The Department of Labor (DOL) recently proposed a new rule requiring investment managers and other service providers to more fully disclose the compensation received for investment management, recordkeeping, and other services provided to 401(k) plans and other employee benefit plans. The proposed rule would also require these service providers to disclose any potential conflicts of interest that may affect the service provider’s performance.

Background

ERISA requires plan fiduciaries to act prudently when selecting service providers. Such prudence includes making informed decisions about the services needed by the plan and the providers of those services, as well as paying only “reasonable” fees for those services. In addition, ERISA generally prohibits the furnishing of goods, services or facilities between an ERISA plan and its service providers. However, certain contracts or arrangements for services between an ERISA plan and its service providers are exempt from the prohibited transaction rules if the contract or arrangement is reasonable, the services are necessary for the establishment or operation of the ERISA plan, no more no more than reasonable compensation is paid for the services, and the plan can terminate the arrangement on short notice without penalty. The proposed DOL regulations seek to clarify what makes a contract or arrangement between a plan and a service provider “reasonable” under the prohibited transaction rules and ensure plan fiduciaries receive adequate information from service providers to properly discharge their fiduciary duty.

Who is Subject to the Rule?

The new disclosures are imposed on the following three categories of service providers:

  • Service providers acting as fiduciaries under ERISA or the Investment Advisers Act of 1940;
  • Service providers who provide banking, consulting, custodial, insurance, investment advisory (plan or participants), investment management, recordkeeping, securities or other investment brokerage or third party administrative services, regardless of the type of compensation or fees they receive; and
  • Service providers who receive any indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal or valuation services.

What Disclosure is Required?

  • Disclosure Must be in Writing and Provided in Advance. The contract or arrangement must be in writing. The service provider must represent in the written contract that all required information was provided to the plan fiduciary before the contract is entered into or renewed. It is not sufficient for the contract to state that the required information will be provided upon request.
    • The proposed regulations do not provide for any particular format for service providers to make the required disclosures; they only require that the disclosures be made prior to the time the contract is entered into, extended or renewed.
    • The disclosures need not be contained in the same document and may be provided in separate documents from separate sources. For example, a prospectus required by federal securities laws may include some of the information the service provider is required to disclose. In this circumstance, the service provider can incorporate such materials by reference as long as the service provider describes the additional materials and explains to the plan fiduciary the information they contain.
  • Disclosure of Services and Direct and Indirect Compensation. The contract must describe all services to be provided to the ERISA plan and all compensation or fees the service provider will receive for such services.
    • “Compensation or fees” is broadly defined to include money and any other thing of monetary value received by the service provider or its affiliates in connection with the services provided to the plan or the financial products in which plan assets are invested. Examples of “compensation or fees” that must be disclosed include, among others, gifts, awards, trips for employees, finder’s fees, placement fees, commissions or other fees related to investment products, sub-transfer agency fees, Rule 12b-1 fees, soft dollar payments, float income and performance-based and asset-based management fees.
    • Indirect compensation also must be disclosed. Indirect compensation includes fees that service providers receive from parties other than the plan, the plan sponsor or the service provider.
    • Compensation or fees may be disclosed in terms of a specific monetary amount, by using a formula, a percentage of plan assets or a per capita charge for each plan participant or beneficiary as long as the service provider describes the compensation or fees in such a way that the plan fiduciary can evaluate its reasonableness.
    • The service provider must describe how the compensation or fees will be paid, e.g., direct billing, fees deducted directly from plan accounts or charge against plan assets. The service provider also must explain how pre-paid fees will be calculated and refunded when the contract terminates.
  • Disclosure of Bundled Arrangements. In the case of “bundled services” whereby multiple services are provided to the plan by the service provider and are priced as a package rather than by the individual service, only the provider of the “bundle” is required to make the disclosures. The bundled service provider must disclose the total direct compensation or fees that will be paid for the bundle as well as the indirect compensation received by the service provider or its affiliates or subcontractors from third parties
    • The service provider is generally not required to break down the total compensation among the individual services comprising the bundle. However, the bundled service provider must separately disclose any compensation or fees charged directly against the net asset value of the plan’s investment or any fees set on a transaction basis. Examples of such fees are advisory fees, float revenue, brokerage commissions and soft dollars.
  • Disclosure of Conflicts of Interest. Service providers must disclose any conflicts of interest that may arise in connection with the services they provide. The service provider must identify and disclose:
    • Whether it will provide services to the plan as a fiduciary under ERISA or under the Investment Advisers Act.
    • Any financial interest or other interest it has in transactions in which the plan will participate.
    • Any material, financial, referral or other relationship it has with various parties that creates or may create a conflict of interest for the service provider in providing the services.
    • Whether the service provider can affect its own compensation without the prior approval of the plan fiduciary and the nature of this compensation.
    • Whether the service provider has policies or procedures in place to manage real or potential conflicts of interest, and if so, an explanation of these policies and procedures and how they address the conflicts of interest.
  • Ongoing Disclosure Requirements. Under the proposed regulations, the service provider must disclose material changes to any previously disclosed information within 30 days. The contract must require the service provider to provide all information requested by the plan fiduciary in order to comply with ERISA’s reporting and disclosure requirements, including all information necessary to complete the Form 5500.

What are the Consequences if the Disclosures are not Satisfied?

If the contract does not include the required disclosures or if the service provider fails to disclose the required information, the contract will not be “reasonable” and will result in a prohibited transaction. In this case, both the plan fiduciary and service provider would be subject to penalties and excise taxes imposed by ERISA and the Internal Revenue Code.

The DOL has also proposed an exemption from the prohibited transaction rules for a plan fiduciary who enters into a contract requiring disclosure, but who does not receive the required disclosures from the service provider. To qualify for this relief, once the plan fiduciary discovers that information was not provided or was insufficient, it must request in writing the required information from the service provider. If the service provider fails to comply with the fiduciary’s request, the plan fiduciary must notify the DOL. The plan fiduciary must consider whether, under the circumstances, to terminate or continue the relationship with the service provider.