Re-Proposed DOL “Investment Advice” Rule Would Expand Who is a Fiduciary and Substantially Change the Provision of Financial Services to Plan and IRA Investors: Regulation Would Likely Limit the Scope of  Financial Services Available to Plans and IRAs, Unless the Plans and IRAs Are Given New Contractual Protections

Sullivan & Cromwell LLP - April 29, 2015
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On April 14, 2015, the Department of Labor (“DOL”) proposed a regulation (the “Proposed Regulation”) defining the circumstances in which a person will be treated as a fiduciary under both the Employee Retirement Income Security Act of 1974 (“ERISA”) and Section 4975 of the Internal Revenue Code (the “Code”) by reason of providing investment advice to retirement plans and individual retirement accounts (“IRAs”). As part of the regulatory package, the DOL also released proposed prohibited transaction class exemptions intended to minimize the industry disruptions that might otherwise result from the Proposed Regulation, most notably, the so-called “Best Interest Contract Exemption.”

The Proposed Regulation is a re-proposal of a 2010 proposed regulation (the “2010 Proposed Regulation”) that was withdrawn by the DOL after extensive criticism from the financial services industry and politicians of both parties.

As discussed in more detail below, investment advisers that provide occasional investment advice to IRAs or retirement plans are, under current law, generally not treated as fiduciaries for purposes of ERISA and the Code. Such advisers may therefore receive commission income and revenue-sharing payments in connection with such advice, as well as other forms of compensation that fiduciaries are generally prohibited from receiving under ERISA and the Code. The primary consequence of the Proposed Regulation is that it would cause such investment advisers to generally be treated as fiduciaries, and accordingly they would only be permitted to receive such income or payments if they satisfy the Best Interest Contract Exemption. The Best Interest Contract Exemption would, in turn, allow IRAs and plans to bring a fiduciary claim against the adviser.

The Proposed Regulation and the associated exemptions are far-reaching, complex, and may require significant clarification and modification. If the Proposed Regulation and Best Interest Contract Exemption are adopted in their current form, they can be expected to significantly alter the delivery of financial services to employee benefit plans and IRAs.

Broadly speaking, if the Proposed Regulation and Best Interest Contract Exemption are adopted:

  • Many common types of investment “recommendations” made to employee benefit plans and IRAs that are not currently subject to the rules governing fiduciaries under ERISA or the Code would constitute fiduciary investment advice;
  • As a consequence, many financial service providers that currently are not subject to ERISA and/or the prohibited transaction rules of the Code would become fiduciaries under ERISA and/or the Code, as applicable, with respect to their employee benefit plan and IRA clients (“Investment Advice Fiduciaries”);
  • Widely used compensation arrangements in the financial services industry—such as sales commissions and revenue sharing arrangements—are not permitted to be received by fiduciaries under ERISA and the Code, and therefore, Investment Advice Fiduciaries would generally not be permitted to receive such compensation unless they qualify for the Best Interest Contract Exemption;
  • An Investment Advice Fiduciary will be entitled to retain commissions, revenue-sharing fees, and other forms of compensation that would otherwise be prohibited by ERISA and the Code if it satisfies the requirements of the Best Interest Contract Exemption:
    • The adviser must enter a contract with the client in which the adviser agrees to follow ERISA-like standards of fiduciary care (the “Best Interest Contract”);
    • The exemption applies only with respect to participant-directed plan participants, IRA owners and the fiduciaries of small plans (fewer than 100 participants)—no relief is provided for large plans; 
    • Only advice regarding enumerated classes of highly liquid investments is covered by the exemption;
    • The exemption applies only to advice given by employees, agents or representatives of financial institutions that are registered investment advisers, registered broker dealers, regulated banks, savings associations and insurance companies;
    • The exemption will not apply unless the adviser receives only “reasonable compensation” and it discloses to the advice recipient, among other things, any “material” conflicts of interest and all of the associated—direct and indirect—fees payable to the adviser, the financial institution, and any affiliates;
    • The exemption will not apply unless the adviser (a) adopts specific compliance procedures (including with regard to the manner in which employees are compensated), (b) satisfies transactional, quarterly and annual disclosures, and (c) provides notice to the DOL regarding transactions that are subject to the Best Interest Contract Exemption;
    • An adviser that does not offer a broad menu of products will be required to comply with additional restrictions to qualify for the exemption.
  • The obligations imposed by ERISA, the Code, and the Best Interest Contract Exemption would be in addition to the suitability standard already imposed on financial service providers under FINRA; and
  • IRA owners, participants of participant-directed employee benefit plans, and sponsors of small, non-participant-directed employee benefit plans would be able to bring a claim against an Investment Advice Fiduciary for a breach of the Best Interest Contract, which is not currently available to IRAs under the Code.

The comment period for the Proposed Regulation and the proposed exemptions ends on July 6, 2015. The final regulations would become effective 60 days after publication in final form in the Federal Register. In order to allow stakeholders time for transitioning current and future contracts or arrangements, however, the requirements of the final regulations would generally not become applicable until 8 months after publication.