Department of Labor's Proposed Regulations Broadly Expand Definition of "Fiduciary" Under ERISA
On October 21, 2010, the Department of Labor (DOL) released long-anticipated proposed regulations substantially broadening the term "fiduciary" under ERISA regulations, and potentially subjecting to ERISA's stringent standards a vast number of plan service providers who previously considered themselves exempt from fiduciary status.
If the proposed regulations do not change substantially before they are issued in final form, their implementation could force plan service providers to significantly revamp their business models and possibly cease providing services to plans, effectively shrinking the vendor marketplace for plan sponsors.
The DOL has been indicating for some time its dissatisfaction with the current definition of fiduciary in connection with persons who provide "investment advice" for a fee. In late 2009, the DOL stated that it believed the current definition is outdated and does not adequately regulate the employee benefit community and financial marketplace. The DOL's 2009 statements coincided with a Government Accountability Office report that found that plan investment consultants (who may not be subject to ERISA's fiduciary standards) often operate in an environment fraught with conflicts of interest that may harm plan participants.
Further, the proposed regulations reflect the DOL's recent multi-pronged effort to heavily scrutinize and regulate the relationships between ERISA plans and their service providers. These efforts include implementing significant changes to Schedule C of the Form 5500, Annual Return/Report of Employee Benefit Plan, which now require substantial detailed reporting of fees paid -- directly or indirectly --to plan service providers from plan assets or participant accounts, issuing an interim final regulation defining what constitutes a "reasonable" service contract or arrangement between certain plan service providers and plans, and issuing proposed regulations under certain sections of the Pension Protection Act of 2006 (PPA) dealing with "fiduciary advisers" in "eligible individual account arrangements."
The current statutory definition of fiduciary under ERISA includes parties who render investment advice for a direct or indirect fee with respect to plan assets. In 1975, the DOL issued regulations providing a 5-part test for determining fiduciary status as a result of providing investment advice. Under this test:
- The advisor must render advice as to the value of securities or other property, or make recommendations as to the advisability of investing in, purchasing or selling securities or other property;
- The advisor must provide the advice on a regular basis;
- The advisor must provide the advice pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary;
- The advice will serve as a primary basis for investment decisions with respect to plan assets; and
- The advice will be individualized based on the particular needs of the plan.
In order to be deemed a fiduciary, the advisor must meet all five of the criteria outlined in the test. The DOL notes in the preamble to the proposed regulations that this existing test significantly limits the applicability of the original regulations and effectively ties its hands with respect to enforcement of ERISA violations. The new test eliminates the five part test, broadens the definition of advice, and most significantly, eliminates the requirement that advice be provided regularly and pursuant to a mutual agreement, and that the advice must serve as a primary basis for investment decisions.
The New Test
The proposed regulations replace the existing five part test with a new test. Under the proposed regulations, the new test includes persons who:
- Provide advice, appraisals or fairness opinions as to the value of investments, recommendations as to buying, selling or holding assets, or recommendations as to the management of securities or other property.
- Acknowledge fiduciary status for purposes of providing advice. This provision is significant because under the old test, a party could acknowledge fiduciary status, and still fail to be held liable if they did not meet all five parts of the old test.
- Are investment advisors under Section 202(a)(11) of the Investment Advisors Act of 1940.
- Provide advice or make recommendations pursuant to an agreement, arrangement or understanding, written or otherwise, with the plan, a plan fiduciary or a plan participant or beneficiary, where the advice may be considered in making investment or management decisions with respect to plan assets, and the advice will be individualized to the needs of the plan, a plan fiduciary or a participant or beneficiary.
Under the new test, the advice no longer needs to be offered on a regular basis -- offering advice on a single occasion could result in fiduciary status.
As well, the new test sweeps in those service providers who provide recommendations with respect to the "management" of securities or other property. It is unclear what "management" means in this context, but it is evident that the DOL broadly construes the term. In the preamble to the proposed regulations, the DOL states that "management" could include such things as voting proxies or recommendations regarding the selection of persons to manage plan investments. This broad definition could create significant uncertainty. For example, a plan consultant could be approached by a named fiduciary of the plan to give an impartial assessment of the pros and cons of including an employer's CFO on the employer's investment committee for its defined contribution plan. It would be difficult to conceive of that assessment constituting investment advice under the current regulation; however, under the proposed regulation, it may well be investment advice provided by a fiduciary.
Further, the advice no longer need be offered as part of a mutual understanding or that the advice will serve as the primary basis for investment decisions – there does not need to be any understanding or agreement in place whereby both parties acknowledge that they are in an advisory relationship. Most importantly, the advice could be a mere recommendation or offhand comment by the service provider and yet constitute investment advice and impose fiduciary status on the service provider because it may be one factor that the plan sponsor considers in making investment decisions.
Under the current regulation, a service provider must meet all five prongs of the test in order to be considered a fiduciary. Under the proposed regulation, meeting any one of the criteria will result in fiduciary status. The proposed regulations also clarify that rendering the advice for a fee includes any direct or indirect fees received by the advisor or an affiliate from any source including transaction-based fees such as brokerage, mutual fund or insurance sales commissions.
Safe Harbor Limitations and Exceptions to Fiduciary Status
The proposed regulations do provide a safe harbor for certain actions that do not result in fiduciary status. These include:
- Recommendations made in the capacity of a seller or purchaser of a security to a plan or participant whose interests are adverse to the plan or its participants, provided that the recipient of the advice or recommendation knows or should have known that the seller or purchaser was not undertaking to provide impartial investment advice (this exception would not include an advisor who has acknowledged fiduciary status).
- Providing investment education information and materials.
- Marketing or making available a menu of investment alternatives that a plan sponsor may choose from, and providing general financial information to assist in selecting and monitoring those investments, provided this is accompanied by a written disclosure that the party is not providing impartial investment advice.
- Preparation of reporting necessary to comply with provisions of ERISA, the Internal Revenue Code, or regulations or forms issued thereunder.
Internal Revenue Code Conformance
The proposed regulations would conform the provisions of Section 4975(e)(3)(B) of the Internal Revenue Code relating to prohibited transactions to the new definition of fiduciary. This means that the significant population of service providers to individual retirement accounts is affected by the proposed regulations.
Effect on Provisions of Pension Protection Act Dealing with Investment Advice
The language of the proposed regulations would expand who is considered a fiduciary adviser under sections of the PPA that create an exemption from ERISA's prohibited transaction rules for "eligible investment advice arrangements" (arrangements that permit advisors to receive fees for providing investment advice, so long as certain conditions are satisfied). The DOL released proposed regulations on these sections of the PPA in March 2010, and is expected to finalize these regulations shortly.
As a result of the exemption under PPA and the proposed regulations expanding the definition of "fiduciary," many plan service providers who intend to continue doing business with plans may view fiduciary status as inevitable and revise their business models to act as fiduciary advisers under eligible investment advice arrangements.
What to Expect Next
The proposed regulations are broad and far-reaching in their current form. It is likely that there will be significant outcry from the plan service provider community (and potentially the plan sponsor community, if it thinks its vendor marketplace will shrink) in response to the proposed regulations. The DOL has invited comments for a period ending in mid-January 2011 and we would expect final regulations to be issued no earlier than late 2011.