On April 14, 2015, after 43 months in development, the U.S. Department of Labor (DOL) released its reproposal to expand the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974, as amended (ERISA), which was published in the Federal Register on April 20, 2015. The DOL’s original October 2010 proposal on this subject was withdrawn, as announced in September 2011 in the face of substantial criticism from the regulated community and Capitol Hill, and, as expected, was replaced with a reproposal that:

• Recedes on the October 2010 proposal to treat the valuation of employee stock ownership plan (ESOP) stock as fiduciary activity;
• Significantly expands the circumstances in which broker-dealers, investment advisers, insurance agents, plan consultants and other intermediaries would be treated as fiduciaries to ERISA plans and individual retirement accounts (IRAs), and therefore precluded from receiving compensation that varies with the investment choices made or from recommending proprietary investment products absent an exemption;
• Provides new proposed exemptions and modifies or revokes a number of existing exemptions addressing those activities; and
• Retains the ERISA distinction between non-fiduciary “investment education” and fiduciary “investment advice,” with important modifications.

The reproposal remains the most politicized and controversial rulemaking ever undertaken by DOL in its administration of ERISA. DOL made a legitimate effort, from its frame of reference, to address a number of criticisms of the earlier proposal made formally during the 2010-2011 rulemaking process and informally during the intervening years. For example, the reproposal is plainly more fully developed than the 2010 proposal, the institutional retirement market is distinguished from the retail market in helpful ways, and DOL specifically invites comments on a range of critical points implicated by this rulemaking. On balance, however, there is substantial reason to question both the justification for and the execution of the reproposal. At bottom, the reproposal does not target “bad actors” for reform. Instead, it would materially modify otherwise permissible practices in the affected industries and impose substantial compliance costs, uncertainties and exposure on “good actors.” Consequently, important interests of plan sponsors, participants, IRA owners, financial services providers and the retirement system as a whole are in play.

Key Dates

• DOL proposed an aggressive timetable for consideration and implementation of the reproposal, which is posted on its website.
• Close of comment period: July 6, 2015. For a proposal of this magnitude, an extension may be necessary and appropriate.
• Hearing: Within 30 days after close of the comment period, with the record open for additional written comments after the hearing. 
• Effective date: 60 days after publication of final rules.
• Applicability Date: Compliance would be required eight months after publication of final rules, which is patently insufficient and will draw requests for extension.

Background

ERISA imposes a famously “comprehensive and reticulated”¹ scheme of regulation for the terms of employee benefit plans, particularly retirement plans, and for plan reporting and disclosure. For the management of plans, however, ERISA instead relies primarily on a standards-based form of regulation, and at the core of that regulation is the concept of a “fiduciary” to the plan. Such fiduciaries are charged with carrying out their duties for the plan in accordance with unusually rigorous fiduciary standards (ERISA §404) and are barred from engaging in certain “prohibited transactions” (ERISA §406). For example, acting with a conflict of interest generally would be contrary to these fiduciary standards, absent an exemption. Fiduciaries for ERISA plans can be personally liable for losses suffered by a plan resulting from a non-exempt violation of these standards, as well as for excise taxes, civil penalties and other remedies. Fiduciaries for IRAs, on the other hand, generally are subject to only the §406 prohibited transaction standards (through Internal Revenue Code §4975) and are liable to the IRS for excise taxes, but not to IRA owners, for violations of those standards, but not to IRS owners. 

ERISA §3(21) provides that three classes of persons are “fiduciaries” for these purposes, generally:

• Persons with discretionary authority or responsibility for the administration of the plan (“plan administration fiduciaries”);
• Persons who provide investment advice for a direct or indirect fee or other compensation with respect to the moneys or other property of the plan (“investment advice fiduciaries”); and
• Persons who manage plan assets on a discretionary basis (“discretionary asset management fiduciaries”).

In 1975, shortly after the enactment of ERISA, DOL promulgated a regulation specifying the circumstances in which a person providing investment advice becomes a fiduciary. For an adviser who does not have discretionary management authority, the 1975 regulation provides that the adviser is a fiduciary only if she satisfies a five-part test, specifically, if for a direct or indirect fee or other compensation (which, in DOL’s longstanding view, includes insurance or securities commissions or similar amounts) she:

1. Renders advice as to the value of securities or other property, or makes recommendations as to the advisability of investing in, purchasing or selling securities or other property
2. On a regular basis
3. Pursuant to a mutual agreement, arrangement or understanding, with the plan or a plan fiduciary, that
4. The advice will serve as a primary basis for investment decisions with respect to plan assets, and that
5. The advice will be individualized based on the particular needs of the plan.

DOL now seeks to replace that five-part test with a more expansive definition, supported by a revised set of exemptions dealing with various investment activities.

DOL’s Justification for an Expanded Fiduciary Definition

The reproposal remains a solution in search of a problem.
 
This is no small matter.

With current assets of approximately $19.5 trillion,² the U.S. private retirement system provides substantial equity and debt capitalization for the U.S. economy. When the question of the ERISA investment advice fiduciary definition was first considered following the enactment of the statute in 1974, the Securities and Exchange Commission (SEC) expressed on the record its serious concern about the risk of disruption to the U.S. capital markets if ERISA fiduciary status was overextended. DOL carefully crafted its five-part fiduciary definition against this background and, in the years since, has sought to balance the uncompromising requirements ERISA imposes on fiduciaries with the structure of and national policies served by the U.S. investment markets as governed by their primary regulators.

Any such balance is missing from DOL’s reproposal. Indeed, the unstated but fundamental premise of the reproposal is that the primary regulation of investment markets–by Congress, state legislatures, the OCC, SEC, FINRA, and other federal or state banking, insurance and securities regulators–is inadequately protecting the interests of at least “retail” retirement plan investors. Thus, the banking, insurance and securities industries, as they participate in the retirement market, are to be restructured by the Labor Department under the auspices of the federal pension law, rather than by the authorities with the direct responsibility and the competence for those industries. And since DOL’s mission under ERISA includes no expertise in or responsibility for the health of those industries or the functioning of the distribution systems that support them, an ERISA regulatory proposal proceeding from that fundamental premise will inevitably lack balance.

Moreover, it is plainly right that the ongoing evolution of the private retirement system, and in particular the shift to reliance on defined contribution plans and IRAs for retirement security, creates a pressing need for plan participants and IRA owners to receive qualified, professional financial services with respect to retirement investments. In addition, investment intermediaries play an instrumental role in bringing plan sponsors, participants and IRA owners into the retirement system and keeping them in the retirement system. Those intermediaries essentially function as the missionaries for the retirement system. In that respect, some sponsors and individuals require more time and attention than others and, if the price for that additional service is a commensurately higher fee reflected in their retirement savings, as opposed to having no retirement savings at all, that incremental cost is money well spent. Accordingly, constraints on the availability of investment services that could result from the DOL's reproposal, particularly for smaller plans or individual retirement investors, can undermine the retirement system in various ways.

Finally, meaningful regulatory changes always create cost and uncertainties. In this case, both would be a tax on the retirement system. And to the extent retirement advisers would face unsettled compliance requirements and thus exposure, those risks would be shared with the plan sponsors or other fiduciaries who engage those advisers.

Given the stakes, then, it would be well that any regulatory restructuring of retirement advice arrangements be based on documented and serious problems arising under existing law, to which the solution least likely to produce adverse or unintended consequences has been tailored.
 
There will be respected commentators in the regulated community who will support the reproposal and the justifications offered by DOL for it–some of which have carried over from 2010 and some of which are new. In the end, however, those justifications do not bear the weight of a proposal as consequential as the proposed expansion of ERISA fiduciary status.

• In the reproposal, DOL does not empirically substantiate any systemic abuse of retirement plans or participants or IRA owners by “conflicted” advisers.
  • Our perspective is that the existing pattern of ERISA regulation of retirement advice (even with its various compromises), coupled with the heavy regulation of investment intermediaries under other federal and state laws, has substantially succeeded in protecting retirement plan investors and provided effective remedies in “bad actor” cases (even if they are not always DOL remedies).
  • Indeed, in the preambles to the reproposal, DOL recognizes that most retirement advisers well serve the interests of their retirement investors.
• Instead, DOL essentially rests its reproposal on a different argument–that in light of the expectations and competencies of retirement investors, the retirement system should not permit “conflicted advice” otherwise allowed under applicable law.
  • The conclusion then follows in a circular manner–fiduciaries are barred from providing conflicted advice, so all retirement advisers should be fiduciaries.
• DOL does attempt to square its reproposal with the statute, by arguing the investment advice fiduciary definition in ERISA §3(21)(a)(ii) is broad.
  • To the contrary, the statute by its terms is neither broad nor narrow; it merely provides that “investment advice for a fee” is fiduciary activity. The statute supplies no definition of or content for what it means to provide “investment advice.” Thus, DOL again assumes the result in making this argument.
• DOL also suggests that the tax benefits afforded retirement plans justify a more rigorous regulation than applies to retail investments.
  • By limiting the application of ERISA to employee benefit plans, which generally do not include IRAs, Congress has already delineated the circumstances in which that argument would or would not be controlling.
• DOL does refer to academic literature and government reports that support its position and speculates about the quantitative benefits to the retirement system from its reproposal.
  • As the commentary to be submitted on the reproposal no doubt will show, however, there is more to that record, which will provide a more nuanced perspective on these points than DOL cities in its advocacy. 

And in the end, even DOL rejects the logical conclusion of its own arguments–that conflicted advice should be banned in the retirement market–in favor of rules conditionally allowing such advice in a variety of circumstances. We summarize below the principal elements of that reproposal.

Arrangements in Scope of the Reproposal

Taking into account, among other things, the expected transfer of savings from retirement plans to IRAs during the baby boomer retirement years, DOL was not persuaded by the arguments that different fiduciary regulatory structures should apply to ERISA plans and IRAs. Accordingly, the reproposal in all of its aspects–the expanded fiduciary definition and the restructured complex of exemptions–would apply not only to ERISA plans (including those §403(b) programs and employer-sponsored IRAs subject to ERISA), but also, by reason of IRC §4975(e)(1), to the following non-ERISA arrangements:

• Traditional IRA accounts and annuities
• Roth IRAs
• Archer medical savings accounts
• Health savings accounts
• Coverdell education savings accounts
  • The proposed “ERISAfication” of IRAs, discussed below, thus would extend to a number of arrangements beyond both (i) DOL’s regulatory purview and expertise, remarkably including Coverdell accounts, and (ii) any meaningful consideration in the justifications or regulatory impact analysis proffered for the reproposal.

The Reproposed Fiduciary Definition

Under the reproposal, the five-part investment advice fiduciary test would be replaced by a greatly expanded definition subject to several carve-outs, as follows:

For this purpose, and consistent with DOL’s prior position, a “fee” would include any direct or indirect fee or other compensation (i) for the advice received by the person (or an affiliate) from any source or (ii) received incident to the transaction for which the advice has or will be rendered, including brokerage fees and mutual fund or insurance sales commissions.

As under the existing rule, the revised definition would go on to provide that:

• Even where the adviser acknowledges fiduciary status, that status is limited to the assets or other matter for which the adviser is acting as a fiduciary and not for any other assets or matter (subject to the co-fiduciary liability provisions of ERISA §405), and
• The execution of a securities transaction specified by another fiduciary is not itself fiduciary activity.

The revised fiduciary definition is the core of the reproposal.

• The reproposal would take a more refined path to largely the same result as the 2010 proposal–that many if not most interactions between investment intermediaries and plans, participants or IRA owners would constitute fiduciary investment advice–and would expressly bring IRA rollover advice into the fiduciary definition even if an investment recommendation is not provided.
• While registered investment advisers would not automatically be investment advice fiduciaries under the reproposal, it appears intended that in most cases they would functionally have that status.
• The preambles contemplate that any client-facing personnel of a financial services provider, including in a call center, may be fiduciaries.
• To the extent an adviser was not previously treated as a fiduciary, that change in status may obligate it to, for example, start providing ERISA §408(b)(2) disclosures by the Applicability Date.
• Conceptually, the most fundamental disruption arising from the expanded definition is its conversion of salespeople into trustees for retail investors. The purpose in the financial system of broker-dealers and insurance agencies, among others, is to distribute investment and insurance products; their function is to be selling firms, and they are subject to both innate regulation and legal obligations to that end. In addition, some companies that manufacture investment products for the retirement market sell their own (i.e., proprietary) products through their own sales force. It is one thing to require selling firms and product manufacturers to engage in fair dealings with their customers. It is something very different to make them legally liable as impartial fiduciaries to their customers, much less to subject them to fiduciary standards that are “the highest known to the law.”³
• The reproposal may make progress on the extent to which valuations are fiduciary activity–the intent appears to be that advice about valuation of an asset in the context of a purchase or sale transaction would be fiduciary investment advice, but, the posting in plan records or statements by a trustee or recordkeeper of asset values (of even hard-to-value assets) on valuation dates, for example, would not–although more clarification may be required on this point.
• The preamble describes the counterparty carve-out as a “seller’s exception” for the institutional market where the plan has financial expertise as determined under the specified factors. This is a significant improvement from the 2010 proposal. Consideration might also appropriately be given to extending the carve-out to plans with fewer than 100 participants, at least where the sponsor either is a business akin to those described in SEC Rule 180 (a law firm, accounting firm, investment banking firm, pension consulting firm, or investment advisory firm, the nature of whose business requires a familiarity with financial matters) or separately has a different, trusted adviser on which it would rely.
• Similarly, the statement of the ERISA plan platform carve-outs has been improved from the 2010 proposal.
• The absence of a carve-out for IRA platforms, however, creates an “inadvertent fiduciary” problem–the point at which the marketing of the platform crosses into fiduciary investment advice cannot be determined in advance with certainty–for which the proposed complex of exemptions may not provide a workable solution.

The Moving Line between Investment Education and Fiduciary Advice

Current law–Interpretive Bulletin (IB) 96-1, as codified by DOL regulation–acknowledges the importance of enabling plan sponsors and service providers to provide participants and beneficiaries with investment educational materials without subjecting them to rigorous fiduciary standards and potential liability. The preamble to IB 96-1 explains that the distinctions between investment education and investment advice were developed after a review of actual investment educational materials. DOL then circulated a draft of proposed guidance to plan sponsors and service providers and released IB 96-1 because “[b]oth plan sponsor and service provider representatives unequivocally agreed that the guidance as drafted would strengthen participant investment education, and urged the Department to proceed as expeditiously as possible to adopt the interpretive bulletin.”

The proposed regulation would supersede IB 96-1, replace it with a carve-out in the revised fiduciary definition, and substantially modify its content in several respects.

• The proposal would narrow the types of information that can be provided to participants–expanded to include IRA owners–as investment education. The most notable change is that investment education materials could not include information, standing alone or in connection with other materials, on specific investment products, investment managers or the value of particular securities or other property. Asset allocation models and interactive investment models would still be permissible but must preclude the identification of plan investment alternatives. The inevitable result, of course, is that the education available to individuals (before triggering fiduciary regulatory compliance) will less effectively help them understand retirement plan and IRA investment options.
• On the other hand, the proposal also contains helpful additions with regard to educational materials on retirement plan distribution forms and retirement risks, such as longevity risk. These additions were drawn from comments solicited by DOL and the Treasuary Department on the use of lifetime income options in defined contribution plans and are consistent with developing policy encouraging the use of these types of investments.

Major differences between current law and the proposed regulation as to the meaning of investment education are as follows:

DOL expressly recognized that the proposal “represents a significant change in the information that may constitute investment education” and invited comments on the appropriateness of these changes.

The Restructured Complex of Exemptions

The proposed expansion of the investment advice fiduciary definition would be accompanied by the most substantial reworking of prohibited transaction exemptions ever undertaken by DOL. The absence of correlative prohibited transaction relief was a major gap in the 2010 proposal, and DOL deserves credit for giving extensive consideration to these matters in the reproposal.

Best Interest Contract Exemption (BICE⁴). The proposed BICE is the centerpiece of the restructured complex of exemptions. It is intended as the generally applicable exemption (and for rollover and other assistance to IRA owners involving many types of investments, the exclusively available exemption) for “retail” advice provided:

The proposed exemption is intended to provide principles-based relief for compensation (which is not prescriptively defined) received by the Adviser, Financial Institution or certain related entities for services provided in connection with the purchase, sale or holding of an Asset as a result of the Adviser’s and Financial Institution’s advice, provided all of the following conditions are satisfied (which, as the preamble makes clear, apply only to in-plan advice and not to any advice or asset outside the plan or IRA).

Because of it is central to the reproposal, the proposed BICE will no doubt draw substantial attention in the commentary. At a high level:

• As a principles-based exemption, the BICE is probably the most conditional exemption ever developed by DOL. The system and compliance costs to satisfy the exemption would be considerable, and compliance with at least some conditions could not be assured in advance.
• For example, the recordkeeping, disclosure and (functionally, under the data request requirement) reporting required at the individual participant/IRA owner level would exceed current systems capabilities in many cases.
• The BICE in form keeps DOL’s promise that commission and other current compensation practices would be allowed. It remains to be seen whether that promise has been kept in substance; unless a Financial Institution utilizes a level fee or fee offset structure, compliance uncertainties about compensation that varies by, for example, product type may create unacceptable risks.
• The BICE materially departs from the statutory structure by, through the contract requirement, extending ERISA prudence and loyalty principles to IRAs and by providing a private right of action for IRA owners–which Congress specifically did not do when it created IRAs in ERISA. With respect, while DOL has the authority to determine the conditions for administrative exemptions it grants, this ERISAfication of IRAs strikes us as a stunning rewriting of the statute.
• In a variety of ways, DOL took pains to create class action and reputational exposure for Advisers and Financial Institutions, apparently intending that risk to incent compliance with the conditions of the BICE.
• The warranty with respect to compliance with other applicable law may burden the settlement of enforcement investigations by the SEC, FINRA, the OCC, and other federal and state banking, insurance, and securities regulators. Financial Institutions rationally will take into account exposures under the BICE in considering whether to enter into such settlements and on what terms. Also, DOL’s notions about the consequences of less substantial violations of other laws may not be binding on a court in the event of private litigation. Finally, it is unclear whether state law claims preempted by ERISA could nontheless be brought by reason of the contract.

DOL also proposed in the BICE conditional relief for (i) the purchase of insurance or annuity products where the insurer is a party-in-interest, and (ii) compensation received after the Applicability Date in connection with Assets previously purchased, held or sold pursuant to a preexisting arrangement, provided no further advice is provided.

Finally, DOL invited comment on the possibility of promulgating a less conditional exemption for advice relating to low-cost, high quality investments.

Other Revisions to the Complex of Exemptions. The reproposal would also add, revise or revoke a number of other prohibited transaction class exemptions (PTE) dealing with investment activities, as follows:

With respect to these revisions, and in addition to the observations above regarding the BICE as applicable:

• DOL did not keep its promise to preserve existing commission and other compensation practices. Although the status of certain indirect compensation practices under existing exemptions was not clear, DOL would specifically disallow such compensation under PTE 84-24 and, as to principal transactions in nonproprietary mutual funds, PTE 86-128. Given (i) the prevalence of these practices in the retirement system and (ii) the qualitative equivalence of the conflicts created by traditional commissions and these other forms of indirect compensation, this is a significant omission.
• There appear to be other important gaps in the network of exemptions affected by the reproposal, including the following:
  • Outside the scope of the BICE, plan-level fiduciary advice with respect to agency transactions in nonproprietary mutual funds, e.g., advice to a §401(k) plan with respect to its mutual fund investment menu, if not covered by the seller’s exception. This is an extraordinarily common occurrence; and
  • Recommendations with respect to the selection of an investment adviser, e.g., in a solicitation regulated by the Investment Advisers Act.

The expansion of the investment advice fiduciary definition exacerbates the need for this exemptive relief, which is not addressed in the reproposal.

■ ■ ■ ■ ■

In the end, it is unclear whether DOL’s ultimate goal is, among other possibilities variously suggested in the preambles, to:

• Punish the occasional “bad actors” among retirement advisers;
• Discourage retirement advisers from recommending actively managed investments rather than passive investments;
• Drive down compensation to retirement advisers;
• Eliminate certain commissions and similar compensation structures because some economic theory contends they are inherently corrupting;
• Move the market to providing only “robo-advice” for retirement investors, out of distrust for any human intervention in that advice;
• Shift fiduciary obligations from plan sponsors, who are seen as falling short of performing those responsibilities as assigned to and expected of them under ERISA, to plan service providers;
• Correct Congress’s lack of foresight in not subjecting IRAs to ERISA.

It is clear, however, that the reproposal is intended to work substantial changes in retirement advice arrangements and investment sales processes, compensation for that advice or sale, and compliance practices and procedures for investment intermediaries. Whether the game is worth the candle–whether the retirement system and retirement investors would be better served given the attendant costs and uncertainties of the reproposal–remains a substantial question. There are points made by DOL that in our judgment have merit – that the “regular basis” element of the five-part test can produce inappropriate results, for example, or that role confusion about advisers should be clarified, or that “bait and switch” about the fiduciary status of an adviser should not be tolerated–but each of those points could be addressed on a far more targeted basis. Absent documented evidence of systemic abuse, a reordering of investment sales processes and retirement advice arrangements on the proposed scale seems difficult to justify.

______________________

¹ Nachman Corp. v. PBGC, 446 U.S. 359, 361 (1980).

² Investment Company Institute, Quarterly Retirement Market Data, Fourth Quarter 2014 (March 25, 2015).

3 Donovan v. Bierwirth, 680 F.2d 263, 272 (2d Cir. 1985).
 
⁴ For clarity of reference, we prefer the Italian-derived pronunciation bee-chay to the French-derived pronunciation baIs or the English pronunciation rhyming with nice.