On June 29, 2020, the U.S. Department of Labor (the Department) formally reinstated its “five-part test” for determining what constitutes “investment advice” under ERISA and Section 4975 of the Internal Revenue Code (the Code).1 Providing “investment advice” in connection with ERISA plan assets is a fiduciary function and subjects the advice provider to ERISA’s fiduciary and prohibited transactions provisions, as well as the prohibited transaction provisions of Section 4975 of the Code if tax-qualified plan assets are involved. The five-part test was in effect from 1975 until the Department adopted a much broader definition of investment advice in 2016 as part of a fiduciary rule package that included (or amended) a number of prohibited transaction exemptions. The Department’s broader definition was challenged in court and ultimately vacated, along with the remainder of the 2016 fiduciary rule package, by the Fifth Circuit in 2018.2 The Department did not appeal.
Along with a formal reinstatement of the five-part test, the Department has proposed a new prohibited transaction class exemption that would provide broad exemptive relief for investment advice fiduciaries to receive additional compensation in connection with their advice and engage in principal transactions with plans and IRAs, if the exemption’s conditions are satisfied.3 The proposed exemption’s conditions require compliance with certain impartial conduct standards (discussed below), which will be familiar to advisers who currently comply with the Department’s temporary enforcement policy (put in place after the Fifth Circuit case), the SEC’s Regulation Best Interest or the SEC’s standards for registered investment advisers. If the exemption is finalized, it would become one of the very few class exemptions allowing a fiduciary adviser to transact with an ERISA plan or IRA on a principal basis.
Similar to the now vacated Best Interest Contract (BIC) Exemption from the 2016 package, the proposed exemption requires IRA advice fiduciaries to comply with duties of prudence and loyalty as a condition for relief, even though IRAs are generally not subject to these duties under ERISA. But unlike the BIC Exemption, the proposed exemption does not create a private right of action for failure to meet the terms of the exemption. Instead, a failure to meet the exemption’s conditions will result in a non-exempt prohibited transaction to which excise taxes will apply under Section 4975 of the Code until corrected.
The Department is accepting public comments on the proposed rule until August 6, 2020. We do not expect the Department to extend, at least substantially, the comment period given the limited time remaining to finalize the rule before a potential change in administration in early 2021.
Five-Part Test
The reinstated five-part test establishes when someone is a “fiduciary” under ERISA and Section 4975 of the Code by reason of providing “investment advice” for a fee.4 A person who meets this five-part test and receives a fee or other compensation, direct or indirect (e.g., 12b-1 fees, sales loads, revenue sharing, mark-ups, and mark-downs) will be an investment advice fiduciary under ERISA and/or the Code, as applicable. Unlike the vacated 2016 rule, the proposal does not contain any safe harbor or other exception from fiduciary status for broker-dealers and other counterparties dealing with sophisticated fiduciaries.5
Rollover Advice
Historically, the Department did not consider advice on whether to rollover assets from an ERISA plan to another plan or IRA, or from an IRA to another IRA, as “investment advice” because any recommendation “regarding the proceeds of a distribution” would relate to funds that are no longer plan or IRA assets. In the preamble to the proposed exemption, the Department indicates that it will now take a different view of rollover advice that otherwise meets the five-part test, explaining that it now views a rollover recommendation as advice to sell, withdraw, or transfer assets currently held in the plan or IRA. Whether advice otherwise meets the five-part test continues to turn on all relevant facts and circumstances. For example, a single instance of rollover advice may fail the test because it was not provided on a “regular basis,” but rollover advice that is part of, or that commences, an ongoing advisory relationship may satisfy it.
In the preamble, the Department cautions that it does not view written statements disclaiming a mutual understanding or forbidding reliance on the advice as a primary basis for investment decisions to be determinative. Thus, while such disclaimers should still be helpful, advisers and others seeking to avoid fiduciary status should also ensure that their disclaimers accurately reflect the underlying facts and circumstances (e.g., that the advice is, in fact, an isolated event or that the client is sophisticated enough to make investment decisions and is not seeking the adviser’s help, which may or may not be the case). The Department also emphasizes that a recommendation need not serve as “the” primary basis of the investment decision, as long as it is “a” primary basis, a lower standard. Advice that is provided pursuant to a separate best interest standard, such as the SEC’s Regulation Best Interest, would likely satisfy this “primary basis” test.
Proposed Exemption
The new prohibited transaction class exemption would allow a registered investment adviser, broker-dealer, bank, insurance company, their affiliates (collectively, Financial Institutions), and their employees or agents to receive additional direct or indirect compensation as a result of investment advice provided to an ERISA plan participant or beneficiary, IRA owner, or a fiduciary of an ERISA plan or IRA. The exemption would not apply to (i) any fiduciary with discretionary authority over the relevant assets, (ii) any advice involving in-house plans, and (iii) robo-advice (unless it utilizes a “hybrid” approach involving some interaction with an investment professional).
The exemption would also allow the Financial Institution (or its affiliate) to trade (including riskless principal trades) with an ERISA plan or an IRA on a principal basis (i.e., out of inventory) and receive a mark-up, mark-down, or other similar payment. Such transactions are currently prohibited under ERISA and the Code because of the financial interests that the Financial Institution has in the transactions, even if their terms are reasonable (or even more favorable) to the plan or IRA. The exemption would broadly cover purchases by the Financial Institution of any asset and sales by the Financial Institution of a specified list of assets.6 The proposal requires disclosure of “material” conflicts of interest, but not the amount of the mark-up or mark-down. Unlike the vacated rule, the proposal contains no requirement to publicly disclose the Financial Institution’s policies and procedures.
Exemptive relief is conditioned on the following “impartial conduct” standards: (i) a “best interest standard,” which includes the duties of prudence and loyalty, (ii) reasonable compensation, and (iii) the absence of any materially misleading statements. Financial Institutions utilizing the proposed exemption would be required to establish, maintain, and enforce written policies and procedures prudently designed to ensure compliance with these standards.7 Financial Institutions would not be able to maintain compensation practices that are reasonably expected to incentivize an adviser to make recommendations that conflict with these standards (e.g., sales quotas and contests). The exemption does not preclude differential compensation to advisers (whether in type or amount) based on the underlying investment decisions by investors, provided that the impartial conduct standards are otherwise met. These standards are similar to and intended to be consistent with the Best Interest standards recently promulgated by the SEC.8
As explained above, like the 2016 package, the exemption requires IRA advice fiduciaries to comply with duties of prudence and loyalty as a condition for exemptive relief. This is so even though the Fifth Circuit vacated the 2016 package in part because of a similar requirement.9 The exemption also requires a written acknowledgement by the Financial Institution of its fiduciary status, disclosure of its material conflicts of interest, and an annual compliance review and report. But while the 2016 package expanded the definition of “investment advice,” thereby turning many broker-dealers and other service providers into fiduciaries and then requiring them to comply with the exemption to continue doing business, the current proposal provides purely optional relief to persons who are already investment advice fiduciaries under the statute and the Department’s historic regulatory position. Further, unlike the 2016 package, the exemption does not create a private right of action for failing to meet the terms of the exemption.10
Fiduciaries with certain criminal convictions or who engage in certain misconduct in connection with covered transactions may not rely on the exemption for 10 years. With respect to a criminal conviction of a Financial Institution, all other Financial Institutions within the same “control group” (based upon an 80% ownership test) would also be disqualified. This is a far less onerous disqualification standard than the one imposed under the “QPAM” exemption. The exemption provides a Financial Institution with an opportunity to appeal any loss of eligibility and a 1-year wind-down period to cease reliance on the exemption.
Compliance with the exemption, of course, does not afford protection from a breach of ERISA’s general fiduciary duties, including the duties of prudence and loyalty.
2 Chamber of Commerce of the United States of America v. United States DOL, 885 F.3d 360 (5th Cir. March 15, 2018).
3 Improving Investment Advice for Workers & Retirees, 85 Fed. Red. 40834 (July 7, 2020).
4 Under the five-part test, for advice to constitute “investment advice,” the person must (1) render advice with respect to the plan [or IRA] as to the value of securities or other property, or make recommendations 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 understanding with the plan, plan fiduciary or IRA owner, that, (4) the advice will serve as a primary basis for investment decisions with respect to plan or IRA assets, and that (5) the advice will be individualized based on the particular needs of the plan or IRA. See 29 C.F.R. section 2510.3-21(c).
5 Under the vacated rule, providing advice to an independent plan or IRA fiduciary with at least $50 million in assets under management or certain banks, investment advisers, insurance companies, or broker dealers acting as a fiduciary of a plan or IRA did not constitute “investment advice” if certain conditions were met. See section (c)(1) of the vacated rule in 81 Fed. Reg. 20946, 20999 (April 8, 2016) (“Transactions with independent fiduciaries with financial expertise”).
6 The following asset types could be sold to a plan or IRA under the proposal: corporate debt securities offered pursuant to a registration statement under the Securities Act of 1933; U.S. Treasury securities; debt securities issued or guaranteed by a U.S. federal government agency other than the U.S. Department of Treasury; debt securities issued or guaranteed by a government-sponsored enterprise; municipal bonds; certificates of deposit; and interests in Unit Investment Trusts. No other asset type could be sold to a plan or IRA under the proposed exemption (e.g., insurance or annuity contract, mutual funds, foreign currency, any transaction in connection with an initial public offering or a private placement of equity securities).
7 The proposal is consistent with the temporary enforcement policy issued by the Department following the Fifth Circuit opinion acknowledging that “many Financial Institutions created and implemented compliance structures designed to ensure satisfaction of the impartial conduct standards.” The temporary enforcement policy provided a defense to any enforcement action by the Department, whereas the exemption, if granted, will provide a defense to private litigation as well.
8 See Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019) and Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248 (June 5, 2019).
9 Chamber of Commerce of the United States of America v. United States DOL, 885 F.3d 360, 378 (5th Cir. March 15, 2018) (Department’s “principal policy concern about the lack of fiduciary safeguards in Title II was present when the statute was enacted, but Congress chose not to require advisers to individual retirement plans to bear the duties of loyalty and prudence required of Title I ERISA plan fiduciaries”).
10 See 85 Fed. Reg. 40834 at 40837 (“The proposed exemption would not expand Retirement Investors' ability to enforce their rights in court or create any new legal claims above and beyond those expressly authorized in ERISA, such as by requiring contracts and/or warranty provisions”).