Issues relating to fees paid to those who provide services to employee benefit plans have increasingly become high-profile issues, stemming from a number of indirect fee class action lawsuits and the press reports that followed. These issues have generated activity in four theatres: (i) the regulations under ERISA Section 408(b)(2) (regulation mandating disclosures of compensation and conflicts of interest by plan service providers), (ii) the rules governing Form 5500, Schedule C, (iii) the fiduciary rules for covered plans with participant-directed investments (see Oringer, "Another Piece of the Extended Puzzle—Proposed DOL Regulations Reach to General Prudence Rules" BNA Pension & Benefits Blog, http://pblog.bna.com/penben/2008/07/another-piece-o.html (July 24, 2008)) and (iv) a number of legislative proposals in Congress. This article relates to the new rules provided by the Department of Labor (the "DOL") for Form 5500, Schedule C.
New Form 5500 Schedule C
In November 2007, the DOL finalized a new Schedule C to the Form 5500 which imposed new requirements for reporting service provider fees and other compensation on Schedule C to the 2009 Form 5500 annual report to be filed for employee benefit plans.1 Schedule C generally requires the disclosure of fees paid directly or indirectly to service providers receiving US$5,000 or more in total compensation for plan services.
With respect to the receipt of "direct compensation," the plan sponsor is generally required to (i) identify each service provider (subject to the US$5,000 threshold), (ii) describe the relationship of the service provider to the plan sponsor (or to any person known to be a party in interest to the plan), (iii) provide the total direct compensation paid to the service provider and (iv) provide a statement of whether the service provider received any "indirect compensation." "Direct compensation" is compensation paid directly by a plan sponsor to a service provider as well as compensation paid or debited directly from a plan account (note, this generally does not include payments made by the plan sponsor that are not reimbursed by the plan).
With respect to "indirect compensation" (that is not "eligible indirect compensation"), the plan must generally (i) provide the service provider's name and tax identification number, (ii) include a statement that the service provider received indirect compensation and (iii) provide the total amount of the indirect compensation received by the service provider (actual or estimated). "Indirect compensation" is all compensation other than direct compensation, received by a service provider in connection with services provided to the plan or in connection with a person's position with the plan. Compensation is received "in connection with" services provided to the plan or a person's position with a plan if the payment is based, in whole or in part, on services provided to the plan or on one or more transactions involving the plan. It does not include compensation that a person would have received if the service for, or transaction involving, a plan had not occurred.
The rules also provide an alternative reporting method with respect to the provision of "eligible indirect compensation." This alternative method permits the plan sponsor to report only the name and tax identification number of any such service provider (or the name and taxpayer identification number of any other person who provided the plan sponsor with the required information about eligible indirect compensation received by the service provider). This alternative method may be used if the plan has received written materials from the service provider that describe (i) the existence of the indirect compensation, (ii) the services provided for the indirect compensation, (iii) the amount (or estimate) of the compensation or a description of the formula used to calculate or determine the compensation and (iv) the identity of the party or parties paying and receiving the compensation. "Eligible indirect compensation" is any indirect compensation received by a service provider as fees charged to investment funds in which a plan invests that are reflected in value of the investment or in the return on investment that constitute compensation for distribution, investment management, recordkeeping or shareholder services or that constitute commissions or finder fees, float revenue, or other transaction-based fees or "soft dollar" revenue.
DOL Frequently Asked Questions (FAQs) on Schedule C
In an effort to address a number of issues regarding the revised Schedule C reporting requirements, the DOL has recently published a series of FAQs. The following is a discussion of certain of the Q&As provided by the DOL in the FAQs:
- Separately Managed Accounts: "Eligible indirect compensation" includes fees or expense reimbursement payments charged to "investment funds" and reflected in the value of the plan's investment or return on investment. According to the FAQs, investment funds include mutual funds, bank common and collective trusts and insurance company pooled accounts. In the DOL's view, "investment funds" also includes separately managed investment accounts that contain assets of an individual plan. Thus, the alternative reporting option described above may also be used for eligible indirect compensation received in connection with separately managed investment accounts of employee benefit plans.
- Fees and Expenses Charged Against Investment Funds That Are Considered Indirect Compensation: In the case of charges against an investment fund, reportable "indirect compensation" includes, for example, the fund's adviser asset-based investment management fee from the fund, fees related to purchases and sales of interests in he fund (including 12b-1 fees), brokerage commissions and fees charged in connection with providing services to plan investors or plan participants such as communications and other shareholder services and fees relating to the administration of the plan such as recordkeeping services, Form 5500 filing and other compliance-related services. Amounts charged against the fund for other ordinary expenses such as lawyer, accountant and printer fees are not reportable indirect compensation for purposes of Schedule C. In addition, brokerage costs associated with a broker-dealer effecting securities transactions within the portfolio of a mutual fund or an investment fund that holds "plan assets" for ERISA purposes, is an operating expense of the fund and is not reportable as indirect compensation paid to a plan service provider. Both proprietary soft-dollar compensation (e.g., research prepared by the entity providing brokerage services) and non-proprietary soft-dollar compensation (e.g., research prepared by third-parties) can be treated as "eligible indirect compensation."
- Indirect Compensation Reporting Requirements for Participant-Selected Investments Through "Open Brokerage" Windows: Certain 401(k) plans contain "open brokerage windows" which permit plan participants to invest in a wide range of funds, stocks, bonds and other investments offered through a designated broker for the brokerage window. The DOL has clarified that, while the requirement to report indirect compensation applies to participant selected investments from a range of investment alternatives under the plan, in the absence of any other guidance Schedule C reporting can be limited to direct and indirect compensation received by the designated broker and other brokerage window providers, transaction fees in connection with the purchase, sales or exchanges made through the brokerage window and any other plan-related fees. Thus, it does not appear that the DOL will require plans to report, for example, the asset-based investment management fee received by a fund if interests in the fund are purchased through a brokerage window.
- Compensation Received in Connection with the Management and Operation of Venture Capital Operating Companies (VCOCs), Real Estate Operating Companies (REOCs) and Other Operating Companies: Under regulations promulgated by the DOL (the "Plan Assets Regulation"),2 as modified by Section 3(42) of ERISA, when an employee benefit plan acquires an "equity interest" in an entity and the equity interest is neither a "publicly-offered security" nor a security issued by an investment company registered under the United States Investment Company Act of 1940, as amended, the assets of the plan will include not only such equity interest, but also an undivided interest in each of the underlying assets of such entity. An exception from this look-through rule in the Plan Assets Regulation, as modified by Section 3(42) of ERISA, applies, such that the underlying assets of an entity in which a Plan makes an equity investment will not be considered "plan assets" if (i) less than 25 percent of the value of any class of equity interests in the entity, disregarding equity interests held by persons with discretionary control over the assets of the entity or who provide investment advice for a fee with respect to such assets, and their respective affiliates, is held by employee benefit plans and other entities whose assets are considered "plan assets" by reason of a Plan's investment in the entity under ERISA and the Plan Assets Regulation, as modified by Section 3(42) of ERISA (the so-called "25% Test") or (ii) the entity is an "operating company" such as a VCOC or REOC.
Private equity and real estate funds typically choose to rely on either the 25% Test or the "operating company" exception. While compliance with either of these exceptions generally has the same result (i.e., preventing such funds from being subject to the panoply of rules and regulations under ERISA), the choice to rely on one exception over the other generally affects how that fund operates.
Although the requirement to report indirect compensation is not limited to fees received by persons managing plan assets, unlike in the case of investment funds (e.g., mutual funds, collective investment funds), fees received by third parties from operating companies, including VCOCs or REOCs, in connection with managing or operating the operating company, generally would not be reportable indirect compensation. However, fees or commissions received by an investment manager or investment advisor in connection with a plan's investment in an operating company would be reportable as indirect compensation. The DOL further states that this analysis, "would not be affected by whether the VCOC, REOC, or other operating company were wholly owned by a plan such that the assets of the entity would be deemed to be plan assets." Thus, the DOL appears to be, at least in the reporting context, for the first time, providing its view that what matters is whether there is an operating company present effectively to block the look-through, not whether the entity's assets technically are "plan assets."
The DOL thus appears to be layering another distinction between funds that choose to rely on the 25% Test and funds that choose to operate as VCOCs or REOCs in that the fund that relies on the 25% Test will be considered an "investment fund" for purposes of Schedule C and will be subject to the indirect compensation requirements contained therein, while VCOCs and REOCs are generally exempt from such requirements. This distinction will likely have the result of adding an additional factor (i.e., the possibility of becoming subject to a new set of reporting rules and DOL scrutiny) for funds to consider when choosing an exception under which to comply. (See also Oringer, ''Now the DOL is FAQuing It—Having Fun with 'Funds' on the Form 5500, BNA Pension & Benefits Blog, http://pblog.bna.com/penben/2008/07/now-the-dol-is.html (July 15, 2008).)
- Bundled Arrangements: Service arrangements where the employee benefit plan hires one company to provide a range of services either directly from the company, through affiliates or subcontractors, or through a combination, which are priced to the plan as a single package are, for purposes of Schedule C, called "bundled service arrangements." As a general rule, in the case of bundled service arrangements, revenue sharing within the bundled group generally does not need to be separately reported on Schedule C.
There are two exceptions to this general rule which provide for certain bundled compensation to be separately reported. These exceptions are: (i) any person in the bundle receiving separate fees charged against a plan's investment (e.g., investment management fees and 12b-1 fees) and (ii) compensation that is commissions and other transaction based fees, finder's fees, float revenue, soft dollar and other non-monetary compensation paid to conflict of interest sensitive persons (i.e., any plan fiduciary and any person providing contract administrator, consulting, investment advisory, investment management, securities brokerage, or recordkeeping services).
Circumstances Under Which a Service Provider is Expected to be Identified on Schedule C for Failing to Provide Information Necessary to Complete the Schedule C: In order to comply with the new Schedule C annual reporting rules that will be required for 2009 plan year reports, certain service providers may have to modify their current recordkeeping and information systems. The DOL stated that it recognizes that not all such service providers will be ready to provide this information when clients start to make requests for, or otherwise need, Schedule C related data for filing their 2009 plan year Forms 5500. Thus, the DOL has provided relief in the FAQs which state that plan administrators will not be required for the 2009 plan year reports to list service providers on the Schedule C that have failed to provide information necessary to complete the Schedule C if the plan administrator receives from the service provider a statement that (i) the service provider made a good faith effort to make any recordkeeping and information system changes in a timely fashion and (ii) despite such efforts, the service provider was unable to complete the changes for the 2009 plan year. This relief (which presumably will spawn quite a lot of "statements") is extremely welcome in light of the fact that, as shown above, even the most basic gateway issues there is a great deal of new concepts, analyses and information to digest. (See also Oringer's blog in the BNA Pension & Benefits Blog cited above.)
These rules are an important aspect of a new era of heightened scrutiny of employee benefit plan expenses. Plan fiduciaries may increasingly have tools enabling them better to understand the various direct and indirect fees paid to service providers. Further, in many cases, service providers will need to establish new procedures in order to provide the information that will be needed by their plan clients.
Compliance with these new rules will likely require significant effort by plan administrators and service providers. With the commencement of the 2009 plan year closely approaching, plan administrators and service providers should begin to establish such procedures now.