Investment Management/ ERISA Fiduciary Alert January 2008 K&L Gates comprises approximately 1,500 lawyers in 24 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit www.klgates.com. DOL Takes Action on Disclosure of Compensation www.klgates.com The U.S. Department of Labor ( DOL ) recently took two actions that will significantly expand the types of information that must be disclosed by persons who provide services to ERISA-covered employee benefit plans. This Alert describes the DOL actions and offers some preliminary thoughts on the practical implications. Overview The two DOL actions on fee disclosures are: A final revision to the schedule plan sponsors must use to disclose fees paid by plans for services. This schedule is part of the Form 5500 Annual Return/Report filed annually by plans and, as revised, will require plan sponsors to disclose both direct and indirect compensation received by plan service providers. These new requirements are applicable for plan years beginning after December 31, 2008. 1 A proposed amendment to DOL s existing regulation implementing the statutory exemption from the ERISA prohibited transaction restrictions permitting parties in interest to provide services to plans. The proposed amendment would require detailed disclosure of direct and indirect compensation received by service providers. These new requirements would be effective 90 days after issuance of the final amendment to the regulation. Comments on the proposed amendment must be submitted by February 11, 2008. 2 For the reasons discussed below, the new requirements will affect virtually all plan service providers and will significantly complicate doing business with ERISA plans. Reporting of Direct and Indirect Compensation to Service Providers ( Schedule C ) Plan sponsors of ERISA-covered employee benefit plans generally must file an annual report for the plan on Form 5500. 3 For plans covering more than 100 employees, the Form 5500 must include a completed Schedule C, setting forth information about fees of $5,000 or more paid by the plan for the provision of services. Completed Form 5500s, including Schedule Cs, are public documents and are widely available. The revised Schedule C: Broadens the definition of service provider whose compensation must be reported, Provides for reporting of direct compensation paid to service providers, and For the first time, requires reporting on indirect compensation received by service providers. 1 72 Fed. Reg. 64731 (Nov. 16, 2007). See also 72 Fed. Reg. 64710 (Nov. 16, 2007) (adoption of final reporting and disclosure regulations conforming with changes to the reporting forms). 2 72 Fed. Reg. 70988 (Dec. 13, 2007). 3 The reporting requirements generally are applicable both to plans with 100 or more participants and to certain pooled investment vehicles that file reports directly with DOL (i.e., direct filing entities or DFEs ). The analysis of the new reporting requirements that follows relates also to filing requirements applicable to the sponsors/managers of DFEs.
These revisions reflect DOL s concern that plan fiduciaries may not have adequate information about the total compensation, especially indirect compensation, received by service providers to plans. Although ERISA requires banks and insurance companies to provide plan sponsors with information needed to complete the Form 5500, there currently is no such requirement for service providers generally. Plan sponsors are keenly aware of their reporting responsibilities, however, and will almost invariably require service providers to provide the needed Schedule C information as a condition to doing business with plans. Service Provider Redefined Under revised Schedule C, the term service provider is defined to include any person who provides services directly to a plan or to another service provider to a plan, as well as any person who provides services in connection with a transaction involving a plan. Thus, persons who have no direct relationship with ERISAcovered plans such as service providers to mutual funds in which plans invest may be considered service providers for purposes of revised Schedule C and, therefore, may be expected to assemble and provide the required information. Direct Compensation Revised Schedule C distinguishes between direct and indirect compensation paid to service providers. The instructions define direct compensation as compensation paid directly by a plan or a plan sponsor to a service provider, as well as compensation paid or debited directly from a plan account. Direct compensation does not, however, include payments made by the plan sponsor that are not reimbursed by the plan. The revised Schedule C requires the plan sponsor to: (1) identify each service provider (subject to the $5,000 threshold discussed above), (2) describe the relationship of the service provider to the plan sponsor (or to any person known to be a party in interest to the plan), (3) provide the total direct compensation paid to the service provider, and (4) provide a statement of whether the service provider received any indirect compensation (discussed below). If a service provider received direct compensation from several plans, the service provider may use any reasonable method of allocating the compensation among the plans. Reporting Indirect Compensation General Rule Indirect compensation is defined in the instructions as all compensation, other than direct compensation, received by a service provider in connection with services provided to the plan or in connection with a person s position with a plan. The instructions indicate that compensation is received in connection with services provided to the plan or a person s position with a plan if the payment is based, in whole or in part, on services provided to the plan or on one or more transactions involving the plan. Thus, for example, indirect compensation received by a provider of brokerage services to the plan, in general, would include payments received by the broker-dealer for order flow in connection with the plan s brokerage transactions as well as sales charge reallowances or revenue sharing received in connection with the plan s mutual fund investments. Indirect compensation does not include compensation that a person would have received if the service for, or transaction involving, a plan had not occurred. Indirect compensation, for Schedule C reporting purposes, includes fees and expense reimbursement payments received from mutual funds, bank commingled trusts, insurance company pooled separate accounts, separately managed accounts, or other pooled investment funds in which a plan invests, if the payments are charged against the fund or account and are reflected in the value of the plan s investment. The material accompanying revised Schedule C indicates that these fees include management fees paid by a mutual fund to its investment adviser, subtransfer agency fees, shareholder servicing fees, account maintenance fees, and 12b 1 distribution fees... (even if the recipients of these fees provide their services only to the fund). The material also indicates that other examples of indirect compensation are finder s fees, float revenue, brokerage commissions, research, other products or services received from a broker-dealer or other third party in connection with securities transactions, and other transaction-based fees received in connection with transactions or services involving a plan. Thus, for example, persons who provide services to an investment fund in which a plan invests and receive asset-based or transaction-based fees from the investment fund would be viewed as service providers for purposes of revised Schedule C, and plan sponsors would be required to report on these fees (subject to the special rule and general reporting threshold discussed below). January 2008 2
If a service provider receives total compensation of $5,000 or more that includes any indirect compensation, the revised Schedule C must (unless the special rule for eligible indirection compensation, described below, is applicable) include: (1) the service provider s name and tax identification number, (2) a statement that the service provider received indirect compensation, and (3) the total amount of the indirect compensation received by the service provider (actual or estimated). If a service provider receives indirect compensation but is unable to determine the specific amount of the compensation, the revised Schedule C must include a description of the method or formula used by the service provider to determine the amount of indirect compensation. If, however, a service provider is a plan fiduciary or provides contract administration, consulting, investment advisory, investment management, brokerage or recordkeeping services and receives $1,000 or more in indirect compensation from any source, then the revised Schedule C must include, for each person paying such indirect compensation: (1) the payor s name and tax identification number, (2) a statement of the total indirect compensation received by the service provider from the payor, and (3) a description of the indirect compensation and any formula used to determine the amount of the indirect compensation. Special Rule for Eligible Indirect Compensation Under revised Schedule C, a plan sponsor is not required to separately report eligible indirect compensation received by a plan service provider. 4 Moreover, if a service provider receives only eligible indirect compensation and certain disclosures are made to the plan, the plan sponsor is only required to report the name and tax identification number of the service provider (or the name and taxpayer identification number of any other person who provided the plan sponsor with the required information about eligible indirect compensation received by the service provider). Eligible indirect compensation is defined as indirect compensation that is received by a service provider as fees charged to investment funds in which a plan invests that are reflected in the value of the investment or in the return on investment and that constitute compensation for distribution, investment management, recordkeeping or shareholder services 4 See revised Schedule C, Part I, line 2, column (g), 72 Fed. Reg. at 64790. or that constitute commissions, finder s fees, float revenue, other transaction-based fees (whether or not they are capitalized as investment costs) or soft dollar revenue. 5 To take advantage of the alternative reporting method for eligible indirect compensation, a plan sponsor must certify on revised Schedule C that it has been provided with written or electronic materials that disclose the following: The existence of eligible indirect compensation; The services provided for the indirect compensation or the purpose for the payment of the indirect compensation; The amount, or an estimate, of the compensation or a description of the formula used to calculate or determine the compensation ; and The identity of the party or parties paying and receiving the compensation. In this connection, the material accompanying the issuance of revised Schedule C states that this information could be provided to the plan in separate disclosures from multiple parties. Excludable Non-Monetary Compensation Revised Schedule C provides that non-monetary compensation, such as business meals, gifts, promotional items and the like, need not be reported if it is both insubstantial and tax deductible to the person paying the compensation. The revised Schedule C defines insubstantial as gifts or gratuities valued at less than $50 that do not in the aggregate exceed $100 annually from any single source. Gifts of $10 or less need not be counted for purposes of the $100 threshold, but all such compensation must be reported if the $100 threshold is reached or exceeded. Although the revised Schedule C is unclear on this point, multiple employees of one service provider entity should probably be treated as from a single source for purposes of the $100 threshold. 6 5 72 Fed. Reg. at 64742 (preamble discussion). The instructions to revised Schedule C, however, omit reference to fees for investment management, 72 Fed. Reg. at 64826, suggesting an inadvertent omission in the instructions or a typographical error in the Federal Register. 6 It is not clear why the insubstantial exceptions for Schedule C purposes are not at the same levels as applicable for purposes of the reporting rules under Form LM-10 for gratuities to union officials, as revised by DOL in 2006. See our November 2005 Client Alert DOL Issues New Guidance Requiring Investment Advisers, Broker-Dealers and Other Financial Institutions to Report Certain Costs of Marketing to Taft-Hartley Plans on Form LM-10. http://www.klgates.com/files/publication/1a85f326-ba8c-4065-975f-f952f36028f8/presentation/publicationattachment/65d08e3f-ab09-4301-b865- e63cdf805853/ima_1105.pdf January 2008 3
Insurance Commissions Service provider compensation that consists only of insurance fees and commissions (which are reported currently on Schedule A of Form 5500) need not be reported on revised Schedule C. Bundled Service Arrangements Revised Schedule C provides that the lead service provider in a bundled service arrangement generally may report all direct compensation received in connection with the arrangement. If, however, another service provider in the bundled arrangement receives compensation that is (i) a separate charge directly against a plan s investment reflected in the net value of the investment or (ii) paid on a transactional basis, that service provider s direct compensation must be reported separately. For service providers in a bundled arrangement that are fiduciaries or that provide contract administration, consulting, investment advisory, investment management, brokerage, or recordkeeping services, the plan sponsor must report indirect compensation separately (as discussed above) regardless of whether direct compensation received by the service provider is included in a report by a lead service provider. Service Providers That Fail or Refuse to Provide Information If a service provider fails to provide a plan sponsor with the information needed to complete revised Schedule C, the plan sponsor must report the name and tax identification number of the service provider and a description of the information that was not provided. Nevertheless, the instructions to revised Schedule C make clear that it is the plan sponsor s responsibility to request the necessary information. The instructions also remind plans to inform service providers that the foregoing information will be provided for service providers who do not supply the needed information; however, plans are not required to do so. Proposed Amendment to 408(b)(2) Regulation Implementing Statutory Exemption Permitting Parties in Interest to Provide Services to Plans Background Persons providing services to an ERISA-covered plan are parties in interest of the plan and are in a seemingly impossible position providing services makes a person a party in interest, and ERISA section 406(a) prohibits parties in interest from providing services to a plan. Fortunately, ERISA section 408(b) (2) breaks this circularity by providing an exemption for reasonable arrangements under which parties in interest may provide services to a plan. The current regulations under section 408(b)(2) were issued by DOL shortly after ERISA was enacted, and their requirements are straightforward: (1) the services must be appropriate and helpful to the plan, (2) the arrangement must be terminable by the plan without penalty on reasonably short notice, and (3) the compensation received by the service providers must be reasonable. Indeed, the requirements of the current regulations have been largely transparent and self-implementing. In most instances, service providers have been eligible for the section 408(b)(2) exemption without the need to consider in any detail how to comply. The proposed amendments to the regulations under section 408(b)(2) will change things dramatically. If the proposed amendments are adopted, in order to rely on the section 408(b)(2) exemption, service providers will need to assemble and report information about a host of matters relating to their direct and indirect compensation. As discussed below, under the proposed regulations, the exemption would be conditioned in part on a requirement that the service provider disclose compensation information to enable the plan to fulfill Form 5500 reporting requirements. Thus, the potential impact of the proposed section 408(b)(2) regulations is that a service provider who fails to provide the information requested by a plan for revised Schedule C purposes (or to satisfy any other requirement of the proposed regulations) could be deemed to have engaged in a prohibited transaction and, thus, exposed to liability unless another exemption is available to the service provider. January 2008 4
Requirements under the Proposed Amendments Under the proposed 408(b)(2) amendments, any service arrangement with a plan must: Be in writing; Specifically require the service provider to disclose, to the best of its knowledge: (1) all services to be provided to the plan, (2) all of the service provider s compensation or fees for the services, and (3) how the service provider will receive such compensation or fees (the expansive definition of compensation or fees for these purpose is discussed below); Include a representation by the service provider that, before the contract or arrangement was entered into, all required information was provided to a responsible plan fiduciary; Require the service provider to disclose information to help the plan fiduciary assess conflicts of interest, including: (1) whether the service provider will be a fiduciary to the plan, either under ERISA or the Investment Advisers Act of 1940, (2) any financial or other interest in transactions to be entered into by the plan in connection with the service arrangement, (3) any material financial, referral, or other relationship with various parties, such as investment professionals, other service providers, or clients, that may give rise to conflicts of interest, 7 (4) whether the service provider can affect its own compensation without the prior approval of an independent plan fiduciary, and the nature of this compensation, and (5) whether the service provider has policies or procedures to manage conflicts of interests and, if so, an explanation of those policies or procedures; Require the service provider to disclose any material change in the information required to be disclosed within 30 days of its knowledge of such change; Require the service provider to comply with requests for fee and compensation information from a responsible plan fiduciary in order to fulfill the reporting and disclosure requirements 7 According to DOL, if the relationship between the service provider and one of the third parties described above is one that a reasonable plan fiduciary would consider to be significant in its evaluation of whether an actual or potential conflict exists, the service provider must disclose the relationship. 72 Fed. Reg. at 70992. of ERISA and the regulations, forms, and schedules thereunder (including Form 5500); and Permit termination of the arrangement by the plan without penalty and on reasonably short notice. 8 Even if the service contract contains all the required provisions, the service provider must actually make the necessary disclosures for the contract or arrangement to be considered reasonable and thus exempt under the proposed amendments. Compensation or Fees The proposed amendments define compensation or fees very broadly to include, in addition to money, any other thing of monetary value received by the service provider or its affiliates in connection with the services provided to the plan. This definition raises many questions on where to draw the line for compensation to be considered in connection with services to the plan. Examples DOL gives of covered compensation include, among other things, gifts, awards, trips, research, float, 12b-1 fees, commissions and various other fees. 9 DOL indicates in explaining the proposed regulations that, if a service provider does not know the exact amount of compensation when it signs a contract with a plan, compensation may be disclosed and expressed in terms of a formula, a percentage of the plan s assets, or a per capita charge for each participant or beneficiary. 10 Bundled Arrangements The proposed regulations would require a provider of bundled plan services priced as a package, rather than on a service-by-service basis, to make all of the required disclosures, even if another provider actually performs one or more of the underlying services. Generally, a bundled service provider would not be required to break down how the compensation relates to each component service within the arrangement, or to disclose how revenue sharing or other indirect payments are allocated among service provider participants in the bundled arrangement. A bundled service provider would, however, be required to disclose any compensation separately paid to an 8 This requirement would be unchanged from the current regulation. See 29 C.F.R. 2550.408b-2(c). 9 72 Fed. Reg. at 70990. 10 Id. January 2008 5
underlying service provider that would be reflected in the net value of the plan s investment. Examples of such compensation include management fees paid by mutual funds to their investment advisers and other asset-based fees charged to pooled investment funds. In addition, a bundled service provider would be required to separately disclose any compensation paid on a transactional basis such as finder s fees, brokerage commissions, or soft dollars. Presentation of Disclosures The proposed regulations do not establish a particular method for making the required disclosures. In the material accompanying the proposal, DOL states that disclosures may be in separate documents, from separate sources, and may be provided in electronic form. DOL also notes that other documents, such as a prospectus or a Form ADV, may contain some of the required information and that contracting parties would be free to incorporate those documents by reference as long as the agreement clearly describes those documents and explains the information they contain. 11 Scope of the Proposed Regulations The new disclosure requirements in the proposed regulations are limited to arrangements with service providers that fall within three categories that DOL believes have the most potential for conflicts of interest: (i) service providers who are also fiduciaries under ERISA or the Investment Advisers Act of 1940; (ii) service providers who provide banking, consulting, custodial, insurance, investment advisory, investment management, recordkeeping, securities or other investment brokerage, or third party administration services; and (iii) service providers who receive indirect compensation in connection with accounting, actuarial, appraisal, auditing, legal, or valuation services. On the general subject of conflicts of interest, DOL states in the material accompanying the proposed regulations: Plan fiduciaries must know of... [a service provider s business] relationships and indirect sources of compensation because they may impact the manner in which the provider performs services for the plan. There may be other, oftentimes subtle, influences on the service provider or its affiliates that may be relevant to a plan fiduciary s assessment of the objectivity of a service provider s decisions or recommendations. 12 11 Id. 12 72 Fed. Reg. at 70991. Proposed Class Exemption DOL issued a proposed prohibited transaction class exemption simultaneously with the issuance of the proposed amendments to the section 408(b)(2) regulations. 13 The proposed class exemption would relieve plan fiduciaries, other than in their capacity as service providers, from liability for engaging in a prohibited transaction in cases where an arrangement with a service provider fails to be reasonable due to the service provider s failure to comply with its contractual disclosure obligations. In order for this relief to be available, a plan fiduciary: Must reasonably believe the contract or arrangement is reasonable as defined in the proposed section 408(b)(2) regulations described above, and must not know, or have any reason to know, that the service provider would fail to meet its obligations. Upon discovery of the service provider s failure to comply with its contractual obligations, must have requested in writing that the service provider furnish the required information. If the service provider does not comply with the request within 90 days after the written request for the required information, must notify DOL. After discovery of the service provider s failure to comply with its contractual obligations, must take the service provider s failure to provide the required information into account in determining whether to terminate or continue the service arrangement. The changes to Schedule C to Form 5500 and the proposed regulations under ERISA section 408(b) (2) are two of three regulatory initiatives undertaken by DOL to revamp its approach to service provider compensation issues. DOL also is expected to propose amendments to the regulations under ERISA section 404(c) to ensure that participants and beneficiaries in individual account plans are provided the information they need, including information about fees and expenses, to make informed investment decisions. 14 13 72 Fed. Reg. 70893 (Dec. 13, 2007). 14 72 Fed. Reg. at 64738. January 2008 6
Please contact any member of the K&L Gates ERISA Fiduciary Group if you have further questions on the issues discussed in this Alert. Members of the ERISA Fiduciary Group and their telephone numbers and email addresses are listed below. Los Angeles Alexandra C. Sparling alexandra.sparling@klgates.com 310.552.5563 William P. Wade william.wade@klgates.com 310.552.5071 Washington, D.C. Catherine S. Bardsley catherine.bardsley@klgates.com 202.778.9289 Susan I. Gault-Brown susan.gaultbrown@klgates.com 202.778.9083 David E. Pickle david.pickle@klgates.com 202.778.9887 William A. Schmidt william.schmidt@klgates.com 202.778.9373 Kristina M. Zanotti kristina.zanotti@klgates.com 202.778.9171 K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please e-mail london@klgates.com if you would prefer not to receive this information. 1996-2008 Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. January 2008 7