On December 13, 2007, - The Department of Labor proposed amendments to regulations that would require enhanced disclosure of service provider fees and third-party relationships that may give rise to conflicts of interest. Potentially sweeping in their impact, the much anticipated proposed amendments to regulations under ERISA section 408(b)(2) will, if finalized in their current form, not only for the first time directly regulate the content of contractual arrangements between plans and service providers, but also fundamentally recast liability exposure under ERISA's prohibited transactions rules. Accompanying the proposed regulations is a proposed class exemption providing limited prohibited transaction relief for plan fiduciaries.
The full text of the proposed amendment (click here) and class exemption (click here) are available online. The Department of Labor also issued a press release (click here) and a fact sheet (click here ) providing additional information about the proposed guidance.
The public comment period on the proposed amendment will remain open until February 11, 2008, and the Department has solicited comments from the regulated public on some specific issues. Following is a brief description of the proposed rules and a first cut at identifying some of the more significant concerns plan service providers and employers may have.
Beginning as early as 2004, the Department initiated a three-prong regulatory project aimed at enhancing the type of information required to be given about service provider fees and other compensation. The first prong of the initiative, completed earlier this year, made sweeping changes to the information employers are required to report on the annual Form 5500. The third prong will be new proposed regulations enhancing the information plans that must be sent to participants and beneficiaries.
The proposed amendments to § 408(b)(2) regulations ("proposed regulation") published December 13, 2007, are targeted at providing more disclosure to plan fiduciaries at the time they enter into contractual arrangements with service providers. The existing regulations interpret the primary statutory class exemption from one of ERISA’s most sweeping prohibited transaction rules. ERISA section 406(a)(1)(C) prohibits the furnishings of goods, services, or facilities between a plan and a party in interest to the plan. Without an exemption from that statutory prohibition, most plans would be unable to contract for basic and essential services, such as legal, accounting, actuarial, or investment management services, among others.
ERISA § 408(b)(2) provides just such an exemption. Provided that a contractual arrangement between a plan and a party in interest to the plan is reasonable and for no more than reasonable compensation, the transaction will be exempt from the prohibition of § 406(a)(1)(C). Existing § 408(b)(2) regulations do not provide much in the way of additional guidance with respect to what type of contractual arrangement will be "reasonable," requiring only that a fiduciary be able to cancel a contract on short notice with no penalty.
There is also no requirement in the current regulations (or anywhere else in ERISA) for service providers to supply any specific type of information to plan fiduciaries. Indeed, until the Department’s disclosure initiative began, the burden of ensuring that arrangements were reasonable and for no more than reasonable compensation, had rested squarely and solely with the plan fiduciary. Moreover, there is nothing currently in ERISA that would require a plan service provider to disclose the identity of third parties from whom it indirectly receives fees or compensation as a result of having a connection with a plan. The proposed regulations, if finalized in current form, would require new disclosures from service providers on both fronts.
Service Providers Covered
The scope of the proposed regulation is limited to certain categories of services providers. Only those contractual arrangements made between a plan and a service provider identified in one of the three categories must meet the disclosure requirements of the proposed regulations. The three categories of covered service providers are:
- Category 1: service providers who provide services as a fiduciary under ERISA or the Investment Advisors Act of 1940;
- Category 2: service providers who provide banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping, securities or other investment brokerage, or third party administration services; and
- Category 3: service providers who receive indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal, or valuation services.
Although the scope of the proposed regulation is limited by this threshold coverage requirement, once a service is in one of the categories, it must fully comply with all the disclosure requirements. In the preamble to the proposed regulation, the Department indicates that is a contract or arrangement is between a plan and a service provider included in one of these three categories, the “terms of such contract or arrangement must satisfy the proposal’s disclosure requirements in order to be reasonable for purposes of [qualifying for the prohibited transaction exemption] regardless of the nature of any other services provided or whether the plan is a pension plan, group health plan, or other type of welfare benefit plan.”
There are at least two noteworthy aspects of the proposed regulation's scope. First, non-fiduciary service providers are going to be more closely regulated by the Department under ERISA than ever before under these regulations. While the Secretary of Labor arguably has always had authority under ERISA's civil enforcement provisions to sue parties-in-interest for willing participation in prohibited transactions with a plan or plan fiduciary, the Department's ability to directly regulate the behavior of non-fiduciaries is more of an open question. The preamble to the proposed regulations does not hint at this potential weakness in the Department's authority, nor is there a recognition that the proposed regulation represents a significant expansion of their regulatory jurisdiction.
The second noteworthy aspect of the proposed regulation's coverage is that Category 3 service providers will have to comply with all of the enhanced disclosure rules, even though they are covered under the regulation solely because of their receipt of indirect compensation in connection with the services they provide to the plan. Those service providers (e.g. actuarial, accounting, and legal service providers, among others) apparently will not have to comply with the enhanced disclosure requirements if they receive only direct fees or compensation. However, it seems clear that once a service provider is identified as fitting into Category 3, it must comply with all the disclosure requirements, which includes disclosure of direct compensation and actual and potential conflicts of interest.
Fee and Compensation Disclosures
Having identified which service providers are covered, the proposed regulation must next detail the type of fee and compensation disclosure that will be required. Here the proposed regulations would squarely place the burden of fee disclosure on the service providers. Rather than solely rely on the prudent exercise of the plan fiduciaries’ obligation to understand the fees being charged to the plan, the Department will now, for the first time, affirmatively require service providers to proactively supply specific information to fiduciaries. Moreover, in a rule reminiscent of a truth in lending statements required to be made by mortgage lenders, service providers would be required to include in their contracts a representation that, before the contract was entered into, “all required information was provided to the responsible plan fiduciary.”
While the proposed regulation does not prescribe the manner in which such disclosures should be presented, it does detail what must be disclosed. Specifically, the proposed regulation would require that plan fiduciaries must receive comprehensive information about “the compensation or fees involved in plan administration and investments, including indirect compensation.” Service providers would also be required to disclose compensation or fees received by their affiliates from third parties. Such disclosure could be done in the form of monetary amounts, or in cases where the “service provider cannot disclose” specific monetary amounts, it may satisfy the disclosure requirements with a formula, a percentage of the plans assets, or a per capita change for each participant or beneficiary.
There are special rules for bundled service providers that generally track the requirements of revisions the Department recently made to the disclosure requirements of Schedule C of the Form 5500. One of the most hotly contested aspects of the fee disclosure debate in the run-up to these proposed regulations had been the different standards that could apply to bundled and unbundled (or independent) service providers, respectively. Bundled service providers have consistently maintained that separate reporting of the cost of each of the bundles’ components would be inefficient and meaningless to plan fiduciaries. Moreover, bundled service providers have asserted that they should not be required to disclose the allocation of revenue sharing payments made to the separate entities within the bundle.
For the most part, the proposed regulations track the position of the bundled service providers, with at least one notable exception. The proposed regulation would require that fees or compensation charged on a transaction basis – as opposed to a flat rate or percentage of assets – must be separately reported, even if being paid to one component entity of a bundled service package. Bundled providers may object that such a rule would require the disclosure of confidential or proprietary information, but the Department made clear in the preamble to the proposed regulation that such arguments were considered, but did not prevail.
Conflict of Interest Disclosure
Apart from knowing how much the plan is being charged for a given service, the Department believes it to be vital to know who else is paying the service provider. Even before these proposed regulations were published, the Department initiated an enforcement program to identity and penalize certain types of fee arrangments that it considers to be prohibited by the fiduciary self-dealing rules in § 406(b) of ERISA.
These proposed regulations go one step further and will require disclosure of potential conflicts of interest, regardless of whether the service provider is acting in a fiduciary capacity to the plan. According to the Department, plan fiduciaries "must know of [service providers’] relationships and indirect sources of compensation because they may impact the manner in which the provider performs services for the plan.” Accordingly, the proposed regulations would require service provider to disclose:
- whether it is acting in a fiduciary capacity under ERISA or the Investment Advisors Act of 1940;
- any “financial or other interest” in transactions in which the plan is participating as part of the arrangement with the service provider;
- its relationships with any other party “that creates or may create a conflict of interest for the service provider.” Although not part of the proposed regulatory language, the preamble to the proposed rule indicates that whether a relationship must be disclosed should be determined from the perspective of a “reasonable plan fiduciary.” If such a fiduciary would consider the relationship to be “significant in its evaluation of whether an actual or potential conflict of interest exists, then the service provider must disclose the relationship.
- whether the service provider can affect its own compensation; and
- whether the service provider has policies and procedures addressing conflicts of interest.
The proposed regulation would also require that service providers notify plan fiduciaries within 30 days of the provider’s knowledge of any material modification to the information provided at the outset of the contractual term. As explained in the preamble, if a change to the information previously provided to the plan “would be viewed by a reasonable plan fiduciary as significantly altering the ‘total mix’ of information … or significantly affecting a reasonable plan fiduciary’s decision to hire or retain the service provider, then the change is material.”
Although the disclosure requirements generally reflect what also must be disclosed on the annual Form 5500, there will likely be some concern about how the Department (and perhaps more significantly) the plaintiff’s bar will use these new sources of information. Because of the complex nature of the fees and relationships that exist in the market place today, it is entirely foreseeable that disclosure given to plan fiduciaries at the beginning of a plan year when an arrangement is entered into or renewed will not precisely match up with reported information at the end of the plan year. There is an open question as to how much in the way of complete synchronicity the Department will require between the initial disclosures and year-end reporting. But even if the Department is willing to permit reasonable deviations, both plan fiduciaries and service providers are bound to feel a bit more exposed to lawsuits if their numbers do not match.
In addition, there are several aspects of the proposed regulation that will likely be of some concern specifically to large, complex financial services institutions. Both the fee disclosure and conflict of interest disclosure represent significant internal tracking and communication challenges to complex companies. For example, the life insurance arm of a financial services group may not have in place data tracking systems that will enable it to know with precision the fees being paid to the registered broker-dealer arm of the same financial service group. Developing such tracking tools will be costly and time consuming, and likely will be the focal point of industry comments.
Similarly, there may be concerns about how separate divisions of a complex financial services firm will be able to meet the 30-day standard for informing plan fiduciaries about material changes in previously disclosed information. The proposed regulation includes the helpful “knowledge” standard, which may give some comfort to complex service provider, but the 30-day deadline seems overly aggressive.
Service providers are not alone in the cross-hairs of the proposed regulation. Although the Department is shifting the disclosure burden from requiring plan fiduciaries to plan service providers, the result of a failure to comply with the proposed regulations will be that the arrangement may be a prohibited transaction under § 406 of ERISA. Such a result will redound to the detriment of the plan sponsor or administrator who contracted with the errant service provider on behalf of the plan. Large plan sponsors in particular – always seen a “deep pocket” by the ERISA plaintiff’s bar – will now need to be even more diligent in demanding the service provider to supply the required information to them prior to entering into an arrangement.
To ensure that innocent plan sponsors are not penalized for the failures of their service providers, despite diligent efforts to obtain information, the Department also released a proposed prohibited transaction class exemption. The Department indicated that it recognizes "there may be circumstances when a plan fiduciary enters into a contract or arrangement that appears to meet the requirements of the [proposed § 408(b)(2) regulation] but unbeknownst to the plan fiduciary, the service provider fails to disclose information consistent with the terms of the regulations.” Provided that the plan fiduciary reasonably believed the service provider had complied, and did not know (or have reason to know) that the service provider had failed to comply with the regulations, the plan fiduciary will be exempt from the resulting prohibited transaction.
Relief for plan fiduciaries, however, is conditioned on the plan fiduciary demanding compliance with the disclosure requirement upon discovery of the failure, and considering whether to terminate the arrangement. Moreover, if the service provider does not come into compliance within 90 days, the plan fiduciary is required to notify the Department, which would result in an administrative investigation of the service provider to determine if a prohibited transaction had occurred.