and evaluate on a regular basis should carefully review the list to determine whether disclaimers they currently carry are adequate.

For those retail securities brokers who choose to act as fiduciaries, they will be required to do foreign exchange and other principal transactions in securities, options, repurchase agreements and the like away from their firms, and their participation in bank deposit sweep programs may be very difficult. They will also be unable to trade in unlisted options, repurchases, reverse repurchases, forwards and securities trades on a principal basis, extending or receiving credit (e.g., margin loans, securities loans, overdrafts, fully paid securities lending), acting as futures commission merchants and rehypothecating collateral. They will be unable to allow for free credit balances and may have to have an affirmative sweep vehicle (unless they have an affiliated bank for deposit sweep, likely an unaffiliated money market fund). They will be unable to accept any trailers from mutual funds or other fees in connection with mutual fund trades, or will have to offset them against their outside advisory fee in accordance with DOL Advisory Opinions 97-15A and 2005-10. They will have to use the class exemption for agency commissions (PTE 86-128, which requires written consent, quarterly reporting, and other conditions) in order to receive agency commissions. If the fiduciary broker charges a fee at the account level, the broker may not cause the plan to invest in an affiliated mutual fund without offsetting the mutual fund’s inside advisory fee in accordance with the class exemption for affiliated mutual funds, PTE 77-4. That exemption may tend to “cannibalize” affiliated product offerings since the broker takes no such reduction if he recommends a third party fund. It will make impossible the recommendation of (or plan or IRA investment in) any affiliated hedge fund, private equity fund, commodity ETF or closed end fund. We think it may be difficult to argue, once a broker is a fiduciary with respect to certain assets of a plan (or a particular IRA), that it is not a fiduciary with respect to other assets in the same account (or in another IRA owned by the same individual). The proposed rule could make every futures merchant a fiduciary because the exception for incidental advice in section 202(a)(11) of the Advisers Act may not cover futures. To the extent that a broker or insurance agent is a fiduciary, urging participants to rollover their balances to an affiliated IRA may violate the prohibited transaction rules.

Institutional broker-dealers will need to take a hard look at their equity and fixed income trading, prime brokerage, derivatives and structured products businesses, as well as programs like capital introduction and pension solutions, for practices that will render them fiduciaries under the proposed regulation. Such fiduciary practices may include performing valuations for hedge funds and other prime brokerage clients; performing ISDA calculation and valuation agent functions; providing pension-related strategies and product solutions; and providing other investment-related information, including analytics, “trend” reports, market forecasts, analysis relating to particular managers, market sectors (e.g., real assets) or issues (e.g., liability-driven investing), whether provided to individual clients or disseminated at investor conferences. Calculation and valuation agents may need to be third parties, and the cost of their services will be added to the cost of the swap, to the further detriment of the plan or fund, unless the Department agrees to clarify the proposed rule to define such functions as nonfiduciary rights of a counterparty. Client conferences may also be problematic unless they are heavily qualified and participants agree to regard the content received at the conference as non-individualized and not impartial. The analytics that are now provided with respect to the swap business to “guide” clients through their available choices may also need to be rethought. While the language in the proposed rule is not free from doubt, we think there are arguments that the kind of “rate-setting” that a prime broker does in borrowing securities from a client account might not be deemed to be a fiduciary function, but we can see good arguments to the contrary, since the information might be deemed to be advice with respect to an investment decision – the decision to enter into a loan. Plans with less than $100 million in assets and IRAs will likely be closed out of the initial public offering market, to the extent that a broker’s affiliate is in the selling syndicate, since the Department’s current exemptions use that dollar amount as the sophisticated investor threshold. Financial institutions without individual IPO exemptions will need to promptly obtain one. Clearing brokers will need to consider whether their valuation of hard to value assets makes them a fiduciary for this purpose and, if so, whether that status implicates any other fees that the clearing broker may receive.

The exclusion for counterparties described above should prove helpful to institutional broker-dealers in reducing their risk of fiduciary status. Key to such risk management will be written acknowledgements from the client plan or fund manager (e.g., in the ISDA Schedule, prime brokerage documentation, client agreement, etc.) that (i) the broker-dealer (and its affiliates) has not represented or acknowledged that it is or will be acting as a fiduciary, (ii) any advice or recommendations provided by the broker-dealer or its affiliates are and will be provided solely in its capacity as a counterparty (or agent or appraiser thereof), (iii) the broker-dealer’s interests are and will be adverse to the interests of the client plan (and its participants and beneficiaries) or fund (and its investors and their participants and beneficiaries), and (iv) the broker-dealer has not undertaken and will not undertake to provide impartial investment advice to the client plan or fund. These acknowledgements should be in addition to documentation of the client’s sophistication with respect to the transactions at issue and the client’s independence. The acknowledgements and documentation may not be bullet-proof; broker-dealers must still avoid conduct that conflicts with such acknowledgements (e.g., assuring clients that they may rely on the broker-dealer’s recommendations).

Other Consultants

As noted earlier, the proposed rule specifically seeks to cover those entities that hold themselves out as consultants and help with asset allocation, creation of target date glide paths, transition management RFP’s, supervision, hiring and retention of managers, liability studies and strategies for defined benefit plans, plan design issues and other kinds of consulting projects. Many of these consultants currently agree to act as a fiduciary, and these regulations should have little effect on them because their businesses have been organized with these issues in mind. On the other hand, consultants with affiliates, especially in the insurance or securities brokerage business, or appraisers, economic consultants or other financial professionals that could sell services to plans, may need to review how the regulation affects their or their affiliates’ receipt of fees from third parties. Another issue is proxy voting: a proxy voting firm that makes recommendations to managers on how to vote on a particular issue may well be a fiduciary for that purpose. Much has been made of accountants, lawyers and actuaries becoming fiduciaries; it is unclear whether the Department will have any interest in creating an exception for such service providers.

Appraisers

The preamble to the proposed rule notes that “[o]ne of the most common violations found is the incorrect valuation of employer securities.” In explaining the Department’s decision to focus on appraisers, the preamble states:

First, the proposal specifically includes the provision of appraisals and fairness opinions. As discussed above, the Department concluded in AO 76-65A that a valuation of closely held employer securities that would be relied on in the purchase of the securities by an ESOP would not constitute investment advice under the current regulation. However, a common problem identified in the Department’s recent ESOP national enforcement project involves the incorrect valuation of employer securities. Among these are cases where plan fiduciaries have reasonably relied on faulty valuations prepared by professional appraisers. The Department believes that application of the proposal to appraisals and fairness opinions rendered in connection with plan transactions may directly or indirectly address these issues, and align the duties of persons who provide these opinions with those of fiduciaries who rely on them. Accordingly, paragraph (c)(1)(i)(A)(1) of the proposal specifically includes the provision of appraisals and fairness opinions concerning the value of securities or other property. This paragraph is intended to supersede the Department’s conclusion in AO 76-65A, but is not limited to employer securities. Therefore, if a person is retained by a plan fiduciary to appraise real estate being offered to the plan for purchase, then the provision of the appraisal would fall within paragraph (c)(1)(i)(A)(1) of the proposal, and may result in fiduciary status under ERISA section 3(21)(A)(ii). The Department would expect a fiduciary appraiser’s determination of value to be unbiased, fair, and objective, and to be made in good faith and based on a prudent investigation under the prevailing circumstances then known to the appraiser.

Most appraisers do not currently agree to be fiduciaries. If the proposal is finalized in its present form, there seems to be no circumstance in which an appraiser would not be a fiduciary. One of the consequences of that status may be the need for a section 412 bond, which appraisers generally do not carry.[3] The usual affiliate issues also arise. For example, if the appraisal is provided by an entity affiliated with a securities firm, that firm would be unable to trade as principal with the plan in employer securities, if the value for those securities had been determined by the firm’s affiliate. Appraisers affiliated with real estate brokers could cause their affiliates to be barred from receiving fees in connection with the property, whether on its transfer or for other purposes, such as property management, leasing or the like.

IRA Custodians

The proposed rule raises serious issues for IRA custodians, which will be caught between these new fiduciary rules and the valuation requirements of the Code for purposes of issuing Form 5498s and Form 1099s. The penalties for failure to correctly report values on the IRS forms are severe, and the fact that the valuation may make the IRA custodian a fiduciary will put additional cost pressure on this business, causing most IRA custodians to hire third parties to value the assets and charge the valuation costs to the IRA. Clearing brokers need to pay special attention to this issue, since they often take in large numbers of IRAs from introducing brokers or other clearing brokers, without good historic values. The consequence of the custodian becoming a fiduciary for setting a value could be far reaching; an IRA owner who takes his required minimum distributions based on this value, who decides to keep or sell the asset based on the value, the obscuring of misconduct and a cofiduciary breach because the client is lead to believe there is no valuation problem.

Insurance Agents

Insurance agents may be severely impacted by the proposed regulation. One of the functions of an insurance agent is to help a plan sponsor select the appropriate insurance contract for the plan – GIC or GAC? Variable or fixed annuity? While the Department always may have believed that insurance agents were fiduciaries and tried to accommodate that status in PTE 84-24,[4] the proposed rule makes it very difficult for an agent to ever prove he was not acting as a fiduciary in connection with the purchase of the contract. There has been some confusion regarding the scope of PTE 84-24 and whether it covers fiduciaries who receive an advisory fee without otherwise exercising discretionary control over the transaction. That scope would need to be confirmed before an insurance agent could comfortably use it. Nonetheless, PTE 84-24 may make it easier for insurance agents to sell proprietary and nonproprietary products. There also are fewer principal transactions involved in the insurance business, compared to the securities business. However, the same valuation issues faced by appraisers may be faced by insurance companies in the recordkeeping and plan administration business. The bar on counseling participants to roll over their account balance to an affiliated IRA or an IRA invested in affiliated products raises similar issues. Payments from insurers or third parties would need to be analyzed under section 406(b)(3) of ERISA.

Hedge Funds and Private Equity Funds

As noted earlier, hedge funds and private equity funds affiliated with broker-dealers will likely lose a significant distribution stream on the plan and IRA front. In addition, placement agents affiliated with broker-dealers will likely need to avoid the plan and IRA market, as well. Even more troublesome for these funds are the valuation issues raised by the proposed rule. To the extent that the funds have hard to value investments, it seems unlikely that prime brokers or fund administrators would be prepared to do anything other than take direction on value. Even though the regulation seems clear that the person supplying the value would be a fiduciary only for this purpose, one can see quite severe consequences to this rule. For example, if the general partner of the fund sets the value for purposes of purchases and sales, does it become a fiduciary to every plan or IRA investing in the fund, and therefore foreclose its receipt of asset-based fees, even where the fund is not deemed to hold plan assets for purposes of ERISA or the Code? If the fund is valued by a fund administration firm, does that firm become a fiduciary by valuing the assets and, thus, its own asset-based fee becomes fiduciary self-dealing, at least to the extent of the hard to value assets? Imposing fiduciary status on a fund’s general partner for purposes of valuing purchases and sales could also expose the general partner to potential co-fiduciary liability for plan losses arising from any fiduciary breach in causing the plan to hold an interest in the fund. All of these issues could cause major disruption at hedge funds and private equity funds.

Banks and Trust Companies

Banks and trust companies have the same valuation issues as described above and will likely require far more direction from plan sponsors and valuation experts than is currently the case. In addition, private wealth management groups may have similar issues as described above for brokers, although exemptions, such as the deposit exemption in ERISA section 408(b)(4), the collective trust exemption in ERISA section 408(b)(8) and the ancillary services exemption in ERISA section 408(b)(6) should provide some relief. However, advice regarding asset allocation for plans and IRAs and recommendations relating to hedge funds or other private funds maintained by the bank or an affiliate will likely need to be curtailed.

Recordkeepers

The proposed rule attempts to exclude recordkeepers from its scope by eliminating the mere maintenance of platforms and menus and regular valuation functions from the definition. However, the same issues on hard to value assets that we have discussed above will impact recordkeepers. In addition, to the extent that sales staff members recommend certain funds or give advice on types of funds or other arrangements, through a call center or otherwise, they could be deemed to be fiduciaries.

Conclusion

The Department’s proposed revision of the definition of fiduciary investment advice, if adopted, will certainly require a major retooling of all service provider relationships, compliance programs, principal transactions and valuation practices.