Key Points about DOL s Proposed Fiduciary Definition

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1 REPRINTED FROM DC DIMENSIONS WINTER 2016 Key Points about DOL s Proposed Fiduciary Definition By Ian Kopelman, Chair, Employee Benefits and Executive Compensation Practice Group, and Joseph Hugg, Of Counsel, DLA Piper IAN KOPELMAN has extensive experience in ERISA and is responsible for all matters involving retirement and other fringe benefit programs for clients ranging in size from major publicly held corporations and public benefit plans to sole proprietorships and partnerships. JOSEPH HUGG also has substantial experience in ERISA and counsels investment advisors to plans and managers of plan asset funds regarding their ERISA fiduciary duties and other ERISA requirements that affect their investments and fund structures. DLA Piper is a global law firm with 4,200 lawyers located in more than 30 countries throughout the Americas, Asia Pacific, Europe, and the Middle East. The US Department of Labor has issued proposed regulations that will have a significant effect on those who recommend or market investment products and services to employee benefit plans and individual retirement accounts. 1 The proposal would change the definition of a fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA) to expand the class of persons and entities that would be subject to strict fiduciary duties and prohibited transaction rules under ERISA and the Internal Revenue Code. The new proposal follows an earlier similar proposal, which was withdrawn. Explanation of Proposals Proposed definition of fiduciary. Under the existing definition, a person (or entity) will be a fiduciary if the person provides investment advice to a plan or IRA (1) on a regular basis, (2) pursuant to a mutual agreement, arrangement, or understanding, written or otherwise, (3) the advice will serve as a primary basis for investment decisions, and (4) the advice will be individualized based on the particular needs of the plan or IRA. Under this definition, it has been widely assumed that brokers, insurance agents, and other persons selling investment products to plans and IRAs are not fiduciaries, although the DOL has noted that in some situations such persons may be fiduciaries. Also, sponsors of investment funds that do not hold plan assets generally have not been thought to be fiduciaries for plans and IRAs when they recommend an investment in their funds. 1. For purposes of new DOL proposals and this summary, an IRA includes an individual retirement account, an individual retirement annuity, an Archer MSA, a health savings account, and a Coverdell education savings account.

2 DC DIMENSIONS Winter 2016 In contrast, the proposed regulation broadly defines fiduciary to include any person who provides the following types of advice in exchange for a fee, whether direct or indirect, to a plan, a plan fiduciary, plan participant, or beneficiary, IRA, or IRA owner: 1. A recommendation on the advisability of acquiring, holding, disposing, or exchanging securities or other property, including a recommendation to take benefits from a plan or IRA, or a recommendation as to the investment of securities or other assets to be rolled over or otherwise distributed from a plan or IRA. 2. A recommendation as to the management of securities or other property, including recommendations as to the management of securities or other property to be rolled over or otherwise distributed from the plan or IRA. 3. An appraisal, fairness opinion, or similar statement, whether verbal or written, concerning the value of securities or other property if provided in connection with a specific transaction. 4. A recommendation of a person who is also going to receive a fee or other compensation for providing any of the types of advice described in (1) to (3) above. To result in fiduciary status, the advice must be provided pursuant to a written or verbal arrangement or understanding that the advice is specifically directed at the recipient for the recipient s consideration, but the advice does not have to be individualized for the recipient IF A PERSON IS A FIDUCIARY UNDER THE PROPOSED DEFINITION, HE OR SHE WILL HAVE TO MAKE INVESTMENT RECOMMENDATIONS THAT ARE IN THE BEST INTEREST OF THE PLANS AND IRAS, WITHOUT REGARD TO THE FIDUCIARY S FINANCIAL OR OTHER INTERESTS OR THOSE OF THEIR AFFILIATES. or provided on the basis that the recommend investments for which recipient will in fact rely on the advice the fiduciary or an affiliate will in making investment decisions. receive fees or other direct or indirect Also, the advice does not have to be compensation. That would constitute provided on a regular basis to result self-dealing, a prohibited transaction. in fiduciary status. Thus, one-time contacts with a plan or IRA may result Carve-outs and exemptions. in fiduciary status. How can anyone recommend and sell investments to plans and The requirement that the IRAs and still receive fees if the advice be provided for a fee, proposed definition of fiduciary direct or indirect, would include becomes effective? The proposed compensation paid to affiliates of regulation includes a number of the person providing the advice in carve-outs or exceptions from connection with the investment. the definition of a fiduciary, i.e., situations in which the DOL does not Finally, if a person dealing with a plan believe fiduciary status is warranted. or IRA claims to be a fiduciary, the Also, proposed new and amended person would be treated as a fiduciary prohibited transaction exemptions without regard to the above definition. accompanied the proposed regulation. Together, the carve-outs and the Consequences of fiduciary status. prohibited transaction exemptions If a person is a fiduciary under cover many (but not all) typical the proposed definition, he or investment situations, subject in most she will have to make investment cases to stringent conditions and recommendations that are in the requirements designed to raise the best interest of the plans and IRAs, level of protection for plans and IRAs. without regard to the fiduciary s financial or other interests or those Seller s carve-out. For plans with of their affiliates. Also, such a fiduciary at least 100 participants or those will be prohibited from engaging in with at least $100 million in assets, certain transactions with the plans the proposed regulation includes and IRAs. Most significantly, in the a seller s carve-out that permits absence of a specific exemption, the a counterparty to provide advice fiduciary will not be permitted to or recommendations to a plan in

3 IF THE PROPOSALS ARE IMPLEMENTED AS PROPOSED, BROKERS, INVESTMENT ADVISORS, INSURANCE AGENTS, AND OTHERS IN THE FINANCIAL INDUSTRY WHO ARE INVOLVED WITH THE INVESTMENTS OF PLANS AND IRAS WILL, AT A MINIMUM, BE SUBJECT TO ADDITIONAL COMPLIANCE REQUIREMENTS THAT WILL AFFECT THEIR BUSINESSES. connection with a sale, purchase, loan, Advice provided by or other bilateral contract with the swap counterparties plan. To qualify for the carve-out, the counterparty must obtain a written Advice provided by employees of representation from an independent a plan sponsor for no additional fiduciary for the plan that the fiduciary consideration beyond their is not relying on the counterparty to regular compensation act in the best interest of the plan, to give impartial advice, or to give advice Advice provided to participantdirected plans (but not to IRAs) as a fiduciary. For plans with at least 100 participants that do not have $100 by service providers that offer million in assets, the counterparty a platform or selection of must also know or reasonably believe investment vehicles, including that the independent plan fiduciary general information but not has sufficient expertise to evaluate the recommendations, about the transaction and determine whether it investment choices is prudent and in the best interest of participants. The counterparty may Certain appraisals and valuation not receive a fee from the plan or plan reports, including appraisals for fiduciary for providing investment investment funds and appraisals advice (as opposed to other services) or valuation reports for purposes in connection with the transaction. If of plan reporting and disclosure this exception applies, merely making a pitch to a prospective plan client that Advice that constitutes investment is at or above the size thresholds and education, although the education receiving fees from the investment may not refer to specific investment will not result in fiduciary status for products or investment alternatives the counterparty. by name Other carve-outs. The proposed As under current law, brokers, dealers, definition of a fiduciary contains and banks that merely execute additional carve-outs, including securities transactions and do not exceptions for: make recommendations would not be treated as fiduciaries. Best interest contract exemption. This proposed prohibited transaction exemption applies to fiduciaries (under the new definition) of retirement investors. A retirement investor is defined as including (1) plan participants and beneficiaries who make decisions (including rollover decisions) about their plan accounts, (2) non-participant directed plans with fewer than 100 participants, and (3) IRAs. The DOL said it intended this exemption to apply to retail investors. The best interest contract exemption is available only to advisers, financial institutions, and their affiliates and related entities, with respect to advice provided by the advisers. An adviser is an individual who (1) is a fiduciary with respect to a plan or IRA solely because of the provision of investment advice and (2) is an employee, independent contractor, agent, or registered representative of a financial institution. A financial institution is defined as including only a registered investment adviser, a bank or similar financial institution, an insurance company, or a registered broker-dealer. The exemption allows advisers and their related financial institutions to receive compensation for services performed in connection with the purchase, sale, or holding of an asset by the retirement investor as a result of the advice or recommendation of the adviser, if certain conditions are satisfied. The compensation may be direct or indirect, and may be paid by a third party. Without this exemption, the receipt of such compensation by a fiduciary with respect to an

4 DC DIMENSIONS Winter 2016 investment that it recommended would be a prohibited transaction. The conditions for applying the best interest contract exemption are quite restrictive and go beyond existing practices. The advisor must acknowledge its fiduciary status in writing. In addition, the advisor must commit in a written contract to basic standards of impartial conduct (the Impartial Conduct Standards ), as follows: 1. Act in the best interest of the plan or IRA. definition of the assets that qualify for the exemption. Under the exemption, an eligible asset includes only the following investment products: (1) bank deposits; (2) certificates of deposit; (3) shares or interests in registered investment companies; (4) bank collective funds; (5) insurance company separate accounts; (6) exchange-traded REITs; (7) exchange-traded funds; (8) corporate bonds offered pursuant to a registration statement under the Securities Act of 1933; (9) agency debt securities as defined in FINRA Rule 6710(l) or its successor; (10) to the impartial conduct standards that apply under the proposed best interest contract exemption. In addition, the exemption includes specific conditions related to the pricing of the debt securities, and the seller would be required to disclose to the purchaser the amount of compensation (e.g., a markup) it will receive on the transaction. Outside the carve-outs and exemptions. If the proposals are implemented as proposed, brokers, investment advisors, insurance agents, and others in the financial 2. Receive no more than reasonable compensation. Other exemptions 3. Do not make any misleading statements about the investments, its fees, or material conflicts of interest it may have. For a complete list of proposed exemptions, please consider reviewing our October 28, 2015, webinar with Dimensional Fund Advisors, which can be accessed at my.dimensional.com/tools/on_demand/172595/. The advisor must also disclose conflicts of interest, warrant that the advisor has adopted practices designed to mitigate the conflicts of interest, and disclose the costs of the advisor s services. The contract may include an arbitration provision but may not preclude class actions. Additional requirements apply if the advisor does not recommend a broad range of investments. Advisors must maintain certain data and make it available to the DOL upon request. Advisors must notify the DOL in advance if they are relying on the best interest contract exemption. Thus, the exemption would provide no relief for an advisor that is inadvertently a fiduciary under the revised definition. The most restrictive provision of the best interest contract exemption is the US Treasury securities as defined in FINRA Rule 6710(p) or its successor; (11) insurance and annuity contracts; (12) guaranteed investment contracts; and (13) equity securities within the meaning of 17 CFR (generally, exchange-traded equity securities). Excluded from this definition is any equity future, put, call, straddle, or other option or privilege of buying an equity security from or selling an equity security to another without being bound to do so. Principal transaction exemption. This proposed prohibited transaction exemption allows broker-dealers and other advisors to sell debt securities to plans, participants, and beneficiaries and IRAs in a principal transaction, i.e., the sale is out of the seller s own inventory. The exemption would require adherence industry who are involved with the investments of plans and IRAs will, at a minimum, be subject to additional compliance requirements that will affect their businesses. For brokers, investment advisors, fund sponsors, and others selling investment services and products that are not on the list of approved assets in the best interest contract exemption, it may take some time to determine whether they can continue to market services and products to retirement investors (i.e., small plans and IRAs), and if so, what alterations in current practices will be necessary. Anticipated effective date. The DOL is expected to issue the final regulation and the exemptions, with a proposed effective date in You should not act or rely on any information contained in this article without first seeking the advice of an attorney. Ian Kopelman is an occasional speaker at Dimensional Fund Advisors LP events.

5 2016 Dimensional Fund Advisors. Reprinted from DC Dimensions Winter This information is intended for registered investment advisors and institutional investors. The views and opinions of the third-party authors do not necessarily represent the views of Dimensional Fund Advisors. The articles are distributed for informational purposes only and should not be considered investment, tax, or legal advice or an offer of any security for sale. Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. To read other articles from the magazine or for more information about Dimensional s DC services, please visit us at us.dimensional.com/services/dc-services.