BLJ Autumn15 DiCarlo - Alston & Bird LLPPatrick C. DiCarlo is counsel in the Atlanta office of...

BENEFITS LAW JOURNAL 1 VOL. 28, NO. 3, AUTUMN 2015

Patrick C. DiCarlo is counsel in the Atlanta office of Alston & Bird LLP, where his practice focuses on counseling plans and financial services providers regarding fiduciary issues, prohibited transactions, fee disclo-sure issues, designing benefit claim procedures, and litigating benefit disputes of all types. Emily Seymour Costin is a senior associate in the Washington, DC, office of Alston & Bird LLP, where her practice involves defending plan sponsors and fiduciaries in claims of all types under ERISA, and counseling plan sponsors and fiduciaries on regula-tory compliance issues and litigation avoidance.

BENEFITS LAWJ O U R N A L

VOL. 28, NO. 3 AUTUMN 2015

‘Fiduciary’ Defined: DOL’s Proposed New Rule Creates More Questions

Than Answers

Patrick C. DiCarlo and Emily Seymour Costin

In April 2015, the US Department of Labor (DOL) proposed its long-anticipated changes to the regulation that delineates when financial advisors become fiduciaries to certain benefit plans, such as retirement plans, individual retirement accounts (IRAs), and health savings accounts (HRAs).1 This is an important distinc-tion because fiduciary status imposes a number of requirements and implicates certain prohibited transaction rules—particularly concerning the receipt of fees.

According to Secretary of Labor Thomas Perez: “This boils down to a very simple concept: If someone is paid to give you retire-ment investment advice, that person should be working in your best interest.”2 As discussed later, however, the proposed rule, and accompanying changes to the available prohibited transaction


DOL’s Proposed New Rule

exemptions, are anything but simple. A large body of long-standing prohibited transaction exemptions is being displaced by a new series of complicated exemptions that interrelate with the new proposed rule, as well as the relevant statutes, in complex ways. The proposed changes take hundreds of pages to explain and, ulti-mately, create more questions than answers.

BACKGROUND

Under the Employee Retirement Income Security Act of 1974, as amended (ERISA), a person can become a fiduciary in three general ways:

(1) They can be designated as such in the plan documents;

(2) They can be a “functional fiduciary” in the sense that they have any control over plan assets and discretionary control over certain aspects of the plan; or

(3) They can give “investment advice” to a plan for a fee.3

Significantly, however, the statute does not define what constitutes “investment advice.”

In 1975, the DOL issued regulations that created a five-part test for determining whether a person can be treated as a fiduciary when providing investment advice for a fee.4 Under the current regulation, a person is deemed to be giving “investment advice” if such a person:

(1) Renders advice to a plan as to the value of securities or other property, or makes recommendation 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 under-standing, written or otherwise, between such person and the plan or plan fiduciary;

(4) That such services will serve as a primary basis for invest-ment decisions with respect to plan assets; and

(5) That such person will render individualized investment advice to the plan based on the particular needs of the plan



regarding such matters as, among other things, investment policies or strategy, overall portfolio composition, or diversi-fication of plan investments.

Each element of the five-part test with respect to the particular advice recipient or plan at issue must be met in order for the person to become a fiduciary.

In recent years, the DOL has expressed concern that the specific elements of the existing five-part test “frequently permit evasion of fiduciary status and responsibility that undermine the statutory text and purposes.”5 In particular, the DOL has expressed concern over the requirement that advice must be furnished on a “regular basis.” Technically, under the current regulation, an advisor could provide an investment recommendation on a one-time basis regarding a large, complex investment, yet have no fiduciary obligation to the plan under ERISA.6 Further, the DOL has noted that fiduciary status can be defeated by arguing that the parties did not have a “mutual” agree-ment, arrangement, or understanding that the advice would serve as a “primary basis” for investment decisions.7

The DOL also has asserted its view that changes in the financial marketplace have “enlarged the gap” between the current regulation and the congressional intent of the statutory definition.8 Most nota-bly, many of the consultants and advisors who provide investment-related advice and recommendations receive compensation from the financial institutions whose investment products they recommend. According to the DOL, this “gives the consultants and advisors a strong bias, conscious or unconscious, to favor investments that provide them greater compensation rather than those that may be most appropriate for the participants.”9 The DOL believes that unless these individuals are “fiduciaries,” they are “free under ERISA and the [Internal Revenue] Code, not only to receive such conflicted compen-sation, but also to act on their conflicts of interest to the detriment of their customers.”10

WHAT IS THE NEW PROPOSED RULE?

Under the proposed rule, a person renders “investment advice” by providing investment or investment management “recommendations” or “appraisals” to a plan.11 Specifically, by providing:

(1) A recommendation as to the advisability of acquiring, hold-ing, disposing, or exchanging securities or other property (including a recommendation to take a distribution of ben-efits or a recommendation as to the investment of securities



or other property to be rolled over or otherwise distributed from the plan or IRA);

(2) A recommendation as to the management of securities or other property, including recommendations as to the man-agement of securities or other property to be rolled over or otherwise distributed from the plan or IRA; or

(3) An appraisal, fairness opinion, or similar statement, whether oral or written, concerning the value of securities or other property, if provided in connection with a specific transac-tion or transactions involving the acquisition, disposition, or exchange of such securities or other property by the plan or IRA.12 In addition, the person:

(a) Acknowledges the fiduciary nature of the advice, or

(b) Acts pursuant to an understanding with the recipient that the advice is individualized to, or specifically directed to, the recipient for consideration in making investment or management decisions regarding plan assets.13

When such “investment advice” is provided for a fee or other compensation, the person giving the advice is deemed to be a “fiduciary” under the proposed rule.14 However, the proposed rule also includes a number of “carve-outs” to this general definition, and is accompanied by proposed changes to the prohibited trans-action rules.15

HOW IS THE PROPOSED RULE DIFFERENT FROM THE CURRENT REGULATION?

The proposed rule (and accompanying prohibited transac-tion exemption changes) marks quite a significant departure from existing law. The biggest difference between the proposed rule and the current regulation relates to the perceived “loop-holes” in the existing regulation noted previously, that is, that the advice be given on a “regular basis” in order to become fiduciary in nature, and that the advice be provided pursuant to an under-standing that such advice would be a “primary” basis for invest-ment decisions.

The proposed rule eliminates both requirements, such that a per-son can provide investment advice (and thus be a fiduciary) even if the advice is provided on a one-time basis, and even if there was no



expectation that the advice would serve as the primary basis for the decision. As discussed in more detail later, however, the proposed changes go further in altering existing prohibited transaction rules, particularly with respect to IRAs and HSAs.

WHAT CARVE-OUTS ARE INCLUDED IN THE NEW PROPOSED RULE?

The proposed rule’s new definition of “fiduciary” is broad and would capture a number of activities that are not, and should not be, fiduciary in nature. Recognizing this, the DOL included a number of carve-outs in the proposed rule to exempt certain activities from being treated as a fiduciary act.

The ‘Seller’s’ Carve-Out

Under this carve-out, incidental advice to a large plan investor with financial expertise in connection with an arm’s-length transaction is not considered to be fiduciary in nature. In order to make use of this carve-out, the person providing advice must either:

(1) Obtain a written representation from the plan fiduciary that such plan fiduciary is a fiduciary of an employee benefit plan that covers 100 or more participants; or

(2) Know or reasonably believe that the plan fiduciary has responsibility for managing at least $100 million in employee benefit plan assets.

In addition, the person giving the advice also must inform the plan fiduciary of the existence and nature of the person’s finan-cial interests in the transaction and may not receive a fee directly from the plan for the provision of investment advice.16 The over-all purpose of this carve-out is to avoid imposing ERISA fiduciary obligations on “sales pitches” when neither side assumes that the counterparty to the plan is acting as an impartial advisor, and both parties are sophisticated enough to take care of their own interests.17

The ‘Swap and Security-Based Swap’ Carve-Out

Under this carve-out, offers or recommendations to enter certain swap or security-based swap transactions under the Commodity



Exchange Act18 or the Securities Exchange Act of 193419 are not con-sidered fiduciary in nature. In order to qualify for the carve-out, the person providing recommendations with regard to the swap must act as a dealer and may not be an advisor to the plan. The person also must have a reasonable basis to believe that the plans have indepen-dent representatives who are ERISA fiduciaries.

The ‘Employees of the Plan Sponsor’ Carve-Out

Under this carve-out, employees of a plan sponsor of an ERISA plan are not treated as investment advice fiduciaries as long as the employee receives no compensation for the advice beyond his or her normal compensation as an employee. The purpose of this carve-out from the scope of the definition recognizes that internal employees, such as members of the company’s human resources department, routinely develop reports and recommendations for investment com-mittees and other named fiduciaries of the sponsor’s plans, without acting as paid fiduciary advisors.20

The ‘Platform Providers’ Carve-Out

Under this carve-out, service providers, such as record-keepers and third-party administrators that offer a “platform” or selection of invest-ment vehicles to participant-directed account plans under ERISA are not considered fiduciaries. The service provider must disclose in writ-ing that it is not undertaking to provide impartial investment advice or to give advice in a fiduciary capacity. With respect to this carve-out, the DOL emphasized that a plan fiduciary is always responsible for prudently selecting and monitoring service providers to the plan. Moreover, IRAs are not eligible under the proposal, and HSAs are treated as IRAs.

The ‘Investment Education’ Carve-Out

Under this carve-out, the provision of investment education infor-mation and materials does not qualify as a fiduciary act. The proposed rule specifies that there are four types of information and materials that may qualify for the carve-out:

(1) Plan information;

(2) General financial, investment, and retirement information;



(3) Asset allocation models; and

(4) Interactive investment materials.

However, any information regarding specific investment products is considered to be individualized advice and will not qualify for the carve-out. For example, one may recommend that a portfolio should contain a certain percentage of stocks and bonds under the carve-out. A recommendation as to which particular stocks and bonds to invest in will not qualify for the carve-out.

This carve-out applies equally to information provided to plan fidu-ciaries and information provided to plan participants, beneficiaries, and IRA owners. It also applies equally to information provided by plan sponsors, fiduciaries, and service providers.

WHAT EXEMPTIONS ARE BEING PROPOSED TO THE EXISTING PROHIBITED TRANSACTION RULES?

The proposed rule would significantly expand the universe of financial service professionals who are subject to fiduciary duties and prohibited transaction rules. Therefore, in addition to the proposed revisions to the definition of “fiduciary,” the DOL also proposed two new prohibited transaction exemptions, as well as proposed amend-ments to certain existing exemptions. Given the expanded definition of “fiduciary,” these simultaneous revisions are necessary because fidu-ciary status makes it more difficult to qualify for a prohibited transaction exemption than is the case for a nonfiduciary service provider. One of the broadest prohibited transaction exemptions is the “service provider” exemption set forth in ERISA Section 408(b)(2), but the DOL has taken the position that Section 408(b)(2) does not provide an exemption from ERISA Section 406(b)(1), which relates to fiduciary self-dealing.21 The new proposed exemptions would allow certain advisors and firms to continue to receive compensation for otherwise prohibited transactions despite their new-found fiduciary status.

Best Interest Contract Exemption

In a departure from past practices, the DOL’s proposed Best Interest Contract Prohibited Transaction Exemption (Best Interest Contract Exemption) is a principles-based exemption, as opposed to other transaction-based exemptions, but applies only to investments in certain products and is subject to a number of fairly onerous requirements. It would be available to investment advice fiduciaries



who receive compensation for investment recommendations to retail investors—including individual plan participants, IRA owners, and small plans (fewer than 100 participants)—but again, only with respect to certain types of investments.

The proposed Best Interest Contract Exemption would require that the investment advice fiduciary and financial institution enter a writ-ten contract with investors including the following provisions:

• Contractual acknowledgment of fiduciary status;

• Commitment to basic standards of impartial conduct (includ-ing to give advice in the customer’s best interests, avoid misleading statements, and receive no more than reasonable compensation);

• Warranty of compliance with applicable laws;

• Warranty of adoption of policies and procedures reasonably designed to mitigate any harmful impact of conflicts of inter-est and ensure compliance with the standards of impartial conduct; and

• Disclosure of basic information on conflicts of interest and fees.

The DOL stressed that the above contractual provisions would be enforceable by plans, participants, beneficiaries, IRA owners, and the DOL to ensure compliance with the exemption. Further, the proposed exemption prohibits exculpatory provisions disclaiming or limiting liability for violations of the contract’s terms. Finally, the proposed exemption contains certain notice and data collection requirements for financial institutions.22

Principal Transaction Exemption

The DOL also proposed a Principal Transaction Exemption that would permit fiduciaries to sell certain debt securities out of their own inventory to plans, participants, beneficiaries, and IRA owners.

The Principal Transaction Exemption would include all of the previous contractual requirements of the Best Interest Contract Exemption. In addition, it would require that the advisor obtain two price quotes from unaffiliated counterparties for the same or a similar security, and the transaction would have to occur at a price at least as favorable to the plan or IRA as the two price quotes. Additionally, the



advisor would have to disclose the compensation and profit it expects to receive from the transaction.

Amendments to Existing Prohibited Transaction Exemptions

In addition to the Best Interest Contract Exemption and Principal Transaction Exemption, the DOL proposed amendments to certain other existing exemptions. The proposed amendments would require adherence to the same impartial conduct standards contained in the Best Interest Contract Exemption. The DOL also proposed amend-ments to Prohibited Transaction Exemption (PTE) 84-24 and PTE 86-128 such that investment advice fiduciaries to IRA owners would not be able to rely on those specific exemptions, but instead would have to rely on the Best Interest Contract Exemption when receiving compensation for certain transactions.

WHAT QUESTIONS HAVE BEEN RAISED ABOUT THE PROPOSED RULE?

The proposed rule raises a number of issues that will need to be clarified at the administrative level or by the courts. As discussed below, there are a number of open questions as to the scope of the rule itself, the scope of the carve-outs, and the new category of litiga-tion created as part of the Best Interest Contract Exemption.

Questions Regarding the Scope of the Proposed Rule and the Carve-Outs

As an initial matter, the old rule included a requirement that the advice be “individualized” to the plan,23 but the new proposed rule requires only that the advice be “individualized to, or that such advice is specifically directed to, the advice recipient” for consideration in making investment or management decisions. So, under the proposed rule, the advice need not be individualized, as long as it is “specifi-cally directed” to the recipient. This raises issues related to when gen-eral communications may be fiduciary in nature.

These questions are compounded by the lack of bright lines for determining the scope of the “Investment Education” carve-out. Although it is true that there must be a “recommendation,” the pro-posed rule defines the term “recommendation” broadly to include any “suggestion that the advice recipient engage in or refrain from taking



a particular course of action.” This may well include suggesting gen-eral investment strategies or products, even if no particular security is recommended. There has to be a fee involved, but what if an advi-sor provides general information to an existing client? What if a call center employee provides information about rolling over plan assets to an IRA for an existing client?

Another problem with the proposed rule is that the definition of “investment advice” is not limited to recommending a transaction involving securities only, but rather includes a recommendation con-cerning “securities or other property.” The “other property” language is quite broad, and could include insurance policies. In other words, the proposed rule also may govern insurance brokers who make recommendations about purchasing particular insurance policies. This would be a broad reading, but it is difficult to conclude that an insurance policy is not “property,” and the definition of “fee or other compensation” specifically includes “insurance sales commissions.”

With respect to the carve-outs, one significant concern is that the “Platform Providers” carve-out is not available to IRAs. The rationale for that decision is that IRA account holders, unlike participants in employer-sponsored plans, do not have another (possibly more sophisticated) fiduciary to look after their interests. However, else-where the DOL determined that HSAs should be treated as IRAs. As a result, HSAs, which typically include platform-like investment options, are not eligible for the “Platform Providers” carve-out under the pro-posed rule, although that particular carve-out seems tailor-made for HSAs and the rationale for excluding IRAs does not apply to HSAs.

Questions Regarding the Best Interest Contract Exemption

According to the DOL, the proposed Best Interest Contract Exemption will allow consumers to hold fiduciary advisors account-able through a private right of action for breach of contract. However, as discussed later, it is not clear how the courts would react to such a claim. If the contractual obligations are violated, in some circum-stances the exemption would no longer be available, and thus would expose financial advisors and institutions to liability for a nonexempt prohibited transaction, which could include:

(1) Civil penalties under ERISA Section 502(i) of up to 5 percent of the amount involved for each year (or part of a year) that the prohibited transaction continues;

(2) Criminal penalties; and



(3) Excise taxes under the Internal Revenue Code (including a tax of 100 percent of the amount involved if the breach is not timely corrected).

Notably, the Best Interest Contract Exemption is not a general exemption from the DOL’s proposed expanded version of the defini-tion of a “fiduciary” for purposes of ERISA and the Code. Entering into a best interest contract could shield a financial advisor or institution from liability for a prohibited transaction, but doing so would not relieve the fiduciary from satisfying the general fiduciary duties under ERISA. Accordingly, the financial advisor or institution could still face potential civil liability for a breach of the contract.

General Litigation Issues

The litigation issues presented in suits to enforce best interest con-tracts are likely to vary depending on whether the underlying invest-ment was made through a plan governed by ERISA (such as a 401(k) plan) or through a retirement plan governed only by the Internal Revenue Code (such as an IRA). However, there are some basic ques-tions that are likely to come up in either type of litigation. Specifically, the DOL has not provided much detail on what best interest contracts need to specifically say or what supporting “policies and procedures” are required.

For example, a best interest contract must include “a commitment to basic standards of impartial conduct,” but the DOL has provided little guidance on what this actually means. The preamble seems to imply that in addition to having the right contractual language, proper execution is also required for the exemption to apply. However, the description of the standards of impartial conduct simply sounds like a discussion of the existing fiduciary duties. Does a best interest con-tract impose duties beyond those imposed by existing law? If not, what is the point of re-imposing existing obligations in a contract? If so, what are the additional requirements?

A best interest contract also must include a warranty that the advi-sor has adopted policies and procedures reasonably designed to “mitigate any harmful impact of conflicts of interest” and disclose “basic information” on conflicts of interest. The preamble makes clear that ongoing compliance with the warranty is not required for the exemption to apply, but failure to comply on an ongoing basis could result in unspecified contractual liability. The preamble also acknowl-edges that the proposal does not mandate the specific content of the required policies and procedures in order to maintain flexibility. However, the lack of specification also creates uncertainty regarding



what is required to avoid contractual liability. Some examples of approaches that could help satisfy the requirements are provided, but what is sufficient to preclude a lawsuit is unclear.

It is also uncertain what the remedies, if any, will be for failing to comply with the best interest contract requirements or the related warranties. If the contract does not say what it is supposed to, the exemption is not applicable and the fees the advisor charges, and potentially other transactions, could become prohibited transactions. However, what, if any, remedies are available for not having sufficient policies and procedures, or any at all? If a customer sues to enforce the warranty, does he or she need to show any actual damages? In other words, if the advisor’s policies and procedures are found deficient, are any damages available absent a monetary loss? Would injunctive relief be available? Are the courts going to be the ones to specify the requirements? What standards would a court apply in defining the required policies and procedures?

If there is a monetary loss, does the plaintiff have to show a causal nexus between the loss and the failure to adopt or imple-ment adequate policies and procedures? In other words, what if there is a failure to adopt or enforce sufficient policies and proce-dures, and there is a financial loss, but the plaintiff cannot prove that the failure to follow adequate policies and procedures caused the loss?

What if a conflict was not sufficiently disclosed, and it is not clear whether the conflict played any role in the recommendation? This may be a common scenario in which the advisor technically has a conflict, but there is otherwise no evidence that the conflict influ-enced the type of advice provided. If the existence of the conflict alone is sufficient to establish causation, the practical impact may look a lot like strict liability for failure to disclose a conflict regarding an investment that happened to result in a loss.

ERISA-Specific Issues

If the advisor’s customer is (or is investing through) an ERISA plan, a whole host of additional issues arise. ERISA preempts state law claims that relate to ERISA plans, and ERISA’s civil remedies provi-sion contains a list of exclusive remedies.24 Will courts view a suit for breach of a best interest contract to be an additional civil remedy not included in the exclusive statutory list? Is it possible to make a claim for breach of a best interest contract under the existing statu-tory structure?

ERISA’s civil remedies provisions generally permit suits to recover benefits due for breach of fiduciary duty and for other appropriate equitable relief to enforce the terms of the plan or ERISA. Could a



suit to enforce the terms of a best interest contract be viewed as suit to enforce the terms of the plan? That seems unlikely as the contract would simply be an agreement with a service provider unrelated to the terms of the plan itself.25

Could a suit for breach of a best interest contract constitute a claim for breach of fiduciary duty? If not, there does not seem to be a way to fit this type of suit within ERISA’s statutory structure. If so, this raises the question of whether the standards of impartial conduct (or any other aspect of the Best Interest Contract Exemption) impose requirements beyond ERISA’s fiduciary requirements. If not, what is the point of a contractual requirement? If so, where is the statutory authorization for imposing additional duties? The bottom line seems to be that the DOL is not going to be able to impose fiduciary obligations beyond what is described in the statute.

Internal Revenue Code Concerns

Other complex issues arise in the context of plans governed only by the Internal Revenue Code (such as IRAs). Could a claim for breach of a best interest contract be based on state law? The question of what constitutes sufficient contractual terms or the requisite policies and procedures for purposes of the Best Interest Contract Exemption would seem to be a matter of federal law. If state law claims are permitted to proceed, there seems to be substantial room for conflicts among state courts and between state and federal courts as to what the Best Interest Contract Exemption requires, what remedies are available and what supporting policies and procedures are required.

Typically, disputes between IRA account holders and investment advisors are subject to the securities laws and Financial Industry Regulatory Authority (FINRA) arbitration. Would the Best Interest Contract Exemption provide an end-run around FINRA arbitration? Would two different sets of fiduciary requirements apply to advisors under the securities laws and the Internal Revenue Code?

CONCLUSION

The proposed rule, if adopted, would have a significant impact on the financial services industry. Many financial services professionals have already expressed deep concerns about the scope of these pro-posed changes. It is likely that additional objections will be raised as the extent of what is being proposed becomes clearer. It would not be surprising to see significant changes adopted following the comment period and public hearings.26



NOTES

1. The proposed regulation is available at 80 Fed. Reg. 21928 (proposed April 20, 2015) (to be codified at 29 CFR parts 2509 and 2510).

2. See Department of Labor, Employee Benefits Security Administration (EBSA) News Release (April 14, 2015), available at http://www.dol.gov/opa/media/press/ebsa/EBSA20150655.htm, last accessed Aug. 18, 2015.

3. 29 U.S.C. § 1002(21)(A).

4. See 29 C.F.R. § 2510.3-21(c).

5. 80 Fed. Reg. 21934.

6. Id.

7. Id.

8. Id.

9. Id. at 21935.

10. Id.

11. Id. at 21956–57.

12. Id.

13. Id.

14. Id.

15. Id. at 21957–58.

16. This carve-out will not apply to cover recommendations to retail investors, which include small plans, IRA owners, and plan participants and beneficiaries.

17. 80 Fed. Reg. 21941.

18. 7 U.S.C. § 1 et seq.

19. 15 U.S.C. § 78a et seq.

20. 80 Fed. Reg. 21943.

21. 29 C.F.R. Section 2550.408b-2(a).

22. The DOL also is seeking public comment on whether it should issue a separate streamlined exemption that would allow advisors to receive compensation in certain high-quality low-fee investments, subject to fewer conditions than in the proposed Best Interest Contract Exemption.

23. See 29 C.F.R. § 2510.3-21(c)(1)(ii)(B).

24. See 29 U.S.C. § 1132.

25. See, e.g., Airparts Co., Inc. v. Custom Benefit Servs. of Austin, 28 F.3d 1062, 1064 (10th Cir. 1994) (ERISA did not preempt state law claims brought by the trustees of an ERISA plan against a non-fiduciary firm “hired by plaintiffs to provide expert benefit plan consul-tation”); Custer v. Sweeney, 89 F.3d 1156, 1167 (4th Cir.1996) (the trustee’s state law legal malpractice claim against an ERISA plan’s attorney was not subject to ERISA preemption).

26. The first comment period for these regulations is now closed. After a public hear-ing, the comment period will reopen for an additional 30 to 45 more days.

Copyright © 2015 CCH Incorporated. All Rights Reserved.Reprinted from Benefits Law Journal, Autumn 2015, Volume 28,

Number 3, pages 12–25, with permission from Wolters Kluwer, New York, NY, 1-800-638-8437,

www.wklawbusiness.com

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