Category Archives: prohibited transaction

What Was Hot in the Second Quarter of 2015

In April, I wrote that the “hot” issues on my desk for the first quarter were: the prospect of the DOL’s fiduciary proposal; allocation of revenue sharing in 401(k) plans; and capturing of rollovers from retirement plans.

Those continued to be the top issues in the second quarter. In fact, two of the issues “merged” in the sense that the hottest issue in the fiduciary proposal is distributions from retirement plans and the capturing of rollovers.

With that in mind, here is a brief description of the hot issues in the second quarter:

  • By the end of June, most people were at least generally familiar with the fiduciary “package,” including the proposal to expand the definition of fiduciary advice and the two prohibited transaction exemptions that apply to the “sales” process. With the July 21 deadline for comments rapidly approaching, the work shifted from education to the preparation of comment letters. Generally stated, that work fell into three categories:
    • Requests for clarifying and limiting the definition of fiduciary advice. For example, the proposal says that a recommendation specifically directed to a person could be fiduciary advice. In theory, that could be a general mailing to thousands of people, but with each letter having a specific addressee. I can’t imagine that the DOL intends for it to be that broad. So, that will likely be limited or, at least, clarified so that only includes specific, rather than general, recommendations. There will likely be some changes to the fiduciary definition, but the final version will probably be much the same as the proposal. So, expect most sales practices to fall under the fiduciary advice definition.
    • Comments to clarify Prohibited Transaction Class Exemption 84-24. These comments are primarily for clarification of some of the conditions. This exemption applies to insurance products that are sold to plans and IRAs (other than individual variable annuities that are sold to IRAs, which are under the Best Interest Contract Exemption, BICE, see below). While the DOL will probably modify and clarify 84-24, it is unlikely that major changes will be made to this exemption.
    • Comments requesting material changes to the Best Interest Contract Exemption. This proposed exemption applies to all other sales and recommendations. The DOL is likely to make significant concessions in its re-write and finalization of this exemption, particularly regarding financial disclosures.

Note that, though, for large plans, there is a sales “carve-out” from the fiduciary rule. However, for small plans, there is not. In other words, for small plans, sales would generally be considered to be fiduciary advice.

Also BICE only applies to certain transparent and/or highly regulated investments, such as mutual funds, bank deposits and insurance contracts. In other words, sales of other investments, such as private equity funds and hedge funds do not have an exemption and, thus, can only be recommended where compensation to the adviser, the adviser’s financial institution, and all affiliated entities is level. That virtually eliminates recommendations of proprietary products of those types.

  • With regard to revenue sharing, the current issue is whether or not it should be “levelized” or “equalized.” Simply stated, the issue is whether the revenue sharing (such as 12b-1 fees and subtransfer agency fees) that is generated by a particular mutual fund should be allocated back to the participants who own that mutual fund. The fundamental question is whether it is fair, or even prudent, for some participants to be invested in high expense funds that pay revenue sharing, while others are lower expense fund that do not pay revenue sharing . . . and the cost of the plan is either entirely or largely borne by the revenue sharing. In other words, is it equitable for a subset of participants to be charged for all or substantially all of the cost of operating a plan . . . through the revenue sharing that their investments generate . . . and through the additional expense that supports those payments? Some providers and plan sponsors have decided that it is not.

Those are the key issues that were on my desk in the second quarter. In the Fall, we will look at the hot issues for the third quarter.

 

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Impact of the DOL’s Fiduciary Proposal on Participant Investment Advice

This client alert, written by Fred Reish, Bruce Ashton, Brad Campbell, Joan Neri, and Josh Waldbeser, from the Drinker Biddle Employee Benefits and Executive Compensation Group, summarizes our conclusions about the impact on participant investment “recommendations” of the Department of Labor (DOL) proposal to expand the definition of fiduciary investment advice.  We also discuss the proposed “Best Interest Contract” Exemption (BICE) permitting financial institutions to receive variable and indirect compensation based on advisor recommendations.

The proposal would significantly impact broker-dealers in assisting participants.  (We use “advisors” to mean a broker-dealer’s registered representatives and/or investment advisor representatives where the firm is dual registered.  For the impact on independent RIAs, see RIA Alert; for the impact on sales of insurance products, see Insurance Products Alert.)

Here are our conclusions, and a link to our more in-depth analysis:

  • The proposal expands the definition of fiduciary investment advice by providing that a “recommendation” to a participant would trigger fiduciary status.  A “recommendation” is a communication that would reasonably be viewed as a “suggestion” that a participant engage in or refrain from a particular course of action.  Under this standard, many common sales and investment education practices would constitute fiduciary advice.
  • Advisors could provide generalized investment education to participants without triggering fiduciary status and prohibited transaction (PT) concerns, if they avoid “recommendations.”  But this will be challenging – under the proposal, referencing available investment options would likely be a fiduciary act.
  • Broker-dealers receive 12b-1 fees and other variable/indirect compensation from investment products they sell.  Advisors who recommend investments to participants influence this compensation.  This would constitute a “fiduciary self-dealing” PT under the proposal, and exemptive relief is needed.
  • BICE would provide an exemption permitting broker-dealers to receive variable and indirect compensation based on their advisors’ non-discretionary recommendations.  However, BICE imposes disclosure and other requirements that may be practically impossible, or prohibitively expensive, to comply with.
  • Broker-dealers and advisors could instead rely on the Pension Protection Act (PPA) exemptions for non-discretionary participant advice, but this provides limited relief and compliance is challenging.
  • For participant non-discretionary investment advice and discretionary management, advisors could use a third-party computer-based asset allocation service – permitted in the DOL’s “SunAmerica” advisory opinion – since the advisor wouldn’t be influencing the broker-dealer’s compensation through its own recommendations.

This is a brief summary of our conclusions.  For the rationale for these conclusions, see our analysis here.

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The Impact of the DOL’s Fiduciary Proposal on Sales of Insurance Products

This client alert, written by Fred Reish, Bruce Ashton, Brad Campbell, Joan Neri, and Josh Waldbeser, from the Drinker Biddle Employee Benefits and Executive Compensation Group, states our conclusions about the impact of the Department of Labor (DOL) proposal to expand the definition of fiduciary investment advice and to modify prohibited transaction (PT) exemptions on sales of insurance products to plans, participants and IRAs.

The proposal affects insurance agents, insurance brokers and pension consultants who receive commissions for selling insurance or annuity contracts to plans and IRAs. (We refer to them collectively as “Insurance Advisors.”) The DOL’s proposal materially expands the definition of fiduciary investment advice to include common investment sales practices. As a result, we use “sales” in this Alert to refer to fiduciary recommendations of insurance products.

Here are our conclusions along with the link to our more in-depth analysis:

  • Conclusion No. 1: PT relief for the receipt of sales commissions has been available under Prohibited Transaction Exemption (PTE) 84-24 for sales by “fiduciary” Insurance Advisors of fixed and variable insurance products to plans and IRAs, and this will continue (but with some changes).  Under the proposal, the PTE will continue to be available for sales of fixed and variable products to plans and participants, and for sales of fixed annuity products to IRAs. (By “fixed,” we mean insurance products that are not treated as securities.) However, for IRAs 84-24 relief will not be available for insurance products that are treated as securities under federal securities laws “annuity securities”).  To satisfy the conditions of the exemption, the Insurance Advisor and the insurance company would need, among other things, to comply with “Impartial Conduct Standards.”  That is, they would need to act in the best interest of the plan, participant or IRA in making recommendations.  Also, Insurance Advisors and their affiliates would not be able to receive revenue sharing, administrative and marketing fees.  
  • Conclusion No. 2: Under the expanded re-definition of fiduciary, recommending a distribution or rollover or making recommendations about the investment of property to be distributed or rolled over also constitutes fiduciary investment advice.  As a result, Insurance Advisors making these recommendations would be considered fiduciaries, would be subject to the ERISA PT rules, and would need exemptive relief to avoid the adverse consequences of a PT.
  • Conclusion No. 3: The exemption for sales of insurance products that are securities under federal securities laws, such as variable annuities, was transferred to the proposed “Best Interest Contract Exemption” or “BICE,” which has a number of new and difficult conditions.

These rules are complex and this email provides a brief summary of our conclusions.  To understand the rationale for these conclusions, see our analysis.

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ERISA Issues for Solicitor’s Fees

Not much has been written about ERISA considerations for referring investment managers to retirement plans . . . and the receipt of solicitor’s fees for a referral.

However, there are a host of legal issues.

First, the person making the referral is receiving “indirect” compensation (that is, the solicitor’s payment by the investment manager), which makes that person a “covered service provider” or “CSP.” As a CSP, he must make 408(b)(2) disclosures (i.e., services, status and compensation). The failure to make timely disclosures is a prohibited transaction.

Second, the compensation cannot be more than a reasonable amount . . . as measured by the value of the services to the plan. But, what if the CSP doesn’t provide any ongoing services to the plan? Does the “compensation” become unreasonable after five years of payments? Ten years? I am not aware of any guidance on that point.

Third, the referral can result in the CSP becoming an ERISA fiduciary adviser. The DOL takes the position that a referral to a discretionary manager is the same as the recommendation of an investment. If it is individualized, based on the particular needs of the plan (or a participant), the DOL says it’s a fiduciary act. For example, in the preamble to its participant advice regulation, the DOL said:  “. . .the Department has long held the view that individualized recommendations of particular investment managers to plan fiduciaries constitutes the provision of investment advice within the meaning of section 3(21)(A)(ii) in the same manner as recommendations of particular securities or other property. The fiduciary nature of such advice does not change merely because the advice is being given to a plan participant or beneficiary.” That conclusion means that the CSP should engage in a prudent process and its compensation must be “level” (that is, cannot vary depending on which investment manager is recommended). I am not aware of any enforcement activity on these issues. However, the DOL position is clear.

While I have opinions about these unanswered questions, the purpose of this article is to alert people about the issues and risks.

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Re-Proposal of DOL Fiduciary Advice Regulation

As you have undoubtedly heard, the Department of Labor has pushed back the date for the re-proposal of the fiduciary advice regulation to January of next year. In addition, the SEC is working with the DOL to help determine the impact of an expanded fiduciary advice regulation on the ability of investors to continue to receive adequate investment services. Finally, the White House is also evaluating the potential impact of a regulation that expands the definition of fiduciary advice. The big question, of course, is what does all of this mean?

As you might expect, everyone has an opinion on that subject. So, depending upon your personal beliefs, you can find opinions that either agree or disagree with your position. But, the truth is that the people who know aren’t talking, and the people who are talking don’t know.

One plausible explanation is that the controversy concerning the regulation has risen to the point that it is a political liability. In other words, that line of reasoning holds that these activities are signs that the re-proposal is in danger.

However, another line of reasoning is that the regulation remains viable, and probable, but that the politicians and the regulators want to make sure that they get it right. (If that is the case, then “right” probably means that appropriate prohibited transaction exemptions are crafted so that valuable services and quality products are not prohibited.)

If I were a betting man (and, for this purpose, I am), my bet would be that the second scenario is the more likely. I have a hard time believing that all of this political and regulatory effort is being made for a proposal that will be killed. In other words, I think that there is a good chance that the DOL will issue a proposed regulation in the first half of next year. I also think that there is a good chance that the proposed prohibited transaction exemptions that accompany the guidance will be more thoughtful and practical than might be expected.

In any event, if and when we get the proposal, the first thing that I will look at is . . . the proposed prohibited transaction exemption concerning fiduciary investment advice to IRAs. In particular, I want to see what it says about variable compensation and about proprietary investments and products.

 

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DOL Proposed Guide

Several of my colleagues and I have provided comments to the DOL about its proposal to require a 408(b)(2) guide   Most other commentators have or will be addressing the policy issue — is it a good idea to require a guide or not?   We avoided the policy issues.   Instead, our comments focused on making the requirements clear and implementable — if the guide requirement is adopted.

For example, we asked that the DOL clarify the requirement to “furnish” a guide and “disclose” changes to the guide later on.   In raising this question, our concern is that the language in the proposal may not clearly express the DOL’s intent.  Without clarity on the meaning of these terms, a service provider might inadvertently violate the requirement.  Since the regulation is a prohibited transaction exemption, an unambiguous statement of the requirements is essential  for us to be able to properly advise our clients on how to comply.

There are a number of other areas on which we requested clarification if the proposal is finalized.  A copy of our comments can be accessed here:  http://www.scribd.com/doc/234166566/060214-Ltr-to-DOL-Re-Proposed-Guide.  The signers of the letter other than me were Bruce Ashton, Brad Campbell, Joan Neri and Josh Waldbeser.

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Capturing Rollovers: A Changing Environment

Recent developments suggest that FINRA, the SEC and the DOL are working together…or, perhaps, have independently reached the same conclusions.

In the past few months, FINRA has discussed rollover IRAs in five publications. The most important of those being Regulatory Notice 13-45, which creates a fiduciary-like process for recommendations about distributions and IRA rollovers. (By the way, I believe FINRA’s Investor Alert on rollovers is helpful and should be given to prospective rollover customers.) Then, to put an exclamation point on that guidance, both FINRA and the SEC listed rollovers to IRAs as one of its 2014 Examination Priorities for broker-dealers.

Finally, it is commonly expected that the DOL will issue its proposed regulation on the definition later this year…and that the proposal will expand its prior guidance on “capturing” rollovers. Fiduciary status alone increases the scope of the DOL’s jurisdiction and implicates it’s prior guidance (see Advisory Opinion 2005-23A). As a result, a broader definition of fiduciary advice will subject more advisers and providers to that guidance. In addition, it is possible that the Department will try to label any recommendation to take distribution as fiduciary advice (by saying, e.g., that a recommendation to take a distribution is inherently also a recommendation to liquidate a participant’s 401(k) investments – similar to what FINRA has done).

To make this even more “interesting,” we are seeing SEC examinations of RIAs where the SEC is finding ERISA prohibited transactions and asserting compliance violations by RIAs. The question is, will that theme carry over into IRA rollovers?

These changes impact broker-dealers, RIAs and their representatives. Less obviously, they also impact the rollover services of recordkeepers.

Bottom line… the rules are changing. Much more attention must be given to practices and disclosures in the distribution and rollover process.

For those of you who are interested in following me on Twitter, I can be found @fredreish, or copy and paste this URL into your browser: https://twitter.com/fredreish

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Fiduciary Advice and 12b-1 Fees

The DOL recently settled a case for $1,265,608.70 with a firm that provided investment advice to retirement plans. Based on the DOL’s press release, the firm served as a fiduciary investment adviser to ERISA plans and recommended investments in mutual funds. In addition to the firm’s advisory fee, it also received 12b-1 fees.

Based on the press release, it appears that the DOL asserted two claims. The first is that the receipt of additional fees (which could include both 12b-1 fees and some forms of revenue sharing) is a violation of the prohibited transaction rules in section 406(b) of ERISA.

The second theory appears to be that, where a fiduciary adviser receives undisclosed compensation, the adviser has, in effect, set its own compensation (to the extent of the undisclosed payments). In the past, the DOL has successfully taken the position that, by receiving undisclosed compensation, a service provider has become the fiduciary for the purpose of setting its own compensation and has used its fiduciary status for its own benefit.

In any event, RIAs and broker-dealers need to be particularly conscious of undisclosed payments and/or payments in addition to an advisory fee. In recent years, the DOL has gained a greater understanding of RIA and broker-dealer compensation and is actively investigating both.

I have reviewed the 408(b)(2) disclosures of a number of broker-dealers. In a few cases, the broker-dealers specifically state that, where they were serving as fiduciary advisers, they were also receiving additional compensation (e.g., revenue sharing). Those disclosures raise issues about prohibited transactions.

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Adequacy of Disclosures

As we get closer to the July 1, 2012 deadline for 408(b)(2) disclosures, more issues emerge concerning the adequacy of disclosures. Of particular concern is the requirement that the disclosures include both monetary and non-monetary compensation. For example, where a mutual fund family or insurance company subsidizes broker-dealer or RIA conferences for plan sponsors or advisers, there is at least an issue of whether those subsidies should be disclosed to the plan sponsor clients of those RIAs or broker-dealers. Another example is where a mutual fund complex or insurance company pays for advisers to attend conferences.

Continue reading Adequacy of Disclosures

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408(b)(2) Disclosures for Solicitor’s Fees

In my last article, I discussed our concerns about the lack of awareness of discretionary investment managers concerning 408(b)(2) disclosures. This article addresses another one of our concerns . . . 408(b)(2) disclosures by advisers who refer investment managers and receive solicitor’s fees.

Continue reading 408(b)(2) Disclosures for Solicitor’s Fees

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