This alert discusses the impact on investment managers of the Department of Labor’s (DOL) “interim final” regulation under ERISA §408(b)(2). Our reference to “investment managers” is intended to cover those investment advisers who have discretionary management authority over “plan assets” directly or through vehicles such as collective investment funds, hedge funds or partnerships that are deemed to hold plan assets.

The regulation is effective for all relationships in effect on January 1, 2012, and all new relationships entered into on or after that date. In light of the severe adverse consequences of a failure to comply with the new disclosure requirements, we are making investment managers aware of their obligations and counseling them as to the steps to take to comply with the new regulation.  

Background  

The new regulation provides guidance about compliance with the ERISA and the Internal Revenue Code “prohibited transaction” exemptions that permit reasonable contracts or arrangements between plans and service providers (such as investment managers). Under the prohibited transaction rules, such arrangements are prohibited unless the arrangement and the compensation paid to the service provider are “reasonable.” The 408(b)(2) regulation provides detailed requirements that must be satisfied to have a “reasonable” arrangement. It does so by requiring the disclosure of specified terms of the arrangement to provide fiduciaries (the “responsible plan fiduciary,” a defined term) with the information necessary to determine whether the arrangement is exempt from the prohibited transaction restrictions.  

Investment managers that fail to comply on a timely basis will engage in prohibited transactions, which result in excise taxes under the Code and a requirement to correct the violation, which may mean refunding the investment manager’s compensation, as well as interest on that money. In addition, if the DOL recovers the money for the plan, an additional 20 percent penalty may be imposed.

A short summary of the key terms in the regulation follows.  

Covered Plans

The regulation applies to “covered plans,” i.e., all ERISA-governed retirement plans other than SEP IRAs and SIMPLE IRAs. (Individual retirement accounts are excluded since they are not ERISA plans.) This means that 401(k) plans, ERISA-covered 403(b) plans, defined benefit pension plans and profit sharing plans, among others, are subject to the regulation.

COMMENT: While there are several categories of plans that are not covered by the regulation, such as governmental and non-ERISA 403(b) arrangements, investment managers may want to comply with the 408(b)(2) standards for all of their retirement plan clients. There are two reasons for this:  

  • First, the laws of some states are virtually identical to ERISA, and it is not hard to imagine that a state court might look to ERISA to determine compliance with the state law.  
  • Second, service providers that serve multiple markets may find it more costeffective and efficient to establish one disclosure regimen rather than trying to determine when the disclosures are required and when they are not.  

Covered Service Providers

The regulation applies to “covered service providers” that reasonably expect to receive $1,000 or more in direct or indirect compensation (apparently over the life of the contract, though this is not altogether clear) and that provide “covered services.”  

For purposes of this alert, there are four categories of services that are the most relevant to investment managers:

  • Services provided directly to a plan as a fiduciary under ERISA §3(21), which would generally include an investment manager providing investment advisory or management services to a plan or participants;  
  • Service provided as an ERISA fiduciary to an investment contract, product, or entity (i) that holds plan assets and (ii) in which the plan has a direct equity investment. This would include, for example, managers of collective trusts, certain hedge funds and private equity partnerships that hold plan assets (a defined term);  
  • Services provided directly to a plan as an investment adviser registered under the Investment Advisers Act of 1940 or state law;  
  • Consulting and investment advisory services if the service provider reasonably expects to receive “indirect compensation” (as defined in the regulation). “Consulting” services are those that relate to the development or implementation of investment policies or objectives or the selection or monitoring of service providers or plan investments. “Indirect compensation” is money or other things of monetary value that are paid by anyone other than the plan sponsor or directly from the plan.

The regulation covers investment managers who manage part or all of pooled funds such as profit sharing or pension plans, but who are not otherwise involved in the retirement plan community. We are concerned that they may be unaware of these new requirements and the significant consequences of a failure to timely satisfy their conditions.

Impact on Investment managers: Investment managers are covered service providers under the regulation. That is, so long as “plan assets” are involved, standard investment management services will satisfy one or more of the definitions of a covered service provider.  

Specific Requirements

Disclosure Must Be in Writing

The regulation requires investment managers to disclose specified information to the “responsible plan fiduciary” (a defined term) in writing. It appears that electronic communications satisfy the “writing” requirement. From a risk management perspective, the email communications should be retained in a searchable database. This is important, because the burden of proof of compliance is on the investment manager.  

Compliance Effective Date

The regulation requires that investment managers comply with the disclosure requirements for all covered plans by January 1, 2012. This means that, prior to that date, the disclosures will need to be given to all of the investment manager’s legacy covered plans. Thus, there are no “grandfathered” clients to whom the disclosures will not need to be made.  

Impact on investment managers: During the “transition period — that is, between now and the compliance effective date — investment managers may develop two approaches to making the disclosures. For new clients, it may be most efficient to deliver the disclosures pursuant to service agreements that comply with the disclosure rules of the regulation. From a risk management perspective, having a signed agreement that contains or specifically references the written disclosures will provide needed proof that the disclosures were made.

For existing — or legacy — covered plan clients (if the investment manager chooses not to enter into a new or amended agreement with those clients), a written disclosure notice could be used. An alternative would be to develop a new agreement and ask all existing clients to sign the new agreement.

Services

The regulation requires an investment manager to describe the services it will provide under the arrangement. The regulation does not specify how the services are to be described, indicating only that the level of detail will vary depending on the needs of the responsible plan fiduciary. And though the format of the disclosure is not specified, the DOL has requested comments on whether it should amend the regulation to require service providers to give a short (i.e., one or two page) summary disclosure to give “a roadmap for the plan fiduciary describing, where to find the more detailed elements of the disclosures required by the regulation.” (See Preamble to the interim final regulation.)

Impact on investment managers: Based on our experience, investment managers that already have ERISA-specific service agreements usually spell out their services in adequate detail. Indeed, from a risk management perspective, we believe this is important to make it clear to the plan exactly what services the investment manager will provide — and the services that it will not provide. Investment managers should describe the scope and extent of their fiduciary services in their agreements, and provide that the fiduciary standard applies only to those services.  

Some investment managers may seek to comply with portions of the disclosure obligation by providing Part 2 of their Forms ADV and incorporating the Forms by reference. This appears to be acceptable under the regulation, though the DOL may add other requirements later (for example, a summary and roadmap requirement). Having said that, in our experience most ADVs lack adequate disclosures to satisfy the 408(b)(2) requirements.  

Compensation

An investment manager must describe any direct and indirect compensation that it (and its affiliates and subcontractors) reasonably expect to receive. Direct compensation means compensation that is received from any source other than the plan, the plan sponsor, the covered service provider, an affiliate of the service provider or a subcontractor of the service provider.

For indirect compensation (including, for example, soft dollars), the regulation also requires identification of (i) the services for which it will be received and (ii) the payer of the indirect compensation.  

Note that the definition of compensation includes both money and “any other thing of monetary value.” For non-monetary items, the proposal does not specify how to disclose the value or cost. However, as a general premise, service providers must disclose whether compensation is a dollar amount, a formula based on plan assets, a per-participant charge or all of the above. Note that the requirement includes any compensation received by affiliates and subcontractors of the service provider related to the covered plan.  

The regulation also requires the disclosure of the manner of payment, e.g., whether the plan will be billed, fees will be deducted from plan accounts or will be reflected as a charge against the plan investments.  

Finally, there is a requirement to disclose any compensation in connection with termination of the contract (e.g., a termination fee) and how prepaid amounts will be calculated and refunded upon termination of the contract (for example, if an investment manager charges in advance for a particularly period, e.g., quarterly).  

There are a number of additional disclosures regarding plan investments that are applicable to recordkeepers, brokers and certain other plan fiduciaries (that manage certain types of investments in which a plan may invest — for example, collective trusts and hedge funds that are deemed to hold plan assets). The information includes (i) a description of the compensation to be received in connection with the acquisition, sale, transfer or withdrawal from the investment; (ii) the annual operating expenses of the investment (unless the return is fixed); and (iii) any ongoing expenses in addition to the annual operating expenses. An investment manager providing fiduciary services with such an investment must provide the information unless it is supplied by the recordkeeper or broker to a participant-directed plan.

Impact on investment managers: Most investment managers with ERISA-specific agreements already provide adequate disclosure of the direct compensation they receive. In many cases, those who receive indirect compensation disclose that fact and the fact that they offset such compensation against the fees they charge. (It would, in most cases, be a prohibited transaction under ERISA §406(b)(3) if they do not offset indirect payments related to recommended investments where they are providing fiduciary investment advice.)

The change that will affect even these investment managers, however, is the requirement to disclose the amount or formula and the payer of any indirect compensation. Thus, in cases where an investment manager has, in the past, made generic disclosure of indirect compensation, but without disclosing the amount of, or formula for, the compensation, and the entity from which the compensation will be paid, more detailed disclosures will be required.  

Fiduciary Status

The regulation requires a service provider to disclose whether it, or an affiliate or subcontractor, will provide any services to the plan as a fiduciary as defined under either ERISA §3(21)(A) or as an investment adviser registered under the ‘40 Act (or state law). If both, then both must be disclosed.  

Impact on investment managers: Investment managers should be careful in how this statement is made, because they may be providing both fiduciary and non-fiduciary services. Thus, as a practical matter, the investment management agreement should distinguish between which are fiduciary services and which are not for risk management purposes, especially since the standard of care for each type of service may vary. It may be possible for the investment manager to obtain an agreement to limit its potential liability for errors in performing non-fiduciary services. This may require some redrafting of investment manager agreements.  

In addition, an investment manager for a vehicle that holds plan assets would presumably want to disclose that it is a fiduciary for the limited purpose of managing that investment and not for any other purpose. Again, the reason for doing so is to manage client expectations and the investment manager’s risk.  

Other Disclosure Issues

Changes in Information: An investment manager must disclose any change to the required information as soon as practicable, but, in any case, no later than 60 days from the date on which the service provider acquires knowledge of the change. There is a provision that allows for additional time in extraordinary circumstances, but it should probably not be relied on unless absolutely necessary.  

Reporting and Disclosure Information: The regulation requires a covered service provider to disclose, upon written request, any other information relating to compensation received in connection with the arrangement, if it is required for the plan to comply with the reporting and disclosure requirements of ERISA and the regulations, forms and schedules issued thereunder. The information must be provided not later than 30 days after receipt of a written request from the responsible plan fiduciary or plan administrator, unless timely disclosure is not possible due to extraordinary circumstances beyond the service provider’s control. In that case, the information must be disclosed as soon as practicable. This requirement would most likely arise in the context of reporting information on Schedule C to the Form 5500 for large plans (i.e., plans with 100 or more participants), but the requirement is not limited to that Schedule or Form.  

Disclosure Errors: The regulation specifies that no arrangement will be considered unreasonable — i.e., a prohibited transaction — solely because the service provider makes an error or omission in disclosing the information so long as two requirements are met. First, the service provider must have been acting in good faith and with reasonable diligence. Second, the service provider must disclose the correct information to the responsible plan fiduciary as soon as practicable, but not later than 30 days from the date on which the service provider knows it made the error or omission. This will protect service providers from innocent mistakes that otherwise could have caused their contract to constitute a prohibited transaction.

Conclusion

It is imperative that investment managers review their existing agreements and disclosures and make the required written disclosures to existing covered plans before the end of 2011. It is equally important that the current agreements and disclosure forms be revised for new covered plan clients by January 1, 2012, and that the client intake policies and procedures be modified accordingly. Failure to do so will result in prohibited transactions and potentially significant excise taxes to the investment manager as well as forfeiture of their advisory fees.