On June 29, 2020, the U.S. Department of Labor (DOL) announced a new proposed class exemption to certain prohibited transaction restrictions in the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (the Code), entitled “Improving Investment Advice for Workers & Retirees.” The proposed exemption is intended to help workers and retirees by preserving the wide availability of investment advice arrangements and products for retirement investors. The proposed exemption is expected to be well-received by “investment advice fiduciaries,” because it is broader and more flexible than the DOL’s pre-existing prohibited transaction class exemptions which generally provide relief for more discrete transactions. Here are five things you should know about the proposed exemption.
In 1975, the DOL established a five-part test for fiduciary status under ERISA. The Code uses identical wording for the five-part test in its definition of fiduciary. Under both ERISA and the Code, a person is an investment advice professional if the person renders “investment advice” for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, OR has any authority or responsibility to do so.
Under the DOL’s five-part test for advice to constitute “investment advice,” a financial institution or investment professional who is not otherwise a fiduciary under another provision of the statute must –
(1) render advice to the plan 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. (emphasis supplied).
There are three consequences under the rule to a financial institution or investment professional that meets this five-part test, and receives a fee or other compensation, direct or indirect: that institution or professional (A) is an “investment advice fiduciary” under ERISA and the Code, (B) is subject to fiduciary duties with respect to an employee benefit plan (Plan) , and (C) is forbidden from engaging in certain “prohibited transactions” involving Plans and individual retirement accounts or annuities (IRAs) unless an exemption applies.
In 2016, the DOL had tried to update and modernize the 1975 rule but a 2018 decision of the U.S. Court of Appeals for the Fifth Circuit vacated the attempt. Effective immediately, the DOL reinstated the 1975 five-part test to determine whether a retirement investment adviser is acting as a fiduciary. The DOL has now issued a revised Proposed Exemption.
2. Proposed Exemption
The proposed exemption would apply to registered investment advisers, broker-dealers, banks, insurance companies, and their employees, agents, and representatives that are considered investment advice fiduciaries under the reinstated five-part test.
The trigger for the application of the proposed exemption is that the investment advice fiduciary is already a regulated entity in the form of an RIA, registered broker dealer, bank or insurance company and their employees, agents and representatives. Apparently, a “country squire” who is not associated with one of these entities cannot avail themselves of the exemption.
The proposed exemption would permit investment advice fiduciaries to receive compensation as a result of providing fiduciary investment advice, including advice to roll over assets from a Plan to an IRA and other similar rollover recommendations (e.g., IRA to IRA).
It would also permit investment advice fiduciaries to engage in “principal transactions” in which they could sell or purchase certain securities and other investments from their own inventories to or from Plans and IRAs.
Note that even though the DOL has provided an exemption for “principal transactions,” the investment adviser must still run the gauntlet of Section 206(3) of the Investment Advisers Act of 1940, as amended, which generally prohibits principal trades unless very specific procedures are followed, including (1) disclosing in writing to the client before completion of such transactions the capacity in which the adviser is acting, and (2) obtaining the consent of the client to such transaction. Further, the SEC has always taken the position that Section 206 applies to all investment advisers, including those not registered as advisers with the Commission.
The proposed exemption would require fiduciary investment advice to be provided in accordance with the “Impartial Conduct Standards” announced in Field Assistance Bulletin (FAB) 2018-02 (discussed in footnote 1). The Impartial Conduct Standards have three components: (1) a best interest standard (i.e., advice is prudent and loyal); (2) a reasonable compensation standard; and (3) a requirement to make no misleading statements about investment transactions and other relevant matters.
The proposed exemption also includes certain additional protective conditions designed to protect the interests of Plans, participants and beneficiaries, and IRA owners – (1) disclosure of fiduciary status to retirement investors, (2) policies and procedures requiring mitigation of conflicts of interest, and (3) an annual retrospective compliance review.
Unlike the overturned exemption, the proposed exemption is designed to align with existing conduct standards issued by other regulators, such as the SEC.
Investment advice fiduciaries could lose access to the proposed exemption for 10 years for certain criminal convictions in connection with the provision of investment advice to retirement investors, or for egregious conduct with respect to compliance with the class exemption.
3. Rollovers from Plans to IRAs
In the preamble to the proposed exemption, the DOL explains that the decision to roll over Plan assets to an IRA is potentially a very consequential financial decision, because amounts accrued in Plans can represent a lifetime of savings, and often comprise the largest sum of money a worker has at retirement. The DOL takes the position that advice to take a distribution of assets from a Plan is advice to sell, withdraw, or transfer investment assets currently held in the Plan, and therefore may be covered by the five-part test to determine whether a retirement investment adviser is a fiduciary.
All five prongs of the five-part test must apply for a financial institution or investment professional to be an investment advice fiduciary when making a rollover recommendation. Accordingly, advice to take a distribution from a Plan and roll over the assets to an IRA provided in an isolated and independent transaction (in contrast with advice as part of an ongoing relationship or an anticipated ongoing relationship with the advice provider) would fail to meet the regular-basis prong of the five-part test.
4. Robo-Advice Arrangements
The proposed exemption would not cover advice arrangements that rely solely on automated investment advice that involves computer models that utilize portfolio management algorithms (i.e., robo-advice). Those advice arrangements are covered by separate statutory exemptions in ERISA and the Code. The proposed class exemption would, however, cover “hybrid” robo-advice arrangements which involve advice generated by computer models in connection with additional advice from an investment professional.
The proposal does not further elaborate on hybrid “robo-advice arrangements,” but presumably an investment professional who consults a computer model and then relays that conclusion as part of an ongoing advice relationship will not be considered a “robo-advice arrangement.”
5. Significance of the Proposed Exemption for Investment Advisers and Plan Fiduciaries
The proposed exemption is significantly broader and more flexible (i.e., it does not identify specific transactions that are covered) than the DOL’s pre-existing prohibited transaction class exemptions for investment advice fiduciaries. Those pre-existing exemptions provide relief for more discrete transactions, and have not been amended to provide relief for compensation arrangements that developed over time (e.g., commissions, 12b-1 fees, revenue sharing, etc.). Investment advisers could choose to comply with pre-existing exemptions or the proposed exemption, based on their needs and business models.
Plan fiduciaries now have certainty that the five-part test should be applied to determine if an investment adviser is acting in the capacity of an investment advice fiduciary for purposes of ERISA and the Code. Provided the proposed exemption is finalized, Plan fiduciaries will want to understand whether investment advice fiduciaries are complying with pre-existing exemptions or the new exemption.
Comments on the proposed exemption are due 30 days following publication in the Federal Register, which is expected to occur in the first part of July 2020 (comments may be submitted at www.regulations.gov at Docket ID number: EBSA-2020-0003). The exemption, if granted, is expected to be available 60 days after the date of publication of the final exemption in the Federal Register. The temporary enforcement policy announced in FAB 2018-02 remains in place.
Compliments of Troutman Pepper LLP – a member of the EACCNY.