On December 13, 2007, the U.S. Department of Labor (“DOL”) published a proposed regulation under section 408(b)(2) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), which would impose advance disclosure requirements regarding fees and conflicts of interest on plan service providers as a condition of compliance with that section’s prohibited transaction exemption. Under the proposal, arrangements involving providers of specified types of services would not meet section 408(b)(2)’s requirements unless the service provider agrees to disclose certain information to the plan fiduciary who has the authority on behalf of the plan to enter into, extend, or renew the arrangement.
DOL also published a proposed class exemption, which would provide relief to a plan fiduciary from engaging in a prohibited transaction because of a service provider’s failure to comply with its disclosure obligations under the regulation.
These proposals are the product of increased scrutiny of the effect of plan service provider fees, especially investment-related fees, on retirement benefits. As compliance with section 408(b)(2) is necessary for plan service providers to avoid violating ERISA’s prohibited transaction rules, the effect of the proposed changes would be to mandate fairly detailed fee and conflict of interest disclosure in connection with many plan service arrangements.
Defined contribution plan fees and fee disclosure have been of significant interest to Congress, regulatory agencies and potential litigants alike in the past year. Beginning in late 2006, several class action lawsuits involving 401(k) fee disclosure disputes were filed claiming breaches of fiduciary duty under ERISA for, among other things, excessive fees and the failure to fully disclose fees charged to 401(k) plans. In addition, three bills are currently pending in Congress, two in the House of Representatives and one in the Senate, to address perceived defined contribution plan fee and conflict of interest issues. At the same time, DOL has been working on a number of regulatory projects aimed at enhancing service provider and plan sponsor fee disclosure. These include modifications to the service provider fee reporting on Schedule C to the Form 5500, which was published in final form on November 16, and a pending project to enhance the information plan administrators must send to participants and beneficiaries of a participant-directed individual account plan. The newly-proposed service provider disclosure regulation, the result of another of DOL’s fee disclosure projects, is designed to make compliance with the section 408(b)(2) statutory exemption contingent upon the satisfaction of several new requirements.
Section 406(a)(1)(C) of ERISA broadly prohibits the furnishing of goods, services, or facilities between a plan and a party in interest to the plan. As a party in interest is defined under ERISA to include service providers to a plan, service arrangements between plans and service providers would violate section 406(a)(1)(C) absent an exemption. Section 408(b)(2) of ERISA provides a statutory exemption to this prohibited transaction rule where a contractual arrangement between a plan and a party in interest is (1) “reasonable,” (2) necessary for the establishment or operation of the plan, and (3) for no more than reasonable compensation. On the requirement that the arrangement be “reasonable,” current regulations provide only that a fiduciary must be able to cancel the contract on “reasonably short notice” and without penalty. DOL has indicated in certain contexts that full disclosure regarding fees may be necessary for a service provider to avoid violating the prohibition against fiduciary self-dealing, and also has emphasized the need for plan fiduciaries to obtain sufficient information to make informed decisions in retaining and monitoring service providers. Nevertheless, under existing law, a service provider is not specifically required to supply any particular type of information to plan fiduciaries.
This would change under the proposed section 408(b)(2) regulation. In further elaborating on the section’s reasonable arrangement condition, the regulation would require the advance disclosure of certain types of information regarding the service provider’s fees and conflicts of interest that DOL believes may adversely affect the service provider’s performance, including, among other things, the identity of third parties from whom the service provider indirectly receives fees or compensation. This parallels the recent modifications made to the service provider disclosure schedule in the Form 5500. The three bills pending in Congress also would make similar changes, although their scope would be limited to 401(k) and possibly other individual account plans, rather than applying to all ERISA plans.
Failure to comply with the regulation could result in personal liability for the plan fiduciary retaining the service provider for engaging in a prohibited transaction under section 406(a)(1)(C) of ERISA, as well as the imposition of excise taxes on the service provider under section 4975(c)(1)(C) of the Internal Revenue Code of 1986, as amended.
Scope of the Proposal
The scope of the proposed rule’s disclosure requirements is limited to three enumerated categories of service providers:
- Those who provide services as a fiduciary under ERISA or the Investment Advisers Act of 1940 (the “Advisers Act”);
- Those who provide banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping, securities or other investment brokerage, or third party administration services; and
- Those who receive indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal or valuation services.
Once a plan fiduciary enters into an arrangement with a service provider that falls within one of the above three categories, the terms of the arrangement must satisfy the proposal’s disclosure requirements in order to be “reasonable” for purposes of the statutory exemption.
While the scope of the proposed regulation applies to only these three types of service providers, DOL cautioned in the preamble that this “should not be construed to imply that responsible plan fiduciaries do not need to obtain and consider appropriate disclosures before contracting with service providers who do not fall within these categories.” (emphasis in original) Therefore, said DOL, general fiduciary obligations under ERISA, as well as the existing requirements under section 408(b)(2), continue to apply to the selection and monitoring of all plan service providers.
The disclosure requirements would not apply to service arrangements to provide benefits to plan participants and beneficiaries rather than the plan itself, such as doctors within a medical provider network who perform their services for plan participants and beneficiaries under contract with the network rather than the plan.
Required Disclosures Generally
Service providers subject to the regulation would be required to supply the requisite disclosures in writing, to the best of their knowledge. The disclosure obligations could be satisfied via an electronic format or by disclosure in multiple documents from multiple sources, including incorporation by reference from a Form ADV or prospectus – there is no prescribed format. The regulation would not mandate any specific timing for this advance disclosure. However, DOL cautioned in the preamble that this information should be provided sufficiently in advance of entering into the contract for the responsible plan fiduciary to prudently consider the information.
The contract with the service provider would include a representation that, before the contract was entered into (or extended or renewed), all required information was provided to the responsible fiduciary.
The information to be disclosed essentially falls within two categories: (1) compensation and fee disclosure and (2) conflict of interest disclosure. Each is described in further detail below.
Compensation and Fee Disclosures
Service providers in any of the covered categories described above would be required to provide to plan fiduciaries comprehensive written disclosure, in advance of entering into a contractual arrangement, of the following information related to fees and compensation:
- All services to be provided to the plan pursuant to the written contract or arrangement;
- The “compensation or fees” to be received by the service provider (or its affiliate) in connection with such services, or because of the service provider’s (or affiliate’s) position with the plan; and
- The manner of receipt of such compensation or fees.
For purposes of these disclosures, the regulation would broadly define “compensation or fees” to include money or any other thing of monetary value, including gifts, awards, finder’s fees, commissions, 12b-1 fees, soft dollars and “float” income, as well as indirect compensation received from a party other than the plan, the plan sponsor, or service provider. Where a service provider is not able to describe the compensation or fees in a specific monetary amount, the regulation would permit the required disclosure to take the form of a formula, asset charge, or per capita charge, so long as the description permits the responsible plan fiduciary to evaluate the reasonableness of the compensation or fee.
The disclosure would cover not only what is received by the service provider itself, but also compensation and fees received by its affiliates – including entities controlled by, controlling or under common control with the service provider, as well as its officers, directors, agents and employees. Because payments from the service provider itself are excluded, DOL indicated that this should not result in “double counting” of any compensation. For example, it would not extend to salary or bonus payments a service provider makes to its employees out of its general assets. Rather, the inclusion of affiliate compensation is intended to assure that the disclosure cannot be avoided merely by paying an affiliate of the service provider as opposed to the service provider itself.
DOL also indicated that the disclosure requirements would apply to those entities that are treated as providing the covered categories of services to plans as a result of plan investments under the “plan asset” rules. This would extend the rules to, for example, bank collective investment funds and private funds that receive 25 percent or more of their investments from ERISA plans.
One of the more contentious issues that has arisen in the broader fee disclosure debate involves how to deal with a bundled service arrangement where services are priced as a package, as opposed to a service-by-service basis. All three pending fee disclosure bills would require that bundled services be unbundled for fee disclosure purposes. Witnesses during recent Congressional hearings on these issues have argued that requiring such arrangements to be “unbundled” would be “inherently artificial” and that any such requirement would be too difficult, if not impossible, for service providers to satisfy. Other witnesses argued to the contrary, stating that, to “ensure a level playing field,” bundled and unbundled service providers should be held to the same comprehensive disclosure standards.
The regulation - which in this regard generally tracks DOL’s recent revisions to service provider reporting on Schedule C of the Form 5500 - would require providers of bundled services to disclose all of the services and the aggregate compensation or fees received, directly or indirectly, by the service provider, its affiliate, or subcontractor, or any other party in connection with the bundle of services. Therefore, with two exceptions, the proposed regulation would not require disclosure of the allocation of the compensation or fees among the individual services comprising the bundle. The first exception is that compensation or fees that are a separate charge directly against the plan’s investment reflected in the net value of the investment, such as management fees paid by mutual funds to their investment advisers and 12b-1 distribution fees, must be separately reported. The second exception requires separate reporting of fees that are set on a transaction basis, such as finder’s fees, brokerage commissions and soft dollars, even if they are paid from mutual fund management fees or similar fees. The preamble indicates that DOL considered, but ultimately rejected, concerns expressed by bundled service providers that these exceptions would result in the disclosure of confidential or proprietary information.
The service provider would also be required to explain the manner of receipt of the compensation – for example, whether it will bill the plan or deduct fees from the plan’s account, or whether the charge will be reflected against the plan investment.
Conflict of Interest Disclosures
In addition to the compensation and fee disclosures described above, the regulation also would require - as does each of the three pending fee disclosure bills - certain disclosures designed to reveal any potential service provider conflicts of interest. According to the preamble, “[p]lan 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.” DOL cited the issues raised in 2005 regarding potential conflicts of interest in pension consultant relationships, and indicated that many plan service arrangements present similar issues. The proposal would therefore require that the service provider disclose whether it or an affiliate:
- Is providing fiduciary services within the meaning of ERISA or the Advisers Act (DOL noted that formal agreements may not be dispositive of this issue, as fiduciary status under ERISA depends on a factual analysis of the person’s activities with respect to the plan);
- Expects to participate or acquire a financial or other interest in any transaction to be entered into by the plan in connection with the contract (for example, if an affiliate owns an interest in real estate it will be buying on behalf of the plan);
- Has any material financial, referral or other relationship with a money manager, broker, other client of the service provider, other service provider to the plan, or any other entity that does, or may, create a conflict of interest for the service provider in performing its services;
- Will be able to affect its own direct or indirect compensation, without prior approval of an independent plan fiduciary, in connection with the performance of the service, and, if so, a description of the nature of such compensation (DOL gave the example of “float” compensation); and
- Has any policies or procedures designed to prevent the above compensation or fees, relationships or conflicts from adversely affecting its services to the plan, such as procedures for offsetting fees received from third parties against amounts it would otherwise charge the plan.
Timing of Initial and Ongoing Disclosures
The regulation would require the service provider to make these disclosures before the contract or arrangement is entered into, or before any extension or renewal.
The service provider would further be required to notify plan fiduciaries within 30 days of acquiring knowledge of any “material” modification to the information previously provided. The preamble indicates that a change would be “material” if a “reasonable plan fiduciary” would view the change as “significantly altering the ‘total mix’ of information,” or “significantly affecting a reasonable plan fiduciary’s decision to hire or retain the service provider.”
Service providers also would be required to furnish all information related to the contract and the service provider’s receipt of compensation or fees that is requested by the plan fiduciary or plan administrator in order to comply with ERISA’s reporting and disclosure requirements (i.e., the service provider reporting in the Form 5500).
Proposed Class Exemption
Although the disclosure burden would be imposed on the service providers, failure to comply may result in prohibited transaction consequences for both the service provider and the responsible plan fiduciary. Given these adverse consequences, DOL has acknowledged that “there may be circumstances when a plan fiduciary enters into a contract or arrangement that appears to meet the requirements of [the regulation] but unbeknownst to the plan fiduciary, the service provider fails to disclose information consistent with the terms of the regulation.” Accordingly, DOL proposed a prohibited transaction class exemption that would provide relief from section 406(a)(1)(C) of ERISA to a plan fiduciary that reasonably believed the service provider had complied with the regulation’s requirements, and did not know (or have reason to know) that the service provider had failed to comply.
Upon becoming aware of the failure, the plan fiduciary must first demand, in writing, that the service provider comply with its disclosure obligations. Following a 90-day cure period within which the service provider has still failed to comply with its disclosure obligations, or within 30 days of the service provider’s earlier refusal to comply, the plan fiduciary must notify DOL, which would then begin an administrative investigation of the service provider to determine if a prohibited transaction had occurred. The plan fiduciary also must consider terminating the arrangement, taking into account, among other things, the availability, qualifications, and costs of potential replacement service providers, and the responsiveness of the service provider in furnishing the information that the service provider should have disclosed.
Comments and Effective Date
Comments on the proposed regulation and class exemption are due by February 11, 2008. DOL also invited comment on the existing requirement that service provider arrangements permit termination by the plan without penalty and on reasonably short notice, and whether the proposed disclosure requirements would affect or be affected by other statutory exemptions that relate to the provision of services. The regulation would take effect 90 days after its publication in final form in the Federal Register.
Implications of the Proposal
The proposed regulation, consistent with the recent changes to the Form 5500 reporting for service providers, would impose new, detailed fee disclosure requirements on plan service providers, including disclosure of certain “indirect” compensation, a term that is broadly defined to include any payments (even “float” income and gifts) received from a party other than the plan, plan sponsor or service provider. While there is a special rule that permits aggregated reporting by bundled service providers, the exceptions for separately-charged and transaction-based compensation may undermine some of the benefits this rule could otherwise provide. As DOL rejected comments on the Form 5500 changes regarding the burdens of such requirements, DOL may not be inclined to make changes based on similar comments in this proceeding. In addition, since the pending bills in Congress would require similar disclosures, DOL may view itself as having Congressional support for imposing these types of requirements.
The proposed conflict of interest disclosure requirements merit close attention. DOL views the ERISA prohibited transaction rules as imposing strict liability for fiduciary self-dealing and conflicts of interest. As a result, these requirements could impose a significant burden on service providers, as they try to disclose their conflicts of interest without unduly exposing themselves to liability.
While DOL limited the disclosure requirements to three categories of providers, those categories are very broad. They would cover all of the principal services provided to plans, including investment management, investment advice, consulting, third party administration and recordkeeping. The proposal would also apply to service providers who are fiduciaries under the Advisers Act, which would cover any federally-registered investment adviser that provides services to a plan, even in what would be a non-fiduciary capacity under ERISA. DOL added that these disclosures may also be appropriate for service providers who do not fall within these categories, in order for the responsible plan fiduciaries to satisfy their ERISA fiduciary obligations. Therefore, this proposal will have an impact on most ERISA plan service providers.
The third component to DOL’s current fee disclosure initiatives is the requirement for additional fee disclosure to participants in participant-directed individual account plans, which is included in the Congressional bills. If the section 408(b)(2) proposal is any indication, DOL’s future proposal on participant disclosure can be expected to bear some resemblance to the pending legislation. That could mean, among other things, that DOL will require that participants be provided with more detailed information on fees charged in connection with plan investments, and that the service provider disclosures required under the proposed section 408(b)(2) regulation be made available to plan participants on request and/or through posting on a plan sponsor website.
Because of the significant scope of the proposal, it can be expected that there will be many comments made to DOL. Firms that will be affected should consider placing their views on record during the comment period, to assure that DOL has considered all aspects of its proposal and the potential affects on plan service providers..