On April 8, 2016, the Department of Labor (“DOL”) issued final guidance dealing with investment advice to ERISA plans and their participants. While this guidance does not by its terms apply to governmental and church plans (which are not subject to ERISA), such plans often use DOL guidance as an indication of best practices which they will follow. Moreover, the DOL suggests that a breach of contract claim may be available to enforce the standards with respect to individual retirement accounts (“IRAs”), which are not subject to ERISA. While the DOL has no authority to regulate governmental and church plans, it has laid out a road map which state courts may use to impose liability on governmental and church plans under a breach of contract theory.
The DOL guidance is in seven parts:
- Final regulations concerning the definition of the term “fiduciary” and conflict of interest rule for retirement investment advice.
- Prohibited Transaction Class Exemption: Best Interest Contract
- Prohibited Transaction Class Exemption for Principal Transactions
- Amendment to Prohibited Transaction Class Exemption 75-1, Part V
- Amendments to and Partial Revocation of Prohibited Transaction Class Exemptions 86-128 and 75-1
- Amendments to Prohibited Transaction Class Exemptions 75-1, 77-4, 80-83 and 83-1
- Amendment to and Partial Revocation of Prohibited Transaction Class Exemption 84-24
The Employee Retirement Income Security Act of 1974 (“ERISA”) sets standards of conduct for those who manage an employee benefit plan and its assets (“fiduciaries”). Fiduciaries must abide by the following standards:
- Exclusive Benefit Rule – The fiduciary must discharge duties with respect to the Plan for the exclusive benefit of the participant and their beneficiaries. 29 U.S.C. §1104 (a)(1)(A).
- Prudent Man Rule – A fiduciary must act “with the care, skill, prudence and diligence under the circumstances then prevailing that a prudent man acting in a like capacity” would act. 29 U.S.C. §1104 (a)(1)(B).
- Diversification Rule – A fiduciary must diversify investments in order to minimize risk of loss unless it would be considered prudent to not diversify investments. 29 U.S.C. §1104 (a)(1)(C).
- Plan Document Rule – A fiduciary must act in accordance with the Plan documents but only to the extent that the Plan is consistent with ERISA requirements. Thus, a fiduciary must know and act in accordance with the Plan and must have sufficient knowledge of the ERISA requirements. 28 U.S.C. §1104 (a)(1)(D)
- Prohibited Transactions – In addition to the fiduciary rules, ERISA contains a “prohibited transaction” rule. This rule prohibits specific types of transactions which offer a high potential for insider abuse. 29 U.S.C. §1106. Rather than putting the burden on the DOL or individual plan participants to prove that such transactions are fair, the law reverses the presumption, allowing them only if they meet certain prohibited transaction exemptions (“PTEs”) embodied in either the statute or exemptions created by the DOL.
These rules apply not only to retirement plans, but to welfare plans such as health plans. Similar rules apply to custodians of individual retirement accounts (“IRAs”).
The question historically has been who is a fiduciary. In the case of defined benefit pension plans (which were at one point the most common type of retirement plan), the answer was fairly clear. A person is a fiduciary with respect to a plan to the extent (i) he exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets, (ii) he renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or (iii) he has any discretionary authority or discretionary responsibility in the administration of such plan. 29 U.S. Code § 1002(21).
However, the issues were far less clear in the case of more modern plans, such as 401(k) plans, in which participants have discretion as to how their accounts are to be invested. You might, for example, have a brokerage firm that maintains a stock fund, a bond fund, a money market fund. While plans are required to abide by fiduciary standards in selecting the funds to be made available, they are not typically liable for a participant’s choice among the funds. 29 U.S. Code § 1104(c).
Because participants often do not have the investment experience to choose wisely among the available investments, employers often provide some sort of education and guidance to assist them. In many instances, such guidance is provided by the entity which offers the various funds from which employees can choose. While the entity was not providing investment advice to the plan as a whole, the question was how far it could go in educating participants before it would be considered to be rendering investment advice to them and thus a fiduciary.
The DOL has expressed two concerns in such situations. The first is that advisors may offer advice which is not in the participant’s best interest due to a conflict of interest. For example, if the advisor receives higher fees when participants invest in the stock fund than when they invest in the money market fund, it may have an incentive to recommend the stock fund even to participants for whom it is not the best investment. The second is that fees charged to participants may be buried in the find print, making it hard for participants to make informed choices.
2010 and 2015 Proposed Regulations and PTEs
Proposed regulations were published in the Federal Register on Oct. 22, 2010. These regulations would have included in the definition of a fiduciary those giving investment advice to participants (“advice fiduciaries”). Under the 2010 proposed regulations, a person would have become an advice fiduciary if the person:
- provided certain types of advice or recommendations to plan fiduciaries or participants (“Covered Advice”),
- had a relationship or status with the plan such that any recommendations or advice provided should be subject to fiduciary standards (“Provider Status”), and
- received compensation.
Concerns were raised with respect to the 2010 proposed regulations on two grounds. First, they raised the possibility that call center services, ordinary sales activities, fund select lists, sample fund menus and other basic investment information could result in fiduciary status, potentially restricting access to such information. Second, while sweeping many service providers into the category of fiduciaries, they did not provide or update PTEs to give protection to many routine kinds of advice.
On February 23, 2015, President Barack Obama made the following announcement:
Today, I’m calling on the Department of Labor to update the rules and requirements that retirement advisors put the best interests of their clients above their own financial interests. It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first.
On April 20, 2015, the DOL released a “re-proposed” ERISA fiduciary rule, proposed amendments to several existing PTEs, and two new proposed PTEs. The re-proposed rule differed from the 2010 proposals in several important respects:
- DOL issued proposed exemptions simultaneously with the proposed regulations.
- DOL consulted extensively with the Securities and Exchange Commission (SEC) and other federal agencies to coordinate its proposed regulations with those of other agencies.
The re-proposal also modified the 2010 proposed rules based on comments received since 2010. Specifically, the proposal:
- Provided a new, broad, principles-based exemption, the best interest contract (“BIC”) exemption described below.
- Included other new, broad exemptions.
- Included a carve-out from fiduciary status for providing investment education to IRA owners, not just to plan sponsors and plan participants as under the 2010 proposal.
- Updated the definition of education to include retirement planning and lifetime income information.
- Classified materials that referenced specific products that the consumer should consider buying as advice subject to fiduciary standards.
- Determined who was a fiduciary based not on title, but rather the advice rendered.
- Excluded valuations or appraisals of the stock held by employee stock ownership plans (ESOPs) from the definition of fiduciary investment advice.
Recommendations to plan sponsors managing more than $100 million in assets would not be considered investment advice if certain conditions were met and hence would not require an exemption.
The BIC exemption would permit a fiduciary to give investment advice if its terms were met. To rely on the exemption, Financial Institutions generally would be required to:
- Acknowledge fiduciary status with respect to investment advice to the Retirement Investor;
- Adhere to Impartial Conduct Standards requiring them to:
- Give advice that is in the Retirement Investor’s Best Interest (i.e., prudent advice that is based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to financial or other interests of the Adviser, Financial Institution, or their Affiliates, Related Entities or other parties);
- Charge no more than reasonable compensation; and
- Make no misleading statements about investment transactions, compensation, and conflicts of interest;
- Implement policies and procedures reasonably and prudently designed to prevent violations of the Impartial Conduct Standards;
- Refrain from giving or using incentives for Advisers to act contrary to the customer’s best interest; and
- Fairly disclose the fees, compensation, and Material Conflicts of Interest, associated with their recommendations.
However, the BIC exemption was available only for investments on an asset list included in the 2015 proposal. Moreover, it required a contract between the party receiving advice and each fiduciary involved, which could be cumbersome if, for example, a participant could be expected to interact with a number of different employees of the same financial investment company.
Final Regulations and PTEs
Under the regulations as finalized, any individual receiving compensation for making investment recommendations that are individualized or specifically directed to a particular plan sponsor running a retirement plan (e.g., an employer with a retirement plan), plan participant, or IRA owner in making a retirement investment decision is a fiduciary. The final rule expressly provides that investment advice does not include communications that a reasonable person would not view as an investment recommendation, including general circulation newsletters; television, radio, and public media talk show commentary; remarks in widely attended speeches and conferences; research reports prepared for general circulation; general marketing materials; and general market data. The guidance also clarifies that advice which would give rise to fiduciary status does not include advice concerning health, disability, and term life insurance policies, or other assets that do not contain an investment component. Recommendations to plan sponsors managing more than $50 million in assets (vs. $100 million in the proposed rule) will not be considered investment advice if certain conditions are met and hence will not require an exemption.
The final guidance modifies the BIC exemption as follows:
- Eliminating the limited asset list
- Expanding the coverage of the BIC exemption to include advice provided to sponsors of small 401(k) plans
- Eliminating the contract requirement for ERISA plans and participants (though not for IRAs), in favor of requiring the fiduciaries to acknowledge in writing that they, and their advisers, are acting as fiduciaries when providing investment advice to the plan, participant, or beneficiary.
- Clarifying how a financial institution that limits its offerings to proprietary products can satisfy the best interest standard.
- Streamlining compliance for fiduciaries that recommend a rollover from a plan to an IRA or moving from a commission-based account or moving from one IRA to another and will receive only level fees.
- Eliminating most of the proposed data collection requirements and some of the more detailed proposed disclosure requirements.
- Requiring the most detailed disclosures envisioned by the BIC exemption to be made only upon request.
- Providing a mechanism to correct good faith violations of the disclosure conditions without losing the benefit of the exemption.
The contract requirement was not eliminated in the case of an IRA. However, it was made less onerous by:
- Not requiring contract execution prior to an adviser’s recommendations.
- Specifically allowing for the required contract terms to be incorporated into account opening documents.
- Providing a negative consent process for existing clients to avoid having to get new signatures from those clients.
- Simplifying execution of the contract by requiring only the financial institution to execute the contract rather than also requiring each individual adviser to sign.
The package also revises existing exemptions, including limiting the so-called “insurance exemption” to recommendations of “fixed rate annuity contracts.” However, advisers can still recommend other insurance products by complying with the BIC exemption.
If advisers and firms do not adhere to the standards established in the exemption, retirement investors will be able to hold them accountable—either through a breach of contract claim (for IRAs and other non-ERISA plans) or under the provisions of ERISA (for ERISA plans and participants).
To allow advisers time to comply with the new rules, an extended compliance period was provided. One year after the rule’s publication, in April 2017, the broader definition of fiduciary will take effect. Even then, to take advantage of the BIC exemption, firms will only be required to comply with more limited conditions, including acknowledging their fiduciary status, adhering to the best interest standard, and making basic disclosures of conflicts of interest. The other requirements of the exemption will only go into full effect on January 1, 2018.
The final rules provide more clarity than the previously proposed rules. They have also liberalized some of the more onerous administrative rules in the proposed regulations and PTEs. At the same time, their finalization means that advisers who have not necessarily considered themselves fiduciaries in the past may now find themselves treated as such. Such advisers must now implement policies and procedures to ensure that they are in compliance with the new rules.