CLIENT MEMORANDUM DEPARTMENT OF LABOR PROPOSES EXPANDED DEFINITION OF FIDUCIARY UNDER ERISA On October 13, 2010, 1 the Department of Labor proposed to expand the definition of fiduciary within the meaning of Section 3(21) of the Employee Retirement Income Security Act of 1974 (ERISA), as it relates to persons rendering investment advice to a plan for a fee or other compensation. The proposed rule, once effective, would have far-reaching consequences for many service providers to ERISA plans who are not currently considered ERISA fiduciaries under the law that has been in effect for the past 35 years. This change could have substantial adverse impacts on broker-dealers, research publishers, and others who are not currently plan fiduciaries but give periodic or more frequent advice to employee benefit plans, plan fiduciaries, or plan beneficiaries. The comment period on the proposed rule expires January 20, 2011. The Current Rule Under the current regulations interpreting this definition, which were issued in 1975, a five-part test is used for determining whether a person will be deemed a fiduciary with respect to an employee benefit plan as a result of providing investment advice to the plan, which requires a showing that (i) (ii) (iii) (iv) (v) the person 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, and he does so on a regular basis, and he does so pursuant to a mutual agreement, arrangement, or understanding with the plan or a plan fiduciary, that the advice will serve as a primary basis for investment decisions with respect to plan assets, and the advice will be individualized based on the particular needs of the plan. All five elements of this test must be satisfied for a service provider rendering investment advice to be considered a fiduciary, unless the service provider also has discretionary authority or control with respect to purchasing or selling securities or other property for the plan. 1 Definition of the Term Fiduciary, 75 Fed. Reg. 65,263 (proposed Oct. 22, 2010) (to be codified at 29 C.F.R. pt 2510). NEW YORK WASHINGTON PARIS LONDON MILAN ROME FRANKFURT BRUSSELS in alliance with Dickson Minto W.S., London and Edinburgh
The Proposed Rule The proposed rule would replace the five-part test with a broader test under which a person renders investment advice, and is deemed to be a fiduciary, to the extent that he both (I) engages in one of the following three services: (x) (y) (z) providing advice, or appraisals or fairness opinions, concerning the value of securities or other property, making recommendations as to the advisability of investing in, purchasing, holding, or selling securities or other property, or providing advice or making recommendations as to the management of securities or other property; and (II) satisfies one of the following four conditions: (i) (ii) (iii) (iv) he represents or acknowledges that he is acting as a fiduciary, he is a fiduciary with respect to the plan within the meaning of Section 3(21)(A)(i) or (iii) of ERISA, he is an investment adviser within the meaning of Section 202(a)(11) of the Investment Advisers Act of 1940, or he provides such advice or makes such recommendations pursuant to an agreement, arrangement, or understanding, written or otherwise, between him and the plan, a plan fiduciary, or a plan participant or beneficiary that such advice may be considered in connection with making investment or management decisions with respect to plan assets, and will be individualized to the needs of the plan, a plan fiduciary, or a participant or beneficiary [emphasis added]. The proposed rule, therefore, does not require a showing that the advice or recommendations are provided on a regular basis or that they will serve as a primary basis for investment decisions with respect to plan assets. Furthermore, the four conditions in the second part of the new test are independent, alternative conditions, only one of which needs to be satisfied to fall within the purview of the rule. Certain activities would be explicitly excluded from coverage under the new rule, except to the extent that they are engaged in by a service provider who represents or acknowledges that he is acting as a fiduciary. Under the proposed rule, a person would not be considered a fiduciary if he can demonstrate that the recipient of the advice or recommendation knows, or under the circumstances should reasonably know, that the person is providing the advice or making the recommendation in his capacity as a purchaser or seller of a security or other property, or as an agent of, or appraiser for, such a purchaser or seller, whose interests are adverse to the interests of the plan or its participants or beneficiaries, and that the person is not undertaking to provide impartial investment advice. - 2 -
In addition, the following actions in connection with individual account plans will not, in and of themselves, be treated as the rendering of investment advice for purposes of the new rule: (i) providing investment education information and materials, (ii) marketing or making available investments through a platform, without regard to the individualized needs of the plan or its participants or beneficiaries, provided that the person discloses that he is not providing investment advice, and (iii) preparing general reports or statements that merely reflect the value of an investment of a plan or its participants or beneficiaries and that are provided for purposes of complying with applicable reporting and disclosure requirements, unless such reports involve assets for which there is not a generally recognized market and serve as a basis on which the plan may make distributions to plan participants and beneficiaries. Two of the changes are particularly important. First, the deletion of the regular basis prong may well cause a service provider (e.g., a broker, dealer, or research producer) to become an inadvertent fiduciary with respect to a large number of employee benefit plans as a result of occasional or sporadic advice. Second, the deletion of the primary basis for investment decisions prong and the substitution of the may be considered test weakens the connection that would have to be established between a service provider and a plan to cause the service provider to have to take on fiduciary duties with respect to the plan. To be covered, advice or research would have to be individualized to the needs of a plan, plan fiduciary, or plan participant, but it is unclear what the contours of this requirement would be and how it might be applied, in enforcement actions, to research or other advice provided to a potentially large group of clients. Consequences of Being an ERISA Fiduciary The impact of the proposed rule will be to sweep into the definition of fiduciary under ERISA a much larger population of plan service providers, thereby exposing such service providers to all the attendant duties placed upon service providers under Section 404 of ERISA. Furthermore, such service providers will need to ensure that any actions taken with respect to their service recipients are not prohibited transactions within the meaning of Section 406 of ERISA. The obligations on ERISA fiduciaries are rooted in a large and complex body of laws, regulations, and Department of Labor Advisory Opinions; therefore, initial compliance measures for persons who have not historically been considered fiduciaries will be substantial. Failure to comply with duties ERISA imposes on fiduciaries, or engaging in prohibited transactions, can result in the imposition of substantial penalties, including the requirement to make the plan whole for losses, disgorgement of profits, civil penalties, and excise taxes. In its proposal, the Department of Labor noted: [I]f more service providers are fiduciaries, more transactions would violate the self-dealing prohibitions contained in ERISA section 406(b). In order to avoid committing prohibited transactions, affected service providers would have to identify transactions that would be prohibited because they involve selfdealing, restructure these transactions, and modify their business - 3 -
Additional Considerations practices in the absence of an applicable statutory, class, or individual prohibited transaction exemption. The Department is uncertain regarding the number of transactions that would have to be restructured, whether an applicable prohibited transaction exemption would be available for such transactions, and if not, the number of prohibited transactions exemption applications the Department could expect to receive regarding the transactions. The Department welcomes public comments regarding this issue. 2 The question arises naturally why the Department of Labor would suddenly, after 35 years, decide that the time had come to engineer such a substantial change in regulation, and further, why it was done in the wake of a clear charge to the Securities and Exchange Commission (SEC) under the Dodd-Frank Act to address the issue. 3 In the release announcing the proposal, the Department cited, among other things, some possible opportunities for abuse under the 35-yearold regulation: In 2009 the Government Accountability Office (GAO) found that many opportunities exist in the 401(k) market place for plans to hire service providers that have business arrangements that could give rise to conflicts of interest. For example, the GAO noted that plans often hire consultants and other advisers to provide advice regarding investment opinions and products that should be offered under the plan and to monitor the performance of the selected investments. In some cases, consultants receive compensation from the investment companies whose products they recommend to the plan, which could lead them to steer the plans toward products for which they receive additional compensation. These arrangements can be harmful to plan participants.... 4 The Department cited in particular its belief that, unless service providers are deemed to be fiduciaries, there would be little basis to proceed against them under ERISA for abusive conduct. 2 3 4 Id. at 65,275. Section 913(b) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376, 1824 (July 21, 2010). The Dodd-Frank Act empowers the SEC to hold broker-dealers to the same standard of conduct applicable to investment advisers when providing retail customers with personalized investment advice about securities. The Dodd-Frank Act also directs the SEC to conduct a study to evaluate the effectiveness of the existing standards of care for brokers, dealers, investment advisers, and others. Definition of the Term Fiduciary, 75 Fed. Reg. at 65,278. - 4 -
One result of the rule s becoming effective as proposed would be that a service provider who is deemed to be a fiduciary thereunder with respect to an employee benefit plan will violate ERISA, and become subject to prosecution and heavy excise taxes, if the service provider engages in a prohibited transaction with the plan, such as most principal transactions. The prosecutor will be able to prove the violation without showing any abuse of the plan or a plan participant or wrongful intent on the part of the service provider. Under ERISA, disclosure and informed consent by a plan are of no avail; they do not cure a violation. In addition, as the Department noted in its proposal, breaches of fiduciary responsibilities, obligations, or duties under ERISA give rise to a private right of action under ERISA Section 502(a)(2). 5 * * * * * * * * * * * * * * * If you have any questions concerning the foregoing or would like additional information, please contact Roger D. Blanc (212-728-8206, rblanc@willkie.com), Frank A. Daniele (212-728-8216, fdaniele@willkie.com), David E. Rubinsky (212-728-8635, drubinsky@willkie.com), or the Willkie attorney with whom you regularly work. Willkie Farr & Gallagher LLP is headquartered at 787 Seventh Avenue, New York, NY 10019-6099. Our telephone number is (212) 728-8000 and our facsimile number is (212) 728-8111. Our website is located at www.willkie.com. November 4, 2010 Copyright 2010 by Willkie Farr & Gallagher LLP. All Rights Reserved. This memorandum may not be reproduced or disseminated in any form without the express permission of Willkie Farr & Gallagher LLP. This memorandum is provided for news and information purposes only and does not constitute legal advice or an invitation to an attorney-client relationship. While every effort has been made to ensure the accuracy of the information contained herein, Willkie Farr & Gallagher LLP does not guarantee such accuracy and cannot be held liable for any errors in or any reliance upon this information. Under New York s Code of Professional Responsibility, this material may constitute attorney advertising. Prior results do not guarantee a similar outcome. 5 Id. at 65,273, n.32. - 5 -