Department of Labor's Proposed Regulations Broadly Expand Definition of "Fiduciary" Under ERISA
On October 21, 2010, the Department of Labor (DOL) released long-anticipated proposed regulations substantially broadening the term "fiduciary" under ERISA regulations, and potentially subjecting to ERISA's stringent standards a vast number of plan service providers who previously considered themselves exempt from fiduciary status.
If the proposed regulations do not change substantially before they are issued in final form, their implementation could force plan service providers to significantly revamp their business models and possibly cease providing services to plans, effectively shrinking the vendor marketplace for plan sponsors.
The DOL has been indicating for some time its dissatisfaction with the current definition of fiduciary in connection with persons who provide "investment advice" for a fee. In late 2009, the DOL stated that it believed the current definition is outdated and does not adequately regulate the employee benefit community and financial marketplace. The DOL's 2009 statements coincided with a Government Accountability Office report that found that plan investment consultants (who may not be subject to ERISA's fiduciary standards) often operate in an environment fraught with conflicts of interest that may harm plan participants.
Further, the proposed regulations reflect the DOL's recent multi-pronged effort to heavily scrutinize and regulate the relationships between ERISA plans and their service providers. These efforts include implementing significant changes to Schedule C of the Form 5500, Annual Return/Report of Employee Benefit Plan, which now require substantial detailed reporting of fees paid -- directly or indirectly --to plan service providers from plan assets or participant accounts, issuing an interim final regulation defining what constitutes a "reasonable" service contract or arrangement between certain plan service providers and plans, and issuing proposed regulations under certain sections of the Pension Protection Act of 2006 (PPA) dealing with "fiduciary advisers" in "eligible individual account arrangements."
The current statutory definition of fiduciary under ERISA includes parties who render investment advice for a direct or indirect fee with respect to plan assets. In 1975, the DOL issued regulations providing a 5-part test for determining fiduciary status as a result of providing investment advice. Under this test:
In order to be deemed a fiduciary, the advisor must meet all five of the criteria outlined in the test. The DOL notes in the preamble to the proposed regulations that this existing test significantly limits the applicability of the original regulations and effectively ties its hands with respect to enforcement of ERISA violations. The new test eliminates the five part test, broadens the definition of advice, and most significantly, eliminates the requirement that advice be provided regularly and pursuant to a mutual agreement, and that the advice must serve as a primary basis for investment decisions.
The proposed regulations replace the existing five part test with a new test. Under the proposed regulations, the new test includes persons who:
Under the new test, the advice no longer needs to be offered on a regular basis -- offering advice on a single occasion could result in fiduciary status.
As well, the new test sweeps in those service providers who provide recommendations with respect to the "management" of securities or other property. It is unclear what "management" means in this context, but it is evident that the DOL broadly construes the term. In the preamble to the proposed regulations, the DOL states that "management" could include such things as voting proxies or recommendations regarding the selection of persons to manage plan investments. This broad definition could create significant uncertainty. For example, a plan consultant could be approached by a named fiduciary of the plan to give an impartial assessment of the pros and cons of including an employer's CFO on the employer's investment committee for its defined contribution plan. It would be difficult to conceive of that assessment constituting investment advice under the current regulation; however, under the proposed regulation, it may well be investment advice provided by a fiduciary.
Further, the advice no longer need be offered as part of a mutual understanding or that the advice will serve as the primary basis for investment decisions – there does not need to be any understanding or agreement in place whereby both parties acknowledge that they are in an advisory relationship. Most importantly, the advice could be a mere recommendation or offhand comment by the service provider and yet constitute investment advice and impose fiduciary status on the service provider because it may be one factor that the plan sponsor considers in making investment decisions.Under the current regulation, a service provider must meet all five prongs of the test in order to be considered a fiduciary. Under the proposed regulation, meeting any one of the criteria will result in fiduciary status. The proposed regulations also clarify that rendering the advice for a fee includes any direct or indirect fees received by the advisor or an affiliate from any source including transaction-based fees such as brokerage, mutual fund or insurance sales commissions.
The proposed regulations do provide a safe harbor for certain actions that do not result in fiduciary status. These include:
The proposed regulations would conform the provisions of Section 4975(e)(3)(B) of the Internal Revenue Code relating to prohibited transactions to the new definition of fiduciary. This means that the significant population of service providers to individual retirement accounts is affected by the proposed regulations.
The language of the proposed regulations would expand who is considered a fiduciary adviser under sections of the PPA that create an exemption from ERISA's prohibited transaction rules for "eligible investment advice arrangements" (arrangements that permit advisors to receive fees for providing investment advice, so long as certain conditions are satisfied). The DOL released proposed regulations on these sections of the PPA in March 2010, and is expected to finalize these regulations shortly.
As a result of the exemption under PPA and the proposed regulations expanding the definition of "fiduciary," many plan service providers who intend to continue doing business with plans may view fiduciary status as inevitable and revise their business models to act as fiduciary advisers under eligible investment advice arrangements.
The proposed regulations are broad and far-reaching in their current form. It is likely that there will be significant outcry from the plan service provider community (and potentially the plan sponsor community, if it thinks its vendor marketplace will shrink) in response to the proposed regulations. The DOL has invited comments for a period ending in mid-January 2011 and we would expect final regulations to be issued no earlier than late 2011.