DOL Proposes Major Changes to Investment Adviser “Fiduciary” Definition

By Jessica Morgan

On April 14, 2015, the U.S. Department of Labor (the "DOL") issued proposed regulations redefining who is a "fiduciary" of an employee benefit plan under the Employee Retirement Income Security Act of 1974 ("ERISA") as a result of giving investment advice to a plan or its participants or beneficiaries. The proposal also applies to the definition of a "fiduciary" of a plan, including an individual retirement account ("IRA"), under the Internal Revenue Code (the "Code"). In connection with the proposed rules, the DOL issued a notice of a proposed class exemption to the prohibited transaction provisions under ERISA and the Code, termed the "best interest contract exemption," and proposed amendments to existing class exemptions.

  • The proposed changes to the fiduciary definition would significantly expand the number of individuals and entities viewed as investment advice fiduciaries to ERISA retirement plans and IRAs.
  • The proposed prohibited transaction class exemption and amendments to existing class exemptions would require significant changes to the business practices and compensation arrangements used by registered investment advisers, brokers, banks, insurance agents and consultants in connection with sales to retirement plan accounts and IRAs.

This Tip gives a broad overview of the proposed definition of an investment advice fiduciary, in conjunction with the prohibited transaction exemption proposals.

ERISA plan fiduciaries are held to high standards of care and undivided loyalty, and are subject to personal liability for breach of those duties. In addition, the "prohibited transaction" provisions of ERISA and the Code generally prohibit plan fiduciaries from engaging in conflict of interest transactions or receiving compensation from third parties in connection with transactions involving ERISA plans and IRAs. Unless an exemption to the prohibited transaction provisions applies, certain types of fees and compensation common in the retail market, such as brokerage or insurance commissions, trailing commissions, sales loads, 12b-1 fees and revenue sharing payments, fall within these prohibitions when received by plan fiduciaries as a result of transactions involving advice to plan participants or beneficiaries, or IRA owners.

The definition of a "fiduciary" under ERISA includes a person who renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of an employee benefit plan. Regulations adopted in 1975, shortly after ERISA was enacted, created a five-part test for defining the circumstances under which a person is treated as providing "investment advice" to an employee benefit plan within the meaning of ERISA. The proposed regulations replace that five-part test.

Proposed Changes
The proposed new definition of fiduciary investment advice covers four categories of advice:  (1) investment recommendations; (2) investment management recommendations; (3) appraisals of investments; and (4) recommendations of persons to provide investment advice for a fee or to manage plan assets. Persons who provide such advice fall within the definition of a fiduciary if they either: (a) represent that they are acting as a fiduciary under ERISA or the Code; or (b) provide the advice pursuant to an agreement, arrangement or understanding that the advice is individualized or specifically directed to the recipient for consideration in making investment or investment management decisions regarding plan assets.

One significant change from the prior "fiduciary" definition is the elimination of the requirement that advice be provided on a "regular" basis. The new definition of an investment advice fiduciary will cover one-time transactions or consultations, such as advice to a plan participant to roll-over the participant's account to an IRA, or advice to a plan sponsor to make a one-time purchase of a group annuity contract. Another significant change is the elimination of the requirement that the parties have a mutual agreement, arrangement or understanding that the advice would serve as a "primary basis" for investment decisions. Under the new definition, all that is required is that the advice or recommendation be individualized or specifically directed at the recipient for consideration in making investment or investment management decisions regarding retirement plan or IRA assets.

The proposed regulations include carve-outs that treat certain conduct that otherwise would fall within the fiduciary definition as non-fiduciary in nature, provided specific requirements are satisfied. Carve-outs apply to (1) certain principal transactions; (2) certain swap or security-based swap offers or recommendations made to ERISA plan fiduciaries; (3) statements or recommendations by an employee of an ERISA plan sponsor to a plan fiduciary, if the employee receives no fee beyond his or her normal compensation; (4) marketing or making available a platform of investment alternatives to be selected by a plan fiduciary for an ERISA participant-directed individual account plan; (5) the identification of investment alternatives that meet objective criteria specified by an ERISA plan fiduciary, or the provision of objective financial data to such fiduciary; (6) appraisals, fairness opinions or statements of value to an ESOP regarding employer securities, or to a plan for meeting reporting and disclosure requirements; and (7) information and materials that constitute "investment education" or "retirement education."

The proposal also creates a new "best interest contract" class exemption and amendments to existing exemptions impose significant requirements on investment advice fiduciaries (an "Adviser") and the financial institutions that employ them (a "Financial Institution"), in connection with advice and recommendations to a plan, participant or beneficiary account, or IRA owner (each, a "Retirement Investor").  Those requirements are briefly summarized below:

  • Written Contract: The Adviser and Financial Institution must enter into a written contract with the Retirement Investor prior to recommending the purchase, sale or holding of an asset. The required written contract must create numerous specific contractual obligations that are legally enforceable by the Retirement Investor.  
  • Fiduciary Status: The contract must acknowledge fiduciary status under ERISA or the Code, or both, with respect to any recommendations to the Retirement Investor to purchase, sell or hold an asset.  
  • Best Interest Standard of Impartial Conduct: The Adviser and Financial Institution must contractually commit to provide advice that is in the "best interest" of the Retirement Investor. Best interest is defined to mean acting with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person would exercise based on the investment objectives, risk tolerance, financial circumstance, and the needs of the Retirement Investor, and acting without regard to the financial or other interests of the Adviser, Financial Institution or their affiliates or any other party.  
  • Reasonable Compensation Standard: The Adviser and Financial Institution must agree that they will not recommend an asset if the total amount of compensation received in connection with the purchase, sale or holding of the asset is not reasonable in relation to the total services provided to the Retirement Investor.  
  • Warranty – Compliance with Applicable Law: The Adviser and Financial Institution must contractually warrant that they will comply with all applicable federal and state laws regarding the rendering of the investment advice, the purchase, sale or holding of the asset and the payment of compensation related to the purchase, sale and holding.  
  • Warranty – Policies and Procedures: The Financial Institution must contractually warrant that it has adopted written policies and procedures designed to protect Retirement Investors against conflicts of interest and ensure that individual Advisers adhere to the Standard of Impartial Conduct described above.  
  • Contractual Disclosures: The written contract must contain specified disclosures regarding material conflicts of interest, direct and indirect fees, and third party payments.  
  • Public Disclosure: The proposed exemption requires that Financial Institutions provide public disclosure of several different types of information on its web page, relating to direct and indirect compensation payable in connection with assets a Retirement Investor is able to purchase, sell or hold through the Adviser or Financial Institution.
  • Point of Sale Disclosure: The proposed exemption also requires point of sale disclosure to the Retirement Investor, prior to execution of the investment transaction, regarding the all-in cost and anticipated future costs of recommended assets.

Comment Period and Effective Dates
The DOL initially provided a 75-day comment period ending July 6, 2015 on the proposed regulations and proposed class exemption, which deadline recently was extended for 15 days, or to July 21, 2015. The DOL proposes that the new regulations and class exemptions will become effective 8 months from the date the final regulations are published. For more information about the proposed regulations and prohibited transaction exemption, please contact a member of Tonkon Torp's Financial Services practice group.

This client update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have any questions regarding this update, or for more information about this topic, please contact any of the attorneys with whom you normally consult.

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